State securities regulators are making noise about implementing changes to policies that would limit how much a client's net worth could be invested in nontraded real estate investment trusts.
As my colleague Mark Schoeff Jr. recently reported, the North American Securities Administrators Association Inc. has been
circulating to industry regulators and representatives a list of 33 proposed changes to its
REIT policy, with the intent to better protect investors. One of the recommendations on the list focuses on how much of a client's net worth can be allocated to nontraded REITs.
And it's no wonder. Such REITs are in regulators' sights because of questions about their fees, transparency and performance during the credit crisis. Some registered reps who sold illiquid REITs before the real estate collapse of 2007 and 2008 have vowed never again to touch the product. Some of the most notable REITs of that era saw dividends slashed and valuations erode 30% to 50%, with investors unable to exit because such REITs are not traded on an exchange.
In response, the $20 billion-a-year industry has taken steps to better protect investors.
(See also: Foot-dragging on rules harms investors)
Nontraded REIT sponsors have essentially eliminated the costly and hard-to- understand fees charged when a REIT absorbs its manager, known as “internalization” fees. After working with regulators at the
Financial Industry Regulatory Authority Inc., the industry is also moving, albeit slowly, to provide greater transparency of pricing on client account statements. Look for that change in the first half of 2016.
But that doesn't mean the financial advice business, which is increasingly focused on complex alternative investments, and the nontraded REIT industry can ignore the problems and abuses of the past, particularly as regulators finish shaping new regulations.
Consider a new Finra complaint against a former broker who invested the portfolios of three clients with unfathomable and dangerous levels of alternative products. The broker sold both high-risk private placements as well as nontraded REITs, with most client money going into private placements.
The clients were between 60 and 77 when the former rep, Steven Stahler, invested perilously high amounts of both their liquid net worth and their investment portfolios in private placements and REITs, according to a Finra complaint dated Aug. 27.
From 2006 to 2009, Mr. Stahler's three sets of clients — a married couple and two women — invested almost $2.5 million in the alternatives. Both private placements and REITs are high-commission products, with the broker typically receiving a 6% to 7% commission.
According to the Finra complaint, Mr. Stahler made unsuitable recommendations to all three clients and misrepresented material facts in connection with those recommendations. While the offering documents characterized the investments as involving “material risks,” “speculative with a high degree of risk” or “highly speculative with substantial risks,” Mr. Stahler “negligently misrepresented” that the securities were “only moderately risky,” the Finra complaint said.
Mr. Stahler made $165,000 in net commissions after selling the products to the clients, for a commission rate of 6.6%.
Meanwhile, the clients are hurting. According to the Finra lawsuit, they have racked up unrealized losses of almost $1.32 million, or 52.8% of the money invested.
The clients would have been better off investing in a low-cost, passive index of large capitalization stocks. For example, from Aug. 1, 2006, to last Thursday, the Standard & Poor's 500 Stock Index has risen 55.4%, even accounting for its disastrous lows of March 2009.
As a result of Mr. Stahler's recommendations, one client, a 77-year-old former nightclub owner and an astrologer, invested 99% of her portfolio and 43% of her liquid net worth in 17 alternative investments, according to the Finra complaint.
"Mr. Stahler vehemently denies Finra's allegations. They are false,” wrote his attorney, Jesse Linebaugh, in an email. “He looks forward to the matter being tried.”
At the time when he sold the REITs and private placements detailed in the Finra complaint, Mr. Stahler was registered with VSR Financial Services Inc., which is being acquired by RCS Capital Corp., the industry leader in packaging and distributing nontraded REITs. VSR has been known as a broker-dealer that gave advisers plenty of room to sell alternative investments to clients.
The firm's clients at one time could have 40% to 50% of their accounts in illiquid investments, in line with Mr. Stahler's recommendations. But after Finra last year fined VSR $550,000 for falling short on watching over concentrated client positions on alternative investments, the firm scaled back the amount of illiquid alternative investments that could be held in client accounts to 35%, with new, tighter limits for older clients.
Mr. Stahler left VSR in 2009 and worked for three other broker-dealers, but he has not been registered with a securities broker-dealer since November 2013.
The dangers to advisers and clients of overcrowding portfolios with illiquid alternative investments are abundantly clear. Securities regulators and both the financial advice and nontraded REIT industries continue to evolve their scrutiny and sale of the products.
Let's hope common sense prevails. A brokerage executive does not have to be able to read the stars to know that a 77-year-old client should not have 99% of her portfolio invested in high-risk, alternative investments.
