FINRA recently issued a regulatory notice (the “Notice”)1 providing guidance to its members (“members”) on communications with the public (“firm communications”) regarding unlisted real estate investment programs, specifically REITs and real estate direct participation programs (“real estate programs”).
The Notice states that recent FINRA reviews revealed deficiencies in firm communications regarding real estate programs. FINRA Rule 2210 requires firm communications to be fair, balanced, and not misleading; in the context of real estate programs, the Notice reminds FINRA members that firm communications must contain accurate and complete statements regarding the potential benefits of such programs, which must be balanced by clear and conspicuous disclosures of the potential risks and contingencies.
The Notice highlights eight specific areas of concern for firm communications regarding real estate programs:
- Disclosure: Firm communications containing descriptions of a real estate program must be consistent with the program’s current prospectus and must not imply an investment in the program is a direct investment in real estate or other assets. Any discussion of the potential benefits of a program must be balanced with disclosure of potential risks, which must be presented in a clear and prominent manner, i.e., not in a footnote and not in a separate document such as the prospectus. If the program has not yet qualified for REIT status under the U.S. tax code, firm communications must disclose that the program has not yet qualified and that it may never qualify for REIT status.
- Distribution Rates: Some programs fund a portion of their distributions through returns of principal or through loan proceeds. In such instances, members must accurately describe the nature of any distributions and may not misrepresent the composition of a distribution or describe it as a yield comparable to a fixed income investment. The Notice advises that firm communications of distribution rates will be deemed fair and balanced under Rule 2210 if they clearly and prominently disclose (each as applicable):
- That distributions are not guaranteed and may be modified;
- The components of the distribution rate that represent cash flows, return of principal, and borrowing;
- The time period during which distributions have been funded from any source other than cash flows;
- That distributions that include return of principal will lessen the money available for the program to invest, which may lower overall returns; and
- That distributions, including borrowed funds, may not be sustainable.
In addition, firm communications may not include an annualized distribution rate until the program has paid distributions that are, on an annualized basis, equal to that rate for two consecutive quarterly periods.
- Stability/Volatility Claims: Members may not make assertions or implications regarding the stability or limited volatility of a real estate program’s value without providing a sound basis to evaluate this claim. Representations regarding stability or limited volatility may not be based on the program being offered at a fixed or stable price without also disclosing that the value of underlying assets will fluctuate, may be worth less than what the program initially paid, and that the investor may not be able to sell the investment.
- Redemption Features and Liquidity Events: Restrictions and limitations on redemption features must be clearly and prominently explained. Firm communications must disclose if the real estate program has not satisfied all investor redemption requests in the past. Any discussion regarding potential liquidity events should disclose if the liquidity event is not guaranteed to occur or if it may be changed at the program’s discretion.
- Performance of Prior Related Real Estate Programs: Discussions of prior or historical performance of related or similar entities should identify all such related entities, may not “cherry pick” those favorable to the current program, and should be clearly differentiated from information regarding the current program.
- Use of Indices and Comparisons: Firm communications that compare a real estate program against a real estate index must indicate that the performance of the index does not reflect a particular program and must describe the index’s components and any relevant differences between the index and the program’s investments.
- Pictures of Specific Properties: Where a firm communication includes pictures or images of properties that are not owned by the real estate program — such as similar properties owned by other programs the sponsor manages or properties that are collateral for mortgages owned by the program — the pictures must include prominent text explaining that the property is not owned by the program.
- Capitalization Rates: Firm communications may include the capitalization rate of an individual property within a real estate program, if the rate is based on current information contained in the prospectus, and the communication explains (i) how the rate was calculated, (ii) that the rate applies to the individual property, and (iii) that it does not reflect a return or distribution from the program itself. However, firm communications generally should not include a blended capitalization rate representing multiple individual properties as the factors that go into such rates will differ between individual properties.
FINRA has consistently focused in recent years on the manner in which firms sell alternative investments, with particular focus on suitability, due diligence, and whether the firms have adequately and fairly disclosed both the risks and the rewards of these investments. This most recent Notice confirms that FINRA’s focus on these investments continues. Firms that sell the sort of non-listed REITs addressed in Regulatory Notice 13-18 should review the Notice carefully to make certain their communications conform to FINRA’s guidance, update their review policies as necessary, and update any communications that stray from FINRA’s guidance.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:Burke-TimothyKroll-AmyWeissmann-Michael
“Communications with the Public,” FINRA Regulatory Notice 13-18 (May 2013).