NASAA REIT Guidelines: Potential Topics to Add/Revise

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1 VIA September 12, 2014 NASAA REIT Guidelines Task Force c/o Mark Heuerman, Chair Ohio Division of Securities 77 South High Street, 22nd Floor Columbus, Ohio Re: NASAA REIT Guidelines: Potential Topics to Add/Revise Ladies and Gentlemen: The Real Estate Investment Securities Association ( REISA ) is a trade association serving the real estate securities industry including all professionals active in offering, managing and distributing non-traded REITs, real estate partnerships, tenant-in-common interests (TICs), Delaware statutory trust interests (DSTs), real estate income and development funds, business development companies (BDCs), oil and gas interests, natural resources and alternative energy investments. REISA works to maintain the integrity and reputation of the industry by promoting the highest ethical standards to its members and provide education, networking opportunities and resources. REISA connects members directly to key industry experts through intimate forums providing timely trends and education and helping create a diversified portfolio for their clients. The association was founded in 2003 and has over 800 members who are key decision makers that represent over 30,000 professionals throughout the nation including: Sponsors and managers of real estate and related offerings Broker-dealers Securities licensed registered representatives Registered investment advisers (RIAs) Investment adviser representatives (IARs) Accountants Attorneys Mortgage brokers Institutional lenders Qualified intermediaries Real estate agents Real estate brokers NASAA s Direct Participation Programs Policy group (the Policy Group ) has asked for comments on the 33 items listed in the NASAA REIT Guidelines: Potential Topics to Add/Revise (the Proposal ). REISA understands that the comments contained herein, and the comments of other groups, will be reviewed and taken into account while the Policy Group drafts revisions to the NASAA REIT Guidelines for the consideration of the NASAA Board of Directors. REISA has the following comments and/or observations regarding the Proposal. To the extent that certain provisions were contained in the Proposal but not contained in REISA s comments below, REISA either believes such changes are noncontroversial and/or are a welcome update. However, REISA still reserves the right to comment once the language of the proposed guidelines has been provided for public comment. The numbers below correspond to the numbered paragraphs in the Proposal.

2 2. Change Independent Trustee definition to clarify that an Independent Trustee may still be independent despite owning an interest in the REIT and limit to two the number of REITs any particular Independent Trustee may serve over a particular time period. REISA agrees with the clarification that Independent Trustees can remain independent despite an ownership interest in the REIT but does not believe that changing the limit of REITs that an Independent Trustee can serve on from three (3) to two (2) results in any significant benefit warranting such a change. Finding qualified independent board members is always a challenge and placing further limitations on the qualifications of such potential board members can result in lesser qualified candidates being placed on boards. REISA believes that the conflict of interest policies adopted and followed by most REITs are sufficient to protect shareholders rather than changing the limit from three (3) to two (2). 7. Change the minimum contribution amount from $200,000 to 1% of the maximum offering amount. There are already significant barriers to entry with respect to the non-traded REIT industry. Increasing the minimum contribution from the current $200,000 to a flat 1% of the maximum offering amount will serve to prevent even more sponsors from coming into the REIT industry. Start up costs are already prohibitively expensive and adding an additional potential of up to $10,000,000 for a sponsor contribution to a $1 billion REIT, which investment cannot be sold for the duration of the REIT, will make it nearly impossible for new sponsors to enter and/or compete in the industry. While REISA believes that $200,000 may not be sufficient to align the interests of the sponsor and the shareholders, REISA also believes that 1% of the maximum offering amount is excessive and would propose a cap of up to $1,000,000 as a more appropriate contribution. 8. Add a provision that independent directors would nominate for vacancies created by an increase in the size of the board. Given that independent directors comprise a majority of the board of directors of a REIT, limiting the nominations for a vacancy to the board created by an increase in the size of the board to the independent directors would not necessarily alter the person chosen. In addition, any change to the nominating process for boards of directors in the event of a vacancy would have to comply with Maryland law (or such other jurisdiction where the REIT was incorporated). 10. Add termination and non-renewal fees to existing prohibition on penalty fees upon termination of advisory contract. REISA does not necessarily understand what would constitute a penalty fee so that it would fall under this new prohibition. Fees that are earned, and that the advisor would be entitled to, prior to termination should not constitute a penalty fee and fall under this prohibition. However, if the Proposal is to characterize termination and non-renewal fees as penalty fees, REISA expects to have further comments depending upon the actual text of the proposed revision. 12. Change the minimum offering amount to the lesser of 5% of the maximum offering amount or $25 million. The purpose of having a minimum offering amount is to assure some level of success if only the minimum offering amount is reached. However, there have been many REIT programs over the years that have not been wildly successful in raising large amounts of capital, but have raised significantly more than $25 million. From an operational perspective, many broker-dealers won t sell the REIT s securities until the minimum offering amount has been reached. Therefore, the minimum offering amount has to be low enough so that it can be

