Articles Posted in Suitability

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Money MazeOn September 25, 2017, the Financial Industry Regulatory Authority (“FINRA”) issued a fine of $3.25 million against Morgan Stanley Smith Barney LLC (“Morgan Stanley”) in connection with the brokerage firm’s alleged failure to supervise its brokers’ short-term trades of unit investment trusts.  Unit investment trusts (“UITs”) are a specific type of Investment Company, as defined by the Investment Company Act of 1940 (the ’40 Act), and subject to regulation by the SEC.  Unlike mutual funds, closed-end funds, or ETFs, UITs are unique in that they are created for a specific, limited time period (e.g., 24 months).  Furthermore, UITs consist of a static investment portfolio as part of a pre-selected pooled investment vehicle.

Typically, UITs impose a number of charges.  Some of these charges include a deferred sales charge, a creation and development fee, as well as annual operating expenses charged as an annual fee to account for portfolio administration and bookkeeping.  In aggregates, these various fees might total approximately 4% for a typical 24-month UIT.  Thus, any investor in a UIT will experience a “drag” on the performance of their UIT portfolio in the form of various fees.

Because UITs carry a substantial fee structure and are subject to termination after a given time period, there exists the potential for some financial advisors to recommend to their clients that they roll-over, or switch, from one UIT to another.  In its worst form, this sales practice amounts to a stock broker seeking enhanced income through switching clients out of one product to another on a short-term basis in order to earn commissions and fees, at the expense of the client.

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Money in WastebasketBank of America Merrill Lynch’s (“Merrill Lynch”) brokerage unit offered Strategic Return Notes (“SRNs”) to customers, resulting in losses of as much as 95% of the principal invested.  First issued in November 2010 and maturing November 27, 2015, the SRNs were designed to be linked to Merrill Lynch’s own proprietary volatility index (the “VOL”) which was designed to calculate the volatility of the S&P 500 Index.  The SRNs, which were issued at $10 per share, ultimately matured at just $0.50 per share.  Thus, investors in Merrill Lynch’s proprietary SRN’s were subjected to an enormous 95% loss on their principal investment.

In recent years, many investors have been solicited by their financial advisor to purchase so-called structured notes, which are often presented to customers as a higher-yielding, but still relatively safe alternative to fixed-income investments such as bonds.  Structured notes are issued and backed by financial institutions.  As hybrid products containing both a bond component and an embedded derivative, structured notes are designed to provide an investor with a return based on an equity index (or some other benchmark), as opposed to an interest rate typically associated with a traditional bond investment.

In theory, a structured note is supposed to provide an investor with an opportunity to earn enhanced income (in excess of the very low interest rates offered in the current environment on most bond investments), while also providing some downside cushion.  In practice, however, many structured notes engineered by various investment banks and sold by their brokers have proved to be horrendous investments.

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Apartment  BuildingAs recently reported, on September 20, 2017, the Enforcement Section of the Massachusetts Securities Division (the “Division”) filed an Administrative Complaint (“Complaint”) against SII Investments, Inc. (“SII”) (CRD# 2225) in connection with the brokerage firm’s marketing and sales of non-traded REITs to certain Massachusetts investors.  SII is an independent broker-dealer within National Planning Holdings, which was recently acquired by Boston-based LPL Financial.

The Complaint essentially alleges that for the past several years, SII has engaged in “[d]ishonest and unethical conduct and failed to supervise its agents by allowing systemic inflation of its clients’ liquid net worth while maintaining contradictory and unclear rules related to the purchase of non-traded real estate investment trusts… .”  Of significance, Massachusetts securities regulations mandate that “[n]o more than 10% of a client’s liquid net worth can be concentrated in one specific non-traded REIT and no more than 20% of a client’s liquid net worth can be concentrated in non-traded REITs in general.”

According to the Complaint, SII’s own internal policies and procedures also would also appear to have been violated by some of SII’s alleged conduct.  For example, on SII’s own suitability and disclosure forms used for the sales of non-traded REITs, the full value of variable annuity products was listed as part of a client’s liquid net worth.  However, as referenced in the Complaint, SII’s own “[C]ompliance Guide states ‘There must not be any representation or implication that variable annuities are short-term, liquid investments.  Presentations regarding liquidity or ease of access to investment values must be balanced by clear language describing the negative impact of early redemptions.’”

