Will FINRA's Complaint Against David Lerner Cause Apple REIT To Deny Redemption Requests By Investors?

June 6, 2011

Last week, FINRA's complaint filed against David Lerner & Associates triggered a storm of media attention scrutinizing the brokerage firm's alleged sales practices violations related to its distribution of Apple REITs investments. The FINRA complaint also exposed that the $11 price per share of all Apple REITs offered are overvalued and that each REIT has been borrowing money to pay dividends. To view the FINRA complaint, click here.

Since 1992, David Lerner has served as best efforts underwriter and sole distributor of a series of ten REITs that have issued nearly $6.8 billion in securities to date. A REIT is a company that owns and usually operates income-producing real estate. To qualify as a REIT, a company must have most of its assets and income tied to a real estate investment and must distribute at least 90% of its taxable income to shareholders annually in the form of dividends. Several of the earlier Apple REITs have been acquired by other companies. However, Apple REIT Six, Apple REIT Seven, Apple REIT Eight and Apple REIT Nine continue to operate but are closed to new investors. Apple REIT Ten opened in January 2011 and is still open to new investors.

Since the complaint was filed, we have received multiple calls from aggrieved investors who want to withdraw their investments from Apple REIT Six through Ten but are concerned that the REITs will not honor their redemption requests. So the question is whether investors will be able to get their money back from the Apple REITs?

First of all, the Apple REITs are illiquid investments because there is no market to sell them to third parties. From a suitability standpoint, these investments are not appropriate for investors who may need access to cash in the short-term (e.g. retirees). Unfortunately, however, the FINRA complaint alleges that David Lerner targeted retirees to sell them Apple REITs. Obviously the risks associated with illiquidity are magnified as more of the investment is purchased. Since there is no market to sell Apple REITs on the open market, investors generally must rely on Apple REIT to honor redemption requests.

Each of the Apple REITs Six through Ten has rules described in the product prospectus regarding whether units of the REITs can be redeemed. The applicable Apple REIT program is referred to in the prospectus as the "Unit Redemption Program" and the language describing how the program works is very difficult to follow.

The language in each of prospectuses does state, however, that the company will not consider any redemption requests made within the first 12 months of purchase. Therefore, since the Apple REIT Ten did not open until January 2011, investors in Apple REIT Ten currently are not eligible to receive any of their money back. To view orginal Apple REIT prospectus, click here.

With regard to Apple REIT Six, Seven, Eight and Nine, it appears that those investors may be eligible to receive redemptions. Approved redemptions are paid quarterly and are considered on a first come, first serve basis. Therefore, if you have already decided that you want to make a redemption request, you have to get in line. Given the negative publicity surrounding these REITs, all of this increases the risk that redemptions will be limited and/or suspended altogether in the coming months. To go to the Apple REIT companies website and view additional information regarding each of these REITs, click here.

Another fact that increases the risks that redemption requests will be denied in whole or part is that the fact that the Unit Redemption Program limits the total amount of redemptions to three percent of the weighted average number of Units outstanding during the 12-month period immediately prior to the date of redemption. Also, the prospectuses state that the company has complete authority to deny redemption requests and to unilaterally change the rules on redemptions at any time. For example, the FINRA complaint alleges that in May 2011, after redemption requests exceeded the 3 percent limit in the first quarter of 2011, Apple REIT Eight raised the redemption percentage to 5 percent but lowered the redemption payout on non-reinvested shares to 92% of the purchase price. In other words, the company unilaterally imposed an 8% redemption charge on the Apple Eight REIT.

Finally, based on the FINRA complaint, the companies are underperforming the $11 per share value currently shown on investors' monthly statements. In addition, the companies are borrowing money to pay dividends. Not a good sign if a thriving investment. Additional redemption requests, will likely increase the burden on the funds, which also increases the likelihood that future redemption requests will be limited or denied altogether.

If the Apple REIT companies do limit or prohibit redemptions altogether, investors should considered seeking to recover these losses from David Lerner. Brokerage firms such as David Lerner have fiduciary duty to its customers to disclose all material facts regarding the recommended investment. Furthermore, David Lerner had a duty to conduct its own due diligence of the viability of these REITs and had a duty to make suitable recommendations to its customers. If David Lerner failed to fulfill its duties, it can be held liable for the resulting losses.

If you have suffered losses in any of the Apple REIT investments, please feel free to contact us for a free consultation.