3 achieved rather quickly in order to induce broker-dealers to sell the securities to their clients. FINRA has taken the position that sponsors cannot advance commissions prior to breaking escrow so the broker-dealers cannot get paid their commissions until the minimum offering amount has been achieved. Requiring a significantly high minimum offering amount disadvantages newer sponsors who are just establishing their broker-dealer networks and competing for shelf space with older, more established sponsors as well as those sponsors who are bringing new and innovative products to the market that require significantly more education and marketing. It is unclear whether raising the minimum offering amount would address any potential concerns related to bad programs or bad sponsors but would certainly create higher barriers to entry, dissuade potential sponsors to enter the industry and therefore hurt investors by limiting the number of REITs available for investment. 14. Add a diversification standard for suitability to harmonize with the new FINRA suitability rule REISA believes that consistency between the FINRA rules and the Proposal is a laudable goal; however, REISA believes that consistency amongst the states with respect to concentration limits would be a much more beneficial change than anything else in this arena. The unique concentration limits imposed by a variety of states creates more complex disclosure and more confusion for sponsors, broker-dealers and investors in determining whether an investor meets the suitability requirement for investment in a particular REIT in a particular state. REISA further believes that a uniform standard is best as the current patchwork of standards is difficult to monitor, is costly to administer and prone to inadvertent errors. 16. Confirm that the suitability obligation is that of the broker-dealer and not the customer and subscription agreement should not contain terms that shift this obligation to the customer. REISA agrees that the suitability obligations are those of the broker-dealer and not the customer; however, the customer must take responsibility for providing true and accurate information to the broker-dealer in order for the broker-dealer to be able to make a proper suitability determination. Thus, the language in the subscription agreement is geared towards eliciting true and accurate information from the investor in order for the broker-dealer to make a reasonable suitability determination rather than shifting the burden from the brokerdealer to the investor. 17. Change completion of sale from 5 to 15 days. The current 5 day period to complete a sale of REIT securities adds additional complexity to the sales process, including determining with certainty whether all current supplements and public information have been delivered to the investor. Increasing the time period for completion of sale to 15 days creates even more complexities from a sales perspective without a corresponding benefit to investors. As an example, an investor receives the prospectus and all supplements on day 1, signs subscription documents and submits the documents to the broker-dealer for the broker-dealer to determine suitability and get the proper internal processing. On day 4, the sponsor issues a new prospectus supplement to disclose a probable acquisition. The sponsor has to provide (by overnight delivery or some other expedited, i.e., expensive, method) the supplement to the broker-dealer (who in turn provides the supplement to the investor) before the sponsor can accept the subscription in compliance with the 5 days proscribed by the Guidelines. Now, imagine if the completion of sale time lag is increased to 15 days between the submission of the subscription documents and the date of possible acceptance of the subscription documents and there are two (2) supplements issued during those intervening days (for a probable acquisition and a quarterly report). Now the sponsor has to send the first supplement and then the second supplement and hope that on day 14, there isn t a third supplement. An investor now has more paper to read and is liable to be

4 confused as to why he is receiving so many updates for this brand new investment (unlike an investment in a mutual fund and/or a listed security) that, in most cases, is not material to the overall investment decision. Instead, REISA believes that investors should be offered a five (5) day rescission period rather than the five (5) (or 15) day completion of sale delay. This rescission period will be easier to administer for all participants in the sales process, including the investors who can proactively terminate an investment they determine is unwanted within that five (5) day period for rescission. 18. Add a general policy to fees and expenses that prevents unfair dilution of profit expectations. It is unclear what unfair dilution of profit expectations means but shareholder dilution as a general matter will happen in any ongoing, continuous offering (and the risk is disclosed in the prospectus). Unfair dilution should be addressed but it is unclear what fees and expenses are targeted or how such fees and expenses may fairly or unfairly dilute profit expectations. 19. Include restrictions on use of cash awards, stock appreciation rights, dividend equivalent rights in addition to performance fees. Disguising impermissible fees by using alternative categories of compensation should be prohibited. However, blanket or significant limitations on these types of compensation could unfairly restrict boards of directors from rewarding an advisor in a way that is least dilutive to shareholders and/or in a way that properly defers such compensation to a later period at the expense of shareholders. Such restrictions may also potentially create a fiduciary conflict for the directors. 20. Include restrictions on internalization fees when internalizing. Allow REIT to acquire assets from Advisor at lower of cost or current market value. Allow REIT to acquire personnel free from employment agreements with Advisor. As noted in previous discussions, recent internalizations have not contained internalization fees and therefore restricting them should be fine. However, allowing (or it would seem more likely requiring) REITs to acquire assets from the advisor at the lower of cost or market value and/or to acquire personnel free from employment agreements would serve to disincentivize advisors from creating a true operating company with value that is more than the sum of its parts. In addition, some advisors advise multiple programs and allowing personnel to leave one program to join another without some type of compensation to the advisor would unfairly disadvantage the program that is not the subject of the internalization. 21. Independent Trustees may evaluate the Advisor compensation based upon the fairness of the allocation of investment opportunities. Given the existing criteria by which the independent trustees evaluate the performance of and compensation to the advisor (REIT Guidelines Section IV.G and in particular IV.G.7), and the fiduciary duties of the independent trustees under current corporate/trust law, this evaluation criteria seems redundant and unnecessary. In addition, rather than dictating all of the elements that should go into an evaluation of the advisor s compensation, the NASAA REIT Guidelines should instead rely upon the fiduciary duties of the independent trustees to make certain that the advisor is being compensated fairly. 22. Provide guidance on limiting equity based compensation not exceed 5% of the total number of outstanding shares.

