COVID-19 and the Potential for a Significant Increase in FINRA Arbitrations
Recent market volatility associated with COVID-19 has the potential to result in a large uptick in arbitration filings with the Financial Industry Regulatory Authority. Following a February to March decrease in the S&P 500 of over 34 percent and the recent historic dip in oil prices, investor confidence is understandably shaken. For broker-dealers and registered representatives, this likely means an increase in claims filed with FINRA. Following the 2008 recession, FINRA reported a sharp increase in the number of arbitration cases filed. The number of arbitration filings leveled off by 2013, and have maintained at around 3,600 cases filed per year since. One group of commentators estimates that based on past investor reactions, the increase in arbitration filings could exceed 75%.
While claims involving common stock and municipal bonds still dominate arbitration filings, one product type that has seen an increase in the number of claims filed in recent years is non-traded Real Estate Investment Trusts. Investopedia defines non-traded REIT as “a form of real estate investment method that is designed to reduce or eliminate tax while providing returns on real estate.” After the 2008 recession, groups of investors flocked to non-traded REITs to avoid the uncertainties associated with the traditional equities markets. While these investments are intended to be held long term to maximize return in the form of passive income, significant swings in the traditional equities markets can lead investors to second guess the benefits in these investments.
In FINRA arbitrations involving non-traded REITs, investors tend to focus on three characteristics of the investments: fees paid to the representative at the initial investment, the illiquidity of the products, and the underlying portfolio of properties. First, because these REITs are not traded with the same frequency of traditional equities, fees to the registered representative are typically front loaded. These fees are intended to compensate for the fact that the rep is not earning commission on multiple transactions while these investments are held long term. Investors, however, focus on the size of the fees relative to a standard buy/sell commission and raise concerns of a breach of fiduciary duty. When investors are already feeling the strain of a downturn in the market, they are increasingly skeptical of fees paid to their registered representatives.
Second, these investments are illiquid and offer investors limited options to retrieve their capital once invested in the REIT. These types of REITs do not trade on traditional equities markets. Secondary markets for non-traded REITs are small and likely require investors to sell at a loss of principal. In addition, because the success of REITs is often dependent on maintaining and investing the capital that is raised through investors, portfolio redemptions programs, where investors are able to liquidate their positions, are typically limited to a small number of investors each quarter. Even if investors are properly diversified, a large portion of their assets could be tied up in a non-traded REIT while their other investments are impacted by the downturn in the traditional equities market as a result of the pandemic.
Finally, a REIT is only as valuable as its underlying portfolio and that portfolio’s ability to generate income for investors. Capital raised by the trusts is used to purchase properties of varying types. The income generated by those properties is then used to pay investors. While the magnitude of the eventual impact is unknown, the real estate market is likely to be affected by the economic fallout from the pandemic. This results in uncertainty in the valuation of the assets underlying the REITs. Broker-dealers are taking this into consideration in their offerings of these products, including limiting or restricting sales of certain products where investors may overpay.
Broker-dealers and registered representatives who have current clients invested in non-traded REITs should ensure that their clients understand their investments and the nature of those investment in the current economic climate. Broker-dealers that maintain non-traded REITs in their product offerings need to ensure that their due diligence is thorough and updated. Finally, representatives that are considering recommending non-traded REITs need to spend extra time with clients to ensure that they understand the valuation, liquidity, and structure of the investment.
Feel free to contact our litigation team if you have any questions about defending FINRA arbitration claims.