Earlier this year, the SEC found that CapWest Securities, Inc., a defunct broker-dealer, had failed to comply with advertising rules in promoting investments that use Section 1031 of the Internal Revenue Code (“1031 Exchanges”) or tenant-in-common investments (TICs).  The SEC’s decision, recently reported by FINRA, upheld FINRA’s decision and sustained the sanctions of a censure and fines totaling $50,000.  The SEC’s findings that the firm’s advertisements were not fair and balanced are worth reviewing in the context of any promotions of complex products.

In its decision, the SEC explained that Section 1031 of the Internal Revenue Code permits an investor to defer paying capital gains tax on the sale of real estate by exchanging the investment for “like-kind” property of equal or greater value.  Such exchanges can be accomplished through TICs, in which an investor obtains an undivided interest in real property.

FINRA’s predecessor, the NASD, issued Notice to Members 05-18 after the sales volume of TICs grew in the early 2000s, reminding members of the obligation to ensure that promotional materials for sales of TICs must be fair, accurate, and balanced.  The NASD noted several risks in these investments, including the fact that they are illiquid with no secondary market, and that the fees and expenses connected to these investments might outweigh any tax benefits.

The SEC found the following violations by CapWest of the NASD rules governing communications:

  • Certain communications promoted the use of 1031 Exchanges or TICs without explaining how they work or the requirements that a given investment had to meet to qualify as a like-kind exchange.  The ads also promoted positive aspects of the investments, such as their “simplicity,” without mentioning any of their negative attributes.
  • Certain communications exaggerated the protection and security that investors can expect as a result of regulatory oversight.  The SEC also cited communications that misleadingly state that 1031 Exchanges allow the investor to avoid taxes altogether, when in fact they only allow tax deferral.
  • Certain communications included improper performance predictions without including any explanation of the historical basis for these claims or the required statement that past results do not guarantee future performance.
  • A particular communication used a customer testimonial without including the required disclosures that the testimonial may not be representative of the experience of other clients, and that the testimonial is no guarantee of future performance or success.

The SEC rejected CapWest’s argument that the communications at issue should be viewed in conjunction with disclosures in the private placement memoranda, stating that advertisements should stand on their own when determining compliance with NASD rules.  FINRA also found that CapWest failed to effectively implement its supervisory system regarding review and approval of communications effectively.

The SEC’s decision, affirming a decision of FINRA’s National Adjudicatory Council, provides a reminder of the regulators’ scrutiny of advertising materials, particularly those promoting unusual or complex instruments.  The SEC specifically stated that FINRA’s sanctions are appropriately remedial because they will remind other firms to comply with FINRA’s advertising rules and deter others from similar misconduct.

Broker-dealers should use the findings of the CapWest decision as additional guideposts for reviewing their advertisements.  They offer at least the following lessons:

  • Do not oversimplify a complex investment.
  • Make sure to balance any positive statements about an investment with any negative characteristics.
  • Be very careful when providing historical results or predicting results; there is much guidance available about the proper ways to make these claims.
  • Be very careful when using testimonials.