## Monday, November 30, 2015

### More Non-traded REIT Perfidy: The Roll-up Grift

By Craig McCann and Regina Meng

We have extensively researched non-traded REITs and concluded that these illiquid direct participation programs have cost investors $50 billion compared to more liquid investments in traded REITs. Our Fiduciary Duties and Non-traded REITs (available here) provides a good overview of the problems with non-traded REITs and a summary of our empirical results. An Empirical Analysis of Non-Traded REITs (available here) contains a more detailed explanation of our research. Our previous blog posts on individual non-traded REITs are available here. This$50 billion cost we identify is a transfer of retail investors’ hard earned and saved assets – including IRA assets – to the Sponsors and third-tier brokers who sell non-traded REITs. Half the $50 billion wealth transfer results from high offering costs charged to investors which are used to pay the high commissions that motivate brokers to recommend such patently bad investments. The rest of the shortfall we attribute to extraordinarily high non-traded REIT ongoing expenses resulting from conflicts of interest in their affiliated party transactions. In recent years there, have been a number of “roll-up” transactions involving non-traded REITs. In a roll-up, a non-traded REIT is acquired by, or merged into, another REIT referred to as the “roll-up entity” in exchange for shares in the surviving firm. Given everything else we have learned about non-traded REIT Sponsors, we shouldn’t have been surprised to learn that they have figured out how to take money from non-traded REIT investors during Roll-up transactions and other “liquidity events”. Roll-ups Non-traded REITs are required by state securities regulators to include language that closely tracks the 2007 North American Securities Administrators Association’s Statement of Policy Regarding Real Estate Investment Trusts (available here) in their bylaws. NASAA guidelines protect shareholders in REITs which have not been trading for at least 12 months before being rolled-up. Non-traded REIT shareholders need protection because, unlike traded REIT shareholders, they can’t observe thickly traded market transaction prices when assessing the value of their shares. Also, non-traded REIT shareholders can’t rely on the market for corporate control to bid up the merger consideration if risk arbitrageurs determine the value offered is too low. This need is especially pronounced when, as is often the case in suspect acquisitions skirting the roll-up protections, the acquiring traded REIT is affiliated with the acquired non-traded REIT through the Sponsor. The protections afforded by the NASAA guidelines include the requirement or a contemporaneous independent appraisal of the non-traded REIT and the option for the non-traded REIT investors who vote against a proposed roll-up to receive their pro rata share of the appraised value. We have preliminarily analyzed 12 transactions: 2 occurred in 2006, 1 in 2012, 3 in 2013, 3 in 2014 and 3 occurred in 2015. The two transactions in 2006 maintain language which closely tracks the NASAA guidelines at the time of the merger. The 10 or more recent roll-ups exhibit a disturbing pattern. While the REITs are selling shares and raising proceeds their bylaws include the protections discussed above. Then shortly before a merger is announced, the non-traded REITs amend their bylaws, changing the definition of a roll-up and removing the investor protections the Sponsors had agreed to provide investors. Griffin-American Healthcare REIT II Consider NorthStar Realty’s acquisition of Griffin-American Healthcare REIT II. The cash and stock merger was announced August 5, 2014 with a Form 8-K (available here) and merger agreement (available here). Griffin-American Healthcare REIT II’s bylaws when money was being raised and securities sold from 2009 to 2014 are available here. The Roll-up definition at page 10 tracks the NASAA guideline language and clearly encompasses the August 5, 2014 acquisition by NorthStar. Griffin-American Healthcare REIT II “corrected” its definition of roll-up on May 1, 2014 to remove the shareholder protections. The filing is available here. The only change in the 2009 bylaws made in 2014 was to replace the language exempting some transactions from the roll-up protections: (a) a transaction involving securities of the Corporation that have been Listed for at least twelve months; was replaced with (a) a transaction involving securities of the Roll-Up Entity that have been listed on a national securities exchange for at least twelve months (emphasis added) Griffin-American Healthcare REIT II defined the Corporation in the original bylaws to be the non-traded REIT and revised the passage replacing the non-traded REIT with the Roll-up Entity effectively defined to be the acquiring firm, NorthStar Realty. Changing the meaning of one word allowed Griffin-American Healthcare REIT II to void the shareholder protections it promised investors - as required by state regulators as a condition to be allowed to sell securities - precisely when investors needed the protection. As a result of Griffin-American Healthcare REIT II’s bylaw changes, there was not an independent expert appraisal and the REIT’s dissenting shareholders were not given the option to take their pro rata share of an appraised value in cash. Why would the Sponsor who controlled the REIT eviscerate the shareholder protections precisely when they would protect shareholders? Maybe it was the$43 million Merger Termination Amount paid to the Sponsor-controlled Advisor to the REIT.

We see similar perfidy in other merger / roll-up transactions.

Carter Validus Mission Critical REIT, Inc.

At page 172 of Carter Validus Mission Critical REIT’s registration statement available here, you can find this language:

A “roll-up entity” is a partnership, REIT, corporation, trust or other similar entity created or surviving a roll-up transaction. A roll-up transaction does not include: (1) a transaction involving our securities that have been listed on a national securities exchange for at least twelve months; or (2) …

Notice there can be no ambiguity over the meaning of the phrase I underlined. The deceptive “correction” to “the Company” in the example above is transparent but this situation couldn’t be clearer.

Recently the Carter Validus REIT sent out a proxy statement (available here) that included a vote to delete the NASAA guidelines’ language.

The substance of the vote is at page 26

The claimed reason for the proposal is at page 24.

This is obviously disingenuous. When Carter Validus’ Sponsor registered securities for sale to the public, state regulators required and Carter Validus consented to provide minority shareholders certain rights if a transaction later occurred while the REIT was still non-traded. The requirement imposed was not that these protections only apply during the capital raise period. In fact, liquidity events include roll-ups typically occur only after the capital raise.

