Wells Real Estate Funds Retreats From Non-Traded REIT Offerings

January 16, 2013 By Jay Eng

Investment News Is reporting that Wells Real Estate Funds is halting non-traded REIT offerings at this time. According to the report,

Wells Real Estate Investment Trust II is moving to become an independent company early this year and the Wells Core Office Income REIT will close to new investments in June, Mr. Wells wrote. The Wells Timberland REIT is also looking toward “its appropriate exit strategy,” he added.

Mr. Wells is one of the most noted real estate sponsors in the independent-broker-dealer industry. Many B-Ds have long sold his REITs, but the nontraded-REIT business is changing in the aftermath of the collapse of the commercial real estate market and credit crisis in 2008.

Mr. Wells is also one of the most outspoken and colorful figures in an industry that has generated plenty of headlines in the past decade. In October 2003, Finra’s precursor, NASD, sanctioned Wells Investment Securities for improperly rewarding broker-dealer reps who sold the company’s REITs. Those rewards included lavish entertainment and travel perquisites. At the time, the regulator also censured Mr. Wells and suspended him from acting in a principal capacity for one year.

Non-traded REITs have come under increased scrutiny recently as brokerage firms improperly recommended these illiquid investments to many of their clients.  Recently regulators filed a complaint against LPL Financial concerning Cole Credit Property Trust II, Inc., Cole Credit Property Trust III, Inc., Cole Property 1031 Exchange, Wells Real Estate Investment Trust II, Inc., WP Carey Corporate Property Associates 17, and Dividend Capital Total Realty.

Massachusetts Regulator Files Complaint Against LPL Financial Concerning Non-Traded REITS

December 12, 2012 By Jay Eng

The Enforcement Section of the Massachusetts Securities Division has filed a lawsuit against LPL Financial, LLC (“LPL”) in connection with their sale of non-traded real estate investment trusts (or “REITs”) to retail investors through LPL’s registered representatives and investment advisors. According to the complaint, which can be found here, LPL “engaged in numerous regulatory violations in connection with the sale of non-traded REITs.” According to the complaint, LPL received commissions starting at 6% and soled over $4 million of non-traded REITS to Massachusetts investors.

REITs are companies which own and manage income producing properties which can be commercial or residential. Regulators note that non-traded REITs are often misunderstood by investors. REITs are often entirely illiquid and sometimes resort to paying distributions out of borrowed monies. Regulators have found that non-traded REITs are “especially risky through limited redemption programs, high fees and commissions and internal conflicts of interest.” Non-traded REITs can have high sales commissions and offering fees from 15-18%.

In its complaint, the Enforcement Section found issues with LPL’s sale of Inland American Real Estate Trust and other non-traded REITs. For example, LPL allegedly “failed to review properly sales of non-traded REITs.” In numerous instances, the Enforcement Section found violations of concentration requirements, net worth, annual income and liquid net worth requirements. Other non-traded REITs reviewed by the Enforcement Section included Cole Credit Property Trust II, Inc., Cole Credit Property Trust III, Inc., Cole Property 1031 Exchange, Wells Real Estate Investment Trust II, Inc., WP Carey Corporate Property Associates 17, and Dividend Capital Total Realty.

Morgan Keegan Enters Into AWC with FINRA Over Leveraged / Non-Traditional ETFs

November 7, 2012 By Jay Eng

On October 24, 2012 Morgan Keegan & Company, Inc. (“Morgan Keegan”) entered into a Letter of Acceptance, Waiver and Consent (“AWC”) with FINRA concerning its supervision of of sales of “Non-Traditional ETFs” which were “not sufficiently tailored to address the unique features and risks involved with these products.”  FINRA rules require a “broker to perform reasonable diligence to understand the nature of a recommended security, as well as the potential risks and rewards.”

