The Massachusetts Securities Division has filed a regulatory action against LPL Financial, LLC (“LPL”), seeking full restitution and other relief for investors residing in Massachusetts who were sold non-traded real estate investment trusts (REITs) in violation of Massachusetts law.  The regulatory action stands out because it finds fault with sales of several non-traded-REITS, more as a category criticism.  This approach contrasts with efforts of other regulators, such as FINRA’s regulatory actions and sanctions imposed upon David Lerner Associates for its sale of just one non-traded REIT product, known as the Apple REITs.  Let’s examine the common threads that bind the multiplicity of non-traded REITs products which Massachusetts securities regulators allege as being problematic.

Allegedly motivated by 6% commissions, LPL advisers sold the non-traded REITs without, for example, providing a prospectus, as well as being in violation of particular REIT requirements, Massachusetts law, and LPL’s own internal compliance procedures.  Further, sales of non-traded REITs were not suitable for investors in view of their investment objectives, risk tolerance, income requirements and liquidity needs.

In particular, there were several general features applicable to all REITs (publicly traded, non-exchange traded, and privately traded) with which Massachusetts securities regulators take issue.  First, REITs “are often entirely illiquid.”  Second, REITs must distribute at least 90% of their taxable income, “however in instances where income does not meet distribution demand, REITs often resort to paying distributions out of borrowed money.”  Those and other features of REITs, the regulators conclude, make the products “a widely misunderstood investment vehicle.”

Non-traded REITs, the regulators allege, are more problematic still.  They “are especially risky through limited redemption programs, high fees and commissions, and internal conflicts of interest.”  Commissions and fees can range from 15% to 18%.  And regarding conflicts of interest, the regulators conclude, “At their core, non-traded REIT products operate through an immensely complex affiliated and subsidiary structure rife with conflict.” 

Those shortcomings require “comprehensive supervision and training”, yet with that Massachusetts regulators conclude that LPL was like “a boat with many holes.”  While “on paper”, LPL “set forth stringent requirements for the sale of non-traded REITs”, in practice LPL allegedly failed in its review of sales of the product.  The prospectus requirement “was overlooked” numerous times.  And the regulators’ complaint notes that many of the non-traded REITs contained in the prospectus a 10 percent concentration (of net worth or liquid net worth) limitation.  Likewise, certain non-traded REITs contained limitations with regard to income requirements.  The regulator also points out that certain non-traded REITs contained even higher liquid net worth, net worth and annual income requirements for Massachusetts residents. 

Yet, the regulators conclude, LPL advisers were “under-educated and under-supervised” with respect to non-traded REIT transactions.  The regulators noted that LPL maintained on paper a document entitled, “LPL’s Alternative Investment Due Diligence Process”, which purported to set forth a system of supervisory review and approval.  Additionally, LPL compliance manuals provided specific requirements and were accompanied by LPL’s written supervisory procedures.  Yet the regulators conclude that, contrary to the LPL’s claims, they were not followed.

The results of LPL’s deficiencies are astounding.  Of the 597 transactions that Massachusetts regulators reviewed, 569 of those transactions violated prospectus requirements, and 77 of those violated concentration requirements imposed by Massachusetts law.  In short, 95% of the sales violated either prospectus requirements or Massachusetts law!

The regulators focused their review on following non-traded REITs: Inland American, Cole Credit Property Trust II, Cole Credit Property Trust III, Cole Credit Property 1031 Exchange, Wells Real Estate Investment Trust II, W.P. Carey Corporate Property Associates 17, and Dividend Capital Total Realty.

Investors must beware of non-traded REITs.  As the LPL decision demonstrates, they are alternative investments not worth the risk.