PROPOSAL FORECASTS GREATER REGULATION OF ALTERNATIVE ASSETS
On July 12, 2022, the North American Securities Administrators Association, Inc. (“NASAA”), an organization representing state securities regulators, released a proposal that would have a significant impact on Real Estate Investment Trusts (“REITs”) by dramatically expanding state regulation of non-traded REITs and other investment vehicles. The effect of the proposal would be to impose requirements that could ultimately limit investment opportunities for investors in this space, while heightening potential liability and risk for broker-dealers and investment advisers who recommend these products.
REITs are an investment vehicle that provides individuals the opportunity to invest in a real estate portfolio that may contain a hundred or more residential or commercial real estate properties. One of the benefits of the REIT structure is that it provides certain tax advantages for everyday investors while also giving them an opportunity to diversify their risk beyond traditional stocks and bonds.
On top of adding additional burdens on the sale of non-traded REITs, the proposal is notable in that it may serve as a template for future regulations that could affect certain asset-backed securities, commodity pool trading products, non-REIT mortgage programs and non-traded business development companies. These restrictions could include more limited accredited investor definitions for the sale of other financial products, and concentration limits that would apply to all products offered by a financial firm, not just REITs. Moreover, it would apply additional and potentially conflicting conduct standards from those already imposed by federal regulation.
The Proposal
In releasing its proposal, NASAA commented that it had been working on updating its guidance, originally drafted in 1996 with minor revisions in 2007, for 15 years for the sale of non-traded REITs. While the proposal purports to update that guidance, its revisions instead impose new additions to the guidance.
NASAA initially provided a 30-day comment period to extend to Aug. 12, 2022, but after pushback from industry participants, extended that comment period to Sept. 12, 2022. The four primary additions are the following:
- Update the conduct standards for brokers selling non-traded REITs by supplementing their suitability duty with the federal best interest conduct standard and a panoply of other conduct standards;
- Raise the net income and net worth financial requirements for investors to account for inflation since 2007;
- Create an aggregate concentration limit for investors covering their investment in non-traded REITs, the REIT’s affiliates (including other funds managed by its sponsor), and non-traded direct participation programs; and,
- Prohibit non-traded REITs from using gross offering proceeds as an investment objective or strategy to make distributions.
Both the financial and concentration requirements for investors stand to vastly impact the sale of non-traded REITs and have broad implications for the rest of the market for alternative products. For example, by imposing aggregate concentration limits on non-listed REIT investments along with investment in the REIT’s affiliates and in other direct participation programs, the proposal would stifle the opportunity of retail investors to obtain access to well-regulated sources of portfolio diversification, inflation protection and income. Many investors will simply seek these benefits through less-regulated products.
These new restrictions would not only decrease the pool of potential investors, but will also increase compliance costs for REIT issuers and federally regulated broker-dealers and investment advisers. The concentration limits in turn would disproportionately impact large firms offering a diverse suite of alternative investments. While there is no comparable restriction at the federal level, widespread adoption at the state level for products with national distribution channels would create a de facto baseline requirement.
Going forward, as states begin adopting heightened financial requirements for investors in non-traded REITs, it seems likely that they begin to question whether the same thresholds should apply to other alternative asset sales. Moreover, while the federal law on the accredited investor standard has not been updated since 1982, adoption at the state level could push the SEC to reassess its rules and potentially adopt further restrictions for all private investment.
Looking Forward
If the proposal is approved without significant revisions, it may be the first step in greater regulation of alternative investments. NASAA states their intent is to use the REIT Guidelines as a template for guidelines on business development companies, asset-backed securities, commodity pools and other products. This is a slippery slope for investors that are seeking access to diversifying products, particularly as traditional equity investments become less attractive with challenging macroeconomic conditions, including inflation and volatility. The real question is whether the proposal is really in the best interests of investors, or if instead, it is designed to codify regulatory requirements that expand state regulators’ enforcement authority.
Brownstein is ready to advise clients on this evolving regulatory landscape and to provide comment on behalf of clients on proposed new rules and regulations.
This document is intended to provide you with general information regarding a potential expansion of state regulation of non-traded REITs and other investment vehicles. The contents of this document are not intended to provide specific legal advice. If you have any questions about the contents of this document or if you need legal advice as to an issue, please contact the attorneys listed or your regular Brownstein Hyatt Farber Schreck, LLP attorney. This communication may be considered advertising in some jurisdictions. The information in this article is accurate as of the publication date. Because the law in this area is changing rapidly, and insights are not automatically updated, continued accuracy cannot be guaranteed.