Broker-dealers’ falling short in due diligence when selling complex, illiquid products has been a focus of FINRA examinations and fines since the market collapse of 2008, writes Bruce Kelly of InvestmentNews.com. FINRA recently fined and sanctioned a handful of broker-dealers that sold two series of private placements that imploded in 2009 — Medical Capital Holdings Inc. notes and preferred shares of Provident Royalties LLC.

This according to comments made last Thursday by Susan Axelrod, executive vice president of member regulation sales practices at FINRA. “In several instances, FINRA examiners have found that firms selling these products failed to conduct reasonable diligence before selling a product and failed to make a determination that the product was suitable for investors.”

“Finra examiners have noted that in the instances of REITs that have experience financial difficulties, red flags existed and should have been considered by firms prior to the product being offered to firm clients,” according to Ms. Axelrod’s prepared comments to the Securities Industry and Financial Markets Association’s Complex Products Forum, which was held in New York.

Ms. Axelrod said that distributions, or dividends, of nontraded REITs are on FINRA’s radar.

“Nontraded REITs may also borrow funds to make distributions if operating cash flow is insufficient,” she said. “And excessive borrowing may increase the risk of default or devaluation. In addition, nontraded-REIT distributions may actually be a return of principal,” she said.

Susan Axelrod added that financial advisers, therefore, “must use caution when discussing distributions with investors, particularly when making comparisons to other dividend-paying investments.”

“FINRA examiners are also reviewing advertising, sales literature and correspondence between brokers and investors, and — in some instances — have found misrepresentations of product features, such as distributions and share values,” she said. “All of these issues raise investor protection concerns.”

(Nontraded REITS = Nontraded real estate investment trusts)

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