Advisers of Real Estate Funds and SEC Enforcement

Recently, the Securities and Exchange Commission ("SEC") settled an administrative proceeding with a pair of non-publicly traded real estate investment funds structured as real estate investment trusts ("REITs") and their advisors.  One of the REITs was registered as a reporting company with the SEC, though it was not publicly traded.  Neither the other REIT nor either REIT's advisors were registered with the SEC in any capacity. Despite this lack of registration, the SEC investigated the practices of these funds and their advisors regarding the allocation of the advisors' expenses across separate fund vehicles.

This would not be terribly surprising if the SEC was announcing a settlement of a more traditional private equity fund, where the fund's advisors were registered as either a broker dealer or investment adviser with the SEC.  However, the advisors of real estate funds and REITs have traditionally not registered as broker dealers or investment advisers because those entities were not trading in "securities." But, the SEC has previously expressed interest in further regulating the real estate investment fund industry.  

This administrative proceeding is a notable example of the SEC applying investment adviser-like standards to persons who are not registered investment advisers or required to be registered as investment advisers.  

In this matter, the REITs' managers improperly charged their overhead expenses to the REITs. In doing so, they actually double-charged for the same overhead costs. Under the funds' governing documents, the managers were responsible for their own overhead costs and those expenses could not be allocated to the funds.  

The SEC regularly examines registered investment advisors for type of conduct as the SEC has interpreted this misallocation of expenses or miscalculation of management or advisory fees to be a "fraudulent, deceptive, or manipulative" practice with respect to investors or prospective investors in a pooled vehicle, conduct specifically prohibited by the Investment Advisors Act of 1940 and corresponding regulations. Here, though, the SEC could not use this tool against the REITs' managers because those managers were not “investment advisors.” Instead, the SEC characterized this conduct as fraudulent under the Securities Act of 1933, contending that the REITs' managers had misled investors in a securities offering.  

This matter is also interesting because it came shortly after the SEC issued new rules defining certain deceptive or manipulative practices in the private funds context. These rules were also issued under the Investment Advisors Act, so they would seemingly not apply to persons who are not "investment advisors," like the managers of the REITs at issue here. However, as this administrative proceeding highlights, the SEC, either formally or informally, may use these new rules as guidance for what is "deceptive" in other contexts.