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Should an Issuer be its own Dealer?
Can I trust an Issuer who is also a Dealer?
Is that even the right question?
As an investor, does it really matter?
The question of how an issuer should determine if they are a dealer and how the business trigger test applies in determining that, was recently posed to me and it got me thinking. I was not sure which angle I should approach it from. Then I saw a customer without a Yacht…..
One of the key issues in the securities market is whether the business that investors are investing in (the Issuer) can also act as a dealer (Broker) for its own securities. This practice has both critics and proponents who have different views on its implications. The critics claim that it creates a conflict of interest, as the issuer may not give impartial advice to investors, but rather try to sell its own securities for its own benefit. The proponents argue that this practice is common among large institutions, such as investment banks, who issue and deal securities within the same organization. They say that this allows them to be more efficient and knowledgeable, as they have a deep understanding of the market and can streamline processes.
For the investor, does it really matter? Does your due diligence process change if the Issuer and Dealer are the same entity or not?
During the 2008/2009 financial crisis, the conflict of interest with credit rating agencies (CRAs) stemmed from their “issuer-pay” business model. This model meant that the entities issuing the securities (like mortgage-backed securities) paid the CRAs to rate them. This created a significant conflict of interest because CRAs were incentivized to give higher ratings to retain business from the issuers. If they didn’t, issuers could simply take their business to a competitor. These conflicts contributed to the financial meltdown by allowing excessive risk to build up in the financial system, ultimately leading to the crisis. Conflicts of interest can distort the information and advice provided by issuers and dealers, leading to bad decisions.
On the other hand, Michael Burry, the hedge fund manager depicted in “The Big Short,” wasn’t fooled by the inflated ratings. Burry conducted his own in-depth analysis of the mortgage-backed securities. He didn’t rely solely on the ratings provided by the agencies. He did not trust. He verified.
Many of you who are reading this article have bought a family home. I pose the following question to you. Before committing to the purchase of your new family home, would you rely solely on the seller's home inspection report provided to you by the seller or the seller’s real estate broker, or would you commission your own home inspection report by your own home inspector?
I argue that as an investor, it should not matter if the issuer or dealer is the same or not. Your due diligence process does not change. You could have an issuer that is not the same entity as a dealer and still have potential conflicts of interest. Remember, vigilance and due diligence are essential. Even when issuers and dealers are the same or separate, investors such as yourself should scrutinize relationships and motivations to protect your interests, for it is your money. Your gain or loss.
I have been advising on transactional risk analysis and due diligence on the buy side and the sell side for a little more than 25 years, involving a few thousand dollars, billions of dollars and everything in between. I have also been hired to conduct risk analysis and due diligence on the ones who conduct risk analysis and due diligence, and I can tell you I never relied on the seller or anyone’s information at face value. I remain skeptical.
I often found a tendency, consciously or sub-consciously, for the seller or the ones representing the sellers to exaggerate, omit some or many crucial material points or even outright lie.
There have been instances where I have found honest sellers or representatives of sellers, though unfortunately, this is not the norm.
One of the most important skills for an investor is to be able to conduct a thorough due diligence. One aspect of due diligence is to be able to detect and avoid conflicts of interest in an investment offering memorandum.
The more pertinent question is how to conduct proper due diligence regardless of whether the Issuer and Dealer are the same entity.
The following is my approach:
Carefully read the offering memorandum provided by the issuer. I would look for sections that discuss conflicts of interest, such as "Risk Factors", "Use of Proceeds", or "Management's Discussion and Analysis". I would pay attention to any disclosure related to compensation, affiliations, or relationships with other parties that could affect the issuer's or dealer's objectivity. If none of these sections exist, ask the questions yourself, or simply run in the opposite direction.
Next is to follow the money trail. Consider the financial incentives tied to dealer activities. Look for any direct or indirect benefits that could influence the dealer's recommendations, such as fees, commissions, bonuses, stock options, or kickbacks. Ask questions like: "Are there any fees or commissions that benefit the dealer?", "Does the dealer have affiliations with other entities that could create a conflict of interest?"
Then check for related-party transactions, look for instances where the dealer engages in transactions with related parties, such as executives, affiliates, subsidiaries, or associates. These transactions can signal potential conflicts of interest, as they may not be conducted at arm's length or in the best interest of the issuer or its shareholders.
What about the practices of the dealer’s firm? Understand the firm's policies and procedures outlined in the offering memorandum. Any practices that is incompatible with client interests constitutes a conflict of interest. Consider how the firm's actions may impact my investment goals.
Lastly, if you cannot do this yourself, seek independent advice. Consult an independent financial advisor who is not affiliated with the issuer or dealer. They can provide unbiased insights and opinions on the quality and suitability of the investment opportunity. They can also help compare and contrast different options and alternatives. If you can do this yourself, then put in the work and do it yourself.
Doing this will help you identify potential conflicts of interest in an investment offering memorandum and allow you to make informed decisions. This would help you avoid investing in opportunities that are not aligned with your interests or values.
You should be careful when investing in companies. Always do your own due diligence and check their numbers with a fine-tooth comb. Don't let yourself be fooled by fancy accounting tricks or misleading disclosure. Remember, as Benjamin Graham said, "the investor's chief problem - and even his worst enemy - is likely to be himself."
Or
Have a healthy dose of skepticism. Do not be lazy, ignorant or naïve. Never trust, just verify.
Or
Never heard of Seller Beware? Definitely heard of Buyer Beware.
