By Emily Flutter
Dec 30 (Reuters) - Ameriprise Financial Inc , the third-largest independent U.S. brokerage firm, is using its size and reach to shape risky securities it sells, sometimes in ways that make them riskier.
At least three times in the past two years, the broker-dealer asked issuers of private real estate investment funds to change the structure of their deals so it could sell more of the securities, according to interviews with multiple sources with direct knowledge of Ameriprise's practices and a review of testimony in an arbitration hearing involving Ameriprise.
One of the deals fell through before it could be sold, but the issuer of two others changed its plans so that Ameriprise could sell a larger number of private placement shares, as these lightly regulated unregistered securities are known. Private placements generate higher commissions than most other products that securities brokers at firms like Ameriprise sell.
Lawyers, issuers of private placements, consultants and other sources said that the practice of broker-dealers asking issuers to change the terms of their deals is becoming increasingly common, especially as persistently low interest rates have held down returns on safer, more traditional investments. They also said the practice creates potential conflicts of interest.
"This is backwards," said Jennifer Johnson, the dean of Lewis & Clark Law School in Portland, Oregon, who has studied private placements. She said issuers should be focused on the strategies, size and risks of the businesses for which they are raising capital, while brokers should be trying to determine the "intrinsic long-term value of the product."
The lure of making more money from crafting these products to maximize sales can be so strong that a broker-dealer ignores warning signs about the deals, said Rose Thomas, an independent analyst in Show Low, Arizona, who is considered an expert on private placement due diligence. "That's not definitely going to happen, but there's a risk there," she said.
Ameriprise, based in Minneapolis, Minnesota, has about 10,000 financial advisers, more than 2 million clients, and roughly $800 billion under management, and it operates across the United States. Its very size is what helps it influence deals.
Twice since 2012, Ameriprise persuaded New York-based real estate investment company Terra Capital Partners to substantially increase the total amount of money raised in private real estate deals, the sources said. The increases allowed Ameriprise brokers to stay within the firm's internal limit on how much of any one deal they can sell to clients, the sources said.
DILUTION FACTOR
Increasing the size of the Terra Capital private placements diluted investors' stakes in those deals by reducing each share's proportion of the total size of the enlarged fund, according to "risk factors" disclosed in the private placement's offering memorandum.
Separately, sources said, Ameriprise persuaded RAIT Financial Trust to consider structuring as a private placement a new product RAIT had been considering. Ameriprise also got the company to shorten the term of the deal without lowering the target return, which would have required RAIT to seek out higher-yield, higher-risk investments in order repay investors in time.
"Issuers routinely increase the size of their offerings based on market demand and opportunities to deploy capital, which leads to diversification and can reduce risk," Ameriprise said in a statement to Reuters.
"We are gratified that investor demand for Terra's funds has been so strong that we have expanded the size of every one of our offerings since 2009," a Terra Capital spokesperson said. "We have financed over 300 properties and have never had a borrower miss an interest payment, while providing an uninterrupted stream of monthly distributions to our investors."
RAIT did not respond to requests for comment.
There is no indication that Ameriprise or the issuers did anything illegal. No laws or regulations prohibit the type of dialogue between broker-dealer and issuer that Ameriprise has engaged in. Indeed, issuers and sources in the private placement industry said a broker's influence can be beneficial to the process because they know what investors want.
"Feedback from the broker-dealers very much informs our process," said Mitchell Sabshon, chief executive of Inland Real Estate Investment Corp, which issues non-traded REITs, some of which are private placements. He declined to name any brokers that had influenced Inland deals.
The larger deals broker-dealers push for can snag higher-quality real estate, he said, adding that some broker-dealers would suggest the certain types of real estate, such as apartment complexes instead of shopping malls as a good fit for a particular deal.
But Sabshon added that ultimately, Inland controls the deal. "If a broker-dealer were to say, 'We think you might want to do this kind of structure or this kind of asset class,' and we felt from our experience that would not do well, we would say, 'Thank you for your input,' " he said.
SELF-PERPETUATING CYCLE
The interaction between issuers and brokers in the opaque world of private placements is shaded by incentives that can encourage the creation and sale of more of these products as an end in itself.
In a self-perpetuating cycle reminiscent of the frothy years that led up to the financial crisis, investors are clamoring for higher-yielding investments, and private placements provide brokers with an ideal way to cater to that demand. Private placements often advertise returns well above 5 percent, an attractive proposition when the yield on 10-year Treasuries is 2.21 percent.
Private placements are considered appropriate for only "accredited investors" - that is, people with net worth of more than $1 million, excluding primary residence, or annual income of more than $200,000. But those limits were chosen in 1982 and have not been adjusted for inflation since, which means many more people now qualify, including retirees and others with far less risk tolerance than what the rule originally intended.
With more qualifying investors, and more investors seeking higher returns, issuers appear eager to oblige. The number of planned issues was 18,187 in 2012, up 32 percent from 2009, according to U.S. Securities and Exchange Commission data. Last year, broker-dealers told the Financial Industry Regulatory Authority (FINRA), the industry group that oversees them, that they intended to sell more than 3,000 new private placements, compared with 971 new offerings of public assets, such as publicly traded stocks, mutual funds and bonds.
In previous articles, Reuters showed that these deals - ranging from oil and gas drilling projects to pools of collateralized debt or loans - are often structured to favor issuers over investors.
For example, the confidential offering documents for Terra Capital's latest fund, reviewed by Reuters, show that 12 percent of the money raised will go toward broker commissions, management fees and other payments to Terra Capital affiliates before Terra invests any money in real estate.
FINRA requires brokers to do due diligence on issuers and their private placements before selling the deals. But as Reuters has reported, that safety net often fails. Smaller broker-dealers tend to hand over due diligence to outside firms that are paid by the issuers themselves, setting up a conflict of interest.
