Alternative investments are back in the news. The Massachusetts Securities Division has announced an investigation of broker-dealers selling oil and gas and car dealership limited partnerships, and has issued subpoenas to sixty-three firms selling the private placements. The Financial Industry Regulatory Authority (FINRA) and Securities and Exchange Commission (SEC) have announced similar inquiries, which are still underway. In May 2020, the Massachusetts Securities Division filed formal charges against GPB Capital Holdings, LLC. GPB, a complex network of car dealerships, waste carting, and oil and gas limited partnerships, is alleged to have raised $1.5 billion based on false and misleading offering statements.
A federal class action in Texas, Kinnie Ma Individual Retirement Account v. Ascendant Capital LLC., alleges that seventy-five broker-dealers facilitated the sale of financially troubled and insufficiently vetted limited partnerships that invested in oil and gas and car dealerships. In addition to the class action, hundreds of individual FINRA arbitration claims have been filed, and it would appear that more are forthcoming.
These developments bring to mind earlier enforcement actions, in the wake of the financial crisis and Great Recession of 2008–2009, which challenged investor exposure to alternative investments and sought to impose concentration limits on such investments for retail investors.
GPB can rightfully be called a major event in the broker-dealer world due to the sheer number of broker-dealers involved. It may also, however, present an opportunity to test some novel legal theories, some of which will be discussed in this article. As explained in detail below, the Uniform Limited Offering Exemption (ULOE), approved by the North American Securities Administrators Association (NASAA) in 1983 and adopted, in varying formats, by eleven U.S. states, provides a presumption of suitability for portfolio allocations of up to 10 percent of alternative investments, such as nontraded real estate investment trusts (REITs) and limited partnerships. The ULOE has not been extensively tested by the courts or arbitration panels. While NASAA has more recently proposed a 10 percent concentration limit for nontraded REITs, that proposal has not been fully adopted.
The Great Recession
The financial crisis of 2008 and the ensuing Great Recession brought unprecedented and unwelcome attention to nontraditional investments, such as nontraded REITS, tenant-in-common investments, oil and gas limited partnerships, and similar alternative investments. With the crash of the real estate markets, investors concentrated in securitized (and nonsecuritized) real estate investments found themselves strapped for cash, as numerous limited partnerships and Regulation D offerings failed or struggled, along with broad swaths of the overall economy. As Warren Buffet famously quipped, “It’s only when the tide goes out that you see who’s been swimming naked.”
Regulators, quick to pounce, prosecuted the issuers and sellers of nontraditional alternative investments. Federal and state regulators brought numerous enforcement actions against issuers of syndicated real estate and other alternatives, along with the broker-dealers who marketed and recommended them.
State Concentration Limits
In the wake of the 2008–2009 financial crisis, many states implemented concentration limits on alternative investments, which they defined as nontraded REITS, limited partnerships, and other alternatives to the traditional baskets of publicly traded stocks, bonds, and money market investments. Alternative investments include structured products, nontraded REITS, limited partnerships, Regulation D offerings, and the like. In order to manage risk and comply with state regulations, many independent broker-dealers have modified their written supervisory procedures to impose concentration guidelines of their own—typically, between 10 and 20 percent of an investor’s net worth, depending on such factors as overall net worth, trading experience, sophistication, and age. NASAA, an association of state blue sky securities regulators, proposed a rule in 2016 that would cap the exposure of nonaccredited investors at 10 percent of liquid net worth. According to NASAA, its proposal “would add a uniform concentration limit of ten percent (10%) of an individual’s liquid net worth, applicable to their aggregate investment in a REIT, its affiliates, and other nontraded REITs, as defined therein.”
While alternative investments are often disparaged, they have some distinct features that make them attractive. For one, alternative investments typically do not correlate with the stock market, which offers investors downside protection in a falling market And while publicly traded REITs provide a measure of liquidity, they tend to rise and fall with the vagaries of the market. Alternative investments clearly offer investors diversification that standard equities do not, but how much is too much when it comes to concentration levels in alternative investments?
