Proposed Amendments to the NASAA Guidelines for Direct Participation Programs

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1 November 27, 2006 Peter Cassidy, Esq. Project Group Chair Office of the Secretary of the Commonwealth One Ashburton Place Room 1701 Boston, Massachusetts Susan Baker-Toth, Esq. Arizona Corporations Commission 1300 West Washington Street 3 rd Floor Phoenix, Arizona sbakertoth@ccsd.cc.state.az.us Rex A. Staples, General Counsel North American Securities Administrators Association, Inc. 750 First Street, N.E., Suite 1140 Washington, D.C rs@nasaa.org Mark Heuerman, Esq. Ohio Division of Securities 77 South High Street, 22 nd Floor Columbus, Ohio mark.heuerman@com.state.oh.us Terri Orton, Manager, Registration Section Regulation & Licensing Department 2550 Cerrillos Road Santa Fe, New Mexico terri.orton@state.nm.us James M. McManus, Esq. Dept. of Insurance, Securities and Banking Regulation 810 First Street, N.E., Suite 610 Washington, D.C james.mcmanus@dc.gov RE: Proposed Amendments to the NASAA Guidelines for Direct Participation Programs Dear Ladies & Gentlemen: The North American Securities Administrators Association (NASAA) Direct Participation Programs Policy Project Group (DPP Project Group) has requested public comments on a proposed revision to its Guidelines and Statements of Policy as to Asset Backed Securities, Commodity Pool Programs, Equipment Programs, Mortgage Programs, Oil and Gas Programs, Omnibus Guidelines, Real Estate Investment Trusts, and Real Estate Programs (NASAA Guidelines). 1 The NASAA Guidelines are meant to serve as guiding principles when state securities regulators review direct participation programs (DPPs) that may be offered to their citizens. The Financial Services Institute 2 (FSI) appreciates this opportunity to comment on the DPP Project Group s proposed changes to the NASAA Guidelines. 1 See the proposing release at 2 The Financial Services Institute, Voice of Independent Broker-Dealers and Independent Financial Advisors, was formed on January 1, Our members are broker-dealers, often dually registered as federal investment advisors, and their independent contractor registered representatives. FSI has 103 member firms, with more than 127,000 registered representatives serving more than 14 million American households. FSI also has more than 3,600 financial advisor members. Financial Services Institute Inc 900 Circle 75 Pkwy Suite 860 Atlanta GA Fax

2 Page 2 The proposed revisions would result in the following changes: Net Worth Redefined - The current NASAA Guidelines exclude the value of the investor s home, its furnishings and any automobiles from the net worth calculation. Retirement assets are included in the calculation. If adopted, the amended NASAA Guidelines would alter the definition of net worth. Retirement assets, including any pension plan accounts or benefits, would be excluded from the new definition. The exclusion of retirement assets from the net worth calculation is intended to insure that investors in DPPs have resources to absorb any losses and face any liquidity needs. 3 Income and Net Worth Standards Revised for Inflation - The current NASAA Guidelines generally require that persons investing in DPPs must have either (1) a minimum annual gross income of $45,000 and $45,000 or more of net worth, or (2) a minimum net worth of $150,000. The amendments to the NASAA Guidelines propose to alter these net worth standards. Investors would be required to have either (1) a minimum annual gross income of $70,000 and $70,000 or more of net worth, or (2) a minimum net worth of $250,000. FSI understands that the DPP Project Group concluded these new standards were necessary in order to recognize the impact of inflation during the 15 years since the NASAA Guidelines were last updated. 4 10% of Net Worth Limitation on DPP Investments The proposed amendments to the NASAA Guidelines would state that the maximum investment in the DPPs of any issuer (or affiliates of any issuer) and other investments with similar investment objectives could not exceed 10% of the purchaser s liquid net worth. The DPP Project Group intends for the limitation to protect investors from over-concentration in any one issuer and asset class. 5 FSI supports NASAA s continuing efforts to enhance investor protection. In particular, FSI supports the proposed amendments to the NASAA Guidelines which would increase the income and net worth figures to reflect the impact of inflation. However, FSI cannot support the adoption of the other proposed revisions to the NASAA Guidelines because they would replace investor choice with overly restrictive criteria which will deprive investors of otherwise suitable DPP products. Background on FSI Members The proposed interpretive guidance is of particular interest to FSI members. Our independent broker-dealer (IBD) members have a number of similar business characteristics. They generally clear their securities business on a fully disclosed basis; primarily engage in the sale of packaged products, such as mutual funds and variable insurance products, by check and application direct with the investment product provider; take a comprehensive approach to their clients financial goals and objectives; and provide investment advisory services through either affiliated registered investment advisor firms or such firms owned by their registered representatives. IBDs also 3 See page 2 of the proposing release at 4 Ibid at page 3. 5 Ibid at page 2.

