How To Defend Nontraded REITs In FINRA Arbitration
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Portfolio Media. Inc. | 860 Broadway, 6th Floor | New York, NY 10003 | www.law360.com Phone: +1 646 783 7100 | Fax: +1 646 783 7161 | firstname.lastname@example.org How To Defend Nontraded REITs In FINRA Arbitration Law360, New York (June 03, 2013, 1:17 PM ET) -- The real estate bubble that spectacularly burst in 2007 produced a flood of securities litigation that continues today. In the Financial Industry Regulatory Authority's arbitration forum, many of these cases have involved so-called public nontraded real estate investment trusts. These publicly registered — but not publicly traded — investments present unique challenges to broker-dealers, registered representatives and the lawyers who defend them. A Brief Background on Nontraded REITs Broadly speaking, a real estate investment trust is a diversified portfolio of interests in real estate, which can be equity, mortgages or a hybrid. REITs have been around since 1960, when President Eisenhower created them by signing the Cigar Excise Tax Extension. “Public” REITs are registered with the U.S.Securities and Exchange Commission and can be listed on a public exchange or sold directly to investors (so-called “nontraded REITs”). REITs can also be privately held. The REIT structure itself has two primary advantages. First, it allows investors to obtain an interest in real estate that might be impossible to access individually, which can aid in portfolio diversification. Second, the income that REITs receive is exempt from corporate taxes, so long as they meet certain requirements. Historically, some REITs have been able to pay handsome dividends to their investors as a result of this feature. There is a complicated maze of laws and regulations that govern nontraded REITs, including those set by the IRS, SEC, FINRA, the public exchanges and the 50 states. But, a few (very) basic principles apply. In order to qualify as a REIT under IRS rules, the REIT must pay out 90 percent of its income to its investors as taxable dividends. A REIT must be held by 100 or more persons and 50 percent of its units cannot be owned by five or fewer people. A REIT also must obtain at least 75 percent of its gross income from real estate interests, as delineated in the Internal Revenue Code and accompanying regulations, and meet various other requirements. FINRA’s Recent Regulatory and Enforcement Activity Nontraded REITs have long been a focus of securities regulators. In the last 10 years, FINRA alone has issued extensive guidance on the sale of these products. Nontraded REITs have appeared in FINRA’s annual regulatory and examination priorities letter for each of the last three years. And FINRA has made a concerted effort to warn investors about the risks of investing in nontraded REITs, especially in the persistently low-yield environment of recent years.
Even with its long-standing concern over nontraded REITs, FINRA recently redoubled its efforts. FINRA has concentrated on two areas: valuation and disclosure. First, FINRA has continued its push to require broker-dealers to reflect a “reliable” value for nontraded REIT investments on customer account statements. In February 2009, FINRA issued Regulatory Notice 09-09, reminding broker-dealer firms that NASD Rule 2340 requires them to report an estimated value of nontraded REIT investments on customer account statements if the annual report of the security includes a per-share estimated value. FINRA also informed firms that, while a REIT’s offering price may be an appropriate estimated valuation during the product’s offering period, firms must update that estimated value after 18 months following the conclusion of the offering period. Since 2011, FINRA has been engaged in further rulemaking surrounding broker-dealer firms’ reporting of the value of nontraded REITs on investor account statements. In April of this year, FINRA concluded its work and filed with the SEC-proposed amendments to NASD Rule 2340 and FINRA Rule 2310. These amendments would require member firms to report a per-share “estimated value” for nontraded REITs (and other direct participation programs) that is derived from one of three prescribed methods or report no value at all. Second, securities regulators have stepped up their attention to the method and manner by which nontraded REITs are sold. Late last year, FINRA entered into a settlement sanctioning broker-dealer David Lerner Associates Inc. over its allegedly deceptive practices in marketing the Apple REIT Ten. Under the deal, the broker-dealer paid approximately $12 million in restitution to its customers. It was also required to change its supervisory system and training processes. Similarly, in February of this year, this country’s largest independent broker-dealer, LPL Financial, agreed to pay approximately $2 million in