5 Creating a hard rule regarding a limitation on equity based compensation would necessitate abdication of a director s role in setting compensation for the program. While guidance on a limitation would have probative value, setting a hard limit would create problems and could disadvantage shareholders by further misaligning the interests of directors and officers and the shareholders. 23. Clarify limits on leverage and eliminate Independent Director override. Elimination of the independent directors ability to exceed the leverage limitations would prevent them from exercising their fiduciary duties and could place impermissible limits on their abilities under Maryland law. The flexibility afforded to the independent directors to exceed the leverage limitations, especially in the early days of a REIT, is crucial. Eliminating that flexibility could harm the REIT and the shareholders by requiring the REIT to forego otherwise good investment opportunities because the directors could not exceed the leverage limitations. 24. Clarify mandatory redemptions and clarify that advance notice to the issuer is necessary for mini tender offerors. Mini tender offers are governed by federal securities laws and should not be addressed in the Proposal. 25. Include limitations/restrictions on equity dilution when options, warrants, or shares are used like cash for acquisitions of properties or services; distributions should be at fair market value. Using equity as currency for acquisitions may, in fact, be beneficial to shareholders and the REIT and should not be limited or restricted if the board of directors (including the majority of independent directors) approves such use. 26. Limit the sources from which distributions may be paid to investors or limit the period of time the issuer may use certain sources to fund distributions. This is a disclosure item that is clearly and fully disclosed in every filing, report and prospectus. Limiting the sources from which distributions may be paid is anti-competitive and could seriously harm the ability for new entrants to come into the industry. If capital raising is slow, the inability to continue to pay distributions will slow the fundraising even further until the REIT is unable to continue for lack of funds. In addition, there should be no limitation on distributions being paid in order to meet the REIT tax requirements. It would not be in the best interests of the REIT or the shareholders to lose REIT status due to a prohibition on paying distributions from whatever source is available. In addition, FINRA s anticipated revised rules regarding customer account statements is expected to include disclosures relating to the sources of distributions so that rather than limiting those sources in the Proposal, investors have a better understanding of the source of the distributions on an ongoing basis in their account statements. 31. Conform changes to provisions that need to be in the articles. The REIT Guidelines already require too many and detailed provisions to be contained in the articles of incorporation and go far beyond what is required by state law to be contained in the articles. In addition, the process to amend the articles of incorporation for changes requested by NASAA are time consuming, expensive and provide little return to shareholders in terms of real value. REISA believes that many provisions currently required to be contained in the articles of incorporation are unnecessary and burdensome. The Proposal

6 should be seeking to determine provisions that can be removed from the articles of incorporation and captured in the disclosure or otherwise rather than adding additional provisions. Conclusion REISA remains committed to collectively working to improve the industry from the standpoint of transparency. REISA believes that while the Proposal contains many good ideas for updating the NASAA REIT Guidelines, there are some practical and other issues with the Proposal that require further discussion and modification. REISA looks forward to continuing to work with NASAA as it moves forward to propose revisions to the NASAA REIT Guidelines. Sincerely, Mark Kosanke President, Real Estate Investment Securities Association cc: Lisa M. Tolar, Alabama Securities Commission Joy Sakamoto-Wengel, Maryland Division of Securities Michael Benson, Pennsylvania Department of Banking and Securities Megan Campbell, Texas State Securities Board Dan Matthews, Washington State Department of Financial Institutions, Securities Division Drafting committee: Deborah S. Froling, Arent Fox LLP John H. Grady, National Fund Advisors, LLC Darryl Steinhause, DLA Piper LLP Thomas Voekler, Kaplan Voekler Cunningham and Frank, PLC