• Broker-Dealer Use Only Materials.  Broker-dealer use only materials must be submitted to the staff prior to use.
• Risk Disclosure.  As appropriate, the staff has asked NTRs to reformat their sales material to relocate risk disclosure from the last page of the materials to a more prominent location, to present the risk disclosure within the text rather than a footnote, or to increase the font size of risk disclosure so it is not smaller than the font used to describe the potential benefits of the investment.
• Distribution Coverage.  For marketing materials including distribution information, the following disclosure should be included:
  • the frequency with which, and the extent to which, the NTR has funded distributions from sources other than cash flows from operations determined in accordance with US GAAP; and
  •  the primary sources of cash, other than cash flows from operations determined in accordance with US GAAP, that the NTR has used to fund the distributions, such as offering proceeds or borrowings.
• Prior Performance.  With respect to prior performance disclosure, there should be clear differentiation of prior performance of affiliated programs from the program being offered as well as balanced disclosure of successful programs with less successful programs and material adverse business developments.
• Property Pictures.  The staff often requests that pictures of properties that the NTR does not own be removed from sales materials; for newly-formed NTRs, when pictures of properties owned by the sponsor are included, presentation of these pictures should be limited and prominent explanatory disclosure included.
• Redemption Programs.  NTRs should present balanced disclosure on redemption programs including restrictions, limitations, and information on whether a NTR has not satisfied all investor redemption requests.
• Non-GAAP Financial Measures.  All sales materials should comply with Regulation G related to non-GAAP performance and liquidity measures.
• Market Performance Data.  NTRs should refrain from presenting data that relates to markets different than those targeted by their investment strategy, or clarify distinctions.  Specific guidance is presented relating to use of NCREIF data; NTRs should describe material differences between NCREIF data and their portfolio, such as the fact that NCREIF data reflects the returns of a blended portfolio of institutional quality real estate and does not reflect the use of leverage or the impact of management and advisory fees.
• Volatility.  Unless the offering price is based on a valuation of the security, the staff objects to statements indicating that a static offering price evidences no volatility in the value of the security and requires removal of statements in the sales material that suggest a static offering price indicates a stable investment.
• Liquidity.  NTRs that disclose in their sales material that they intend to list their securities or liquidate their portfolio by an approximate date should clearly state in their discussion of the intended timeframe for a liquidity event that the actual date of the liquidity event may differ significantly and is at the discretion of management.

Interestingly, with respect to distributions, the staff indicated that “if earnings repeatedly have been insufficient to cover distributions, we ask registrants to disclose that fact in the sales material.”  Based on the context of this comment, it is unclear whether this disclosure is required only when disclosure on distributions is already contained in sales materials, or in all situations where the comment applies.

Clearly, the SEC is focused on the NTR industry.  We hope issuers heed this guidance and continue to improve disclosures to broker-dealers and investors.  Better understanding of the benefits and risks of investing in NTRs can only serve to strengthen the industry.

• Balboa – this complaint indicates that a fund portfolio manager, Balboa, was able to inflate fund returns despite using an outside administrator and auditor.  Balboa accomplished this by feeding phony mark-to-market quotes to purportedly independent brokers, which fed these quotes to the third-party administrator and auditor.  It appears the fraudulent quotes were being used in the months leading up to the fund’s collapse in October 2008.  The complaint indicates that fund offering memoranda highlighted the independence of the third-party administrator and its responsibility to value the fund’s entire portfolio and did not indicate that valuations could be supplied by management. Interestingly, the investments in question were Nigerian payment adjustment warrants and Uruguayan value recovery rights, which are generally illiquid and traded OTC.
• Kapur – this complaint is based on a much simpler set of circumstances.  The principal of the manager of the funds involved in this complaint had sole responsibility for performance reporting, a clear conflict of interest.  A third party was never engaged to independently verify or generate performance data, indicating a clear operational weakness.
• Rooney – this manager allegedly invested a significant portion of fund assets into a financially troubled microcap company for which the manager served as chairman.  This investment was not disclosed, resulting in misrepresentation of the fund’s portfolio and investment strategy to investors, which indicated that the fund’s investments were diversified.  This highlights the need to examine a fund’s actual holdings rather than relying on management’s representations of investment strategy and portfolio composition.  Apparently, 80% of fund assets were invested in the single microcap stock, a clear red flag.
• Leaddog Capital Markets – among the cornucopia of alleged misrepresentations cited in this administrative proceeding, the key issue here was again misrepresentation of the nature of the portfolio to indicate that positions were liquid and could be marked-to-market daily, when in fact the majority of the portfolio consisted of illiquid microcap companies, each of which had received “going concern” opinions from auditors and most of which were owned or controlled by management or affiliates.  Similar to the Rooney matter, an examination of the fund’s portfolio could have revealed the discrepancy between management’s representations and reality.  Unfortunately, an investor who did attempt to conduct due diligence prior to investing in this fund did not receive audited financial statements until after he made an investment, at which point he realized that management’s statements about liquidity were false, but he was unable to redeem his investment.  Further, although the fund’s financial statements were audited, management misrepresented facts to the auditor, indicating there were no undisclosed related party transactions, and as a result the auditor issued an unqualified opinion; this highlights the fact that the existence of an audit does not always guarantee absence of fraud.  When the auditor learned of management’s omissions, it issued a retraction letter and resigned.