restitution and a $500,000 fine after the Secretary of Massachusetts alleged state sales rule violations in connection with LPL’s sale of several nontraded REITs. Massachusetts followed that up with a notable encore in May, reaching settlements with five other independent broker-dealers totaling approximately $6 million in restitution and $975,000 in fines. Also in May, FINRA issued Regulatory Notice 13-18. In it, FINRA delineated a number of concerns regarding broker-dealer firms’ communications with the public about non-traded REITs. These included that broker-dealer firms may not adequately communicate the risks of REIT programs, may misleadingly describe the nature of the investment, and may inaccurately report distribution rates, especially when distributions actually contain an element of return of principal. Defending Nontraded REITs in FINRA’s Arbitration Forum The combination of regulatory attention and (until recently) terrible real estate economy has resulted in a number of FINRA arbitration cases involving nontraded REITs. These products pose several unique challenges for broker-dealers and the lawyers who defend them. 1. Hindsight Bias Many nontraded REITs performed poorly in the recent downturn, some of them dramatically so. These losses disguise at least two important facts. First, at the time that many investors purchased their nontraded REITs, real estate as an asset class had a strong and consistent performance record. From January 1987 to its peak in April 2006, the Case-Schiller 10-city composite housing index increased almost 260 percent. Similarly, according to U.S. census data, the median price of new homes sold in the
United States skyrocketed from $104,500 in 1987 to $246,500 in 2006. Second, the financial crisis that started in 2007 was unique in its breadth, depth, and length. It was a “fundamental disruption” that constituted the “greatest financial crisis since the Great Depression.” Almost no sector was left unscathed. In this regard, investments in real estate-based holdings such as REITs were hardly unique in their loss of value during the downturn. Today, many nontraded REITs are making a comeback. Some have recently begun paying dividends again, after several years of halted distributions. Others have gone public or announced that they plan to do so. Recently, some media outlets have even touted the future potential of nontraded REITs. Attorneys for broker-dealers that sold nontraded REITs must take care to neutralize hindsight bias by reminding arbitrators of these important facts. 2. Numerous Suitability Standards Public nontraded REITs are not “private placement” investments subject to the “accredited investor” standards set forth in the SEC’s “Regulation D.” Disgruntled investors sometimes attempt to lump nontraded REITs together with other direct alternative investments such as oil and gas or tenant-in- common interests. In reality, broker-dealers that offer public nontraded REITs to investors are subject to FINRA’s suitability rules, standards set forth in product prospectuses, and individual states’ regulations, which sometimes set minimum net worth (e.g., $250,00 liquid) or annual income standards (e.g., $45,000 per year). The different standards for nontraded REITs and Regulation D private placements reflect important regulatory and policy decisions that cannot be brushed aside. 3. Disclosure Nontraded REITs provide extensive detailed disclosure to investors. They must file a voluminous prospectus and regular reports with the SEC. Investors also typically complete multiple forms in order to purchase a nontraded REIT, including a broker-dealer’s new account form, forms related specifically to nontraded REITs, the sponsor company’s subscription agreement, and an acknowledgement that they have read the REIT’s prospectus. Thus, the documentation surrounding a nontraded REIT sale can be critical to the defense of a particular transaction. 4. Current Valuation Some disgruntled investors who purchased nontraded REITs at the height of the real estate boom argue that they are worthless today. While some nontraded REITs went bankrupt in the recent downturn, many are still viable going concerns backed by valuable assets such as equity in real property or mortgages. Unfortunately, current and accurate data regarding the value of a single investor’s interest in a particular nontraded REIT can be difficult to derive, as reflected in FINRA’s prolonged rulemaking process in this area. Values reported by sponsor companies in a REIT’s annual Form 10-K can be a good starting point. Limited secondary-market trading data can also be found on some nontraded REITs through services such as REITbid.com. To the extent such trades are made by distressed sellers, however, the trading prices may understate the actual value of the nontraded REIT. Broker-dealer firms can oftentimes offer arbitrators a persuasive
