AI Quarterly Spring 2016

Q U A R T E R LY

Alternative Investments QUARTERLY

spring 2016 volUME 10 issue 2

DOL Q&A

The DOL Fiduciary Rule—How Will Industry Professionals Adapt?

Economic Forecast:

Market Commentary April 2016

U.S. has the ability to weather the perceived risks lingering in the marketplace

I The Rise of Liquid Alts I Dual BD/RIA Registration PART I I ADISA News

Q U A R T E R LY

SPRING 2016 volUME 10 issue 2

Alternative Investments QUARTERLY

1 President’s Letter ADISA Leadership Continuing to Advocate For You

2 ADISA Editorial Board Chair I Brandon Raatikka I FactRight, LLC

Executive Director’s Letter ADISA at the Office of Management and Budget

Linda Dewlaney I Preferred Partnership Services Peter Magnuson I Securities America

CONTACT INFORMATION ADISA I 10401 N Meridian St., Suite 202 I Indianapolis, IN 46290 Direct: 317.663.4180 I Toll Free: 866.353.8422 Fax: 317.815.0871 I E-mail: adisa@adisa.org John Harrison I Executive Director I 317.663.4172 Adam Abubakr I Director of Accounting & Data Systems I 317.663.4177 Tanisha Bibbs I Director of Event Planning I 317.663.4174 Jennifer Fitzgerald I Director of Marketing I 317.663.4175 Tony Grego I Associate Executive Director I 317.663.4173

4 Q1 Economic Forecast: Market Commentary April 2016

8 The DOL Fiduciary Rule: How Will Industry Professionals Adapt?

12 Dual Registration: Duties, Risks and Rewards for Broker Dealers and Investment Advisers

Erin Balcerzak I Administrative Assistant I 317.663.4183

20

Design I DesignMark I Susie Cooper

The Rise of Liquid Alts: Interval Funds

adisa.org Copyright © 2016

By ADISA (Alternative & Direct Investment Securities Association), formerly REISA, formerly the Tenant-In-Common Association.

All rights reserved. Readers may copy sections of this publication for personal use. However, it is a violation of U.S. copyright laws to copy substantial portions of the publication for any reason without permission. The Copyright Act of 1976 provides for damages for illegal copying. If you wish to copy and distribute sections of this publication, contact Jennifer Fitzgerald at jfitzgerald@adisa.org.

26 ADISA News

President’s Letter

ADISA Leadership Continues to Advocate For You

By Mike Bendix, DFPG Investments

The second quarter of 2016 has just barely begun so there’s really not much to report. That is, unless you consider implementation of FINRA’s Regulatory Notice 15-02, the Department of Labor’s long-anticipated announcement of its final fiduciary and best interest contract ruling and a record-setting Spring Symposium to be big news.

What stands out to me is that, despite all of the industry uncertainty, and a contentious political climate and election season, the likes of which we have never seen, the industry that ADISA represents has shown remarkable resiliency. I can’t help but think that the leadership of our association played an essential role in helping to create that stability.

In recent months, members of our leadership have appeared in front of FINRA, the SEC, the Department of Labor and the Office of Management and Budget. I am proud to report that ADISA, along with numerous industry partners, has become an important voice in communicating the interests of our members to our elected officials and the regulators. Many thanks are owed to Executive Director John Harrison and to John Grady and the rest of ADISA’s Legislative and Regulatory Committee for their outstanding work on behalf of all of us.

ADISA’s core mission is to provide the best combination of education, advocacy and networking opportunities for its members. Our board of directors has established an ambitious list of priorities to help each of us adapt to a constantly-changing regulatory environment and the increasing complexity of alternative products. ADISA is the industry leader in alternative investment education and we intend to take that to an even higher level. A record number attended our Spring Symposium in March to learn from key industry experts at the over fifty panels and general sessions. ADISA’s summer Due Diligence Forum and our showcase event, the Annual Conference in Las Vegas, promise to build on that success.

Our work in Washington continues to be a top priority. ADISA’s advocacy efforts are being enhanced to address such issues as the accredited investor definition, the seemingly constant threats to IRS Section 1031, and reaction to the DOL ruling, where our real work may just be beginning.

Ultimately, the primary responsibility for each of us is to our common client: the investor. Let’s continue our commitment to keeping our compass pointed in that direction.

Continued success. ▲

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Executive Director’s Letter

ADISA at the Office of Management and Budget

By John Harrison, Executive Director, ADISA

Call it the last clear chance or call it the Charge of the Light Brigade, but before the issuance of the new DOL Fiduciary Rule, ADISA proudly argued the industry’s case before the Office of Management and Budget—the OMB is the last stop before a regulation is made final. We were the only trade association from the non-traded alternative space to appear, and it was just the two of us—John Grady, ADISA’s L & R Committee Chair, and me, ADISA’s Exec— to face the panel of inquiry.

No one outside the hallowed halls of that grand old building next to the White House, the Old Executive Office Building (now called the Eisenhower Building), knows what results come from such appearances, but by our own account we did our very, very best. It’s not often you come away from an interview not wishing you had said this or that differently. But we had no regrets. We left it all on the table; here is my take on how it went.

First, I’m frequently on the Hill and know that dealing with Congress means in large part dealing with very smart and often young staffers; they run most of the offices and are the gatekeepers, initial policy schedulers, and overall worker bees of the Legislative Branch. There’s not necessarily anything wrong with this, we just don’t think about it—sort of like we also never really ponder that the world is in the hands of babysitters on Saturday nights. Of course, the Executive Branch is completely different. The Executive Branch world is run by slightly older and often extremely well educated young staffers—many of whom have already served in some capacity somewhere in government (rarely in the private sector), and now they’re getting somewhere ostensibly more stable and higher up the Washington, D.C. food chain.

Thus, the John Grady and John Harrison duo sat down before six fresh faces appointed in theory on behalf of the President, and there was one older face from the DOL—just an observer in the corner, we were told.