These cases illustrate some of the many ways that unscrupulous fund managers attempt to defraud investors.  While reasonable due diligence cannot be expected to ferret out every type of fraudulent activity, cases such as these provide valuable lessons on both the importance of due diligence and areas on which it should focus.

…The larger importance of this story relates to the effectiveness of the Dodd-Frank, Sarbanes-Oxley regulatory model.  Americans have been told that, in response to the 2008 financial crisis that regulators failed to predict or prevent, regulators needed to have vast new powers to prevent the next crisis.  But in MF Global the regulators failed the law’s first serious test.

So who was watching MF Global in this case?  The list is long:

• MF Global, Inc. is a registered broker-dealer (ultimately regulated by the SEC) and a FINRA member firm (CRD# 6731) – interestingly according to its BrokerCheck (as of December 1, 2011) it had reported 35 disclosure events and three arbitrations;
• MF Global, Inc. is a registered futures commission merchant and commodity pool operator (ultimately regulated by the CFTC) and a member of National Futures Association (a self-regulatory organization with delegated authority from the CFTC), a search on the NFA’s BASIC database on December 1, 2011 indicated a number of regulatory actions, arbitration awards and CFTC reparations cases;
• MF Global Holdings Ltd is a traded public company, subject to various reporting, corporate governance and regulatory compliance requirements, including the requirements of the Sarbanes-Oxley Act of 2002 and the SEC rules and regulations implementing that Act, the Exchange Act, the NYSE listing standards and regulatory requirements such as the BASEL II capital adequacy framework and the Markets in Financial Instruments Directive. (see page 45 of its annual report on Form 10-K);
• MF Global was one of 20 primary dealers authorized to trade U.S government securities with the Federal Reserve Bank of New York (see page nine of its quarterly report on Form 10-Q);
• MF Global’s subsidiaries are members of various international commodities, futures, and securities exchanges in Europe and the Asia Pacific region and accordingly are subject to local regulatory requirements including those of the U.K. Financial Services Authority (see page nine of its quarterly report on Form 10-Q).

The failure of MF Global despite this degree of regulatory oversight highlights the fact that just because an entity is regulated one cannot assume that it is being operated in a sound, compliant manner.  Regulators establish rules under which entities they regulate must operate, and may periodically review regulatory filings or examine entities for compliance.  They do not have the resources, and it is typically not in their mandate, to carefully scrutinize all disclosures by and activities of regulated entities on a continuous basis, however.  This affirms the need for careful, detailed due diligence prior to entering into a transaction, regardless of the level of regulatory oversight.

• The name (Altus Group U.S., Inc.) of the third party firm engaged in connection with the valuation and the procedures and standards it followed;
• The respective roles of Altus, the advisor, and the board in determining the value;
• The methodology used in determining value, which was a net asset value rather than an enterprise value;
• A breakdown of the key components (real estate, debt, other) of the valuation; and
• The key assumptions used in the discounted cash flow models to estimate the value of the REIT’s real estate assets, and the sensitivity of changes in the real estate valuation to changes in the discount rate assumption.

While the disclosure is not exceedingly detailed, it does provide the reader with significantly more transparency than previous disclosures by non-traded REITs.

If adopted, FINRA Rule 5123 would require that broker-dealers that offer or sell certain types of private placements, or participate in the preparation of PPMs, term sheets or other disclosure documents in connection with those private placements, provide disclosures to each investor prior to sale of the anticipated use of offering proceeds, the amount and type of offering expenses and offering compensation.  FINRA Rule 5123 also would require that the PPM, term sheet or other disclosure documents and any exhibits be filed with FINRA no later than 15 calendar days after the date of the first sale, and any material amendments to the document, or any amendments to the disclosures mandated by the rule, be filed no later than 15 calendar days after the document is provided to any investor or prospective investor. The rule would require that each member that participates in a private placement make the requisite filings.