In the AWC, FINRA contented, among other things, that

During the period from January 2008 through June 2009 (the “Relevant Period”), Morgan Keegan failed to establish and maintain a supervisory system, including written procedures, reasonably designed to achieve compliance with applicable NASD and/or FINRA rules in connection with the sale of leveraged, inverse, and inverse-leveraged Exchange-Traded Funds (“Non-Traditional ETFs“). Leveraged ETFs seek to deliver multiples of the performance of the index or benchmark they track. Some Non-Traditional ETFs are “inverse” or “short” funds, meaning that they seek to deliver the opposite of” the performance of the index or benchmark they track. Some funds are both inverse and leveraged, meaning that they seek to achieve a return that is a multiple of the inverse performance of the underlying index or benchmark.

Non-Traditional ETFs have certain risks that are not found in traditional ETFs, such as the risks associated with a daily reset, leverage and compounding. The performance of Non-Traditional ETFs over longer periods of time can differ significantly from the performance of their underlying index or benchmark, especially in volatile markets. Nonetheless, Morgan Keegan supervised Non-Traditional ETFs the same way it supervised traditional ETFs. Thus, Morgan Keegan failed to establish a reasonable supervisory system and written procedures to monitor the sale of Non-Traditional ETFs. Morgan Keegan also failed to establish adequate formal training regarding Non-Traditional ETFs during the Relevant Period.

See FINRA Letter of Acceptance, Waiver and Consent, No. 20090191135 (10/24/2012) (emphasis added).

 

Risks and Problems with Sales of Reverse Convertible Securities

October 10, 2012 By Jay Eng

At a the recent SIFMA Complex Products Forum, Susan F. Axelrod Executive Vice President, Member Regulation Sales Practice, discussed recent problems with reverse convertible securities.  In her prepared remarks, Axelrod noted that “reverse convertibles are often attractive to customers because of the high initial yields they offer.”  Axelrod commented that

Investors and brokers may misunderstand this complex product—and its downside. A reverse convertible is a note that pays a high initial fixed coupon—sometimes ranging up to 30 percent per year. The return of principal is tied to the performance of a basket of stocks or, sometimes, the performance of a specific security. I will call these the “underlying assets,” or just “the assets,” for our discussion today. The performance of the assets determines whether, at a specified date or performance level, the investor will receive the assets—essentially giving the issuer a “put” option should their value decline. The investor typically does not benefit if the underlying assets increase in value. And, it is generally true that the higher the coupon rate, the higher the volatility of the underlying asset. This can increase the chance that the investor will receive less than a full return of principal.

(Emphasis added).

FINRA has discovered that some brokers have over-concentrated their customers in reverse convertibles due to unsuitable recommendations.  Further  FINRA has brought a number of enforcement actions against firms for failing to ensure that their supervisory systems were adequate.

FINRA Hearing Panel Hammers Brookstone Securities for Securities Fraud In Connection With CMO Sales

June 6, 2012 By Jay Eng

A FINRA Hearing Panel has hammered Brookstone Securities of Lakeland, Florida.  According to a FINRA release, the panel found that from July 2005 through July 2007, the firms owner and a former broker “intentionally made fraudulent misrepresentations and omissions to elderly and unsophisticated customers regarding the risks associated with investing in [collateralized mortgage obligations].” The panel fined Brookstone $1 million and ordered it to pay restitution of more than $1.6 million to customers.  The decision may be appealed to FINRA’s National Adjudicatory Council.

A collateralized mortgage obligations or “CMO” is a security that is collateralized by mortgage-backed securities, which in turn are undivided interests in a pool of mortgages. The principal and interest from the mortgages underlying a mortgage-backed securities are used to pay CMO investors principal and/or interest, depending on the type, or “tranche,” of CMO that they own. CMOs are classified, in part, based on the entity that guarantees them.

In Notice to Member 93-78,FINRA provided guidance to brokers alerting them to their obligations when recommending CMOs stating, in part, that

In light of the complexity and the varying risk characteristics of CMOs, under Article III, Sections 1 and 2 of the Rules of Fair Practice, members and their associated persons must be conversant in all of the characteristics of CMOs to assess adequately the suitability of CMOs for their customers. Moreover, they must ensure that their customers understand the characteristics and risks of CMOs. Further, adequate supervisory procedures must be in place to monitor CMO activity within each NASD member firm.