We compared who went to school where, a good enough icebreaker (there was luckily my lowly big state school counterpart—from my same school even, University of Georgia); and of course, Mr. Grady reluctantly brought out his Ivy League credentials to meet theirs. So far, we’re hanging with these guys.

I started with a two page summary of about a dozen studies to support our argument. Humbly, I pointed out that one of the studies had data which I could not readily test, and I wanted to admit that right off. The rest of the data I had been through, and the studies showed the power and need for financial advice, the value of diversification with alternatives and illiquid products, and the potential harm to the average person which would likely come to pass should the Rule proceed as initially planned.

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I saw the light bulb go off for their chief Ivy Leaguer, and slightly later — and to my relief ­— my UGA counterpart raised an eyebrow in understanding too.

We were on to something here.

John Grady then walked them through some examples—even using the young investor of modest means (someone like themselves presumably). Bingo. They asked him about commission vs. fee as applied to one of his examples. Slowly and eloquently he fielded

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that question, showing that many investment products do not easily lend themselves to charges for an annual advisement fee.

I saw the light bulb go off for their chief Ivy Leaguer, and slightly later—and to my relief—my UGA counterpart raised an eyebrow in understanding too. We were on to something here.

We continued, answering more questions on product types: non-traded BDCs and the like. We gave them ADISA’s new and popular Guide to Alternative Investments, and I noticed one of the OMB crew dove into it right away. Our time to state our case was up. John Grady and I left, knowing we had done our very best for ADISA and for this industry. We had been heard by our government. Perhaps we were even understood. ▲

The

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Q1 Economic Forecast: Market Commentary April 2016

By Ladenburg Thalmann Asset Management

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Equity markets did not give investors any time to get comfortable in 2016.

After only six weeks, the S&P 500 had corrected 13.3% from November highs and was down more than 10% for the year on February 11th. Markets suffered from a steady drumbeat of negative news related to China’s demise, falling commodity prices, and the possibility of a U.S. recession. Additional toxic ingredients included uncertainty surrounding the Fed, speculation on the negative effects of energy defaults on banks, unusual currency volatility and large sell-offs in high-flying growth stocks that investors fell in love with in 2015. As history has shown over time, market volatility is the price of admission and often creates more opportunities than it takes away.

Domestic Equities For the first time since the Great Depression the S&P 500 finished positive after falling more than 10% intra-quarter, ending the quarter up 1.4%. In the large cap space, last year’s darlings like Amazon and Netflix each sold off roughly 25% as a huge disconnect emerged between the economy and the markets. While the U.S. economic backdrop continues to solidify, equity markets have not reflected that. The U.S. economy is growing faster than most of the developed world and the U.S. consumer is riding a wave of positive momentum.

Notably, unemployment in the U.S. has declined to pre-recession levels, at 5%, and the early signs of wage growth are emerging.

Over time, improving economic growth, persistently low interest rates, modest inflation and a more stable U.S. dollar will be positives for corporate earnings, which have been poor for consecutive quarters.

Eventually, these tailwinds should translate into an increase in stock prices, however patience is required as this process will take time to come to fruition.

More discretionary income for U.S. consumers will equate to more customers for U.S. businesses.

Over time, improving economic growth, persistently low interest rates, modest inflation and a more stable U.S. dollar will be positives for corporate earnings, which have been poor for consecutive quarters.

Eventually, these tailwinds should translate into an increase in stock prices, however patience is required as this process will take time to come to fruition. Looking ahead, stronger corporate earnings will need to materialize before investor apprehensions moderate enough to allow for a widespread reentry into equities. It is our expectation that markets will continue to be volatile for the remainder of 2016.

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International Equities With the expectation that the Federal Reserve would begin raising interest rates at regular intervals and other developed nations moving in the opposite direction by implementing more accommodative policies, the majority of people expected European and Japanese equity markets to outperform. Unfortunately for the majority, that narrative did not play out as the MSCI Europe Index was down -2.5% and the MSCI Japan Index was down -6.5%. Though developed international markets were negative on the quarter, valuations remain attractive relative to U.S. equities and continue to be an important part of a global equity allocation.

Conversely, emerging markets bounced back after three years of pain finishing the quarter up 5.7%. The strengthening dollar and falling commodity prices were significant impediments to emerging markets in 2015. This year, that story has reversed as the dollar has weakened, playing an important role in stabilizing commodity prices and other currencies. Most notably, prices for a barrel of WTI increased 58% from February 11th to March 22nd, which spurred a rally in some of the most beaten down areas of the market. Despite the rally, uncertainty still persists in the commodities and currencies space and it will take more than one quarter to know if this rally is sustainable.

When used appropriately, alternatives serve as invaluable diversifiers by acting in ways that are different than traditional equity and bond markets. We have always believed in the power of alternatives to add further diversification and protect against downside moves.

Fixed Income Bonds were the premiere asset class in the first quarter as the Barclays Intermediate Government/Credit Index finished up 2.5% and the Barclays High Yield Index was up 3.4%. The Fed indicated in December they were set on raising interest rates four times this year which led to a widespread belief that a rising rate environment was finally upon us. However, this was another lesson in humility as the yield on the 10 Year Treasury proceeded to fall from 2.27% to 1.76% in the quarter as fear drove investors into safe-haven government bonds. The market turbulence and global uncertainty sent the Fed a pronounced message that they needed to take their foot off the gas, which has since resulted in the Fed clarifying they will err on the side of caution, making two rate increases in 2016 the most likely result.

The Fed does not want to make a policy mistake that could derail the recent stabilization by tightening too quickly, which leads us to believe the next increase will most likely come in June. If the Fed raises rates gradually over a longer period of time, as expected, focusing portfolios on income can offset the decline in price. We continue to believe we are locked in a “lower for longer� rate environment and are positioning portfolios with intermediate term bonds, as well as less interest rate sensitive bonds represented through an allocation to high yield.

