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Do new T shares skirt fiduciary rules?

A year and a half ago, FINRA announced it would start requiring nontraded REIT sponsors and brokers to show just how big a bite commissions – of 12% to 15%, or even more – take out of client investments in this asset class.

In an almost-immediate response, the industry created a new T share class, which replaces high, upfront commissions with trailing commissions. The result is that T shares can extract a similar magnitude of commissions as nontraded REITs over time in a steady drip.

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"People started putting [the T shares] into the market … once the FINRA rule was finalized and the implementation" period scheduled, says John Grady, president-elect of the Alternative & Direct Investment Securities Association.

Read more: Expect close monitoring during fiduciary rule implementation

Grady’s organization, among others, persuaded the Department of Labor to continue allowing advisers to invest clients' money into nontraded REITs despite regulators’ initial intention of banning them from Americans’ retirement accounts. The new rules will require that advisers get clients to sign a best interest contract exemption in order to invest in nontraded REITs.

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By March, a month before that DoL rule was announced and the same month that the new FINRA rule took effect, T shares – which results in commissions being deducted monthly, quarterly or annually – accounted for more than half of new money invested in nontraded REITs, Grady says. Although T shares exist for some mutual funds, their definition is not standardized throughout financial services.

The new nontraded REIT share class is the kind of move fiduciary advocates were expecting from the industry in response to the new regulations.

"I think [the T shares] are really designed to get around the FINRA requirement" and the new DoL rule, says Craig McCann, a former SEC economist and lead author of a new study of nontraded REITs in the Journal of Wealth Management that criticizes the securities as incompatible with fiduciary client service. "If the traditional sale [of nontraded REITs] fails the DoL test," McCann says, then the sale of the same investment via the new share class "should also fail that test."

If a client signs a best interest contract exemption, the new share class will likely allow nontraded REIT sponsors to maintain sales while being compliant with the stronger regulations – which McCann finds upsetting.

Nontraded REIT sponsors "shouldn't be able to undo the investor protections by this flimflam," McCann says. "It's just more of the same. I'm hoping that there is some regulatory response.” Labor Department officials had no comment on the T shares, a spokesman said.

Characterizing the T Shares as flimflam is not fair, Grady insists. "This is what came out of the dialogue within the broker-dealer community of what they felt was fair compensation," he says.

The new shares will actually be better for investors over the long haul by making sure more of their money goes into the investment initially, while commissions are extracted gradually, he says.

"You might improve the actual end result for shareholders," Grady says. "I don't think it was a matter of hiding [commissions], but coming up with a kind of structure for clients [in which] a high proportion of [their investment] was going into assets."

In a striking example of the magnitude of alleged abuse that has resulted in improper sales of nontraded REITs, FINRA in April accused broker Gopi Krishna Vungarala of hiding nearly $10 million in commissions he made selling $190 million in nontraded REITs and other alternative investments to a Native American tribe for three-and-a-half years ending in 2015. Vungarala, who worked for the broker-dealer Purshe Kaplan Sterling Investments in Albany, N.Y., could not be reached for comment. Firm officials did not immediately return a call seeking comment. The case is pending.

While many large independent broker-dealers, including AIG Advisor Group and Cetera Financial Group, permit their advisers to sell nontraded REITs, at least one – Raymond James Financial Services – won’t sell them.

"Our alternatives analysts," says its president, Scott Curtis, "when they took a look at the liquidity of those products, the high commissions of the products, the high expenses and [reported] net asset values that didn't reflect the true value of the underlying portfolio … we just didn't think that the potential relative returns of the nonpublic REITs made sense versus the fully liquid public REITs."

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