The Financial Industry Regulatory Authority warned broker-dealers Friday that they were failing to properly communicate to investors all there is to know—including the potential pitfalls—of investing in nontraded real estate investment trusts.
"Recent reviews by FINRA of communications with the public regarding real estate programs have revealed deficiencies," FINRA told BDs in its Regulatory Notice 13-18.
Those deficiencies include making "inaccurate or misleading statements" on the potential benefits of investing in real estate programs. Other BD communications have emphasized the distributions paid by a real estate program while failing to adequately explain that some of the distribution is return of principal.
In addition, FINRA said that some communications "have not provided sufficient discussions of the risks associated with investing in the products in order to balance the presentation of benefits."
In February, LPL Financial was ordered by Massachusetts regulators to pay up to $2 million to investors who had bought shares of nontraded REITs and pay a $500,000 administrative fine.
The case, announced in in December, concerns close to 600 transactions of nontraded REITs that took place from 2006 to 2009, valued at about $28 million. The Massachusetts Securities Division's enforcement unit noted that 36 trades worth about $2.1 million were made in violation of prospectus rules and asset-concentration limitations.
Nontraded REITs also topped the areas where FINRA levied disciplinary actions last year, with the self-regulator also issuing an alert on REITs' illiquidity.
FINRA offered guidance to BDs on how to communicate with investors in the following eight areas:
Disclosure
In describing real estate programs, firms must ensure that their communications accurately and fairly explain how the products operate. Descriptions of real estate programs in communications need to be consistent with the representations in the program's current prospectus. For example, communications that include discussion of a program's objectives that are inconsistent with the objectives included in the program's prospectus or that do not explain that there is no assurance that the objectives will be met would not meet Rule 2210's requirements.
Since an investor's participation in a real estate program is an investment in the program and not a direct investment in real estate or any other assets owned by the program, communications that imply that they are direct investments also would be inconsistent with Rule 2210's requirements. Similarly, if a real estate program has not yet qualified under the U.S. tax code as a REIT, but is being marketed as a REIT, firms should ensure that the marketing communication discloses this fact and the possibility that the real estate program may not qualify as a REIT in the future.
Distribution Rates
Firm communications concerning real estate programs often include distribution rates. Some real estate programs fund a portion of their distributions through return of principal or loan proceeds. For example, a portion of a newer program's distributions might include a return of principal until its real estate assets are generating significant cash flows from operations. Rule 2210(d)(1)(B) prohibits firm communications from making any false, exaggerated, unwarranted, promissory or misleading claim. Accordingly, the rule prohibits firms from misrepresenting the amount or composition of a real estate program's distributions. Nor may firms state or imply that a distribution rate is a "yield" or "current yield" or that investment in the program is comparable to a fixed income investment such as a bond or note.
Stability/Volatility Claims
Rule 2210(d)(1)(A) requires firm communications to provide a sound basis for evaluating the facts in regard to any particular security or type of security, industry or service. In addition, Rule 2210(d)(1)(D) requires communications to be consistent with the risks of fluctuating prices and the uncertainty of dividends, rates of return and yield inherent to investments.
Accordingly, a firm may not assert or imply in communications that the value of a real estate program is stable or that its volatility is limited without providing a sound basis to evaluate this claim. The fact that a program offers its securities at par value, or at another relatively stable price, does not evidence stability in the value of the underlying assets.