Alternatives In a quarter characterized by elevated volatility in fixed income and equity markets, alternatives are an important defense mechanism and play a key role in diversification.

When used appropriately, alternatives serve as invaluable diversifiers by acting in ways that are different than traditional equity and bond markets. We have always believed in the power of alternatives to add further diversification and protect against downside moves. As an example, in the month of January when the S&P finished down -4.9%, the Credit Suisse Hedge Fund Index was only down -1.4%, providing the diversification benefits we would expect.

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In our view, however, the negative headlines were overstated, as the U.S. has the ability to weather the perceived risks lingering in the marketplace and the consumer sector is the healthiest it has been in years.

Real Estate After a slowdown in home sales into year end, buying activity picked up modestly to start 2016. Home sales data is volatile from month to month, but the longer term trends are pointing in the right direction and there are a couple of reasons for optimism in a sustainable housing rally. First, it looks like employment gains and looser mortgage financing are starting to have a positive effect on prospective buyers. Second, wage growth is improving, making the prospect of purchasing a home more reasonable for people. As a result, further gains in home sales and home prices in 2016 should be expected.

Conclusion As the calendar turned over to 2016, investors focused attentively on negative news stories which lead to a rise in investor anxieties and a very uncomfortable first six weeks of the year. From the February lows, the market proceeded to turn on a dime and a snapback equity rally tied to rising oil prices and improving sentiment followed. In our view, however, the negative headlines were overstated, as the U.S. has the ability to weather the perceived risks lingering in the marketplace and the consumer sector is the healthiest it has been in years. Undoubtedly, we anticipated that 2016 was not going to be without challenges, but the U.S. economy remains in a slow and steady state of improvement behind a strong labor market, improving wages, and a resilient U.S. consumer. All of

Although this market outlook has been prepared from public and private sources and data that LTAM believes to be reliable, LTAM makes no representation as to its accuracy or completeness. Any securities, indices, and other financial benchmarks shown are provided for illustrative purposes only, and reflect reinvestment of income, dividends, and other earnings. They do not reflect the deduction of advisory fees. Indexes are unmanaged and investors cannot invest directly in an index. Investors should bear in mind that past performance is no guarantee of future results and there can be no assurance that the Program will achieve comparable results. Investment products are subject to investment risk, including possible loss of the principle amount invested and should review the prospectus before investing. The information and views expressed are given as at the date of the writing and are subject to change. This information is not to be used or considered as an offer or the solicitation of an offer to sell or buy any securities mentioned herein. Ladenburg Thalmann Asset Management Inc. is a registered investment advisor and subsidiary of Ladenburg Thalmann Financial Services Inc. which is traded on the NYSE_MKT: LTS.

these factors will continue to provide modest improvements for investors.

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The DOL Fiduciary Rule: How Will Industry Professionals Adapt?

Q&A With John Grady, ADISA President-Elect

DOL Q&A

The Department of Labor’s fiduciary rule, finalized and published in early April, includes three primary takeaways for the alternative and direct investment industry and ADISA’s membership: the proposed asset list was eliminated, financial advisers may still offer investments that pay commissions and the full implementation date was extended to April 2017, with some provisions not fully in place until January 2018. Still, change is on the horizon. ADISA will host a series of webinars to discuss the impact of the DOL fiduciary rule and concerns that come with its implementation. For this issue of AIQ, we sat down with John Grady, ADISA’s president-elect and chairman of its legislative and regulatory committee, to discuss reactions to the rule, concerns and what may be coming for ADISA members.

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Q:

The DOL fiduciary rule encompasses many changes for the financial industry. Focusing

on alternative and direct investments in particular, what was ADISA’s initial reaction to the rule?

What challenges are ahead for the industry as a whole, and for ADISA’s members in particular?

A:

ADISA was pleased that many of the requested changes that the industry and associations like

ADISA had submitted were included in the final rule. And, in some respects, the exemption was made more workable for the broker-dealers and others who will have to implement it in order to charge variable compensation. However, on balance, the rule making and accompanying exemption are still an enormous change for sponsors and broker-dealers, and will require significant changes to business practices as well as investments in systems and new operating models. As a result, I don’t think that ADISA can understate the amount of change and cost and dislocation that this will create, despite there being a less than complete record on how these changes will positively benefit investors.

The industry as a whole is going to need to start work right away to prepare for implementation, which is coming in a short period of time. The firms will have to assess their willingness to utilize the exemption in their business models and understand what deciding to do so will mean—both for their clients as well as their own representatives and business models. If nothing else, firms should be reviewing critical portions of the exemption to see if they are willing to continue to incorporate variable compensation products and services into their business model.

Q:

What would you say are some of the major areas of concern or question for ADISA and

its members under the rule? And under the BIC exemption? Is the rule and the accompanying exemption likely to change the investment landscape for investors? Will the new “best interest contract” exemption generate significant investor protection?

A: ADISA understands that the rule touches the way that members ranging from products sponsors to broker-dealers and financial advisers can operate in the future when it comes to serving retirement savers and retirement accounts. With this in mind, we believe that the challenges and issues for our members range from product design and development on the one hand, to costs and fees on the other. This is all in addition to other important issues, such as internal procedures at the broker-dealer level and an operating environment that helps minimize potential liabilities that the revised regulation and new exemption are introducing.

From the standpoint of the retirement saver community and the various constituencies that serve it, there’s a potential for some aspects to change very little under the regulation and exemption. There are ways of managing their assets now that will continue to be available going forward. On the other hand, there’s a large and important role in serving the retirement saver community that is or can be played by alternative investments, and various aspects of their construction and use will be subject to change as a result of the DOL’s actions. Investors may see fewer products and/or different service models, and they might even see severely limited choices in alternative investments from what they enjoy now. They might even see the cost of investment advice go up, or the availability of quality investment advice go down. In the worst case, some investors will actually not be able to obtain the investment advice they need other than by interacting with computers and computer models, given either the size of their accounts or the types of strategies that they wish to employ.

