Finra plan could upend illiquid investment reporting

Finra’s board of governors has put in motion a plan that has the potential to drastically change how broker-dealers report the value of illiquid investments such as nontraded real estate investment trusts on client account statements.
The Financial Industry Regulatory Authority Inc. has been working on revising rules about REIT and private-placement valuations on client account statements since September 2011, when it issued its first notice to members on the issue. It followed with another notice last March, with the goal of giving investors greater transparency regarding what their illiquid REITs and other investments are really worth.
On April 19, Finra’s board laid out two options for broker-dealers in its proposed changes to Rule 2340, which Finra plans to file with the Securities and Exchange Commission.
In the first scenario, a broker-dealer simply would not be required to include a per-share estimated value of an unlisted private placement or REIT in a customer account statement.
In a second, a broker-dealer could rely on a valuation if done by one of three methods: an independent, outside valuation service performed at least once every three years; a valuation handled by any service conducting valuations according to a methodology disclosed in the prospectus; or, for two years after first investing, a “net investment,” valuation that consisted of the offering price minus cash distributions to investors, and “organization and offering expenses” funded through borrowing or offering proceeds.
Missing from the board of governor’s meeting notes, however, is the specific language firms would have to use if choosing the first scenario, meaning if a firm did not include a per-share value on a client account statement.
In a March notice to members, Finra stated that firms could mark a security as “not priced” if an appraised value had not been included in its second quarterly report. That “not priced” security could leave a confusing hole in client account statements. The board of governors meeting note does not mention the potential for listing the securities as “not priced,” but such language could be included in the rule filing itself.
“I think we’re well positioned for these potential changes,” said Nicholas Schorsch, CEO of REIT sponsor American Realty Capital, who added that greater disclosure and transparency were good for the nontraded REIT industry.
Most nontraded REITs are sold at $10 per share and remain at that value on a client’s account statement until 18 months after the REIT has stopped raising money — as required by Finra. That means that three, five or perhaps even seven years can pass before a client sees a valuation for a nontraded REIT other than $10 per share. REITs that raise money through an initial offering and then follow-on offerings have been called “zombie REITS” by some in the industry.
When Finra initially issued the proposed rule change in September 2011, it favored subtracting expenses to create a value of a REIT.
Kevin Hogan, chief executive officer of the IPA, said he could not comment on potential changes from the coming Finra proposal until he had read and studied it.
The issue of how a nontraded REIT should be valued, and the obligation of a broker-dealer to note that valuation on clients’ account statements, has been a contentious one in the years since the credit crisis. That’s when some of the largest nontraded REITs suffered sharp declines in valuations quarter after quarter, after years of reporting a value of $10 per share, leaving investors and advisers struggling to understand how, why and to what degree the declines occurred.