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Building DemolishedInvestors who purchased shares in United Development Funding IV (“UDF IV”) upon the recommendation of their financial advisor – pursuant to a misleading sales presentation or if the recommendation to invest lacked a reasonable basis or was otherwise unsuitable – may be able to recover their losses in FINRA arbitration.  UDF IV is one of a number of successive funds offered by the real estate finance limited partnership, United Development Funding (“UDF”), headquartered in Grapevine, TX.  UDF IV was formed as a Maryland REIT in May 2008.  By December 31, 2012, UDF IV had issued 17,642,839 common shares in exchange for gross proceeds of approximately $352.5 million.

Unlike other non-traded UDF funds, UDF IV is unique in that, while it was initially distributed as a non-traded REIT, in June 2014 UDF IV went public and listed its shares (NASDAQ: UDF, now OTC: UDFI).  UDF IV operates as a real estate investment trust (“REIT”), focusing on originating, purchasing, participating in, and holding investment secured loans for the acquisition and development of parcels of real property as single-family residential lots, as well as the construction of new homes and the development of mixed-use master planned residential communities.

By late 2015, following allegations of misconduct by a Dallas hedge fund manager, UDF’s share price suffered a severe decline.  The allegations raised concerned the overall UDF business model and called into question whether the UDF enterprise was propping up poorly performing investments in earlier funds with new investor capital raised from later fund vintages.

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Building DemolishedInvestors who purchased shares in the publicly registered non-traded REIT United Development Funding III (“UDF III”) upon the recommendation of their stockbroker or financial advisor may be able to recover their losses in FINRA arbitration if the recommendation to purchase shares lacked a reasonable basis or the nature and characteristics of the investment were misrepresented.  UDF III is one of a number of successive funds offered by the real estate finance limited partnership, United Development Funding (“UDF”), headquartered in Grapevine, TX.  Formed as a Delaware limited partnership in June 2005, UDF III, according to its publicly filed Registration Statement, was “… formed primarily to generate current interest income by investing in mortgage loans.”  By April 2009, UDF III had completed its securities offering, having raised net proceeds of approximately $290.7 million.

Following allegations of misconduct by a Dallas hedge fund manager, the share price of UDF III suffered severe decline in late 2015.  These allegations by the hedge fund manager concerned UDF and its various funds, including UDF III, allegedly exhibiting potential signs of a Ponzi scheme, including propping up poorly performing investments in earlier funds with new investor capital raised from later fund vintages.  By November 30, 2015, UDF III filed an involuntary bankruptcy petition in the U.S. Bankruptcy Court for the Western District of Texas against UDF III’s largest non-affiliated borrower.

Many investors in UDF III have come to learn of the many risks inherent in investing in a non-traded REIT.  To begin, a non-traded REIT is generally a very illiquid investment vehicle, given the fact that its shares do not trade on a national exchange.  As such, when investors seek to exit their position, they may only do so by redeeming their shares directly with the issuer (often such redemptions are limited in terms of when they may occur, and in what amount), or through attempting to sell shares on a limited and fragmented secondary market.

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Piggybank In A Cage As recently reported, the Woodbridge Group of Companies, LLC (“Woodbridge”) of Sherman Oaks, CA, continues to face considerable regulatory scrutiny in connection with allegations of offering and selling unregistered securities.  To date, Woodbridge has been the subject of investigations by state securities regulators in Arizona, Texas, Massachusetts, Pennsylvania, and Michigan.  Several of these investigations have resulted in regulators issuing cease-and-desist orders, requiring Woodbridge to stop offering and/or selling unregistered securities, and further, to stop otherwise violating applicable securities laws.

As of mid-November 2017, Woodbridge has settled regulatory actions in Pennsylvania, Texas and Massachusetts.  The company, which has offered a number of various Woodbridge Mortgage Investment Funds (“Woodbridge Funds”), has marketed so-called “First Position Commercial Mortgages” (or “FPCMs”) to investors nationwide through issuing promissory notes in exchange for investments backing certain hard money loans secured by commercial real estate.

At the federal level, for the past year the Securities and Exchange Commission (“SEC”) has also been investigating Woodbridge.  Specifically, according to a publicly available court filing, the SEC “[i]s investigating the offer and sale of unregistered securities, the sale of securities by unregistered brokers and the commission of fraud in connection with the offer, purchase and sale of securities.”

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Money in WastebasketAs part of its ongoing enforcement focus on variable annuity (“VA”) sales practices, the Financial Industry Regulatory Authority (“FINRA”) recently censured and fined Hornor, Townsend & Kent, Inc. (“HTK”) $275,000 for its alleged failure to supervise its brokers’ sales of VAs.  HTK (CRD# 4031), headquartered in Horsham, PA, is a full-service broker-dealer that offers a range of investment, including VAs.