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Q:

The final version of the BIC exemption raises a significant question: to wit, what is

“reasonable” compensation? How are firms going to decide what is “reasonable” in relation to a wide range of investment products and services?

A:

This question gets at the heart of one of ADISA’s concerns for its members as a result of the

new regulation and exemption. In particular, the reasonable compensation concept requirement in the exemption is going to put a huge burden on broker-dealers to assess the cost and expense of different investment types for their clients, both at the time of investment and over the longer term. It’s not clear, at this point anyway, how broker-dealers are expected to make that determination and what universe of comparable products, services and costs they are going to be expected to take into account. In addition to that uncertainty, the Department made clear that the standards in general for reviewing alternative investments that are complex products are even higher, and require more diligence and more oversight, and potentially, offer greater liability to the firms that offer them.

Q:

Broker-dealers and others looking to rely on the BIC exemption will have to make

operational changes. Can you provide a brief synopsis of what these changes may be, and how you see this affecting alternative investment offerings?

A:

At the heart of the Department’s rulemaking is a definition of the term “fiduciary” that will likely

sweep in nearly all financial advisers who provide advice to retirement savers. The only way forward for those advisers employing transaction-based compensation models is to use the exemption, which is named the best interest contract exemption for a reason. At bottom, the exemption requires a contract to be entered into between the retirement saver and the financial advisory firm. This contract will provide for everything from new rights and liabilities, on the one hand, to requirements relating to disclosure, reporting and other operational matters, on the other. When advisers are looking at the ability to employ a transaction compensation model in the future, they will be looking at a wide range of operational requirements and constraints, which run the gamut from client acceptance of the new contract to dealing with the liabilities established by that new contract; they will also have to deal with the requirement to establish policies and procedures to govern how they provide services to retirement savers. In short, there are a host of operational challenges that come with significant potential legal liabilities for the firms that choose that path.

Q:

The general consensus is that sponsors of products that were nearly blocked via the

proposed asset list are now in the clear with the list’s elimination. Is that truly the case?

A:

The good news is that the industry was able to convince the Department of Labor to eliminate

the idea that only certain investments could be recommended under the exemption. But that good news is paired with the fact that the exemption more or less requires broker-dealers to implement a costly service model that involves consideration of the role of alternative investments in client portfolios. Sponsors are going to be expected to understand the challenges that broker-dealers using the variable compensation model will face, and those broker-dealers are going to want help from the sponsors in everything from product design to comparative data and other information. So, while sponsors are and should be pleased that the list approach was abandoned by the DOL, I think that their willingness to address these issues in working with broker-dealers will be a competitive issue and a means of enhancing the success of their overall distribution efforts in the future. ▲

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Dual Registration: Duties, Risks and Rewards for Broker Dealers and Investment Advisers

By Brittany Burns, WealthForge

I’m a Broker Dealer.

I’m an investment adviser.

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White Paper Part I of II (Part II will be published in the next issue of AIQ)

On April 6, 2016, the Department of Labor (“DOL”) announced its final “conflict of interest” rule which expanded the definition of fiduciary to include “any person who provide[s] investment advice or recommendations for a fee or other compensation with respect to assets of a plan or IRA.”1 As reflected by the rule, the line between registered investment advisers (“Advisers”) and broker-dealers (“Brokers”) has become blurred.2 Historically, Advisers had a fiduciary duty to their clients to act in the client’s best interest.3 In contrast, Brokers were only required to ensure that their recommendations met a suitability standard, in that the recommendation would be suitable for an investor based on factors such as investment goals, income and risk tolerance.4 Under the DOL’s fiduciary rule, however, “brokers and dealers could be considered fiduciaries when they provide recommendations to participants in retirement plans.” 5

The rule reflects a growing movement

Characteristics of an Adviser v. Broker

in the regulatory sphere to delineate the

The line between Advisers and Brokers has become blurred, largely due

duties required by Brokers who are dually

The definitions of an investment adviser and broker offer little help in

registered as Advisers or who perform advisory services. This whitepaper provides an overview of the differences between an Adviser and a Broker, the friction points of

to a growing number of registered persons acting in both capacities. differentiating the two positions. An “investment adviser” is defined as “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.”6 In

being dually registered as both, and the

comparison, a “broker” is defined as “any person engaged in the business

risks and benefits of dual registration.

of effecting transactions in securities for the account of others.”7 While the definitions may seem similar, there are important differentiations between an Adviser and a Broker. First, Advisers and Brokers are

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regulated under different laws, with Advisers primarily falling under the Investment Adviser Act of 1940 and Brokers primarily falling under the Securities Exchange Act of 1934. While both Advisers and Brokers are regulated by the SEC,8 Brokers must also comply with additional rules promulgated by the Financial Industry Regulatory Authority (“FINRA�) and other self-regulatory organizations.

Brokers and Advisers also have different disclosure requirements, permissible compensation schemes and fiduciary duties. These three differences provide the most friction when an individual is dually registered as an Adviser and Broker. Understanding the individual responsibilities of an Adviser and a Broker, and how dual registration can change those responsibilities, is paramount for Advisers and Brokers to remain in compliance with applicable law.

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The biggest point of friction between Advisers and Brokers is the different duties owed by the Adviser/Broker to his or her clients. In terms of an Adviser, the Supreme Court has interpreted the antifraud provision of the Investment Adviser Act as imposing a fiduciary duty on Advisers when dealing with clients...

