Monthly Archives: October 2012

Non-traded real estate investment trusts (REITs) are bringing more bad news for David Lerner Associates. Last week, the Financial Industry Regulatory Authority (FINRA) ordered the firm to pay $12 million in restitution to clients who bought shares of Apple REIT 10. In addition, FINRA fined Lerner more than $2.3 million for charging unfair prices on municipal bonds and collateralized mortgage obligations.

David Lerner, the firm’s chief executive, was fined $250,000 and suspended from the securities industry for one year. Following the ban, he faces a two-year suspension from acting as a firm’s principal. Lerner’s head trader, William Mason, was fined $200,000 by FINRA and suspended from the securities industry for six months.

“David Lerner and his firm targeted unsophisticated and elderly customers, grossly failing to comply with basic standards of suitability in selling Apple REIT 10 to thousands of customers,” said Brad Bennett, FINRA’s chief of enforcement, in a statement about Lerner.

More than regulatory problems, however, David Lerner Associates faces a slew of investor arbitration complaints from clients who bought certain REITs from the company.

Lerner was the sole distributor of Apple REITs. According to FINRA, Lerner solicited thousands of customers and, specifically, targeted unsophisticated investors and the elderly without performing adequate due diligence to determine whether the REITs were suitable investments.

To sell the Apple REIT 10, FINRA says that Lerner used misleading marketing tactics that promised 7% to 8% annual returns. What the firm reportedly did not disclose was that income from the REIT was insufficient to keep paying out distributions without taking on significant amounts of debt.

Between January and December 2011, Lerner allegedly recommended and sold more than $442 million of Apple REIT 10 to investors.

The Financial Industry Regulatory Authority (FINRA) is calling out David Lerner Associates in a big way over alleged unfair sales practices and excessive markups concerning a non-traded real estate investment trust (REIT) known as Apple REIT 10. On Monday, the regulator ordered Lerner to pay $12 million in restitution to clients who bought shares of the non-traded REIT.

David Lerner Associates was the sole distributor of the Apple REITs. According to FINRA, the company solicited thousands of customers and, specifically, targeted unsophisticated investors and the elderly. FINRA says that as Lerner sold the illiquid REIT, it failed to perform adequate due diligence to determine whether the product was suitable for investors.

FINRA noted that in order to sell the Apple REIT 10, David Lerner Associates used misleading marketing materials in which performance information for the closed Apple REITs had been presented without also disclosing that income from those REITs was insufficient to support the distributions to unit owners.

In addition to the $12 million in restitution to clients, FINRA fined David Lerner Associates more than $2.3 million for charging unfair prices on municipal bonds and collateralized mortgage obligations (CMOs) that the company sold over a 30-month period.

The firm’s founder and chief executive, David Lerner, was fined $250,000 and suspended from the securities industry for one year, followed by a two-year suspension from acting as a firm’s principal.  William Mason, the firm’s head trader, was ordered to pay $200,000 and suspended for six months.

“David Lerner and his firm targeted unsophisticated and elderly customers, grossly failing to comply with basic standards of suitability in selling Apple REIT 10 to thousands of customers,” said Brad Bennett, FINRA’s chief of enforcement.

In concluding the settlement, David Lerner Associates and Lerner neither admitted nor denied the charges, but consented to the entry of FINRA’s findings.

The Securities and Exchange Commission (SEC) is putting registered investment advisers who inflate their professional credentials on notice: They may very well be called out for their fabrications.

At a compliance conference held last week by the National Regulatory Services (NRS), the SEC revealed that it is actively reviewing the ADV forms of advisers for what it calls “suspect” information.

“Some of the areas they’re looking at are education, business background, disciplinary disclosures and credentials,” said Marilyn Miles, vice president at NRS, in an Oct. 12 story by Investment News. “They’re not taking [those items] at face value anymore.”

In other words, if an investment adviser lists summa cum laude as part of his or her educational background it’s likely to be independently confirmed by the SEC.

In addition to using the Internet and other filings to verify information, SEC examiners plan to cross-check business experience information listed on Form U-4s and compare it to the ADVs.

On Oct. 2, Vanguard Group announced that some of its mutual funds planned to drop MSCI as the provider of the market benchmarks the funds track and switch to indexes from the University of Chicago’s Center for Research in Security Prices, while six foreign stock funds will begin tracking FTSE indexes.

The news promptly caused MSCI’s share price to tumble. MSCI’s stock price was around $36 in September, but dropped to about $27 following Vanguard’s announcement.

More interesting, however, may be the footnote to the MSCI story. As reported in a blog by the Securities Litigation & Consulting Group, a substantial insider sale took place less than a month before the MSCI/Vanguard news.  The insider was C.D. Baer Pettit. Pettit, according to the Form 4 filed with the Securities and Exchange Commission (SEC), was Head of Index Business at MSCI on Sept. 7, 2012, when the transaction took place.

