Nontraded real estate investment trusts and potential shortcomings in how broker-dealers sell them are clearly in the cross hairs of examiners from the Financial Industry Regulatory Authority Inc.
Over the past two years, Finra examiners have scrutinized “numerous retail sellers of nontraded REITs,” according to comments made late last month by Susan Axelrod, executive vice president of member regulation sales practices at Finra.
“In several instances, Finra examiners have found that firms selling these products failed to conduct reasonable diligence before selling a product and failed to make a determination that the product was suitable for investors,” she said in prepared remarks to the Securities Industry and Financial Markets Association's Complex Products Forum.
“Finra examiners have noted that in the instances of REITs that have experienced financial difficulties, red flags existed and should have been considered by firms prior to the product being offered to firm clients.”
Independent broker-dealers' shortcomings in due diligence when selling complex, illiquid products have been a focus of Finra exams and fines since the market collapse of 2008. Finra recently has fined and sanctioned a handful of broker-dealers that sold two series of private placements that imploded in 2009 — Medical Capital Holdings Inc. notes and preferred shares of Provident Royalties LLC — citing shoddy due diligence.
Ms. Axelrod said that distributions, or dividends, of nontraded REITs also are on Finra's radar.
“Nontraded REITs may also borrow funds to make distributions if operating cash flow is insufficient,” she said. “Excessive borrowing may increase the risk of default or devaluation. In addition, nontraded-REIT distributions may actually be a return of principal.”
Financial advisers “must use caution when discussing distributions with investors, particularly when making comparisons to other dividend-paying investments,” she said.
Some broker-dealers, meanwhile, have failed to conduct adequate training for the advisers who sell the products, Ms. Axelrod said.
“Finra examiners are also reviewing advertising, sales literature and correspondence between brokers and investors, and — in some instances — have found misrepresentations of product features, such as distributions and share values,” she said. “All of these issues raise investor protection concerns.”
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