In contrast, Brokers are generally excluded from the definition of ‘investment advisers’ and are not held to the high fiduciary standard encompassed in that designation. Instead, Brokers have a duty of fair dealing, a duty to make suitable recommendations, and a duty of best execution.14

Duties of Advisers and Brokers The biggest point of friction between Advisers and Brokers is the different duties owed by the Adviser/Broker to his or her clients. In terms of an Adviser, the Supreme Court has interpreted the antifraud provision of the Investment Adviser Act as imposing a fiduciary duty on Advisers when dealing with clients.9 This duty requires Advisers to offer neutral and disinterested advice that is solely in the best interest of the client. The SEC has interpreted several obligations flowing from an Adviser’s fiduciary duty, including: (1) full disclosure of material facts, conflicts of interest, and disciplinary events and precarious financial conditions; (2) providing suitable advice10; and (3) having a reasonable basis for recommendations.11 The fiduciary duty is absolute and does not require a showing of scienter on the part of the Adviser or actual injury to a client.12 Thus, an Adviser is strictly liable under the Investment Adviser Act’s antifraud provision for any breach, intentional or non-intentional, of their fiduciary duty to their clients.

In addition to their fiduciary duties, Advisers have a duty of best execution and a duty to make suitable recommendations.

In contrast, Brokers are generally excluded from the definition of ‘investment advisers’ and are not held to the high fiduciary standard encompassed in that designation.13 Instead, Brokers have a duty of fair dealing, a duty to make suitable recommendations, and a duty of best execution.14 These duties, like the fiduciary duty, are intended to protect investors but are a much lower threshold than the fiduciary standard imposed on Advisers. Courts have upheld these duties under the “shingle” theory, which holds that by conducting business as a Broker (i.e. “hanging your shingle”), the Broker implicitly represents that he will deal fairly with customers, consistent with the standards of the profession, and imposes on him a “special duty, in view of [their] expert knowledge and proffered advice, not to take advantage of [their] customers’ ignorance.”15

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The “suitability” duty differs from the fiduciary duty imposed on Advisers because it does not require the Broker to act with total indifference to the Brokers’ own personal interest.

The “suitability” duty differs from the fiduciary duty imposed on Advisers because it does not require the Broker to act with total indifference to the Brokers’ own personal interest.

Instead, Brokers are only required to act in accordance with industry standards. Thus, Brokers can make recommendations to clients that will benefit the Broker, so long as the client meets suitability requirements and the recommendation is one that is consistent with industry standards. Advisers are required to act with complete loyalty to the customer and must avoid conflicts of interest that may benefit the adviser, even if the benefit does not detriment the client. In contrast, Brokers may weigh different factors and suggest securities that directly benefit the Broker, so long as the customer is informed and the Broker is acting in concert with industry standards.

As part of the duty to deal fairly with customers, Brokers have an obligation to only recommend investments and investment strategies that are suitable for their customers, as well as a duty to ensure customer-specific suitability.16 In determining whether an investment is suitable for a customer, Brokers must have an “adequate and reasonable basis” for their recommendation.17 This requirement invokes a due diligence analysis by the Broker to obtain information about the customer, which may include, but is not limited to: (i) age; (ii) other investments; (iii) financial situation and needs; (iv) tax status; (v) investment objectives; (vi) investment experience; (vii) investment time horizon; (viii) liquidity goals; and (ix) risk tolerance.18 The Broker has a duty to request the information, however, a recommendation may still be made if not all the information is available so long as the Broker has a reasonable basis to believe the recommendation is suitable, based on the information available.19 In addition, in order to make a recommendation that is adequately and reasonably based,

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Even if a Broker is acting in the best interests of the customer, a dually registered individual will still be scrutinized heavily in certain situations where a conflict of interest is unavoidable.

a Broker must “understand the risks and rewards inherent in that recommendation.”20 In essence, the suitability requirement is two-fold, Broker’s must know their customers and know the details of the security they are recommending.

Finally, Brokers have a duty of best execution, which requires Brokers to “use reasonable diligence to ascertain the best market for the security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.”21 FINRA Rule 5310 defines specific factors that are used in determining whether a member used “reasonable diligence,” which are measured without regard to the Broker’s mental state. In addition, if a Broker has scienter or acts recklessly when selling a security, he may be found additionally liable under Exchange Act §10b and SEC Rule 10b-5.22 The difference between the duties owed by Advisers and those owed by Brokers is where the most friction occurs when an individual is dually registered. Both Advisers and Brokers

One way in which a dually registered individual can mitigate liability for breach of fiduciary duties is to act in the best interest of the client at all times and refrain from any activity that conflicts with the client’s interest.

have a duty of best execution and a duty of suitability, but these flow from their overarching fiduciary duty and duty of fair dealing, respectively.

The different duties stem from the historically different roles that Advisers and Brokers occupy for investors. Advisers have historically been viewed as trusted resources who are consulted to give advice solely with the client’s best interest in mind, free from any influence or conflict that may sway the adviser’s recommendation. This is reflected in the compensation structure of most Advisers and in the Court’s interpretation of the duties owed by Advisers to their clients. In contrast, Brokers have historically been viewed as intermediaries, their purpose being to facilitate transactions and connect investors to investments.23 Investors are aware of the commission based compensation that most Brokers receive and thus are unlikely to place the same level of trust that the Broker is acting solely in their best interest.

The roles that investors perceive Advisers and Brokers playing causes a conflict when an individual is dually registered and provides both services to a client.