Yet, Carter Validus and other non-traded REITs in 2015 are saying we no longer need to have the protections since we are not raising any more equity proceeds. These REITs are really saying that they don’t intend to register any more securities for sale, and so its shareholders and NASAA can go to Hades.

Moreover, the shareholder vote mechanism isn’t redeeming. The NASAA guidelines are to protect the minority from a deal the majority approves of. A two-step vote – first one to remove the guidelines’ protections and then a second vote to approve a merger that should invoke the roll-up protections – can’t be allowed to void the protections that a majority vote on the same transaction alone would invoke.

Sophisticated people might call this conduct a clear breach of fiduciary duties but simple folks would surely call this stealing.

## Tuesday, November 24, 2015

### Only a Faulty Auto-liquidator Pays More for An Option Than it Can Ever Be Worth

By Craig McCann, PhD and Mike Yan, PhD

In two previous blog posts we documented how auto-liquidators appear to have executed option trades at distorted prices to their clients’ detriment on August 24, 2015. The price distortions were caused by massive sell or buy orders on thinly traded securities being dumped into the market by auto-liquidation programs. These distortions were reversed within minutes, but not before causing investors millions of dollars of unnecessary losses.

In “The Recent Market Turmoil Spells Trouble for Auto-liquidators like Interactive Brokers” (available here), We showed that thinly traded long-dated, deep out-of-the money SPX put options were bought on August 24, 2015 at implausibly high prices, purportedly to cure margin deficiencies. We showed the price of one SPX put option increased from $4 to as high as$83 in seconds as a result of auto-liquidation transactions after which the option price quickly dropped back to around $4. These auto-liquidation trades converted an account from a credit balance to a debit balance in seconds when a rational liquidation would have cured the margin deficiency and left the account equity intact. In “More Signs of Trouble for Auto Liquidators” (available here) we explained how rational liquidations would have saved an auto-liquidated account using another stylized example from an account that was liquidated to a debit balance during the morning of August 24, 2015. We used prices of near expiration, at-the-money call options on Barclay’s VXX ETN linked to the VIX index with different strikes to demonstrate the harm caused by auto-liquidations that occurred while an investor was blocked from making trades in alternative strike prices within the same options class. In this post we discuss another type of transaction executed by auto-liquidators which no informed, self-interested trader would execute, because it involves paying as much or more now for a security than it can ever be worth in the future. American-style put options give the holder the right to sell the underlying asset at a fixed “strike” price on or before the option’s maturity date. For example, a call option on the VXX expiring August 28, 2015 of strike$24 gives the owner the right to sell VXX at $24. If VXX closes at$26 on August 28, 2015, the option expires worthless, because no one would exercise their right under the contract to sell VXX for $24 when it can be sold for$26 in the open market. On the other hand, if VXX closes at $22, then the option pays its holder the$2 difference between the $24 strike price and the$22 cost of contemporaneously sourcing VXX in the market.

The maximum possible price of a security is limited by the sum of the maximum possible cash flows attributable to it prior to expiration. The highest possible payout the owner of a put option can realize is the put option’s strike price. For this payout to occur, the price of the underlying security on which the put option is written would have to drop to $0 on the option’s expiration date. In all other possible states of the world, the put option’s payoff at maturity is less than the option’s strike price, since the payoff is the greater of the difference between the option’s strike price and the underlying security’s price at expiration or zero. In the example, since the VXX put option with a$24 strike can never pay out more than $24, and will usually pay substantially less than$24, no one would pay more than $24 now for the payoff on some future date. See Figure 1. Figure 1: Option Prices Can’t Exceed Their Maximum Future Payoff In a FINRA arbitration earlier this year, Glen Lyon Long-Term Options, LP, alleged that Interactive Broker’s auto-liquidator did not liquidate positions to meet a margin deficit in a commercially reasonable manner. In fact, IB’s auto-liquidation program executed two transactions at theoretically impossible prices. The Glen Lyon account was short these put options and so the auto-liquidation program bought these options ostensibly to reduce a margin deficiency. Table 1 summarizes two auto-liquidation trades executed in the morning of January 12, 2011 in VVUS put options expiring on January 19, 2013. Those long-term, thinly-traded put options had a strike price of$2.5, and hence had a theoretical price ceiling of $2.5. The Glen Lyon account was short these put options and so the auto-liquidation program bought these options ostensibly to reduce a margin deficiency. Table 1: Summary of trades with prices outside of theoretical possibilities. Within seconds surrounding those transactions, the prices of the$2.50 put option jumped from $0.6 to$3.80 and reversed back to $0.6. The trades in this$2.50 strike price put IB’s auto-liquidation program executed at $3.80 were cancelled later in the day but IB let stand the trades at$2.81 and $3.15. In both transactions, the trade price exceeded the strike price of the option –$2.50. These automated trades, executed by the IB’s auto-liquidator closed out short positions in Glen Lyon’s account at not only unfavorable but also theoretically impossible prices. Only a deeply flawed auto-liquidation program would execute such transactions since they were sure to make the margin deficiency worse not better. The award in the Glen Lyon v Interactive Brokers FINRA arbitration is available here

Surprisingly that is not the end of it. In August 2015, there were at least three transactions involving ACI (“Arch Coal, Inc.”) put options with theoretically impossible prices. Table 2 lists the trades executed at prices above the put options’ strike prices.

Table 2: ACI Put Options with Theoretical Impossible Prices.

We don’t know whether these trades resulted from an auto-liquidation at Interactive Brokers or somewhere else, but they clearly were not executed by an informed trader, since the purchaser paid more than the options could ever be worth in the future.