On October 10, 2014, the SEC approved FINRA’s proposed changes to NASD Rule 2340 and FINRA Rule 2310 regarding valuations and customer statements. SEC approval means that the proposed rule is consistent with the Security and Exchange Act’s requirements. While separate, these two rules are linked, and affect both broker dealers and their clients. These new rules become effective April 11, 2016.
NASD Rule 2340
Currently, NASD Rule 2340 requires broker dealers to send account statements to its customers at least quarterly. These statements must include an estimated value for each non-traded real estate investment trust (ntREIT) and direct participation program (DPP) investment held in the customer’s account. The current rule allows the broker dealer to report the original purchase price as the value of the investment until an estimated value is reported by the issuer, which is required to occur no later than 18 months after an offering closes. The methodology to be used for that valuation is under Rule 2310.
Summary of Changes
Under the new SEC-approved rule, the broker dealer must include an estimated per share value, provided that the valuation is reliable, and certain disclosures on a customer account statement. The new rule defines two valuation methodologies that are presumed reliable.
Net Investment Method
This methodology may be used any time from the offering’s effective date until 150 days following the second anniversary of the offering breaking escrow.
The “net investment” disclosed by the Issuer Report may be used if it is based:
- on the “amount available for investment” percentage in the “Estimated Use of Proceeds” section of the Prospectus; or
- on another equivalent disclosure showing the estimated percentage of sales commissions, dealer manager fees, and estimated offering and organization expenses deducted from the aggregate purchase price.
If a range of amounts available for investment is provided, the maximum amount may be used unless the broker dealer has reason to believe that that percentage is unreliable. In that case, the minimum amount must be used.
Disclosure using Net Investment Method
If this methodology is used, the broker dealer must include a specific disclosure that states “IMPORTANT – Part of your distribution includes a return of capital. Any distribution that represents a return of capital reduces the estimated per share value shown on your account statement.”
Appraised Value Method
This methodology can be used at any time if an appraised valuation is disclosed in the Issuer Report.
The appraised value may be used if:
- It is based on valuation of the assets and liabilities of the offering, performed at least annually, by or with the material assistance or confirmation of a third party valuation expert or service; and
- Is derived from a methodology that conforms to a standard industry practice.
Disclosure using Appraised Value Method
This methodology does not have a specific disclosure. However, regardless of the methodology used, the customer account statement must disclose that such securities are not listed on a national securities exchange, are generally illiquid, and even if a customer is able to sell the security, the price received may be less than the per share estimate value provided in the account statement
If the broker dealer is able to show that the estimate per share value was not developed in a reasonably reliable way, not created using the methodologies presumed reliable for example, then it does not have to include an estimated per share value for that security on the customer account statement.
FINRA Rule 2310
A broker dealer is not allowed to participate in a public offering of securities in a ntREIT or DPP unless the program’s general partner or sponsor will disclose a per share estimated value, the method used, and the date of the data used to develop the value in its annual investor report.
Summary of Changes
Going forward, a broker dealer shall not participate in a public offering of securities in a ntREIT or in a DPP that is not subject to the requirements of the Investment Company Act of 1940 unless the Issuer has agreed to disclose:
- a per share estimated value that is developed in a manner reasonably designed to ensure reliability (as described above);
- the methodology used to develop that valuation;
- the date of the valuation; and
- and within 150 days following the second anniversary of the security breaking escrow, an Issuer Report containing a per share estimated value that:
- Is based on valuation of the assets and liabilities of the DPP or REIT performed at least annually, by or with a third party valuation expert or service;
- Is derived from a methodology that conforms to a standard industry practice; and
- Is accompanied by a written opinion or report of the issuer, delivered at least annually, that explains the review’s scope, the valuation methodology, and the basis for the reported value.
What Does This Mean?
We’ve finally received clarity on future changes to customer account statements that reflect values of ntREITs and DPPs. This process began in 2011, and since that time, FINRA issued several proposals before settling on the changes to Rules 2340 and 2310 as outlined above. If you ever doubt the ability of regulators willingness to collaborate with an industry during the rulemaking process, then look no further than the process leading to these changes as evidence that collaboration is possible. The dialogue between FINRA and leading industry firms and associations clearly shaped how the final rule was written. Previous proposals contained provisions that would have been difficult to administer, with the potential to create more confusion than necessary. The associations lead the charge in opposition to these provisions, and FINRA listened.
Now that firm rules are in place, we can begin to test both the existing and new product structures against the rules to measure output on client statements. Fortunately, since the industry knew of FINRA’s intention to make changes, a period of “research and development” of new products began in 2011. The Daily NAV and multi-share class products are a result of this R&D process, and we may see more innovation in the coming months. You can rely on FactRight to continue assisting your firm in understanding new products structures, and how these new rules apply to them.
Remember, these rule changes apply only to FINRA member firms, not product sponsors. We advise all broker/dealers to reach out to their non-traded REIT product sponsors and begin a dialogue on how they plan to adjust their product structures in response to the changes. The changes to product structure will continue, and more than ever before, broker/dealers need to be informed and advised on these changes.
- The net investment method of Rule 2340 won’t be an easy, straightforward application, and guidance is needed on many issues. The rule places a burden on firms if they have reason to believe the percentages outlined in the estimated use of proceeds are unreliable. Firms cannot “set it and forget it”. BDs need to maintain constant oversight on the actual use of proceeds if using the net investment methodology for statement valuations.
- The appraisal methodology provision is vague, but for good reason. When valuing shares, sponsors may use a methodology that conforms to “standard industry practice” when valuing shares of a ntREIT. Uncertainty remains about what qualifies as “standard” when valuing these shares. This approach is needed, however, to cover the variety of assets that may be acquired by ntREITs.
- Advisors NEED information and education on the coming changes. The new rule will impact ntREITs and DPPs upon its effective date and does not have a “grandfather clause” for products that began raising capital prior to that date. Educational initiatives should begin in 2015.