Finra's announcement of a $14.3 million settlement with David Lerner Associates Inc. sparked a verbal donnybrook that illustrates how high the stakes are when regulators penalize a firm or individual for poor or misguided behavior.
As renowned U.S. District Judge Jed S. Rakoff has pointed out, the language of such settlements often falls maddeningly short. The settlements can give regulators the appearance of carrying a big stick while allowing a securities house an easy out, often at the expense of the investors who own the securities at the center of the regulator's action.
The war of words between David Lerner Associates and the Financial Industry Regulatory Authority Inc., goes at least one step further.
When Finra released its order and penalties against David Lerner Associates and its eponymous founder two weeks ago, the firm pushed back — hard. Indeed, David Lerner Associates quickly released a statement responding to Finra that went far beyond the normal industry pablum, which usually declares that the firm is glad to have the episode behind it, at last.
David Lerner Associates declared, in so many words, that Finra failed to pin the goods on the firm when it alleged that a certain nontraded real estate investment trust wasn't suitable for some investors.
And as any broker-dealer executive will say, the staff at Finra doesn't like it when the industry pushes back.
Meanwhile, David Lerner Associates clients remain in the dark as to the fair valuation of their shares of Apple REITs, a series of illiquid REITs sold exclusively by financial advisers with David Lerner Associates. Finra's rules for such securities require that broker-dealers that sell nontraded REITs and other illiquid investments state on client account statements an estimated value for the securities 18 months after the fundraising for the offering is closed.
The estimated valuations of large nontraded REITs sponsored by firms such as Behringer Harvard and Inland Real Estate Corp., which have sold billions of dollars of the products, have fallen by 25% to 50% since they were launched. They have had to deal with the pain and headlines of those revaluations.
So why haven't David Lerner Associates and the Apple REITs released recent valuations?
We will get to that. First, back to the settlement.
RESTITUTION AND FINE
Finra ordered David Lerner Associates to pay $12 million in restitution to clients who bought shares of Apple REIT 10, a $2 billion nontraded REIT. It also fined the firm $2.3 million for allegedly charging unfair prices on municipal bonds and collateralized mortgage obligations.
Finra's chief of enforcement, Brad Bennett, focused on whether Apple REIT 10 was a suitable investment for some David Lerner Associates clients. Suitability, of course, is the bedrock of a securities transaction.
“David Lerner and his firm targeted unsophisticated and elderly customers, grossly failing to comply with basic standards of suitability in selling Apple REIT 10 to thousands of customers,” Mr. Bennett said in Finra's statement announcing sanctions against the firm and Mr. Lerner, who was fined $250,000 and suspended from the industry for one year. “Firms must conduct a thorough suitability analysis before selling products and make accurate disclosure of risks and features at the point of sale, especially with alternative investments such as nontraded REITs.”
David Lerner Associates didn't take kindly to Mr. Bennett's assessment regarding suitability, and made its feelings known.
“Contrary to Finra's suggestion in the press release, there were no charges, nor findings, that any of the investments were not, in fact, suitable for any of the individual investors,” the company said in a statement Oct. 22, not long after Finra made its announcement.
Finra must have gotten in David Lerner Associates' face about that statement because the firm later removed that sentence from versions of its news release.
In fact, Finra contacted InvestmentNews last Monday requesting that the publication erase that sentence from its initial story, which the paper declined to do.
Finra spokeswoman Michelle Ong said last Thursday that the self-regulatory organization had no comment regarding the change in David Lerner Associates' statement.
Nor would Finra comment on David Lerner Associates' practice of listing the value of Apple REITs, which were sold originally at $11 per unit, as “unpriced” on client account statements, she said.
David Lerner Associates' attorneys, however, wanted to shed light on the initial statement.
The firm “wanted to clarify that while the Finra settlement involved allegations that [David Lerner Associates] did not perform sufficient due diligence prior to selling Apple REIT 10, there were no allegations of point-of-sale, customer-specific suitability violations,” said Kevin Harnisch, an attorney with Fried Frank Harris Shriver & Jacobson LLP, who represents the firm. “The sentence at issue was intended to provide that clarification.”
But — still — why is David Lerner Associates not revaluing the Apple REIT shares?
A scan of a few Apple REIT annual reports shows that the REITs simply do not give an estimated value. Other REIT sponsors, however, do provide such an appraisal. And Apple is not a broker-dealer and therefore is not under Finra's rules.
David Lerner Associates' general counsel, Joseph Pickard, said that “after June 2011, DLA adopted what it believed was a straightforward and conservative approach by removing any reference to Apple REIT valuations in the customer monthly account statements and simply reflecting the customer's Apple REIT holdings as "not priced' in the body of the statement.”
The firm “is continuing to monitor and evaluate this topic, and will look to the issuer, Apple REIT companies, for guidance in the event that it changes its procedures for pricing Apple REIT securities on a go-forward basis,” he said.
And what about the performance of Apple REITs, of which David Lerner brokers have sold some $7 billion?
In the past, they have shown some success. A June study of nontraded REITs identified Apple Suites Inc. as the only one of 17 nontraded REITs in the past 20 years to outperform two customized benchmarks.
Past performance, of course, is no indication of what will happen in the future, so no one knows how the holders of other Apple REITs will fare.
But at least they should have a recent and fair appraisal of the value of their shares. That would give them some knowledge as to the future value of their investments.
And no war of words be-tween a regulator and broker-dealer should draw attention away from that.
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