By Soyoung Ho
The SEC in the past several years has been getting rid of old “Industry Guides” one by one to be replaced by formal and more consistent corporate disclosure rules for industries to follow. And most recently, the commission is working to revamp an outdated guide for the real estate industry.
For the first time, the capital market regulator put Industry Guide (IG) No. 5 for real estate limited partnerships on its near-term rulemaking agenda in its most recent update. It was previously on the long-term agenda for a couple of years.
Under Chairman Jay Clayton, the SEC’s short-term agenda reflects rulemaking that can be acted on within a year. And the commission is planning to propose a rule related to the real estate industry guide around the fall of 2020.
Experts welcomed the planned overhaul of the disclosure rules for the real estate industry given the changes in the market since IG 5 was written in 1976. The industry guides express the disclosure practices that the commission’s staff wants companies in particular industries to follow so investors get the necessary information to make informed investing decisions.
Karen Garnett, a former official in the SEC’s Division of Corporation Finance—the division that would be in charge of drafting updated disclosure rules for the commissioners’ consideration—explained that IG 5 was originally issued to address concerns about real estate limited partnerships. Today, real estate companies are largely structured as real estate investment trusts (REITs). REITs are companies that own or operate properties to generate income.
Real Estate Limited Partnerships Were Popular in the 1970s
Real estate limited partnerships were “very aggressive and sometimes abusive investment vehicles that were set up in the 1970s, and … there was a lot of concern about ‘do investors know what they are buying here?’” said Garnett, now a partner at Proskauer Rose LLP.
She explained that most such partnerships were structured as blind pools. They would solicit and get investors to buy equity and generate cash. Then they would invest in properties. This meant that investors did not know what they were getting into.
To fill the gap, IG 5 requires the disclosure of a narrative summary of the track record or prior performance of programs sponsored by the general partner and its affiliates.
“The SEC staff at the time said, ‘you know, it would be a good idea since you don’t have anything in your investment portfolio for this offering, why don’t you tell investors how successful you have been at your other deals,’” Garnett said. “So, there is a lot of information in there about proceeds from the offering and how the proceeds were used, kind of overall intended to reflect some measure of success or failure of the prior offerings with the thought that, if we can’t just get this disclosure about a specific portfolio, then we can get some past performance information about the sponsor, whether the sponsor is a good bet.”
Effects of Tax Code
Further, the real estate limited partnership was largely formed as a tax shelter, said Evan Hudson, a partner with Stroock & Stroock & Lavan LLP.
The partnership “syndicated its interests out to individual investors who could take advantage of the depreciation provisions of the tax code,” Hudson said. But “that market went away after 1986 when there was tax reform. So, this guide still applies to real estate sponsors that are raising third-party equity.”
He was making a reference to the Tax Reform Act of 1986 which was aimed at simplifying the income tax code and broadening the tax base by eliminating many deductions and tax shelters.
“Today’s deals are really about economics, so Guide 5, it’s still a lot of ink discussing tax treatments of the vehicles and how that’s supposed to disclosed,” Hudson said. “It talks about depreciation; it talks about tax opinions. So, it isn’t as relevant today.”
Ineffective Quick Fix?
Thus, to address the changes in the industry since the 1970s, the SEC’s CorpFin issued staff interpretive guidance—CF Disclosure Guidance: Topic No. 6—in July 2013. While it may have solved one set of problems, it may have created another problem.
“If you had an outdated Industry Guide 5, and then you add on Disclosure Topic 6, that can be confusing to read those documents together,” said Jason Goode, a partner with Alston & Bird LLP and co-chair of the Institute for Portfolio Alternatives’ (IPA) policy and governmental affairs committee. “You look at Guide 5, and this is what they say you have to do for prior performance. And then, you read Disclosure Topic No. 6, and it says, ‘well, you actually don’t have to do some of these things or you do some of them for different time periods.’ So, that’s pretty confusing. And so, if you could come up with a better way to help investors by giving them the important information about other programs that had been sponsored by that sponsor, I think that would be productive.”
In Hudson’s view, the current state of play is “Byzantine.”
“Not only is Guide 5 non-binding guidance, but there is even non-binding guidance about Guide 5,” he said referring to the 2013 staff guidance.
Former CorpFin staff Garnett explained that both the industry guide and Disclosure Topic No. 6 are neither commission rules nor commission interpretation. But companies still follow them. Otherwise, they risk getting SEC staff comment letters for inadequate disclosures when the staff reviews company filings.
Too Burdensome to Comply with Rules
In the meantime, the problem with the guide is not only about how dated it is. It has been a compliance burden, and the industry would welcome efforts that would simplify the rules.
About four years ago, when the SEC put out a concept release—a preliminary rulemaking document—soliciting the public’s input about ways to improve Regulation S-K, the National Association of Real Estate Investment Trusts (NAREIT) said IG 5 “currently prescribes multiple quantitative disclosures in tabular format, making preparation onerous.”
Reg S-K lays out the reporting requirements for various SEC filings.
“We suggest that these requirements be reevaluated and streamlined so that material quantitative information may be disclosed into a single table. Further, we are generally concerned that additional static, line-item requirements would not benefit investors, and we therefore urge the SEC against attempting to broadly codify guidance contained in Industry Guide 5 into Regulation S-K, as some have suggested,” NAREIT wrote in a July 2016 comment letter to the SEC.
“The correct approach—and the one the staff, I think, is taking—is that less is more, and we are paring back prior performance disclosure. There are too many tables,” Hudson said. “Large sponsors complain about the prior performance table because there is so much track record to disclose, and it’s so long and so much manpower to put the disclosures together. But then, interestingly small sponsors also complain because small sponsors might not have the resources at all to put these disclosures because it takes a huge accounting and financial staff to put the tables together.”
Aiming for Consistent, More Formal Rules
So far, the SEC’s approach to updating the disclosure rules for certain industries has been to rescind the guide but codify the updated rules in Reg S-K. This would provide for more formal and consistent application of rules.
The SEC in December 2008 got rid of IG 2 for oil and gas companies. The regulator wrote new Subpart 1200 of Reg S-K. Then, 10 years later, the SEC rescinded IG 7 while creating Subpart 1300 of Reg S-K to govern the disclosures for mining companies. In September 2019, the SEC issued a proposal to rescind IG 3 for bank holding companies and create Subpart 1400 of Reg S-K.
“And Guide 5 would be the same idea,” Garnett said.
This article originally appeared in the March 16, 2020 edition of Accounting & Compliance Alert, available on Checkpoint.
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