In recent months, FINRA has ramped up its enforcement focus on VA sales practices.  Ever since handing down a $20 million fine against MetLife Securities, Inc. (“MSI”) in May, 2016 (in addition, FINRA ordered MSI to pay $5 million to customers in connection with allegations of making negligent material misrepresentations and omissions on VA replacement applications), FINRA enforcement has continued to fine numerous member firms concerning VAs sales practice issues.  In particular, FINRA has targeted brokers recommending unsuitable VAs, in the first instance, as well as recommending the sale of one VA for another in order to generate commissions (a practice akin to churning, and commonly referred to as “switching”).

FINRA’s recent censure and fine against HTK involves sales of L-share VAs, which were allegedly made without proper supervision.  FINRA determined that the activities in question took place between April 2013 and June 2015; during this time frame, it was determined that 7,398 or nearly 47% of the 15,815 VA contracts sold by HTK registered representatives were L-share contracts.

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woodbridge-300x82The U.S. Securities and Exchange Commission (“SEC”) obtained an order on September 21, 2017 requiring the Woodbridge Group of Companies LLC (“Woodbridge”), of Sherman Oaks, California, to produce the documents of several company executives and employees, including the President and CEO.  This order reportedly relates to an SEC investigation of Woodbridge.

The SEC is reportedly investigating whether Woodbridge and others have violated or are violating the antifraud, broker-dealer, and securities registration provisions of the federal securities laws in connection with Woodbridge’s receipt of more than $1 billion of investor funds.  According to the SEC’s application and supporting papers filed in federal court in Miami on July 17, 2017, investors from around the country may have been affected.

On January 31, 2017, in furtherance of the SEC’s probe into Woodbridge, SEC staff in the Miami Regional Office reportedly served Woodbridge with a subpoena seeking the production of electronic communications that the company maintained relating to Woodbridge’s business operations, as well as other documents.  Court papers filed by the SEC allege that the company has failed to produce any relevant communications in response to the subpoena, including those of three high-level Woodbridge officials, despite being legally required to make the production.  The Court overruled Woodbridge’s objections and ordered the documents produced.

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Oil Drilling RIgsIf your financial advisor has recommended an unsuitable investment in a Master Limited Partnership (or “MLP”) without a reasonable basis for the recommendation, you may be able to recover losses through arbitration before the Financial Industry Regulatory Authority (“FINRA”).  Recently, a three-member all public FINRA arbitration panel ordered RBC Capital Markets and one of its registered representatives to pay $723,000 to a former client, an elderly customer from Norwell, MA, in connection with losses sustained on an overconcentrated portfolio of oil and gas MLPs (FINRA Case No. 17-0305 – Nourie, et al v. RBC Capital Markets).

The investments at issue before the panel in the Nourie case included the following:

  • Breitburn Energy Partners (OTC MKTS: BBEPQ);
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Investors faced the prospect of losses as Corporate Capital Trust, a former non-traded business development company listed its shares on the New York Stock Exchange this week under the ticker symbol CCT.  In early trading on November 14 and 15, 2017, the price of CCT shares fluctuated between $16.56 and $18.63 a share.  Accounting for the October 31, 2017 2.25-to-1 reverse split in CCT’s shares, this trading range means that a pre-split share of CCT is now worth between $7.36 and $8.28 a share- down from offering prices of between $10.00 and $11.30 a share at which investors purchased shares before the company was publicly traded

CCT is now reportedly the largest publicly-traded business development company, and the company raised billions of dollars in its public offerings of stock.   Corporate Capital Trust also commenced a tender offer to purchase up to $185 million in shares of its common stock at $20.01 per share, the company’s most recent net asset value per share, as of September 30, 2017.   The tender offer expires at 5:00 p.m. (EST) on December 12, 2017.  The tender offer price is a significant premium to the market price.

Corporate Capital Trust’s initial public offering was declared effective by the SEC in April 2011 and raised a total of $3.3 billion before closing its follow-on offering in October 2016.  The managing dealer, CNL Securities Corp., sold approximately 141 million shares in CCT’s initial public offering and sold an additional 168 million shares in a follow-on public offering, which closed on November 1, 2016.   CNL Securities Corp. was generally entitled to receive selling commissions of up to 7% of the gross proceeds of shares sold in the offerings and a marketing support fee of up to 3% of the gross offering proceeds of shares sold in the offerings, some of which may have been shared with other broker-dealers who sold shares to customers.

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