A Delaware Statutory Trust (DST) is a legally recognized trust that is created for a specific business purpose. Traditionally, DSTs are utilized to provide a governing agreement by which real estate can be purchased, held, managed, and administered among a pool of investors who own participation interests in the DST. The DST allows an investor the opportunity to own an interest in the underlying real estate without the responsibility of managing the property. A trustee is appointed to manage the property on behalf of the investor pool. A Tenant-in-Common or TIC investment offering is similar to a DST in that both investment vehicles pool investor capital toward the purchase of underlying real estate, but the legal ownership structure is different. DST and TIC investments are commonly used as a mechanism through which real estate owners can facilitate a 1031 exchange, which refers to a section of the Internal Revenue Code that allows a seller of real estate to defer paying capital gains taxes if the sale proceeds are reinvested in qualified real estate within a designated period of time.
DSTs are an Alternative Investment. Alternative Investments have been a focus of FINRA for many years because of the opaque and esoteric nature of these products. Notice to Member 03-71, FINRA stated:
In the aftermath of the recent downturn in the equity markets, NASD reviewed the services and products offered by members and observed that retail investors were being offered an array of different investments as alternatives to conventional equity and fixed-income investments. These alternative investments do not fall under a common category; the staff review indicates that brokers and retail investors have shown increased interest in products such as asset-backed securities, distressed debt, and derivative products (for ease of reference these products are collectively referred to as non-conventional investments or “NCIs”). NCIs often have complex terms and features that are not easily understood.
Notice to Member 03-71 further provides that “Members must establish sufficient internal controls, including supervision and training requirements, that are reasonably designed to ensure that sales of NCIs comply with all applicable NASD and SEC rules. Members must ensure that their written procedures for supervisory and compliance personnel require that (1) the appropriate due diligence/reasonable-basis suitability is completed before products are offered for sale; (2) associated persons perform appropriate customer-specific suitability analysis; (3) all promotional materials are accurate and balanced; and (4) all NASD and SEC rules are followed. In addition to establishing written procedures, members also must document the steps they have taken to ensure adherence to these procedures.
FINRA Regulatory Notice 12-03 requires member firms to implement “heightened supervision of complex products.” Specifically, 12-03 provides that product “complexity adds a further dimension to the investment decision process beyond the fundamentals of market forces. This may be the case even though the complexity of some products may arise from features that seek to reduce the probability of investment losses in particular situations. Regulators have expressed concern about complex products because the intricacy of these products can impair the ability of registered representatives or their customers to understand how the product will perform in a variety of time periods and market environments and can lead to inappropriate recommendations and sales.”
“Reasonable diligence must provide the firm or registered representative ‘with an understanding of the potential risks and rewards associated with the recommended security or strategy.’ This understanding should be informed by an analysis of likely product performance in a wide range of normal and extreme market actions. The lack of such an understanding when making the recommendation could violate the suitability rule. Firms should have formal written procedures to ensure that their registered representatives do not recommend a complex product to a retail investor before it has been thoroughly vetted. Those procedures should ensure that the right questions are answered before a complex product is recommended to retail investors.”
These due diligence obligations are further codified in Notice to Members 10-22, which “reminds broker-dealers of their obligation to conduct a reasonable investigation of the issuer and the securities they recommended in offerings.” “A BD ‘may not rely blindly upon the issuer for information concerning a company, nor may it rely on the information provided by the issuer and its counsel in lieu of conducting its own reasonable investigation…firms are required to exercise a ‘high degree of care’ in investigating and independently verifying an issuer’s representations and claims.” Thus, FINRA makes it clear that brokerage firms have an affirmative obligation to conduct comprehensive due diligence before recommending Alternative Investments.
An Example Of Fraud In Connection With The Sale Of DSTs
In a recent securities fraud involving DSTs, the Wolper Law Firm, P.A. successfully represented a number of clients who were sold a DST that owned apartment complexes in Illinois that were used for university student housing. The DST was issued by Sandlapper Securities.
The brokerage firms that sold the Sandlapper DST represented that they conducted due diligence and that the investment was “safe,” “secure” and that Sandlapper and its CEO, Trevor Gordon, were reputable sponsors that would effectively represent the investors’ interests in the management of the property.
In reality, the brokerage firms had not conducted adequate due diligence regarding the investment or of Sandlapper. Had they done so, they would have discovered that the Sandlapper Student Housing DST was a property that was entirely dependent on a publicly funded university in Illinois—Western Illinois University. In June 2015—months before the investments were made the State of Illinois failed to pass a budget, which resulted in a lack of funding for the university and, in turn, dramatically impacted occupancy at the property underlying the Sandlapper Student Housing DST. This budget impasse was not disclosed even though it was central to the investment and was something that could have discovered with a simple Google search.
In addition, Sandlapper Securities and Trveor Gordon were the subject of a FINRA investigation for securities fraud, which culminated in a November 2018 recommendation by a FINRA hearing officer that both Sandlapper Securities and Mr. Gordon be permanently barred from the securities industry for, among other things, “willfully defrauding investors” in connection with privately held investments in saltwater disposal wells. This regulatory investigation had been pending since 2014 but it was also never disclosed.
If your Financial Advisor recommended that you invest in a DST, and you have experienced losses, you may be able to recover your investment losses through a FINRA arbitration claim. Contact the Wolper Law Firm, P.A. at 800.931.8452 for a free consultation to discuss your legal rights.