The rule would exempt from its requirements certain types of private placements, including those sold to institutional accounts, qualified purchasers, qualified institutional buyers, and investment companies, among others. In addition, it would exempt certain types of offerings, including offerings of certain “exempted” securities as defined in specified sections of th1933 and 1934 Acts; offerings of certain variable contracts and guaranteed annuity contracts; offerings of securities issued in conversions, stock splits and restructuring transactions that are executed by an already existing investor without the need for additional consideration or investments on the part of the investor; offerings of non-convertible debt or preferred securities by issuers that meet the eligibility criteria for incorporation by reference in Forms S-3 and F-3; and offerings of securities of a commodity pool operated by a commodity pool operator.  It would generally apply, however, to traditional offerings of equity or debt securities to retail investors.

FINRA originally proposed to expand existing Rule 5122, which applies to “member private offerings,” to cover a broader range of offerings.  After a period of comments on the original proposal, the new proposal reflects several significant changes, including elimination of a proposed requirement that 85 percent of the proceeds raised be used for the business purposes described in the disclosure document and modification of a proposed requirement that a member file information with FINRA by the time an offering document is provided to any investor so that it would now be a post-sale filing requirement.

While the proposal dropped any substantive regulation of the use of proceeds, it is noteworthy that the proposing release states that “FINRA continues to believe that the manner in which offering proceeds are used is critically important in a private placement – and that offerings in which a large percentage of offering proceeds are for other than business purposes raise regulatory concerns – FINRA believes that these concerns can be addressed through the obligations of broker-dealers, under the suitability and anti-fraud provisions of the securities laws and FINRA rules, to conduct a reasonable inquiry of an issuer.”  In the context of due diligence and suitability analysis it is important for broker-dealers to assess not only the disclosure concerning use of proceeds but also the substance of how they are used.

Comments on the proposal must be submitted to the SEC no later than 21 days following publication of the proposal in the Federal Register.  The implementation date will be no more than 180 days following SEC approval.  The SEC release relating to the proposal may be found by clicking on the following link: http://www.sec.gov/rules/sro/finra/2011/34-65585.pdf.

A conservative approach would be to calculate cap rates based on the “all-in” cost of a property and either the trailing 12-month actual cash NOI or estimated first-year cash NOI based upon first-year rental income under in-place leases.  A number of non-traded REITs are not doing this, however, and instead are using methodologies that may result in higher cap rates. For example,

• Many issuers present “unloaded” cap rates, which use the contract purchase price of the property rather than the overall cost of the acquisition, including acquisition fees and expenses.  By ignoring these real costs, the denominator is smaller than it otherwise would be, resulting in a higher cap rate and thus the appearance of a higher yield on the investment.
• Some issuers are presenting “average” cap rates, which use an accrual  version of NOI that reflects straight-lining of rents.  This means that an average annual rent is calculated taking into account rent increases over the life of a lease.  As a result, the NOI used in calculating the cap rate can be significantly higher than the cash  NOI will be in the first year following the acquisition, resulting in a higher cap rate than if historical or first year cash NOI were used.
• Some issuers are presenting cap rates based on “projected” NOI, without disclosing historical NOI or the assumptions that go into the projected NOI.  For example, issuers have indicated they made assumptions relating to “timing and rental rates related to re-leasing vacant space” and expenses based on the “operating history of the property and [the issuer’s] plans and projections for operation of the property.”  Without knowing what the assumptions are, it is difficult to tell whether a reported cap rate is realistic and whether it is substantially higher than those that would result from a calculation based on in-place leases.

The cap rate is an important analytical tool in evaluating a non-traded REIT, particularly when it comes to its ability to cover its distributions.  It is a positive development that many non-traded REITs have begun disclosing acquisition cap rates; however, they are taking a varied approach to what they mean by cap rates.  Disclosure appears to have improved somewhat –rather than simply disclosing a cap rate, there typically is a general description of how the reported rates are calculated.  However, more detailed disclosure might further enhance the ability to assess how meaningful the disclosed rates are.  Those who read non-traded REIT filings should be cautious before reaching conclusions based on disclosed cap rates without making sure they have a full understanding of the underlying calculations and assumptions.  Further, when using cap rates to assess ability to pay distributions, keep in mind that most cap rates do not include the impact of organizational and offering expenses, capital expenditures, REIT-level expenses or leverage.

Kurcias, Jaffe & Co. LLP (“Kurcias Jaffe”) acted as the independent auditor for the Globex Fund from 2001 through February 2009, during which time Mr. Joseph F. Sofo acted as the audit engagement partner responsible for the annual audit of the financial statements of the Globex Fund.  The SEC indicated that Kurcias Jaffe had no expertise in conducting an audit of a hedge fund prior to its acceptance of the Globex Fund as a client.

