Real estate is not a security? But an interest in a REIT is?

The title to this post is the title of an email I received from a Series 65 candidate who--like most people--is still struggling to get over the hurdle known as the Series 65 Exam. What stands out to me is this--her question actually explains THE point when trying to determine if an investment is actually a "security." But before I go there, let's first ask the more important question: why does the test ask me if something is or is not a security? Because of two things: the anti-fraud statutes, registration requirements. If the investment is not a security, the Uniform Securities Act has no authority over it, period. For example, you cannot commit securities fraud when offering/selling a fixed annuity--it's not a security. But, a mission investment fund security offered by a religious organization--Lutheran, Catholic, etc.--does meet the definition of a security. It is, therefore, subject to anti-fraud rules, and if investors are sold securities based on insufficient or erroneous offering documents, that is securities fraud. The security is exempt from the registration requirements of the Uniform Securities Act, but all SECURITIES are subject to the Uniform SECURITIES Act. And, the Uniform SECURITIES Act doesn't cover fixed annuities any more than it covers baseball cards.
Or, does it cover baseball cards?
I don't know--tell me more. If we're talking about some guy with a shoe box full of rare and valuable baseball cards, we're definitely talking about somebody with something of value--an investment of money that has likely gone up in value over time. But baseball cards are tangible items, things. Securities are always intangible. This piece of paper represents a debt obligation of a corporation; this piece of paper represents an ownership stake in a C-corporation trading on the NYSE, etc. So, a baseball card collection is an investment of money in collectible items--not a security. We could use baseball cards, on the other hand, to create an investment of money that would meet the definition of a "security."  Using the criteria from the Howey Decision, what would we call a situation in which 27 investors put $25,000 into an enterprise that uses that infusion of capital to travel the country going to baseball card swaps. Each investor receives a 1.5% ownership stake of any net profits/dividends. We don't call it "stock" or anything like that? Well, no one cares what it's called.  The question is--how does it function? It functions as an investment of money in a common enterprise where the investors profit solely through the efforts of others. It's an investment contract, which is a security.
Similarly, if you purchase a commercial building--which I so do not recommend--you have invested in real estate. This is not a security. However, if you put together a bigger real estate program funded by investors who put in money in exchange for an equity/ownership stake, now you have created a security. Chances are, you have created a REIT (real estate investment trust), in which investors will receive a share of net income, assuming there is any. So, the customer's email was perfectly titled--real estate is just real estate. If you sell ownership interests in a real estate program--now you're talking about a security. Need Help with Series 65/66?

What the Heck Is a Willful Violation?

Let's see how the Uniform Securities Act explains the meaning of the term "willful violation." The notes to the USA state: As the federal courts and the SEC have construed the term “willfully” in § 15(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78o(b): all that is required is proof that the person acted intentionally in the sense that he was aware of what he was doing. Proof of evil motive or intent to violate the law, or knowledge that the law was being violated, is not required. So, don't think for a moment that a willful violation occurs because the person clearly knew he was violating the law or maybe even the specific statute.  No, no, no. The so-called "investment adviser" was not declared mentally incompetent at the time she created a little-pretend family of mutual funds. So . . . she obviously knew the "mutual fund investments" she was "selling" to people were bogus. Willful violation. Of course, the New Jersey Bureau of Securities took away her license as an RIA. . . more importantly, the attorney general's office got a plea bargain out of her in a criminal proceeding leading to PRISON time. For more on this case, see http://www.nj.gov/oag/newsreleases08/pr20080429c.html.

But, that's just ONE example of a "willful violation." A "willful violation" could involve a financial planner getting her license revoked by the state but continuing to offer and provide financial planning services, anyway. That could--believe it or not--lead to criminal penalties. But that would be highly unusual.

The Uniform Securities Act  makes it clear that one can defraud an investor without any intent to defraud. Through negligence, incompetence, or breach of fiduciary duty, you can be sued and/or lose your license, but it's not a crime to buy somebody an inappropriate security. It's just often a career-ender. Check out what the Uniform Securities Act has to say at the very beginning: Part I Fraudulent and Other Prohibited Practices

Sec. 101. [SALES AND PURCHASES.] It is unlawful for any person, in connection with the offer, sale or purchase of any security, directly or indirectly

(1) to employ any device, scheme, or artifice to defraud,

(2) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading, or

(3) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.

