In a sharp blow to independent broker-dealers and nontraded real estate investment trusts, Massachusetts securities regulators today sued LPL Financial LLC over sales practices of brokers regarding the REITs.
Secretary of the Commonwealth William Galvin charged LPL Financial with a failure to supervise registered reps who sold the nontraded REITs in violation of both state limitations and the company's rules. The Securities Division also charged LPL Financial with dishonest and unethical business practices.
The charges stem from sales of $28 million of nontraded REITs to almost 600 clients from 2006 to 2009. Of those transactions, the Securities Division found that 569 had regulatory violations. Those included sales made in violation of Massachusetts 10% concentration limits; sales made in violation of prospectus requirement; and sales made in violation of LPL compliance practices.
The firm received gross commission of $1.8 million for those sales, according to the complaint.
Of the REITs listed in the complaint, the largest amount of sales was for Inland American Real Estate Trust Inc., the largest nontraded REIT in the industry, with $11.2 billion in real estate assets. Massachusetts investors put at least $20.1 million in Inland American, which is currently the focus of a fact-finding investigation by the Securities and Exchange Commission.
Massachusetts' investigation “revealed significant and widespread problems with LPL's adherence with product prospectus and (state) requirements,” according to the complaint. By testimony of LPL reps, the Securities Division “uncovered similar issues with other nontraded REITs. In many ways, the division's investigation unearthed a boat with many holes.”
“On paper, LPL set forth stringent requirements for the sale of nontraded REITs,” according to the complaint. “In practice, LPL failed to review properly sales of nontraded REITs. While purporting to conduct a thorough review of offering documents, LPL overlooked prospectus requirements in numerous sales of nontraded REITs.”
“LPL's supervision employees had only a cursory understanding of specific state requirements, including Massachusetts concentration requirements,” according to the complaint. Many nontraded REIT prospectuses contain a 10% concentration limitation, designed to cap an individual investor's purchase to 10% of his or her liquid net worth, the complaint stated.
Massachusetts is seeking full restitution to clients in the state who were sold REITs allegedly in violation of state and prospectus requirements. It is also seeking an unspecified administrative fine against the firm.
Massachusetts began its investigation after receiving complaints regarding LPL sales of REITs in the fall of 2011, according to the complaint. An LPL registered representative described the REITs as providing stable principal preservation and income generation and downplayed the illiquidity of nontraded REITs.
The Massachusetts Securities Division this year started requesting information from LPL, according to the lawsuit.
The firm has changed its policies around the sale of the product, according to the complaint. “In July of 2012, LPL changed its policies and procedures creating a separate complex-products team to review all alternative investments.”
An LPL spokeswoman, Betsy Weinberger, said the firm believes that the claims included in the Massachusetts complaint were “substantially overstated.”
“LPL Financial takes protection of investors' interests seriously,” she said. “We have always endeavored to promote a strong culture of compliance and continue to do so.”
The firm has 21 days to respond to the Massachusetts complaint.
By 1:30 p.m. EST, LPL's share price was up 3 cents at $27.98.
LPL Financial is the largest independent broker-dealer, with more than 13,000 registered reps and advisers. Along with Ameriprise Financial Inc., its platform is one of the largest sellers of nontraded REITs, which are sold only through independent broker-dealers. The investments are marketed primarily as a way to diversify an investor's portfolio and generate income.
Nontraded REITs, which are enjoying a banner year with close to $10 billion of sales, have drawn attention from regulators and the market recently. Many notable REITs took hits in 2008 and 2009 during the broad downturn of the commercial real estate market. Some of the industry's largest REITs have suffered a drop in valuations of 25% to 50%, and some REITs have also cut “distributions” — dividends — to investors.
“LPL's lack of adequate training and supervision only exacerbated problems resulting from LPL's oversight of nontraded-REIT-prospectus and Massachusetts state requirements,” the complaint stated. “Both LPL employees responsible for the review and approval of nontraded REIT transactions and LPL representatives facilitating sales were undereducated and undersupervised with respect to nontraded REIT transactions.”
Alex Kramm, an analyst with UBS who covers the stock of LPL, in September downgraded the stock to a “sell” from “neutral,” and part of his reasoning was the firm's large exposure to nontraded REITs.
LPL is a big seller of variable annuities and nontraded REITs, and at the time he downgraded the stock, Mr. Kramm noted that those products were facing heightened scrutiny from investors as well as regulators. Variable annuities account for 45% of the company's commission revenue, while nontraded REITs could represent more than 75% of the company's commission revenue from alternative investments, which are expected to be $143 million on an annualized basis this year.
Complaints by regulators pose other risks.
In an interview Wednesday afternoon, Mr. Kramm said: “Lawsuits can take managements' attention away from running the business.”
In addition, complaints by regulators have acted as blue prints for plaintiffs attorneys seeking clients in order to sue the broker-dealer in question.
Massachusetts, for example, sued Securities America Inc. in 2010 over its sale of Medical Capital Holdings notes. The firm later settled with the regulator and paid $2.8 million in restitution to clients.
But in a separate series of claims, Securities America in in 2011 agreed to pay investors $150 million as part of global settlement over sales of Medical Capital and Provident Royalties LLC. The Securities and Exchange Commission charged both those series of private placements with fraud in 2009.
Lawyers who sued Securities America on behalf of Medical Capital clients routinely used the Massachusetts complaint as part of their claims. It is therefore possible that LPL Financial could see an increase in investor arbitration complaints in the wake of the Massachusetts lawsuit.
The Massachusetts complaint includes excerpts of interview with unnamed LPL employees and brokers, and those brief passages show the alleged shortcoming of LPL's oversight of REIT sales.
“LPL allowed individuals to approve transactions without specific product or issuer training,” according to the complaint. A senior member of LPL's supervision staff was asked, “Have you had any training in regards to nontraded on nonlisted REITs?”
According to the complaint, the supervisor replied: “You know, we've had PowerPoint presentations on REITs. Management has gone over certain training aspects of it, so that's probably the extent of out training.”
When the supervisor was asked if he or she received any specified training as to specific REITs, the supervisor responded: “No, just REITs in general,” according to the complaint.