One way in which a dually registered individual can mitigate liability for breach of fiduciary duties is to act in the best interest of the client at all times and refrain from any activity that conflicts with the client’s interest. Elevating Brokers to a fiduciary standard of care has gained traction in recent years, culminating with the Department of Labor’s fiduciary rule that will expand the definition of investment advice to encapsulate Brokers who provide recommendations to retirement plan participants.24 In response to the Department of Labor’s proposal, FINRA chairman and CEO Richard Ketchum issued remarks at the 2015 FINRA Annual Conference rejecting the Department of Labor’s proposal, while advocating for a “best interests of the customer” standard that would closely parallel the fiduciary duties required by Advisers.25

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However, even if a Broker is acting in the best interests of the customer, a dually registered individual will still be scrutinized heavily in certain situations where a conflict of interest is unavoidable. An example of an unavoidable conflict is a Broker selling interests in his or her own outside business activity (“OBA”). There is an obvious conflict in that the Adviser/Broker has an interest in selling the securities and raising capital for his OBA. The Adviser/Broker can disclose this conflict of interest, but under the fiduciary standard of care disclosure does not waive the duty act in the best interest of the investor. Therefore, the dually registered individual has a very high threshold to prove the security was suitable for the investor, that the transaction will be executed under the most favorable terms, and that the investment is in the best interest of the investor. This leaves the Adviser/Broker open to a great deal of liability because any small discrepancy or proof that the investment was not in the best interest of the client is cause for a breach of duty action against the Adviser. ▲

1—29 CFR 2510.3-21 (April 6, 2016).

13—Investment Adviser Act § 202(a)(11)(C) (“’Investment adviser’…does not include (C) any broker

2—Id. The rule expanded the definition of what constitutes “retirement investment advice,” and thus

or dealer whose performance of such services is solely incidental to the conduct of his business as a

expanded who constitutes a “retirement investment adviser.” Retirement investment advisers owe a

broker or dealer and who receives no special compensation therefor.”).

fiduciary duty to act in the best interest of their clients, and under the new rule can include “a broker,

14—See Exchange Act § 9(a) (prohibiting particular manipulative practices regarding securities

registered investment adviser, insurance agent, or other type of adviser.” See Department of Labor

registered on a national securities exchange); Exchange Act § 10(b) (prohibiting the use of “any

Proposes Rule to Address Conflicts of Interest in Retirement Advice, Saving Middle-Class Families

manipulative or deceptive device or contrivance” in connection with the purchase or sale of any

Billions of Dollars Every Year, United States Department of Labor (2016), available at http://www.dol.gov/

security); Exchange Act §§ 15(c)(1) and (2) (prohibiting broker-dealers from effecting transactions in,

ebsa/newsroom/fsconflictsofinterest.html.

or inducing the purchase or sale of, any security by means of “any manipulative, deceptive or other

3—SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 201 (1963)(“The statute, in recognition

fraudulent device.”; See also FINRA Rule 2111, FINRA Rule 5310.

of the adviser’s fiduciary relationship to his clients, requires that his advice be disinterested”).

15—Charles Hughes & Co. v. SEC, 139 F.2d 434, 437 (2d Cir. 1943); see Study on Investment

4—See FINRA Rule 2111, Suitability, available at http://finra.complinet.com/en/display/display_main.

Advisers and Broker Dealers, Securities and Exchange Commission, 1 (Jan. 2011) [hereinafter 2011

html?rbid=2403&element_id=9859&print=1.

SEC STUDY], available at https://www.sec.gov/news/studies/2011/913studyfinal.pdf; see also In re

5—John J. Topoleski and Gary Shorter, Department of Labor’s 2015 Proposed Fiduciary Rule: Background and Issue, Congressional Research Service (October 8, 2015) [hereinafter “DOL PROPOSED RULE STUDY”].

6—Investment Advisers Act of 1940, § 202 (a)(11); 15 U.S.C. § 80b-2(a)(11) (2016) [hereinafter “Investment Advisers Act”].

7—Securities Exchange Act of 1934, § 3(a)(4)(A); 15 U.S.C. §78c (a)(4)(A) (2015) [hereinafter “Exchange Act”]. A “dealer” is defined as “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.” See Exchange Act §3(a)(5)(A).

8—Investment Advisers are regulated by the SEC if the adviser (1) manages more than $100 million in customer assets, (2) advises certain funds or business development companies, or (3) works in a state that does not register Advisers. See 17 C.F.R. § 275.203A-1 (2011); See also Stephen Wink, Stefan Paulovic and Michael Shaw, Dually Registered Brokers and Advisers, 46 The Review of Securities and

Duker & Duker, Exchange Act Rel. No. 2350, 1939 WL 36426, at *3 (Dec. 19, 1939) (“Inherent in the relationship between a dealer and his customer is…that the customer will be dealt with fairly, and in accordance with the standards of the profession.”).

16—U.S. Securities and Exchange Commission Division of Trading and Markets, Guide to BrokerDealer Registration, U.S. Securities and Exchange Commission (April 2008), available at https://www.sec. gov/divisions/marketreg/bdguide.htm.

17—Hanley v. SEC, 415 F.2d 589, 597 (2d Cir. 1969) (a broker-dealer “cannot recommend a security unless there is an adequate and reasonable basis for such recommendation”); see FINRA Rule 2111 (“A member or an associated person must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer”).

18—FINRA, Suitability: What Investors Need to Know (last accessed on March 30, 2016), available at http://www.finra.org/investors/suitability-what-investors-need-know.

Commodities Regulation 15 (September 4, 2013) (“S&C Regulation Article”).

19—Id.

9—SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963) (holding that under Section

20—Michael Frederick Siegel, Exch. Act Rel. No. 58737 (October 6, 2008).

206 of the Investment Advisers Act, advisers owe an affirmative fiduciary duty of “’utmost good

21—FINRA Rule 5310.

faith, and full and fair disclosure of all material facts,’ as well as an affirmative obligation ‘to employ

22—2011 SEC STUDY, supra note 18, at 70.

reasonable care to avoid misleading’ his clients.”).

10—Investment Advisers Act Release No. 1406 (March 16, 1994); see also General Information on the Regulation of Investment Advisers, U.S. Securities and Exchange Commission (2011), available at https:// www.sec.gov/divisions/investment/iaregulation/memoia.htm.

23—Id. at 8.