OKAY, notice the last two lines under (3)??That means that a sloppy/incompetent/negligent person can violate the securities laws of the state by "engaging in a course of business which does or would operate as a fraud." How? Because the dude is so incompetent that all investors likely get bad information or no information. He's not going to jail; he's just going into a new industry at his earliest convenience. For example, a few years ago a new registered representative in Illinois had an elderly client who wanted "government bonds for safety and income." Dude bought her government bonds . . . issued by Honduras and Nicaragua. Was the investor defrauded? Yes. Did the dude go to jail? No. And since he didn't mean to hurt anyone, he's still a registered representative, right? Wrong. He acted in a way that operated as a fraud on the investor. He's not a criminal; he's just incompetent. And now, he's in a new line of work, hopefully one more suited to his particular skill set.

Cash Flow

A company reports its net income after tax (net profit) on the income statement. That net income is reduced if the company is subtracting large amounts for depreciation/amortization. If a company bought a printing press for $1 million cash a while ago, they might be subtracting $100,000 a year until they've written down the cost to zero, in order to spread the cost over the useful life of the equipment. But those subtractions now are not cash--they are a reality check. Since depreciation/amortization is a non-cash subtraction on the income statement, analysts often add back that subtraction to the net income in order to estimate how much cash the company is generating.

In the 10K, the company shows its balance sheet and income statement, and also a statement of cash flows. There are three ways a company can use or generate cash each year: operations, investing, financing. A company can generate or use up cash operating its business, but also by investing in equipment (or selling it off) or issuing securities (or buying them back). So, if the company's cash position increases, analysts would note perhaps that it's simply due to a recent offer of stock or convertible debentures (financing). If the cash position drops this year, maybe it's only because the company wisely invested cash into better equipment (investing). For extra credit "google" a public company's 10K and read thru the consolidated financial statement and the notes to it. It could REALLY help you on a few test questions. NEED HELP with your exam?

Self-Directed IRAs and 401Ks

Some folks might pretend they know the ins and outs of all available retirement plans, but that is not likely. For example, few people know that within an IRA account, an individual can actually invest in real estate, private placements, notes, and other investment options far outside the typical CDs and mutual funds. Self-directed IRAs allow individuals to invest in the typical securities investments that typical IRAs do but also expand into real estate, or possibly even providing start-up capital to a speculative company. Only certain companies can act as the administrator for the self-directed IRA account, but you can certainly find a few if you google the term "self-directed ira" or "self-directed 401K." I guess if I were impressed with my returns on real estate thus far, I might consider switching my Traditional or my Roth IRA to a self-directed account. But, since I prefer to buy REITS to financing and managing my own properties, I will continue to let my current broker-dealer/custodian hold the assets. But, who knows, some investors may want to explore the opportunity of investing in, for example, real estate or start-up companies. The test might even bring up the expanded investment options allowed in "self-directed IRAs" or "self-directed 401Ks."more help CLICK here

How to think about SECURITIES

When confronting tough questions concerning securities, try to process the information like this:


1. Is the INVESTMENT of money a SECURITY? 
     If so, it is subject to the state's anti-fraud authority.
2. Is the security exempt? 

3. Is the transaction exempt? 
      If no on both questions--somebody forgot to get the thing registered!


Okay, let's apply that little list. An indexed annuity is outside the scope of the SECURITIES act, so it's not even subject to the Uniform Securities Act's anti-fraud statutes. On the other hand, a church bond is merely an exempt SECURITY. That means it escapes registration fees and paperwork but is still subject to the Uniform Securities Act's anti-fraud statutes. Finally, a private placement involves a NON-exempt security being offered/sold in a special way. The people connected to the offer, sale, or purchase of this security are all subject to the state's anti-fraud authority.


Now you see why the Howey Decision was so important--if the respondent's lawyers can convince the hearing officer or judge that the investment was not a security, the client walks. Right? If it's not a security . . . it's not a security. If it IS a security it IS subject to anti-fraud rules AND will either need to be registered or exempted from registration.

