We rely on financial experts for advice on how to invest our savings. We trust those experts to provide honest and complete information about the underlying investments. Unfortunately, sometimes our trust is misplaced and so called financial experts, such as stock brokers and financial planners, make recommendations as to what is best for their pocket book and not their client’s long term financial interests. Other times, they fail to conduct appropriate due diligence and omit material facts about risks of the investment. An investor who entrusts his life savings with such an advisor can suffer devastating financial losses. In the wake of the economic and financial crisis in this country, many such aggrieved investors were persuaded to purchase unlisted REITS and 1031 tenants-in-common (TICs) investments, based upon false or materially incomplete information regarding the particular real estate investment.
B) What are Unlisted REITS
Unlisted REITs are registered with the U.S. Securities & Exchange Commission (SEC) but the shares of these REITs are not publicly traded on any national stock exchange. Accordingly, unlisted REITs do not offer the liquidity of a publicly traded REIT and the investors’ returns are based upon the performance of the real estate owned by the REIT.
Many of these investments involve Section 1031 tax-deferred exchanges of real property for certain tenants-in-common (TIC) interests in real property offerings. In a TIC exchange, interests in real property are exchanged for instruments that generally are securities for purposes of the federal and state securities laws. Thus, investors are protected by the anti-fraud provisions of federal and state law.
C) Brokerage Firms must Conduct Due Diligence into Unlisted REITS
Moreover, Brokerage firms and their stock brokers must comply with all applicable FINRA (formerly NASD) rules, including those addressing: suitability, due diligence, splitting commissions with unregistered individuals or firms, supervision, and recordkeeping.
FINRA states that typically the sale of an investment, including an investment in real estate, is a taxable event, with the seller being responsible for capital gains taxes on the appreciation of the investment. Under Section 1031 of the Internal Revenue Code, however, an investor in income-producing or rental real estate may exchange the investment for another investment in income-producing or rental real estate of equal or greater value and defer payment of capital gains. In order to qualify for a deferral under Section 1031, an investor must acquire an interest in real estate in the exchange, not an interest in a partnership.
According to FINRA, TIC interests are a type of non-conventional investment (NCI). FINRA requires that firms engaged in the sale of NCIs must ensure that those products are offered and sold in a manner consistent with the firm’s general sales conduct obligations. Brokerage firms and their associated persons must:
- conduct appropriate due diligence
- perform a reasonable-basis suitability analysis
- perform customer specific suitability analysis for recommended transactions
- ensure that promotional materials used by the firm are fair, accurate, and balanced
- implement appropriate internal controls
- provide appropriate training to registered persons involved in the sale of these products
Before recommending a TIC exchange, brokerage firms and their brokers must have a clear understanding of the investment goals and current financial status of the investor. In many cases, a TIC interest will constitute a significant portion of an investor’s total assets. Because of the favorable tax treatment, investors often elect to invest the entire proceeds from the sale of an investment property in a TIC exchange. Concentration of an investor’s assets in a single asset class, however, is not suitable for many investors. Brokerage firms must, with respect to each customer for whom they make a recommendation, consider the risks from over-concentration against the benefits of tax deferral and the investment potential of the underlying real estate asset(s).
It is not appropriate for brokerage firms to simply rely on representations made by the sponsor in an offering document. While the nature and extent of verification will vary with the facts and circumstances related to particular sponsors and offerings, firms should make a reasonable investigation to ensure that the offering document does not contain false or misleading information.
Such an investigation should include:
- background checks of the sponsor’s principals
- analysis of return projections
- review of all budgets which include revenues, expenses, and capital expenditures review of the agreements (e.g., property management, purchase and sale, lease and loan agreements)
- review of environmental reports
- on site property inspection
As part of its inquiry, FINRA states that “a firm should determine the amount of the distributions that represents a return of investors’ capital and whether that amount is changing. In addition, firms should consider whether there are impairments to the real estate investment program’s assets or other material events that would affect the distributions and whether disclosure regarding dividend distributions needs to be updated to reflect these events. For example, firms should obtain information regarding whether there have been unscheduled cancellations of existing leases that impair or materially affect a real estate investment program’s operating cash flows. If operating cash flows decline substantially, the program may decide to lower the dividend distributions or try to maintain historic dividend payments by borrowing funds or returning investors’ capital. Paying dividend distributions that are unsustainable over the long term due to cash flow difficulties presents a significant risk to investors’ future returns and to the long-term viability of the program.”
D) Brokerage Firms Who Outsource Due Diligence of Unlisted REITS Remain Fully Responsible
Brokerage Firms Reliance on Third Party companies to conduct due diligence does not diminish a brokerage firm’s responsibility for either its performance or its full compliance with all applicable federal securities laws and regulations, and FINRA rules.
Many brokerage firms are increasingly contracting with third-party service providers to perform certain activities and functions related to their business operations and regulatory responsibilities that members would otherwise perform themselves – practice commonly referred to as outsourcing.
Specifically, outsourcing a due diligence analysis of an investment in a non-listed 1031 REIT investment to a third party does not relieve members of their ultimate responsibility for compliance with all applicable federal securities laws and regulations and NASD rules.
Many industry experts recommend that the firms institute a formalized due diligence process to screen outsourced providers for proficiency to ensure they can monitor and assess the third-party’s own procedures and performance and the accuracy and quality of the work product produced on a continuing basis.
After the brokerage firm has selected a third-party provider, the member has a continuing responsibility to oversee, supervise, and monitor the provider=s performance of covered activities. This requires the member to have in place specific policies and procedures that will monitor the third party’s compliance with the terms of any agreements and assess its continued fitness and ability to perform the covered activities being outsourced.
E) Firms Often Fail to Conduct Appropriate Due Diligence in Unlisted REITS
In connection with the sale of unlisted REITS, it is all too common to discover that financial advisors made untrue statements of material fact or omitted to state material facts to investors regarding the due diligence.
For example, we have encountered instances where:
- the offering documents contained false and misleading information;
- the firm failed to perform adequate background checks of the sponsor’s principals;
- the return projections were grossly exaggerated;
- the review of the property management and lease agreements was deficient,
- significant environmental concerns were overlooked; and
- there were no on-site property inspections.
F) Investors Remedies
If your brokerage firm and its financial advisor failed to conduct adequate due diligence or make proper suitability determinations then you need to consult an experienced securities attorney to take appropriate legal actions to recover your losses and protect your legal rights.
Citations to be added