picture of the overall performance of the REIT by pointing to the numerous geographic and sector- specific indices, such as the Case-Schiller Regional Indices or the FTSE NAREIT U.S. Equity Lodging/Resorts Index, for example. Conclusion Nontraded REITs and the broker-dealers that sell them have been subject to regulatory and litigation challenges. Regulators have increased their scrutiny while allegedly defrauded investors have brought numerous claims. This has not deterred broker-dealers from selling these unique investments or investors from pouring $62 billion into them. As alternative investments continue their explosive growth, lawyers that defend broker-dealers will need to develop innovative ways to address the sale, disclosure and valuation of these products before arbitrators and regulators alike. —By Justin P. Krypel, Faegre Baker Daniels LLP Justin Krypel is an associate in Faegre Baker Daniels LLP’s securities and financial services litigation practice in Minneapolis. He represents broker-dealers in court and in FINRA arbitrations around the country. Disclosure: Although this article does not refer or pertain to any specific pending matter, Faegre Baker Daniels represents several broker-dealer firms in litigation involving nontraded REITs. The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.  This includes Regulatory Notices 13-18, 09-09, 08-81, and 08-35; and Notice To Members 05-65, 05- 26, 03-71, and 01-08; see also Regulatory Notice 10-22 (Regulation D private placements); 08-77 (estimated annual income and estimated yield); 07-43 (obligations to seniors); Notice to Members 05-59 (structured products); and 05-18 (exchanges of tenant-in-common interests).  See FINRA, FINRA Annual Regulatory and Examination Priorities Letter, 2006-2013 versions available at: http://www.finra.org/home/Industry/Regulation/Guidance/CommunicationstoFirms/P122861.  FINRA Investor Alert, “Public Non-Traded REITs — Perform a Careful Review Before Investing,” last Updated 8/15/2012, available at http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/REITS/P124232.  Richard G. Ketchum, “Update: FINRA Board of Governors Meeting,” April 19, 2013, available at: http://www.finra.org/Industry/Regulation/Guidance/CommunicationstoFirms/P244913.  FINRA, News Release, “FINRA Sanctions David Lerner Associates $14 million for Unfair Practices in Sale of Apple REIT Ten and for Charging Excessive Markups on Municipal Bonds and CMOs,” October 22, 2012, available at: http://www.finra.org/home/Newsroom/NewsReleases/2012/P191729.  In The Matter Of: LPL Financial, LLC — Non Traded REITS, No. E-2012-0036, Consent Order, Feb. 6, 2013, available at: http://www.sec.state.ma.us/sct/current/sctlpl/LPL%202012- 0036%20Consent%20Order.pdf.
 In The Matter Of: Ameriprise Financial Services, Inc. — Non Traded REITS, No. E-2013-0045, Consent Order, May 22, 2013, available at: http://www.sec.state.ma.us/sct/current/sctfive/AmeripriseSignedConsentOrder.pdf; In The Matter Of: Commonwealth Financial Network — Non Traded REITS, No. E-2013-0046, Consent Order, May 22, 2013, available at: http://www.sec.state.ma.us/sct/current/sctfive/CommonwealthFinancialNetworkSignedConsentOrder. pdf; In The Matter Of: Lincoln Financial Advisors Corp. — Non Traded REITS, No. E-2013-0047, Consent Order, May 22, 2013, available at: http://www.sec.state.ma.us/sct/current/sctfive/LincolnSignedConsentOrder.pdf; In The Matter Of: Securities America – Non Traded REITS, No. E-2013-0048, Consent Order, May 22, 2013, available at: http://www.sec.state.ma.us/sct/current/sctfive/SecuritiesAmericaSignedConsentOrder.pdf; In The Matter Of: Royal Alliance Assocs. — Non Traded REITS, No. E-2013-0044, Consent Order, May 22, 2013, available at: http://www.sec.state.ma.us/sct/current/sctfive/RoyalAllianceSignedConsentOrder.pdf.  U.S. Census Bureau, “Median and Average Sales Prices of New Homes Sold in the United States,” last accessed May 31, 2013, available at: http://www.census.gov/const/uspriceann.pdf.  National Commission on the Causes of the Financial and Economic Crisis in the United States, THE FINANCIAL CRISIS INQUIRY REPORT, p. xv (2011).  See, e.g., Bruce Kelly, “Nontraded-REIT party is about to commence,” InvestmentNews, May 5, 2013; Diana Olick, “REITs Return Big as Investors Pour In,” CNBC.com, May 14, 2013, available at: http://www.cnbc.com/id/100734766.  Caitlin Nish, “Regulators Focus on ‘Nontraded’ REITs,” the Wall Street Journal, May 4, 2013, p. B9.  Onur Erzan, Kurt MacAlpine, and Nancy Szmolyan, “The Mainstreaming of Alternative Investments: Fueling the Next Wave of Growth in Asset Management,” McKinsey & Company, June 2012, pp. 5-13, available at http://www.mckinsey.com/clientservice/financial_services/knowledge_highlights/recent_reports/~/me dia/reports/financial_services/altinvest_web.ashx. All Content © 2003-2013, Portfolio Media, Inc.
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