Pettit sold more 72,000 shares of MSCI – or more than 38% of his ownership. According to the SLCG blog, the average price Pettit received from that sale was $36.61. (The transaction was executed in multiple trades at prices ranging from $36.52 to $36.69.)

The price is nearly $10 more than what Pettit would have received had he waited a few weeks to sell his shares.

MSCI’s closing price on Oct. 1, 2012 was $35.82 and the closing price on Oct. 2, 2012, was $26.21.  The shares Pettit sold on Sept. 7, 2012, would have lost more than $694,572.

Meanwhile, Pettit’s transaction coincidentally accounted for more than 38% of MSCI shares sold by insiders during the 12 months preceding the sale.

Huge financial losses in a group of troubled Morgan Keegan & Co. bond funds affected thousands of investors, including former Chicago Bulls NBA star Horace Grant. In 2009, arbitrators awarded Grant $1.46 million for his losses in the funds. Since then, however, he’s been waging an ongoing court battle to thwart Morgan Keegan’s attempts to overturn the ruling.

Grant and other former Morgan Keegan clients contend the firm owes them millions of dollars after a group of its bond funds suffered massive losses in 2007 and 2008. The brokerage has faced more than 1,000 investor arbitration cases, as well as paid a $200 million civil regulatory fine.

As reported Oct. 15 by the Chicago Tribune, Morgan Keegan is fighting to overturn some of these awards to investors, including Grant’s. Other cases are still in the process of arbitration.

Investors and their lawyers say Morgan Keegan promoted the group of bond funds as safe, even though they had invested in highly risky mortgage-backed securities. The funds ultimately lost as much as 80% of their value following the implosion of the housing market.

Regulators have since alleged that one-time Morgan Keegan fund manager James Kelsoe deliberately inflated the value of the securities. Kelsoe later agreed to pay $500,000 in penalties and be barred from the securities industry by the Securities and Exchange Commission (SEC).

A decision in the Grant case is likely months away. Meanwhile, the former NBA player remains puzzled as to why he must continue to fight a legal battle after Morgan Keegan has paid a fine to regulators over the funds in question and one of its star fund advisers – Kelsoe – was barred from the industry altogether.

Grant noted in the Chicago Tribune article that he has been able to cash in other investments to pay his living expenses, but that other Morgan Keegan customers might not be so fortunate.

“Someone 65 or 70 years old has to go back to work because of Morgan Keegan,” Grant said in the story.

Closed-end bond funds saw some significant losses last week, shining the spotlight once again on the issue of “valuation” and investors’ understanding of the concept.

Just one week ago, shares of many high-yielding closed-ends were trading far above net asset value, or what their underlying assets are worth. Some funds were priced at 20% to 30% above NAV, according to an Oct. 6 article by Barron’s. One fund – Pimco High Income Fund (PHK) – was trading at a 70% premium to NAV.

Last week, Pimco’s $1.5 billion High Income Fund dropped 12.1%.

“These funds are an expensive bet on vehicles that historically have sold near net asset value. The current distortion relates to the hunger for yield at a time when 10-year Treasuries yield a pathetic 1.7%,” writes Barron’s Jacqueline Doherty.

Sixty-six percent of taxable bond funds and 73% of municipal-bond funds trade above NAV now, versus roughly 30% a year ago and in 2006, before the financial crisis, according to Thomas J. Herzfeld Advisors, a closed-end specialist in Miami Beach.

Closed-end bond funds are mainly bought and sold by retail investors. Strong demand for the funds has pushed their share prices higher than the net asset value of the underlying assets. To generate impressive distributions, many closed-end funds turn to using leverage. If interest rates rise, however, or the economy falters, the funds’ investments can quickly deteriorate in value.

More than leverage, some closed-end funds use options and short-selling to enhance their returns. For example, Gabelli Utility relies on auction-rate securities for leverage; Pimco Strategic Global Government Fund (RCS) uses reverse repurchase agreements, and Cushing MLP Total Return Fund (SRV) uses a margin account.

As reported in the Barron’s article, leverage may have enhanced these funds’ returns since the markets bottomed, but it will amplify any losses if the markets turn down.

State regulators are calling on the Securities and Exchange Commission (SEC) to start over on a proposed rule to authorize advertising for private placements.

Two months ago, the SEC put forth the proposed rule on private-placement advertising as part of regulations to implement the JOBS Act. Supporters of the bill contend it is designed to ease financial regulations on start-up companies, as well as help spur economic growth. Critics, however, say the SEC’s proposed rule is too vague and ultimately would be a disservice to investors.

“Lifting the advertising ban on these highly risky, illiquid offerings without requiring appropriate safeguards will create chaos in the market and expose investors to an even greater risk of fraud and abuse,” said Heath Abshure, Arkansas’ securities commissioner and president of the North American Securities Administrators Association (NASAA), in an Oct. 9 story by Investment News.