Ameriprise does its own due diligence on private placements. "We would put our due diligence, supervision and compliance against anyone else in the industry, and when it comes to selecting product options for our clients, we reject substantially more than we accept and only offer products that are appropriate for our clients' needs," Ameriprise said.
EMAIL TRAIL
An example of Ameriprise's approach to due diligence was on display in its efforts to sell the RAIT deal.
In 2012, representatives from Ameriprise's external products division, which is responsible for sourcing new products, contacted RAIT and said they would be willing to sell a significant portion of a private deal to their brokerage customers, three sources said.
RAIT put together a team to run and structure Independence Mortgage Fund I, the firm's first private placement, which would invest in the bridge and mezzanine loans that RAIT was making, the sources said.
By August 2012, the RAIT team believed it was close to launching a deal. But at a lunch that month, Ameriprise representatives asked RAIT to shorten the term of Independence Mortgage Fund 1 to five years from seven. They also wanted to collateralized mortgage debt included in the fund, rather than only whole loans made by RAIT, the sources said. The objective was to set the RAIT deal apart from the Terra deals that Ameriprise was already selling, and to use the collateralized mortgage debt to try to juice the fund's returns, according to the sources.
In January 2013, a member of Ameriprise's external products division who was doing due diligence on the fund began interviewing for a job as a salesman for RAIT's Independence Mortgage Fund 1. He told his Ameriprise bosses about the likely job move and continued his work vetting that very fund, according to a recording of testimony from an arbitration case later filed against Ameriprise by another employee.
During the due diligence process, James Kirk, another member of the Ameriprise team, discovered that RAIT had received a big loan from a private equity firm, New York-based Almanac Realty Investors, and that the terms allowed Almanac to call the loan if RAIT came under SEC scrutiny that had a material impact on the company. RAIT had already disclosed that it was under investigation by the SEC for transactions made by an affiliate, Taberna Capital Management. The SEC probe, Kirk concluded, could result in the Almanac loan being pulled, putting RAIT at serious financial risk.
The task fell on the employee who was planning to leave Ameriprise for RAIT to ask RAIT's Independence Mortgage Fund 1 team - his new bosses - whether they thought the investigation could have any material impact on RAIT or its new fund. They said they did not think it was important, according to the arbitration testimony. What happened next sank the deal.
Kirk, who disagreed with the employee and the RAIT team, wrote a memo to his Ameriprise bosses, Dena Froiland and Frank McCarthy, detailing his views on why the SEC investigation could be bad for the private placement, according to a recording of testimony from the arbitration case Kirk later filed against Ameriprise.
In recorded testimony, McCarthy said in the arbitration that Kirk's doubts about the deal could come up if the private placement ever went sour and became subject of an investor lawsuit or arbitration.
"I said, 'Here's how I want to deal with these: When you have this kind of situation when you want to make an opinion, let's talk to Dena or me first, before you document it,'" McCarthy told the arbitration panel. His fear, he said, was that the email would be used as evidence "if there's a problem later with a product arbitration." The deal was never sold.
Ameriprise fired Kirk several months later. He filed a complaint to FINRA, claiming he was fired in retaliation for whistle blowing. Ameriprise executives said in Kirk's arbitration that they fired him for poor performance. A three-person arbitration panel ruled in Ameriprise's favor.
In September this year, RAIT said it would pay $22 million to resolve the SEC probe, which focused on $15 million in restructuring fees Taberna received from various securities issuers over three and a half years.
Ameriprise declined to make McCarthy and Froiland available. In its statement, Ameriprise said: "The context for these allegations [of tainted due diligence] is an arbitration hearing brought by a terminated, short-tenured employee who lost his case on all counts."
A WORKAROUND
Some state regulators prohibit brokers from having too high a concentration of private placements and other illiquid investments in their clients' portfolios. And many broker-dealers have set internal limits on sales of illiquid investments as a proportion of clients' total assets.
Such limits reflect the risky nature of private placements and are aimed at preventing a firm from being overexposed to any one deal. Though the limits are internal policies, regulators hold brokerages to them.
Last year, Massachusetts securities regulators levied millions of dollars of fines against six of the country's top 10 independent brokerage firms, including Ameriprise, for violating those limits with sales of non-tradable shares in REITs, which possess many of the same qualities as private placements but which at times operate under a slightly different regulatory regime.
None of the other nine independent broker-dealers would discuss whether they pressed issuers to change the terms of their deals or comment for this story.
In August last year, Terra Capital launched fundraising for its most recent private placement, Secured Income Fund 5, which will make mezzanine loans to commercial real estate projects. The minimum buy-in is $50,000.
Sources said Ameriprise had earlier persuaded Terra Capital to increase Fund 4, which it eventually did by 80 percent, to $90 million. Multiple sources familiar with the situation said demand for Fund 5 was so high that Ameriprise soon ran into its internal rule of not selling more than 25 percent of any one deal to its clients.
So Ameriprise executives asked Terra Capital to increase the size of the offering, the sources said. In August this year, Terra raised the target for Fund 5 by 60 percent to $160 million.
Brokers from Ameriprise and other firms selling the Fund 5 securities would get a 7 percent commission, the offering memorandum shows. Even the most expensive mutual funds typically pay a commission of around 5.5 percent.
A larger deal means more money for the fund to make more loans, which is good for risk management because it can increase diversification.
However, the memorandum shows that Terra Capital has a history of concentrating its exposure. All four of earlier funds in the series contain stakes in properties that are held in at least one other of the funds.
The memorandum warns that no return is guaranteed. The fundraising is scheduled to close at the end of this year.
(Edited by John Blanton)