24—DOL PROPOSED RULE STUDY, supra note 5, at “Summary”; see also Helen Quigley, Kicking the Can Down the Road: Dodd-Frank’s Attempted Reform on Broker-Dealers, 59 N.Y.L. Sch. L. Rev. 561 (2014-2015) (outlining the SEC’s actions regarding implementing a fiduciary standard from receiving

11—Regulation of Investment Advisers by the U.S. Securities and Exchange Commission, U.S.

rulemaking authority under Dodd-Frank in 2010 through the SEC requesting public comment regarding

Securities and Exchange Commission (2013), available at https://www.sec.gov/about/offices/oia/

a standard in 2013).

oia_investman/rplaze-042012.pdf.

25—Richard G. Ketchum, Remarks from the 2015 FINRA Annual Conference (May 27, 2015) (last

12—Capital Gains, 375 U.S. 180, 195 (1963) (holding that “Congress, in empowering the courts to

accessed on March 31, 2016), available at https://www.finra.org/newsroom/speeches/052715-

enjoin any practice which operates ‘as a fraud or deceit’ upon a client, did not intend to require proof

remarks-2015-finra-annual-conference (“I continue to believe today that, for both investor protection

of intent to injure and actual injury to the client.”).

and firm cultural reasons, a best interest standard for broker-dealers – under the securities laws – is the direction we must go”).

© 2016 WealthForge. All rights reserved.

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A FULLY INTEGRATED REAL ESTATE COMPANY PROVIDING INSTITUTIONAL INVESTMENTS SINCE 1998

SPECIALIZING IN 1031 EXCHANGES

2050 MAIN STREET, SUITE 650 | IRVINE, CA 92614 | P: 949.442.1000 | WWW.PASSCO.COM IRVINE, CA | DENVER, CO | AUSTIN, TX | DALLAS, TX | ATLANTA, GA

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The Rise of Liquid Alts: Interval Funds

By Larry Lyons, Kalos Financial

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Morningstar Directsm recently reported, that for the 12 months ending December 31, 2015, net outflows for the U.S. equity category was a net negative of $66.4 billion while flows into taxable bond and municipal bonds were a net positive of $45.2 billion. This trend does not appear to be slowing. The Investment Company Institute® (ICI) reported that for the week ending April 6, 2016, investors pulled $5.8 billion from equity mutual funds and directed $6.6 billion into bond mutual funds.

What do these numbers reveal? That investors are searching for income and less volatility in their portfolios.

The Search for income and less volatility The word “diversification” is used frequently in our industry and, to the everyday investor, I suspect that they interpret that term to mean they should diversify among stocks, bonds and cash. But is that all there is? Stocks can create sleepless nights and anxiety, fixed income yields are at historical lows and high-yield seems to be the solution for many yield chasing investors, but at what cost? And cash? We might as well store that in our mattress these days since it earns us nothing in the way of interest.

The life stage of an investor is an important factor to consider when making portfolio recommendations. Investors in the accumulation stage tend to be younger and therefore may be able to stick with the traditional allocation of stocks, bonds and cash via their employer sponsored savings plan and be okay, thanks to the benefit of time.

However, if an investor is exposed to other asset classes, e.g. alternative investments,

Liquid alternative investments burst onto the investment scene in the public arena beginning in 2009, however, the public non-traded sector has recently faced some major challenges due to the regulatory environment.

their portfolio will most likely be more diversified, and in-turn, may experience less volatility, and generate more income, over time. The variance in volatility will be dependent on whether or not the alternatives are publicly traded, i.e. daily liquid mutual funds, or non-traded direct participation programs (DPP).

Liquid alternative investments burst onto the investment scene in the public arena beginning in 2009, however, the public non-traded sector has recently faced some major challenges due to the regulatory environment. The recent roll-out of the final version of the Department of Labor’s Fiduciary Rule, FINRA’s 15-02 statement rule, and NASAA’s Model Act that proposes changes to the maximum allocation percentages permitted in alternative investments, have caused industry leaders, broker-dealers and financial advisors to scratch their heads and wonder “where do we go from here?” All the while, investors are asking their financial professional, is there anything else we can allocate to besides stocks and bonds to help me generate income and reduce volatility?

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In order to navigate the current regulatory environment and meet investor demand for more sophisticated product choices, industry innovators have created a product structure that offers greater transparency, daily valuation and an opportunity for liquidity rather than having to “lock-up� their money for an extended period of time.

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In order to navigate the current regulatory environment and meet investor demand for more sophisticated product choices, industry innovators have created a product structure that offers greater transparency, daily valuation and an opportunity for liquidity rather than having to “lock-up” their money for an extended period of time.

Enter Interval Funds Simply put, interval funds are mutual funds as defined in the 1940 Investment Company Act, and Securities Act of 1933, and Securities Exchange Act of 1934, that offer daily purchases for investment with certain liquidity opportunities that are made at stated “intervals” throughout the year, usually quarterly. Technically, they are classified as a closed-end fund, but have features that the everyday investor is more accustomed to in regards to reporting and tracking.

Interval funds offer several advantages to both the investor as well as the financial professional. They can invest in both private and public securities within a structure that offers liquidity, daily valuation and transparency via audited financials. Liquid interval funds can often have multiple underlying sub-managers in addition to the fund manager that is charged with making the allocation decisions at the fund level.

The Appeal In a post 15-02 world, and in order to help level the playing field for every day investors, interval funds are an attractive option because their structure already addresses pricing issues now imposed on other alternative asset class structures. Other benefits include: • Clients and advisors alike are able to track the Fund’s value daily for greater transparency.

Funds are given a CUSIP that can be monitored.

• Liquidity is offered on a predetermined basis (generally quarterly). The amount available for redemption is typically 5% of the total shares outstanding each quarter, or 20% per year.

• In order to meet the Fund’s required redemptions, they must have sufficient liquid assets.