According to Barbara Roper, director of investor protection at the Consumer Federation of America, the SEC is rushing to advance the proposal in order to meet a congressional deadline.

Meanwhile, NASAA wants the SEC to redo the rule to ensure that an investor is accredited before purchasing shares in a private placement. It also wants to require the filing of Form D before ads are launched.

State securities regulators had harsh words for the Securities and Exchange Commission (SEC) earlier this week over a proposal that would end advertising restrictions on private placements.

Private placements have been at the center of scrutiny by regulators following the debacle involving Medical Capital Securities and Provident Royalties. Both entities were charged with securities fraud by the SEC in July 2009. Both deals, which the SEC has called Ponzi schemes, cost investors dearly: $1 billion in the case of Medical Capital and more than $485 million for Provident Royalties.

The SEC’s new proposal would essentially open the door to general solicitation for private securities issued under Rule 506 of SEC Regulation D. The change is mandated under the Jump-start Our Business Startups Act.

“Overall, we are greatly disappointed in the proposed amendment to Rule 506,” the North American Securities Administrators Association stated in a comment letter, according to an Oct. 3 article by Investment News.

“It fails to give sufficient guidance to issuers, even though that type of guidance is mandated by the JOBS Act, and it fails to implement any protections for investors, even those that would be minimally burdensome to issuers,” the NASAA letter went on to read. “In short, the commission has neglected its duty to both issuers and investors.”

Rule 506 is considered a “safe harbor” for the private offering exemption of Section 4(2) of the Securities Act. Companies using Rule 506 exemption can raise an unlimited amount of money from accredited investors. Currently, the rules do not allow general solicitation or advertising of private offerings. 

State regulators argue that without the advertising prohibition, additional investor protections are needed, such as stricter verification mechanisms to ensure only accredited investors buy private deals.

As investors search for better yields with their investments and firms look for innovative financial products to meet that demand, the potential for sales practices abuses also becomes bigger than ever. Richard Ketchum, Chairman and CEO of the Financial Industry Regulatory Authority (FINRA), recently offered comments on this topic at the Securities Industry and Financial Markets Association’s Complex Products Forum in New York.

In his remarks, Ketchum drew attention to today’s growing array of new and complicated investment products and the importance of customer suitability, financial advisor and investor education, due diligence, and the role they play in the sale of complex products to retail investors.

Among other things, Ketchum said broker/dealer firms that offer products such as private placements, structured notes, non-traded real estate investment trusts (REITs) and inverse and leveraged exchange-traded funds (ETFs) must step up their efforts to supervise sellers at every stage of the investment process.

“In the words of the great American philosopher, Casey Stengel: “Most ball games are lost, not won,” Ketchum said. “A baseball game is more likely lost through unforced errors, poor judgment and boneheaded play. Often, the team’s management will properly be held accountable. As we have seen in recent years, a firm that becomes unduly aggressive about the products it sells will forfeit its reputation, its customers and, ultimately, its market share.”

Ketchum noted the need for continuing education for financial advisers who sell complex investments to make sure they are qualified to do so. He also advised firms to more closely review any special incentives provided to their advisers and whether those incentives influence their recommendations or selling methods.

Ketchum concluded his remarks by calling for a heightened awareness on the part of advisors to ensure customers who purchase complex products understand their basic features.

“Some firms only permit the sale of these products to customers who are qualified to trade options,” Ketchum said. “The sale of complex products through discretionary accounts is a particular issue. As we have repeatedly stated, financial advisers should discuss the basic features of these products with retail customers, and include in the discussion the potential risks of those products under different market scenarios. Other additional steps might be needed to ensure that the recommendation of the structured note is consistent with the investment objectives and risk tolerance of particular customers.”

Non-traded real estate investment trusts (REITs) and the ways in which broker/dealers market and sell them to investors are facing increased scrutiny by the Financial Industry Regulatory Authority (FINRA).

FINRA has issued several Investor Alerts on non-traded REITs over the past two years, with examiners ramping up efforts to investigate the sales practices of sellers of the products. As reported Oct. 1 by Investment News, FINRA found shoddy due diligence at several firms in those investigations, as well as a failure of some to heed the red flags that existed prior to selling the products to investors.

Non-traded REITs were the focus of a speech made Sept. 27 by Susan F. Axelrod, FINRA’s Executive Vice President, Member Regulation Sales Practice, for the Securities Industry and Financial Markets Association’s Complex Products Forum. In her comments, Axelrod stated that investigations by FINRA examiners found many non-traded REIT investors to be confused about the features, fees and liquidity of non-traded REITs, as well as the distribution structure and the fact that there’s no guarantee distributions will continue in the same amount or at all.

Axelrod also noted that some firms failed to conduct adequate training for brokers who sell non-traded REITs. In other instances, Axelrod says FINRA examiners uncovered misrepresentations of the product’s features, including information on distributions and share values, in the advertising, sales literature and correspondence between brokers and investors.