FINRA Reminds Firms of Their Duties Relating to Real Estate Investment Programs
Recently, FINRA issued Regulatory Notice 13-18 to remind financial services firms of their duties relating to unlisted real estate investment trusts (REITs) and unlisted direct participation programs (DPPs) that invest in real estate. In those investment programs, investors buy an equity interest in a pool of real estate assets, including land, office buildings, hotels and shopping centers, or in mortgages secured by real estate. However, FINRA is concerned that investors are not adequately protected, noting that its reviews of firms “have revealed deficiencies.” Accordingly, FINRA has issued the notice to remind firms of their current and important obligations. Let’s highlight those obligations.
Preliminarily, FINRA outlines the general duties applicable to all communications with the public. Pursuant to FINRA Rule 2210, all communications must be “fair, balanced and not misleading.”
First, FINRA reminds firms that all descriptions of real estate programs must “accurately and fairly explain how the products operate.” Moreover, firms must ensure that all descriptions of real estate programs must be consistent, including being consistent with any disclosures in the program’s prospectus. Regarding risk disclosures, FINRA reminds firms of several important obligations. Among them, firms must “balance any presentation of the potential benefits of such investments with disclosure concerning potential risks.” This disclosure, moreover, must be “clear and prominent”, “commensurate with the discussion of benefits”, and “not relegated to a footnote.” Critically, FINRA reminds firms that, “Providing risk disclosure in a separate document, such as the prospectus, does not substitute for the required disclosure, even if a communication is accompanied or is preceded by a prospectus.”
Second, FINRA focuses on communications with regard to real estate program distribution rates. FINRA warns that some programs may not make a distribution from cash flows from operations. Instead, the distribution may come from the return of the investors’ own principal that they have invested. Or the distribution may come from a loan that the program has taken out. Whatever the case, FINRA warns firms that it must communicate accurately. Examples include not misrepresenting the amount of composition of a program’s distribution, not stating or implying that a distribution rate is a “yield”, “current yield”, or equating the real estate program to a fixed income investment like a bond or a note.
Further, FINRA outlines what firms must disclose clearly and prominently so as to comply with Rule 2210:
1) Distribution payments are not guaranteed and may be modified at the program’s discretion;
2) Exact composition of each distribution to disclose how much of it is return of principal, borrowings, and cash flow from investment or operations;
3) The time period during which the distributions have been funded from return of principal, borrowings or any sources other than cash flow from investment or operations;
4) A warning that if the distribution includes a return of principal, then the program will have less money to invest and may experience lower overall returns; and
5) A warning that if the distribution includes borrowed funds, then the distribution rate may not be sustainable.
Third, FINRA addresses what it calls “stability/volatility claims.” FINRA cites factors affecting stability and volatility, including fluctuating prices, uncertainty of dividends and rates of return. Then it delivers this very powerful warning regarding communications discussing par value: “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.” FINRA reminds firms that their communications cannot state otherwise, because “price stability does not indicate stability in the value of the underlying assets, which will fluctuate and may be worth less than the real estate program initially paid, and that the investor may not be able to sell the investment.”
Fourth, FINRA cautions firms that its communications must describe all of the restrictions and limitations associated with a program’s redemption features and liquidity events. Regarding redemptions, FINRA instructs firms to communicate clearly and prominently, for example, if management may terminate or modify the ability to redeem. Similarly, communications should include a warning if not all redemption requests in the past have been satisfied. Regarding liquidity events, FINRA advises that there must be a warning communicated if any liquidity event is not guaranteed, or if liquidation features may be changed in the discretion of management.
Fifth and finally, FINRA reminds firms of their obligations in communicating the performance of prior related real estate programs, as well as the use of indices and comparisons. The warnings to firms are detailed and sometimes technical. However, as with all communications, the essence of each warning is that the communication must be fair, balanced and not misleading.
As one can see, a firm’s obligations regarding communications relating to real estate investment programs is highly regulated. Given that FINRA has noted deficiencies, let’s hope that, moving forward, the firms’ communications will catch up to the firms’ obligations.