3 Page 3 include DPP products in their approved product list and establish their own appropriate suitability standards for their sale. Our financial advisor members are independent contractors, rather than employees of the IBD firms. These financial advisors are typically located in communities where they know their clients personally and provide them investment advice in face-to-face meetings often times over the client s kitchen table. Most of their new clients come through referrals from existing clients or other centers of influence. Due to their close ties to the community in which they operate their small businesses, these financial advisors have a strong incentive to make the achievement of their clients investment objectives their primary goal. Many of these financial advisors offer DPPs to appropriate investors as part of a portfolio designed to achieve the client s stated investment objectives with due consideration for their financial and tax status, risk tolerance, investment time horizon, and other relevant factors. FSI supports NASAA s efforts to update the income and net worth standards of the NASAA Guidelines to reflect the impact of inflation. However, we have serious concerns about the unintended consequences of other provisions of the proposal. If adopted, these amendments to the NASAA Guidelines would harm IBDs, affiliated financial advisors and their clients by: Interjecting the state regulator s own judgment into suitability decisions that are best left to an investor in consultation with his financial advisor. Eliminating DPPs from consideration in the development of financial plans for many investors who could benefit from such products. Denying firms the clarity necessary to ensure they have achieved compliance through the use of the ill defined phrase other investments with similar investment objective in the NASAA Guidelines. As a result of these concerns, FSI cannot support the proposed amendments to the NASAA Guidelines in their entirety. Detailed Comments Here are our concerns in more detail: 1. Suitability Standard Abandoned FSI acknowledges that it is appropriate for the NASAA Guidelines income and net worth calculations to be periodically updated to reflect inflation. As a result, FSI supports this portion of the proposal. However, the proposed revisions to the NASAA Guidelines go far beyond reasonable adjustments such as these to eliminate many investors ability to make otherwise suitable investments in DPPs. The result is that investor choice is replaced by overly restrictive criteria imposed without regard to the individual investors financial and tax situation, risk tolerance, time horizon, investment experience, or goals. These concerns are further heightened by efforts in several states to require the incorporation of the NASAA Guidelines into DPP charters. FSI believes NASD Conduct Rules 2310 and 2810 adequately address the issue of investment suitability by placing the responsibility for making appropriate investment recommendations upon the financial advisor. The NASAA Guidelines would unreasonably interfere with this effective regulatory scheme by interjecting the state

4 Page 4 regulator s own judgment into the suitability decisions that should be left to an investor in consultation with his financial advisor. 2. Unreasonable Exclusion of Retirement Assets from the Net Worth Calculation The DPP Project Group proposes to radically alter the NASAA Guidelines by excluding retirement assets, including any pension plan accounts or benefits, from the net worth calculation. According to statistics found in the Federal Reserve Board s Survey of Consumer Finances 6, the current NASAA Guidelines exclude approximately 64% of the typical American family s net worth by leaving their home, its furnishings and any automobiles out of this calculation. The new proposal would eliminate nearly one third of the remainder from the net worth calculation. In fact, the exclusion raises the net worth requirements so high that it eliminates the consideration of other factors relevant to the suitability determination, including the age of the investor, the investor s expected liquidity needs, the amount of time the investor has until retirement, and the extent of an investor s accumulated retirement assets. The portfolios of many investors have benefited from the ability to invest a portion of their assets in DPP programs. Unfortunately, the adoption of the proposed revisions to the NASAA Guidelines would result in the elimination of DPP products from consideration in the development of financial plans for many, if not most, investors. 3. Maximum Investment Limitation is Overly Restrictive and Vaguely Defined The proposed revision to the NASAA Guidelines would establish a provision designed to insure investors avoid an undue concentration of their assets in DPPs. The provision states that the maximum investment in the issuer, affiliates and other investments with similar investment objectives shall not exceed 10% of the purchaser s liquid net worth. 7 Unfortunately, the proposal fails to define the term other investments with similar investment objectives. The failure to define this term raises several important questions. For example: Would an investor be prohibited from investing more than 10% of his net worth in a non-traded REIT and a REIT mutual fund? Would an investor be prohibited from investing more than 10% of his net worth in income generating DPPs and bond mutual funds? Would an investor be prohibited from investing more than 10% of his net worth in DPPs that utilize entirely different business models, but each generate income? Do all DPPs have essentially the same investment objectives? Legitimate unanswered questions such as these indicate that the maximum investment limitation proposed by the DPP Project Group is overly restrictive and vaguely defined. As a result of these concerns, FSI cannot support the attempt to re-define net worth or the adoption of the proposed maximum investment limitation contained in the proposed revisions to the NASAA Guidelines. We are committed to constructive engagement in the regulatory process and, therefore, would welcome the opportunity to work with you to find solutions to these concerns that achieve your objectives of investor protection without the unintended consequences we have outlined above. 6 See at 7 Emphasis added. See the proposing release at

5 Page 5 Again, thank you for the opportunity to comment on the proposed NASAA Guidelines. Should you have any questions, please contact me at Respectfully submitted, Dale E. Brown, CAE Executive Director & CEO