FINRA issued Regulatory Notice 11-44 (the “Notice”) seeking comments on a proposal to amend NASD Rule 2340 (Customer Account Statements) to address the way that the per share estimated values of unlisted real estate investment trusts (“REITs”) and unlisted direct participation programs (“DPPs”) are reported by FINRA member firms on the account statements they provide to their customers. The amendments would, among other things, limit the time period during which the offering price may be used as the basis for the per share estimated value to the “Initial Offering Period,” as defined in the amended rule (and discussed below), and require firms to deduct organization and offering expenses from per share estimated values during the Initial Offering Period. After the Initial Offering Period, firms would be required to calculate the per share estimated value based on an appraisal of the assets, liabilities and operations of the REIT or DPP.
Unlisted REITs and DPPs. REITs, defined in section 856 of the Internal Revenue Code, are pass-through entities that offer investors an equity interest in a pool of real estate assets. DPPs are defined in FINRA Rule 2310 and offer investors an equity interest in an entity such as a limited partnership that provides pass-through tax consequences and distributes income from underlying assets, which may be real estate or other types of assets. REITs and DPPs may be offered privately or registered with the SEC for sale to the public. REITs and DPPs may also be listed on an exchange or unlisted. Because the value of listed securities of REITs and DPPs is established by the market, the definitions of REIT and DPP found in NASD Rule 2340(d) exclude securities listed on a national securities exchange. The definitions also exclude REIT and DPP issuers that are not public companies.
Customer Account Statements. NASD Rule 2340 requires general securities firms (i.e., firms other than those that do not carry customer accounts and do not hold customer funds or securities) to send account statements to customers at least quarterly. The account statements must include a description of any securities positions, money balances and account activity since the firm issued the prior account statement. Rule 2340(c) addresses the estimated values of DPPs and REITs on customer account statements and states that the estimated value for DPP and REIT securities may be obtained from the annual report, an independent valuation service or any other source. The Rule requires that firms develop a per share estimated value on a customer account statement from data that is not more than 18 months old.
Rule 2310, applicable to offerings of DPPs and REITs, prohibits a firm from participating in a public offering of a DPP or REIT unless the general partner or sponsor represents that it will include a per share estimated value in each annual report. In the Notice, FINRA states that current industry practice is to use the value in the issuer’s annual report as the per share estimated value on a customer account statement.
Initial Offering Period Defined. “Initial Offering Period,” would be defined in the proposed amendments by reference to the period in SEC Rule 415(a)(5), which applies to shelf offerings. This period would be three years from the effective date of the shelf plus, in the event that a new registration statement is filed with the SEC during the initial three-year period, a period ending on the earlier of the effective date of the new registration statement or 180 days after the end of the initial three-year period.
Use of Offering Price During Initial Offering Period. Unlisted REITs and DPPs are generally sold at a fixed price during the initial offering period and beyond. The proposed amendment would permit firms to base the per share estimated value on the offering price only during the Initial Offering Period, but would require that the per share estimated value so derived reflect a deduction of the amount of organization and offering expenses as defined by FINRA Rule 2310(a)(12). Rule 2310 provides conditions for member participation in public offerings of DPPs and REITs, including a limit on the total amount of organization and offering expenses.
Calculating Per Share Estimated Value after the Initial Offering Period. The proposed amendments would provide that after the Initial Offering Period, members furnishing per share estimated values in customer accounts may only use a per share estimated value calculated based on an appraisal of the assets, liabilities and operations of the DPP or REIT and derived from data no less current than the data in the most recent annual report. The Notice states that firms would not be required to immediately update the per share estimated values shown in customer account statements when a new value appears in the DPP or REIT annual report, but that firms must use reasonable efforts to address operational or technical requirements associated with updating per share estimated values, to ensure that updating occurs as promptly as practicable. The Notice further states that firms that require more than one statement cycle to update the per share estimated values are likely to raise a presumption that the firm is not making reasonable efforts.
Unreliable or Non-Compliant Information. The proposed amendments would provide that a member must refrain from providing a per share estimated value, from any source, if it knows or has reason to know the value is unreliable, based upon publicly available information or nonpublic information that has come to the member’s attention, and that a member may refrain from providing a per share estimated value if the most recent annual report of a DPP or REIT does not contain a per share estimated value that complies with the requirements of the amended rule for the applicable period. If the member refrains from providing a per share estimated value, the customer account statement must disclose:
that unlisted DPP or REIT securities are illiquid;
that the value of the security is different from its purchase price and may be less than the purchase price;
that an estimated valuation of the security is unavailable; and
the reason the value does not appear in, or has been removed from, the account statement.
Public Comment Requested. FINRA has requested comments on the proposed amendments to Rule 2340. The comment period expires on November 12, 2011.