On May 20, 2014, the Securities and Exchange Commission initiated proceedings to determine whether to approve a proposal by the Financial Industry Regulatory Authority, Inc, (FINRA) to amend the NASD and FINRA rules governing estimated valuations for unlisted direct participation program (DPP) and real estate investment trust (REIT) securities. On January 31, 2014, FINRA filed a proposed rule change to amend NASD Rule 2340 (Customer Account Statements) and FINRA Rule 2310 (Direct Participation Programs), both of which address per share estimated valuations for unlisted DPP and REIT securities.
FINRA proposes to eliminate the requirement in NASD Rule 2340 that general securities members include the per share estimated value contained in a DPP or REIT security’s annual report but allowing any member to do so “if the value has been developed in a manner reasonably designed to ensure that it is reliable, the member has no reason to believe that it is unreliable, and the account statement includes certain disclosures.” In order for FINRA to presume an estimated valuation is reliable, the value must be developed under one of two methodologies: the “net investment methodology” or the “independent valuation methodology.”
FINRA further proposes to amend FINRA Rule 2310 to prohibit a member from participating in a public offering of a DPP or REIT security unless “(A) A per share estimated value is calculated on a periodic basis in accordance with a methodology disclosed in the prospectus, or (B) the general partner or sponsor has agreed to disclose in the first periodic report filed pursuant to Section 13(a) or 15(d) of the Act after the second anniversary of breaking escrow: (1) A per share estimated value of the DPP or REIT calculated by, or with the material assistance of, a third-party valuation expert; (2) an explanation of the method by which the per share estimated value was developed; (3) the date of the valuation; and (4) the identity of the third-party valuation expert used.” The general partner or sponsor of the DPP or REIT must also have agree to ensure that “the valuation is conducted at least once every two years; is derived from a methodology that conforms to standard industry practice; and is accompanied by a written opinion to the general partner or sponsor of the DPP or REIT that explains the scope of the review, the methodology used to develop the valuation, and the basis for the per share estimated value.”
It is hard to criticize the goal of providing accurate valuations. But critics of the proposed rule change have pointed out difficulties with the net investment methodology, opposed the elimination of a per share requirement of DPP and REIT securities in customer account statements, the need for an extended implementation period, the timing of valuations, and the potential for unforeseen economic effects. Initial comments must be made to the SEC by June 26, 2014, and rebuttals to other commentators’ submissions must be filed by July 11, 2014.