According to the SEC, the Globex Fund purported to keep the majority of its holdings in a related entity, under the common control of Mr. James M. Peister.  From 2003 until April 2009, Mr. Peister and the general partner of the Globex Fund (also controlled by Mr. Peister) intentionally overstated the assets of the Globex Fund.  During 2005 and 2006, the Globex Fund claimed to have held approximately $10.8 million and $13.2 million in its affiliate, respectively; however, the actual total assets held in the affiliate for 2005 and 2006 were $65,000 and $73,000, respectively.  Mr. Peister concealed the true financial condition of the Globex Fund, in part, by keeping its affiliates’ bank and brokerage statements secret from the auditors.

The SEC found that Mr. Sofo was aware of the common control exerted by Mr. Peister over the Globex Fund and its related entities, but made limited and flawed attempts to obtain independent confirmation of the fund’s financial information, which did not satisfy the requirements of GAAS.  The SEC went on to state that Mr. Sofo had “failed to exercise due professional care, professional skepticism, and failed to obtain sufficient competent evidential matter to support Kurcias Jaffe’s unqualified audit opinions.”

This action by the SEC reminds us that while independent audits are an important part of assessing the integrity of a fund’s financial information, it is generally not prudent to rely conclusively on the fact that an audit has occurred; financial statements and performance information may require additional scrutiny, particularly when the stated results raise red flags such as, in this instance, “claims of extraordinarily consistent returns.”  In addition, the size, reputation and expertise of an audit firm should be considered when judging the reliability of an audit opinion.  While the size of an audit firm should not be viewed as indicative of the quality and accuracy or the work it produces, additional scrutiny may be required when reviewing financial statements audited by smaller firms, firms that are not registered with the Public Company Accounting Oversight Board and firms with limited expertise with the type of fund being audited.

“The Board considered amendments to the customer account statement rule to revise the manner in which broker-dealers report estimated per share values of non-traded REITS and direct participation programs on their customer account statements. The proposed amendments would (1) require, if par value is shown, that it be netted by the up-front fees and expenses that are deducted from the offering proceeds, (2) permit broker-dealers to use par value only under the initial offering period, and not during a second offering period, and (3) clarify that if the broker-dealer has reason to believe that the estimated per share value in the annual report is inaccurate, then the broker-dealer must remove that value from its account statements.

The Board authorized staff to issue a Regulatory Notice requesting comment on the proposed amendments.”

“The estimated value was determined by the use of a combination of different indicators and an internal assessment of value utilizing internal financial information under a common means of valuation under the direct capitalization method.  No independent appraisals were obtained. Specifically, the estimate of the estimated per-share value was made with primary consideration of the valuation of the Company’s real estate assets which was determined by the Company’s management using methodologies consistent with publicly traded real estate investment trusts in establishing net asset values, and the estimated values of other assets and liabilities determined by the Company’s management as of March 31, 2011.”

As disclosed on page 26 of its Form 10-K for the year ended December 31, 2010, Inland Western’s last reported value of $6.85 was dated as of December 31, 2009, and, it disclosed that as it intended to pursue the initial listing of its existing common stock on a national securities exchange within the next 12 months, it was not planning to publish an estimated annual statement of value of its common stock as of December 31, 2010.

Here is a link to Inland Western’s Form 8-K:

http://www.sec.gov/Archives/edgar/data/1222840/000110465911035529/a11-15223_18k.htm

In making its determination of value, the board considered (i) valuations of Hines REIT’s real estate investments provided by management and unidentified “independent third parties,” (ii) valuations of notes payable provided by an unidentified “independent third party,” and (iii) estimated values of other assets and liabilities determined by management.  Hines REIT engaged an independent third party to review management’s market value estimates for selected assets that represented a substantial portion of its property portfolio, and the third party opined that management’s market value estimates are fair and reasonable.  Hines REIT does not disclose specifically how the value was determined; rather, it includes general statements such as the estimate was made with consideration of “valuations of the Company’s real estate investments, including estimates of value which were determined by the Company’s management and independent third parties using methodologies that are commonly used in the commercial real estate industry (including discounted cash flow analyses and reviews of current, historical and projected capitalization rates for properties comparable to those owned by the Company)[.]”

Beginning with distributions previously declared for April, May and June of 2011, which will be aggregated and paid in July 2011, participants in Hines REIT’s dividend reinvestment plan will acquire shares at a fixed price of $7.78, rather than the previous DRIP price of $9.58.

Hines REIT declared distributions for the month July 2011 at the same rate as prior distributions (5% based on a purchase price of $10.08).  A portion of the July 2011 distributions will be designated as a special distribution and a return of capital, representing a portion of the profits from sales of investment property.

In the Form 8-K filed on May 26, 2011, Hines REIT also announced that its advisor has agreed to waive a portion of the monthly asset management fee for the period from July 1, 2011 through December 31, 2012, such that the fee will be reduced from 0.75% to 0.50% (on an annual basis) of the net equity capital Hines REIT has invested in real estate investments.