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JP Morgan's $2 billion boner

So, obviously, we don't wanna tick off employees of JP Morgan, especially as no one reading this blog had a darned thing to do with the loss of $2 billion from bad derivatives trading. But, there is a tie-in to a couple of testable points, and all public companies are fair game, so here goes. When/if you see the term "forward" on your exam, you'll need to remember that these derivatives are private, unregulated arrangements between two parties. Because forwards--unlike options and futures--do not trade on regulated exchanges, with settlement dates and margin requirements enforced, we occasionally end up hearing about some tsunami-like effect when one side finally has to admit to themselves, their trading partners, and the regulators--uhhhhhhhhhh, we really screwed up here--wtf? Even though the housing crash was inherently linked to the speculation in mortgage-based derivatives, here we are four years later with the same stuff still happening. Why? Way beyond the scope of the exam and this blog. I just want you to associate the term "forwards" with "unregulated derivatives" and remember that they are private arrangements between two parties.
And, man, do some of these contracts get creative. You're afraid that a corporation you lent $300 million to might default? Structure a derivative in which the other side agrees to pay you X amount if that happens. You find yourself sitting on a portfolio of $5 billion worth of "sovereign debt" issued by OPEC nations and start to worry they maybe cannot or will not pay? Structure a derivative that works like an insurance contract that pays out if that disaster strikes. Or, just make wild speculative bets that X, Y, or Z will occur across the globe, whether it's a bond default, a weather-based event, or probably a hundred things my limited imagination has never considered. Unfortunately, not everyone fully understands what they're getting into, and they frequently forget that the things in life that will "never happen" always do eventually. Only worse.
In any case, I'm not worried about the survival of JP Morgan, but I definitely understand the concerns of the regulators trying to avoid another credit crunch or series of big bank failures. The "banks" these days get to take FDIC insured deposits and then use those funds to make esoteric bets using unregulated derivatives few seem to understand. Obviously, it doesn't work out so well sometimes. Who should pay the price? Shareholders, in my opinion. And then the you-know-what needs to roll UPhill--the shareholders need to organize, vote down the executive compensation packages and even remove the members of the board of directors who don't seem to have any more ability to avoid a $2 billion loss than any random person swearing at an ATM at any Chase(TM) location this afternoon.  More Help Click HERE

Mutual Fund Prospectus, SAI, Shareholder Reports

To REALLY understand mutual funds--and investment vehicles in general--download a mutual fund prospectus, and an SAI, and a shareholder report. If you want the scaled-down, bare-bones disclosure document, download the prospectus or the even slimmer summary prospectus. You'll find the risks and objectives and policies of the fund, the fees and expenses, the taxation issues, etc. But if you want to see precisely what's in the portfolio, download the statement of additional information or SAI. For example, when I look at the prospectus for the American Balanced Fund, I see that: "The fund invests in a broad range of securities, including common stocks and investment-grade bonds (rated Baa3 or better or BBB- or better by Nationally Recognized Statistical Rating Organizations designated by the fund’s investment adviser or unrated but determined to be of equivalent quality). The fund also invests in securities issued and guaranteed by the U.S. government and by federal agencies and instrumentalities. In addition, the fund may invest a portion of its   assets in common stocks, most of which have a history of paying dividends, bonds and other securities of issuers domiciled outside the United States." Okay, that's a good general statement that could attract or repel from an investment in this conservative mutual fund. But if I'm willing to download the statement of additional information/SAI, I can get more detail on the portfolio. For example, I see that within the 69.73% of the portfolio devoted to common stock, there are some 45,386,600 shares of Wells Fargo worth at the time $1.25 billion. The portfolio holds 16 stocks in the "financials" sector, which represents both 10.8% of the fund's industry allocation and approximately $5.3 billion of market value.  By the way, I notice that this mutual fund holds large positions in at least four other companies that issue and/or manage mutual funds. Hey--why not--it's a great business? So, the SAI gives a much more detailed look at the mutual fund portfolio than the prospectus or summary prospectus.  If I want to know that and also how much money the fund pays in expenses to all the various service providers, I need to download the shareholder report--either semi-annual or annual. In this report, I discover that the following parties were paid the following amounts:
  Investment advisory services   121,350,000
  Distribution services  182,738,000
  Transfer agent services  42,807,000
  Administrative services   30,064,000
  Reports to shareholders  2,393,000
  Registration statement and prospectus  762,000
  Trustees’ compensation  458,000
  Auditing and legal   133,000
  Custodian   278,000
  Other   2,214,000
TOTAL EXPENSES $383,197,000

So, the fund's income statement shows that the portfolio earned $1,306,571,000 in dividends and interest, and after deducting $383,197,000 for expenses, the net investment income was $923,374,000. Notice that the adviser earned about $121 million managing the portfolio; the distributor earned about $182 million marketing the shares and providing other services. Heck, just generating the semi-annual and annual reports themselves cost about $2.4 million a year! In any case, I find this stuff interesting. It's painful to dig in at first, but the rewards are pretty high. I mean, if you understand mutual funds to this level, how hard are the test questions really going to be?