The North American Securities Administrators Association (NASAA) has offered support for recent efforts by FINRA to improve the valuation of unlisted direct participation plan (DPP) and real estate investment trust (REIT) offerings. In a comment letter to FINRA on April 11, NASAA said that FINRA's efforts in Regulatory Notice 12-14 and the proposed amendments to NASD Rule 2340 should help customers to comprehend the value of unlisted DPPs and REITs held in their accounts. Noting the concern of state regulators regarding inaccurate valuation methods presently used by issuers and broker-dealers to present investment values on customer statements, NASAA believes that a more uniform and accurate valuation method will benefit not only investors but issuers and FINRA member firms.
NASAA observed that Regulatory Notice 12-14 extends and modifies Regulatory Notice 11-44, which NASAA had supported in a previous comment letter. NASAA wrote that it continues to support Regulatory Notice 11-44’s proposed limit on the period during which a per share estimated value based on the net offering price may be included on a customer account statement. Under Regulatory Notice 11-44, the use of estimated valuations based on the net offering price is limited to the Initial Offering Period provided under Securities Act Rule 415(a)(5).
NASAA also continues to support the proposal in Regulatory Notice 11-44 that following the Initial Offering Period, a per share estimated value included on a customer account statement must be based on an appraisal of a DPP’s or REIT’s assets, liabilities and operations. NASAA suggested, however, that FINRA add a requirement that such appraisals must be conducted by qualified independent appraisers, using Rule 2-01 of Regulation S-X, or a similar rule, as guidance. NASAA also suggested that the selection criteria for those portfolio assets to be appraised be set by rule in order to help alleviate any conflicts of interest the appraiser and the issuer may have in manipulating its net offering price or NAV in future periods.
NASAA disagreed, however, with FINRA's modifications to the definition of "net offering price" contained in Regulatory Notice 12-14. Regulatory Notice 11-44 had defined “net offering price” as the gross offering price less all organization and offering expenses, including issuer expenses reimbursed or paid for with offering proceeds, underwriting compensation, and due diligence expenses. Regulatory Notice 12-14, however, redefines “net offering price” as “gross offering price less any front-end underwriting compensation expenses.”
NASAA acknowledged that subtracting fees and expenses from an already arbitrary price simply yields a different arbitrary price. NASAA nevertheless believes that, since front-end fees and expenses are not made available for investment by DPP and REIT programs, deducting them from the gross offering price results in a more accurate, estimated per share value. Accordingly, NASAA suggests that other standard costs incurred during the Initial Offering Period should also be deducted, such as acquisition fees and expenses, incurred advisory fees, and other incurred fees and expenses, as such costs continue to erode the value of a customer’s initial investment.
NASAA supported Regulatory Notice 12-14's proposal that a FINRA member firm may present a modified version of net offering price or list the securities as "not priced" during the period in which the issuer has not provided an appraised value. This period, however, may extend no longer than the second quarterly filing after the initial offering period. As no ready market exists for shares of non-traded DPP and REIT offerings, NASAA reasoned, the price a customer would receive if it were able to find buyers for its shares would likely represent a significant discount to even the “net offering price.” Therefore, “net offering price” may still be misleading to investors. NASAA believes that presenting such shares as “not priced” on customer account statements, while not providing much information to customers about the current value of their investments, is less likely to confuse them as to the liquidation value of their accounts.
NASAA strongly urged FINRA to reinstate a requirement proposed in Regulatory Notice 11-44 that would prohibit a member firm from using a per share estimated value “if it knows or has reason to know that the value is unreliable.” Member firms have a role to play as gatekeepers, NASAA argued, and prohibiting member firms from reporting valuations that they have reason to know are unreliable is central to maintaining customer and market confidence in the integrity of reported valuations of securities. Removing the proposed requirement tacitly permits member firms to report unreliable information that could undermine such customer and market confidence. If the proposed rule is reinstated, NASAA also encouraged FINRA to provide additional guidance to help member firms comply with this provision. This would include a review of the financial statements and a U.S. GAAP or IFRS (as allowed by law) analysis in assessing the appropriate valuation.
Finally, NASAA suggested that unlisted DPPs and REITs using daily net asset value (NAV) pricing should required to calculate daily NAV using fair value pricing under acceptable methods detailed under the FASB Accounting Standards Codification Topic 820. Additionally, NASAA noted that it is important for NAV to not be presented as an on-the-market price unless liquidity and risk adjustments are made to NAV since, if the issuer were to sell its real estate assets, it would incur exit and carrying costs and face potential liquidity issues. Using gross on-the-market pricing for NAV, especially if used in determining compensation elements and various other expenses, will likely cause such elements and expenses to be unnecessarily higher than if determined on a fair value GAAP pricing, liquidation pricing, or Investment Company pricing model, NASAA believes.