On Advice

The ghost of private placements past

IBDs are racking up a bonanza from the sale of alternatives, namely nontraded REITS

Dec 1, 2013 @ 12:01 am

By Bruce Kelly

As the year comes to a close, it is evident that independent broker-dealers are racking up a bonanza from the sale of alternative investment products, namely nontraded real estate investment trusts.

As noted in this column two weeks ago, independent registered representatives have poured a mountain of client cash into nontraded REITs this year — an expected record $20 billion in sales.

Indeed, LPL Financial, with more than 13,000 independent registered reps and financial advisers, reported a booming increase in commissions in the third quarter for sales of nontraded REITs and other alternative investments, increasing 160.1% and reaching $81.2 million.

LPL, of course, isn't alone in this commission windfall from sales of nontraded REITs.

Smaller independent broker-dealers also are joining the festivities, including some firms that made serious errors in judgment when they approved private-placement alternative investments that turned out to be frauds in the four or five years before the market crash of 2008. Dozens of the broker-dealers that sold those products have gone out of business, unable to operate under the burden of client lawsuits and regulatory scrutiny.

Others, however, survived. And it looks like they are continuing to generate significant income and revenue from the sale of alternative investments.

Have those firms learned from their mistakes?

Capital Financial Services Inc., with 120 independent registered reps, is one such firm.

Its parent company, Capital Financial Holdings Inc., last month reported third-quarter earnings and noted a significant surge in income due to increased marketing dollars from alternative investment sponsors.


“Interest and other income for the nine-month period ended Sept. 30, 2013, was $430,534, an increase of 149% from $172,632 during the same period in 2012,” Capital Financial Holdings reported. “The increases were due to an increase in the marketing income received related to alternative investment products.”

Capital Financial Services has seen severe problems with alternative investments in the recent past. It was one of the leading sellers during the past decade of a series of private placements that failed and were later accused of being fraudulent by the Securities and Exchange Commission.

Capital Financial reps sold $60 million of Provident Royalties preferred shares. In August 2011, Capital Financial and the Financial Industry Regulatory Authority Inc. reached a $200,000 settlement over the sale of the failed private deals.

The firm “failed to conduct adequate due diligence” on the two series of offerings and failed to put in place a supervisory system to achieve compliance when selling the private placements, according to Finra's letter of acceptance, waiver and consent.

John Carlson, president of Capital Financial Services, declined to comment about the company's earnings report.

Meanwhile, Ladenburg Thalmann Financial Services Inc., which is the parent of three independent broker-dealers, last month reported a healthy boost of 20% in commission revenue for the nine-month period ended in September due, in part, to sales of alternative investments.

Ladenburg reported $293.5 million in commission revenue for the first nine months of the year, compared with $243.9 million a year earlier.

“The increase in commission revenue resulted primarily from increased sales of alternative investments, mutual funds and variable annuities in the 2013 period as compared to the 2012 period,” the company reported.

One of Ladenburg's broker-dealers is Securities America Inc., which was the leading seller of MedCap notes, with almost $700 million in sales. Its former owner, Ameriprise Financial Inc., along with Securities America, announced two settlements with MedCap investors in 2011, totaling $150 million, before the firm was sold that year to Ladenburg.

Ladenburg spokeswoman Emily Deissler and Securities America spokeswoman Janine Wertheim didn't return calls seeking comment.


To be clear, a broker-dealer selling fraudulent private placements isn't akin to selling nontraded REITs. Private placements offer scant disclosure to advisers and investors and often are shrouded in mystery reminiscent of hedge fund marketing.

MedCap and Provident promised annual returns of 12% to 17% and had no audited financial statements.

Nontraded REITs are designed to be “steady as she goes” investment products with yields of 5% to 7%.

And nontraded REITs are registered securities and have copious amount of disclosure from the product sponsor. The industry has taken strides to improve disclosure, including working with regulators to promote the sustainability of dividends and create standards for valuation and account statement reporting.

Regardless, the commission bonanza that some firms are seeing from sales of alternative products must be taken seriously if the independent broker-dealer industry wants to avoid potential disasters from selling such investments.

The questions for those firms and the independent broker-dealer industry at large are:

As the year comes to a close and sales of nontraded REITs continue to sizzle, do broker-dealers have the systems and personnel in place to properly watch the sales of alternative investments such as nontraded REITs or business development companies?

As the independent broker-dealer industry enjoys the fruits of the commission revenue from these products, did it learn from the private-placement debacle of the recent past?

Broker-dealers that sold MedCap notes and Provident preferred shares typically relied on outside due-diligence analysts, often paid for by MedCap and Provident, to kick the tires on the product.

Have broker-dealers ditched this practice, performing their own due diligence on products such as nontraded REITs? Some firms already do this, but all should, and in one way or another pay for the due-diligence analysis for the nontraded REITs or BDCs out of their own pockets.

History has a way of repeating itself. Let's hope that isn't the case for the independent broker-dealer industry and hot sales of alternative investments.


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