Emphasis added.

FINRA Sanctions Citigroup, Morgan Stanley, UBS and Wells Fargo over Unsuitable Severaged and Inverse ETFs

May 12, 2012 By Jay Eng

FINRA has announced that three of the country’s largest brokerage firm: Citigroup Global Markets, Inc (“Citigroup”); Morgan Stanley & Co., LLC (“Morgan Stanley”); UBS Financial Services (“UBS”); and Wells Fargo Advisors, LLC (“Wells Fargo”) were sanctioned for sales of leveraged and inverse exchange-traded funds (“ETFs”) without reasonable supervision and without a reasonable basis for recommending these ETFs. The firms were fined more than $7.3 million. FINRA’s press release stated that:

FINRA found that from January 2008 through June 2009, the firms did not have adequate supervisory systems in place to monitor the sale of leveraged and inverse ETFs, and failed to conduct adequate due diligence regarding the risks and features of the ETFs. As a result, the firms did not have a reasonable basis to recommend the ETFs to their retail customers. The firms’ registered representatives also made unsuitable recommendations of leveraged and inverse ETFs to some customers with conservative investment objectives and/or risk profiles. Each of the four firms sold billions of dollars of these ETFs to customers, some of whom held them for extended periods when the markets were volatile.

Inverse and leveraged ETFs have been under scrutiny for several years. Many investors purchased inverse ETFs believing that these products would protect them by market downturns. However, the design of the products did not protect investors from the protracted and volatile downturns in the 2008 market collapse. In 2009, FINRA issued a regulatory notice stating that “inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”

SEC AND FINRA ISSUE AN ALERT REGARDING LEVERAGED AND INVERSE ETFs

August 19, 2009 By Jay Eng

On August 18, 2009, the SEC staff and FINRA jointly issued an Alert regarding the confusion investors may have about the performance objectives of leveraged and inverse exchange-traded funds (“ETFs”). The Alert states that “[s]ome investors might invest in these ETFs with the expectation that the ETFs may meet their stated daily performance objectives over the long term as well. Investors should be aware that performance of these ETFs over a period longer than one day can differ significantly from their stated daily performance objectives.” (Emphasis added).

The SEC further cautioned: “While there may be trading and hedging strategies that justify holding these investments longer than a day, buy-and-hold investors with an intermediate or long-term time horizon should carefully consider whether these ETFs are appropriate for their portfolio. As discussed above, because leveraged and inverse ETFs reset each day, their performance can quickly diverge from the performance of the underlying index or benchmark. In other words, it is possible that you could suffer significant losses even if the long-term performance of the index showed a gain. ” (Emphasis added).

FINRA has also published a Non-Traditional ETF FAQ.

FINRA’S Notice to Firms That “Inverse and Leveraged ETFs That Reset Daily Typically Are Unsuitable for Retail Investors Who Plan to Hold Them for Longer Than One Trading Session”

August 3, 2009 By Jay Eng

On June 11, 2009, FINRA issued Regulatory Notice 09-31 regarding “Non-Traditional ETFs” stating:

Exchange-traded funds (ETFs) that offer leverage or that are designed to perform inversely to the index or benchmark they track—or both—are growing in number and popularity. While such products may be useful in some sophisticated trading strategies, they are highly complex financial instruments that are typically designed to achieve their stated objectives on a daily basis. Due to the effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective. Therefore, inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatilemarkets.

This Notice reminds firms of their sales practice obligations in connection with leveraged and inverse ETFs. In particular, recommendations to customers must be suitable and based on a full understanding of the terms and features of the product recommended; sales materials related to leveraged and inverse ETFs must be fair and accurate; and firms must have adequate supervisory procedures in place to ensure that these obligations are met.

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