Financial Services Alert - May 21, 2013

FINRA issued Regulatory Notice 13-18 to provide guidance to firms on communications with the public concerning unlisted real estate investment programs (“real estate programs”), including unlisted REITs and unlisted direct participation programs that invest in real estate.  Communications with the public are covered by FINRA Rule 2210, which generally requires that a firm’s communications be based on principals of fairness, good faith, and balance, and that they not be misleading.  The Notice was issued in response to recent findings by FINRA that communications regarding real estate programs: (1) contained inaccurate or misleading statements regarding the potential benefits of investing in real estate programs; (2) emphasized the distributions paid by a real estate program and failed to adequately explain that some of the distribution constitutes return of principal; and (3) have not provided sufficient discussions of the risks associated with investing in the products in order to balance the presentation of benefits.

The Notice provides guidance for compliance with Rule 2210 regarding general disclosure standards, as well as disclosure standards specifically covering (a) distribution rates, (b) stability/volatility claims, (c) redemption features and liquidity events, (d) performance of prior related real estate programs, (e) use of indices  and comparisons, (f) pictures of specific properties, and (g) capitalization rates.

Disclosure.  Communications must accurately and fairly explain how the products operate, and descriptions of real estate programs must be consistent with the representations in the program’s current prospectus.  Additionally, communications that imply that real estate programs are direct investments, or that a real estate program is a REIT before it has qualified under the U.S. tax code as a REIT, would be inconsistent with Rule 2210.  Firms that discuss the benefits of an investment are also required to include a discussion of the risks in the same communication and the discussion of risks should not be relegated to a footnote.

Distribution Rates.  Firms may not 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.  Additionally, presentations of distribution rates should clearly and prominently disclose certain information (including, among other things, that distributions are not guaranteed and that distributions include return of principal, if applicable) and should not include an annualized distribution rate until the program has paid distributions that are, on an annualized basis, at a minimum equal to that rate for at least two consecutive full quarterly periods.

Stability/Volatility Claims.  A firm may not state 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 the claim.  Also, a communication cannot state that the price at which the program is offered is stable or that its volatility is limited without disclosing that the price stability does not indicate stability in the value of the underlying assets and that the investor may not be able to sell the investment.

Redemption Features and Liquidity Events.  If discussing a redemption feature, a communication should clearly and prominently explain the restrictions and limitations of the feature, and should also disclose the fact, if applicable, that the real estate program has not satisfied all investor redemption requests in the past.  Additionally, a communication may not comply with Rule 2210 if in discussing potential liquidity events, or their timing, the communication does not disclose that the date of any liquidity event is not guaranteed or may be changed at management’s discretion, if applicable.

Performance of Prior Related Real Estate Programs.  If a communication includes prior performance or other historical information about related or affiliated entities, then information about all related or affiliated programs, not just those with the most favorable results, should be included with equal prominence and should be presented in such a manner that it is easy to differentiate it from information about the current program.

Use of Indices and Comparisons.  If discussing index performance, a communication must indicate that the performance is not that of a particular real estate program and must also describe the index’s components and any relevant differences with the program’s portfolio investments.  FINRA stated, as an example, that it would be misleading to cite the performance of an index of traded REITs to indicate how an unlisted REIT may perform.

Pictures of Specific Properties.  Communications for new programs can include photographs or other images of properties owned by investments managed by the program’s sponsors that are similar to the properties the program expects to purchase; however, prominent text explaining that the property is owned by an investment managed by the sponsor and not the program must be included with each depiction.  Firms are advised to include depictions of properties that are limited to investments owned by the program once it has acquired a portfolio.

Capitalization Rates.  A communication may include a capitalization rate for an individual property within a real estate program, provided the rate is based on current information contained in the prospectus, and includes (1) an explanation of how the rate was calculated, (2) that the rate applies only to the individual property, and (3) that it does not reflect a return or distribution from the real estate program itself.  A communication should not include a rate that reflects a blending of multiple individual properties’ capitalization rates.

In an April 9, 2013 discovery order (the “Order”) the U.S. District Court for the Southern District of New York (the “Court”) ruled that the bank examination privilege did not protect documents containing certain sensitive communications (the “Documents”) between the OCC and the Bank of China (the “BOC”) related to the BOC’s anti-money laundering (“AML”) compliance performance.

On May 10, 2013 the OCC filed a brief (the “Brief”) with the Court in which the OCC asked the Court to reconsider and vacate the Order.  The OCC argued in the Brief that the OCC, as holder of the bank examination privilege, must be provided an opportunity to review the Documents, and to assert the privilege and object to their production, prior to the production of the Documents in civil litigation.  The OCC asserted that in rendering the Order the Court failed to appropriately consider the so called “Fleet” factors articulated in In re Subpoena Served upon Comptroller of the Currency (Fleet) 967 F.2d 630 (D.C. Cir 1992).  The Fleet factors provide that before deciding whether documents subject to the bank examination privilege should nonetheless be produced in civil litigation, a court should consider: (1) the appropriateness of the scope of the production request, which goes to the relevance of the documents sought; (2) the availability of other non-privileged evidence; (3) the seriousness of the litigation and the issues involved; (4) the role of the government in the case; and (5) the possibility of future timidity by government employees who will be forced to recognize that their secrets are violable i.e., in the context of confidential bank regulatory communications, whether overriding the privilege could have a chilling effect on the free flow of information between a bank and a bank regulatory agency.  In the Brief the OCC argued, among other things, that (1) non-privileged internal BOC documents would provide the substance of the information sought by the plaintiffs in the case; (2) the Court had given insufficient weight to the OCC’s interest and role in enforcing U.S. AML laws; and (3) the Court had failed to give adequate weight in this case to the chilling effect overriding the bank examination privilege would have on a bank’s communications with its bank regulators.

The Alert will continue to follow this case and developments regarding the bank examination privilege.

The Office of Financial Research (the “OFR”) of the U.S. Department of the Treasury released a white paper authored by Douglas J. Elliott of the Brookings Institute, Greg Feldberg of the OFR and Andreas Lehnert of the FRB (the “Authors”) which the Authors state provides the first comprehensive survey and historic narrative concerning how macroprudential policies have been used in the U.S. “to constrain the build-up of risks in financial markets, for example, by dampening credit-fueled asset bubbles.”  The Authors explain that in speaking of macroprudential policies they are focusing on those polices used to control credit growth and are addressing policy tools used to manage factors that could endanger the financial system as a whole, rather than microprudential policies, which are designed to regulate individual financial institutions.

The Authors divide macroprudential tools into two groups and they examine their respective historic use in the U.S.  The first group includes tools affecting demand for credit: (1) loan-to-value ratios; (2) margin requirements; (3) loan maturities; and (4) tax policies and incentives.  The second group of tools examined by the Authors affect the supply of credit and include: (1) lending rate ceilings; (2) interest rate ceilings; (3) reserve requirements; (4) capital requirements; (5) portfolio requirements; and (6) supervisory pressure.  The Authors provide what they describe as “very preliminary statistical analyzes of the effectiveness of [the application of various macroprudential policies].”  The Authors state that these preliminary analyses suggest that macroprudential tightening lowers the level of consumer debt; but macroprudential easing does not appear to increase the level of consumer debt.