Uniform Limited Offering Exemption
While the trend over the past ten years has clearly been in favor of imposing concentration limits, the converse question is worth considering. In other words, if a recommendation of over, say, 10 percent of an investor’s portfolio in alternative products is presumed unsuitable, is the converse true? Is an investment of 10 percent or less of the same customer’s net worth in an alternative investment presumed to be suitable? This question is posed in Securities Regulation by Professors Coffee, Sale, and Henderson. John Coffee and his co-authors discuss the Uniform Limited Offering exemption, adopted by NASAA in 1983 under the authority of §19 (d) of the 1933 Securities Act, which was intended to create an exemption from state registration and qualification for certain specified private offerings. While the ULOE references some of the terms and standards in SEC Regulation D, it also contains a suitability standard.According to Coffee and his colleagues, “Even more importantly, [the ULOE] includes a suitability standard for sales to non-accredited investors, which requires that the investment be suitable for the purchaser upon the basis of the facts, if any, disclosed by the purchaser as to other security holdings and as to his financial situation and needs.” The ULOE “then adds a presumption that if the investment does not exceed 10% of the investors’ net worth, it is presumed to be suitable.”
The text of the ULOE provides the following: “For the purpose of this condition only, it may be presumed that if the investment does not exceed 10% of the investors’ net worth, it is suitable.” The ULOE applies to any offer or sale of securities sold under Reg. D Rule 506 (§ 505 having been repealed subsequent to issuance of the ULOE), “including any offer or sale made exempt by application of Rule 508(a).” Thus, thirty-seven years ago, NASAA suggested that at least for some Regulation D issues, a recommendation of no more than 10 percent of an investor’s net worth would be presumed suitable. And while in 2016 NASAA proposed imposing a concentration limit of 10 percent on nontraded REITs, that proposal has yet to pass.
Eleven states have adopted the suitability presumption in the NASAA ULOE. For example, Alabama and Indiana provide a presumption of suitability if an alternative investment does not exceed a specified minority presumption of the investor’s net worth. For Alabama, suitability is presumed if alternatives do not exceed 20 percent of the investor’s net worth; in Indiana, the presumption applies for a recommendation of no more than 10 percent. Tennessee agrees that, for an alternative investment, “It may be presumed that if the investment does not exceed 10% of the sum of the purchasers’ net worth, the investment is suitable.” Louisiana provides that “it may be presumed that if the investment does not exceed 25% of the investor’s net worth, it is suitable.” These various state regulations survived the 2008–2009 financial crisis and the ensuing Great Recession, and, while they harken to an earlier era, they seem to bespeak a more balanced view of customers’ investment portfolios. Thus, at least in some states (by our count eleven), while an overconcentration in alternative securities might be deemed unsuitable, alternatives are presumed to be suitable in smaller doses.
This allocation approach is consistent with the philosophy that suitability must be viewed on balance as a whole and not in isolation. This viewpoint is also consistent with the teaching of the FINRA suitability rule, Rule 2111, which provides that suitability should include an assessment of the customers’ other securities holdings (quantitative suitability), net worth and income, along with other traditional factors such as customers’ risk tolerance and investment objectives.
Moreover, the presumed suitability of relatively modest concentrations is consistent with the teachings of new Regulation Best Interest (Reg. BI), which imposes a three-tiered approach to suitability. Under Reg. BI, a registered representative should consider three aspects of suitability. First, is the investment suitable for anyone? Second, is the investment suitable for this investor? Third, the registered representative must determine whether the recommended quantity is suitable for the customer in question.
This is not to suggest that the presumed suitability of smaller holdings, under 10 percent concentration levels, can be bootstrapped into a substitute for the suitability of a product that is not suitable for anyone or not suitable for this specific customer under any circumstances under Reg. BI. A product that was never suitable for any investor cannot be sanitized by a presumed statutory concentration level. Moreover, there probably are some products that, while objectively suitable, will likely be viewed as unsuitable for particular investors based on the product’s complexity. However, regulators, particularly those in jurisdictions that have been aggressive in securities enforcement, should be mindful of these concentration presumptions in their prosecutions. Moreover, firms that have complied with their state’s concentration guidelines might make the argument that an overall view of a balanced portfolio is more appropriate than the cherry-picking approach favored by some regulators and claimants’ lawyers. If alternative investments, generally, are viewed as a legitimate tool for diversifying a client’s portfolio, it would appear to be unfair to punish an advisor for a small portion of a portfolio that did not produce that same rate of return as equities in a rising market, for example.