• Interval funds are not subject to the stringent regulations as illiquid alternative investments and are exempt from state suitability guidelines, which can make compliance oversight less rigorous and time consuming.

• They may be sold in fee-based accounts. Many interval funds offer multiple share classes and are able to accommodate the advisor’s business model quite easily.

• Advisors may find interval funds offer a simpler way to introduce investors to alternative investments via a pooled fund approach rather than proposing a single concentrated alternative investment.

• Investors gain access to institutional money managers that otherwise would be inaccessible to them due to minimum investment requirement and/or lack of accreditation.

• Many interval funds have an income component that competes quite favorably with more traditional fixed income investments.

• Allocation to illiquid assets within the fund can be an advantage for investors because some of the underlying investments are not exposed to the whipsaw effect of the traded market on a daily basis, and the “interval” redemption feature means that investor emotions can’t override the funds management objective at a time when the investor may be tempted to sell at the low point of the market.

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Allocation to illiquid assets within the fund can be an advantage for investors because some of the underlying investments are not exposed to the whipsaw effect of the traded market on a daily basis, and the “interval” redemption feature means that investor emotions can’t override the funds management objective at a time when the investor may be tempted to sell at the low point of the market.

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Fees Protections & Structure

Non-Traded REITS

Acquisition Fees

✔

Disposition Fees

✔

Non-Traded BDCs

Interval Funds

✔

Property Management Fees

✔

Debt Placement Fees

✔

Asset Management Fees

✔

✔

Incentive Fees

✔

✔

Statement Pricing During Offering

Two Years, Five Months After Offering Close

Appraisal-based NAV

Priced Daily NAV

Priced Daily at NAV

1940 Act Protections

✔

✔

✔

Impacted my 15-02

Yes

Yes

No*

Leverage Limits

No Regulator Debt Limit

Up to 50% of Assets

Up to 33% of Assets

Fixed Portfolio

No, unless specified in prospectus

No

No

Priced at a % of the Priced at a % of the Public Offering Price Public Offering Price

Priced Daily at NAV

*Interval funds price daily.

To give some context to how fast the interval fund market is growing, Randy Sweetman of Robert A. Stanger & Company, Inc., a Shrewsbury, New-Jersey-based investment banking firm which specializes in alternative investments, indicated that there are currently 22 active interval funds on the market today, and another 13 currently in registration. With the recent passage of the DOL Fiduciary Rule, and FINRA 15-02, this trend will not be slowing anytime soon. ▲

The article and opinions in this publication are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you consult your accountant, tax, or legal advisor with regard to your individual situation.

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ADISA

News

Events

ADISA’s 2016 Spring Symposium Draws Record Attendance

Hot topics at the conference included impending regulation, non-traded REITs, Section 1031 Exchanges, oil & gas, and more.

ADISA, the nation’s largest trade association representing the

state of the non-traded REIT, Section 1031 exchange and Reg

alternative and direct investment industry, held its 2016 Spring

A+ markets; discussions of the proposed “fiduciary rule” by the

Symposium in San Diego March 21-23, drawing in nearly

DOL; the implementation of 15-02; and an update on navigating

700 alternative investment professionals for networking and

the oil & gas market.

education covering the full spectrum of alternative investment products and issues.

the full spectrum of alternative investment products and issues.

“We couldn’t have been more pleased with the outcome of

Overall topics involved the fundamentals of BDCs, real estate

our 2016 Spring Symposium,” said ADISA Executive Director/

investment trusts, Section 1031 exchanges, private equity

CEO John Harrison. “The conference brought together a diverse

and regulatory audits; diversity; real estate conservation; due

attendance of broker-dealers, registered representatives, RIAs,

diligence; the latest research in the market and more.

due diligence officers, product sponsors and other influential

Attendees listened to a REIT CEO panel and broker-

alternative investment professionals, resulting in well-balanced

dealer CEO panel, during which participants of each general

discussions that help grow our industry. ADISA specializes in

session provided perspective on new regulation in alternative

education, networking and advocacy in alternative investments,

investments, as well as an outlook on where the market may

and we believe our conference brought each of these elements

be headed.

to the attendees and the professionals they will share their information with moving forward.”

Hot topics at ADISA’s 2016 Spring Symposium included the

26

The conference included 50 educational sessions regarding

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Kimberlee Levy, chief compliance officer with Concorde Investment Services, acted as the conference chair for the symposium. ▲

Attendees enjoy the ADISA 2016 Spring Symposium in San Diego.

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Best Panel of 2015 Each spring, ADISA presents a Best Panel award for the previous year. The Best Panel of 2015 award was given to Mark Kosanke, Concorde Investment Services; Dan Shaeffer, Cottonwood Residential; Bill Winn, Starboard Realty Advisors; and Rahul Sehgal, Inland Private Capital Corporation, for their session “1031 Advanced Discussion: Asset Classes, Taxes & Exit Strategies.”

The session was dedicated to discussing the exchange market cycle and how various asset classes perform within it. The panel consisted of exchange professionals who covered advanced topics of exchanges including an update and status discussion of full cycle programs, the use of 721 UPREITs, and the changing nature of commissions compared to associated risks. ▲

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ADISA

July 12-13, 2016 I Renaissance Boston Waterfront Hotel

Due Diligence Forum 2016

ADISA’s Due Diligence Forum is designed for industry professionals who are employed with a Broker-Dealer, RIA, Due Diligence Firm, or select others, that offer alternative investments in their business.

See You in Boston? Yes ➤

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10401 North Meridian Street Suite 202 Indianapolis, IN 46290

SEPTEMBER 26-28, 2016

THE COSMOPOLITAN OF LAS VEGAS

ADISA 2016 ANNUAL CONFERENCE + TRADE SHOW The industry’s largest event, designed for those who sponsor, analyze, market, distribute or sell alternative investments.

1,000 ATTENDEES / 80 EXHIBITORS / 50 EDUCATION SESSIONS /

+