FINRA announced that it has issued a complaint (the “Complaint”) commencing disciplinary proceedings against the best efforts underwriter and sole distributor (the “Distributor”) of a series of ten real estate investment trusts (the “REITs”). The Complaint alleges that since January 2011 the Distributor has solicited investors to purchase shares of the most recently launched REIT (the “New REIT”) without conducting a reasonable investigation to determine whether the New REIT was suitable for investors. The Complaint also alleges that the Distributor provided misleading information on its website regarding performance figures and the source of the distributions made by the New REIT. This article summarizes FINRA’s allegations in the Complaint as to which no findings had been made as of this article’s publication.
Background. The Distributor has served as the best efforts underwriter and sole distributor of the REITs since 1992. Providing services to the REITs has been the principal source of income for the Distributor, accounting for 60-70% of gross revenue annually since 1996. The securities of each of the REITs are registered with the SEC and the REITs are reporting companies; however, the securities of the REITs are not traded on any stock exchange and are illiquid. The New REIT was opened in January of 2011 and since that time the Distributor has sold over $300 million of the total $2 billion offering. There are currently four REITs, other than the New REIT, that continue to operate (the “Existing REITs”). Each of the Existing REITs is closed to new investment. The Existing REITs were founded and managed by the same manager and invest almost exclusively in the same subsection of the real estate market (i.e., extended stay hotels).
The Existing REITs were opened between 2004 and 2008 with an offering price of $11 per share and have maintained an $11 price per share despite (1) market fluctuations, including as a result of the economic downturn for commercial real estate in general and the hotel and hospitality industry in particular, (2) net income declines, (3) increased leverage through borrowings, and (4) return of capital to investors through distributions. Since inception, each Existing REIT has paid monthly distributions to its shareholders at a rate of between 7.0% and 8.0%. Each of the REITs provided for dividend reinvestment at $11 per share through a Dividend Reinvestment Plan (the “DRIP”), and provided for limited redemption of shares at $11 under a Unit Redemption Program (the “URP”). The Existing REITs based their unchanging valuations upon the fact that they were continuously selling and redeeming shares at $11 per share under the DRIP or URP, as applicable.
Failure to Conduct a Reasonable Investigation. FINRA alleges that the Distributor failed to conduct due diligence into the valuation of the New REIT’s shares that was sufficient to serve as a reasonable basis for recommending that its customers, who are primarily unsophisticated investors and the elderly, invest in the New REIT. The Complaint notes that in addition to its customer-specific suitability obligation, the Distributor and its registered representatives have a duty to perform reasonable due diligence to understand the potential risks and rewards associated with a security it recommends to customers, and to determine whether the recommendation is suitable for at least some investors based upon that understanding (so-called “reasonable basis” suitability).
FINRA alleges that the Distributor was aware, or should have been aware, of certain valuation irregularities and other improprieties related to the earlier REITs that should have caused it to engage in further due diligence before recommending and selling the New REIT’s shares. Specifically, FINRA alleges that (a) the failure of the Existing REITs to change their valuation or sufficiently reduce their distributions in light of (1) changes in market conditions and (2) changes or declines in financial performance of the respective REIT, and (b) the fact that the distribution rates of the Existing REITs were not supported by Funds from Operations (a non-GAAP measurement frequently used by real estate investment trusts), were red flags that should have caused the Distributor to engage in further due diligence before recommending any investment in the New REIT.
The Distributor’s due diligence process is alleged to have been insufficient because of its reliance in large part upon information in the REITs’ public securities filings (including the opinions issued by the REITs’ outside auditors which did not address the valuation process), brief meetings with management and inadequately performed analysis, that, among other failures, did not address the red flags highlighted above. The Complaint notes that, as sole distributor, the Distributor cannot accept the valuation and other material disclosures in the public filings, but rather, has a duty to conduct its own due diligence into such matters. Moreover, the Complaint states that the Distributor had not sufficiently availed itself of the privilege under the terms of an agency agreement between the Distributor and the REITs to request certain non-public information concerning the “business and financial condition” of the REITs.
Misleading Statements. The Complaint alleges that, by providing performance figures for all of the REITs in conjunction with a presentation of the New REIT on its website, the Distributor misleadingly implied that the New REIT would achieve similar results. Moreover, the performance figures for the prior REITs were misleading because, among other things, they (1) masked reductions in the distribution rates made by certain of the Existing REITs, (2) failed to disclose material information regarding the distributions of the prior REITs, including the fact that the income from those REITs was insufficient to support the 7% -8% returns that the REITs sought to pay, and that the REITs borrowed funds to meet their distribution goals, and (3) mischaracterized the source of distributions as “net income and a return of capital, primarily in the form of depreciation” when, in fact, the return of capital was not primarily from depreciation.
Violations and Relief Requested. FINRA alleges that by failing to conduct adequate due diligence to fulfill its reasonable-basis suitability obligation, which also violates its duty to observe high standards of commercial honor and just and equitable principles of trade, the Distributor violated NASD Rule 2310 and FINRA Rules 2310(b) and 2010. Additionally, FINRA alleges that by distributing communications with the public that contained misleading statements and omitted material information, which also violates its duty to observe high standards of commercial honor and just and equitable principles of trade, the Distributor violated NASD Rule 2210(d)(1) and FINRA Rule 2010. For these violations, FINRA has requested that, among other things, the Distributor be subject to one or more of the sanctions found in FINRA Rule 8310(a), including monetary sanctions and full disgorgement of, or restitution for, any and all ill-gotten gains.