Sponsor Relationships: Considerations for Best Practices

by Julie Baird, Lucas Ecklund-Baker, and Geoff Flahardy
(Reprinted from the May 2018 FEA Newsletter)

QIs and DST/TIC sponsors have long-established relationships in the 1031 exchange industry. Fractional ownership real estate products are an important part of the 1031 exchange business, and clients look to sponsors for access to high-quality assets and broad diversification of investments.

When the relationships between a QI and sponsors become blurred-such as when a QI accepts or solicits fees from DST or TIC sponsors-QIs can face ethical, risk management, technical, and liability issues and further, securities law violations. Several industry best practices and the FEA Code of Ethics offer suggested guidance to protect FEA member QIs, vendors, their clients, and the 1031 exchange industry. We offer these points as important considerations.

DST and TIC products are securities
DST and certain TIC products are securities, fall under SEC and FINRA regulations, and require special procedures. Investments that are not registered securities, but fall within the description of a security, leave both sponsors and QIs vulnerable. The 1946 Supreme Court case, SEC vs. Howey, specifies an investment contract as a security if the transaction is an investment of money, provides the expectation of profit, is a common enterprise, and profits come from the efforts of a promoter or third party. As such, receiving compensation as a QI related to the sale of securities may be a violation of FINRA Rule 2040. The rule also applies to DST and TIC sponsors, as well as a financial advisor or Registered Investment Advisor seeking to pay a referral fee to a QI.

By accepting fees, QIs face both technical and risk management issues
From a technical perspective, referral fees can place QIs in opposition with the regulations. QIs cannot be the agent of the taxpayer; financial relationships and referral fees between QIs and DSTs and TICs, even with disclosure, can position a QI as an unregistered agent of the client or even of the sponsor. By accepting fees for referrals, QIs can be vulnerable to risk management issues.

Should the taxpayer determine the investment was not appropriate or profitable, the taxpayer might attempt to hold the QI liable for negligent referral. While liability is neither dependent upon nor due to a referral fee, the case that a referral was self-serving can be stronger when a fee is involved.

FEA recommendations for best practices and FEA ethics requirements offer guidance
Industry best practices guide QIs to offer contact information for several vendors at the request of the client, with the recommendation that the client consult his tax, legal, and financial advisors for due diligence on professionals and to determine the most appropriate relationships for the client. The FEA Code of Ethics specifically requires disclosure of relationships between QIs and vendors. A QI must "disclose to the client that it may receive a financial benefit, such as a commission or referral fee as the result of such recommendation." The Code guides QIs not to "suggest the use of services of another organization or business entity in which the Exchange Accommodator has a direct or indirect interest without full disclosure of such interest."

These guidelines can also help FEA members better manage risk in navigating relationships between the QI and a DST or TIC sponsor:

• Do educate your client as to the like-kind nature of the ownership. DSTs are governed under Rev. Ruling 2004-86 and TICs are guided by and can request a private letter ruling under Rev. Proc. 2002-22.
• Do get to know the FEA Affiliates that are either financial advisors or TIC/DST sponsors. Advisors and sponsors often meet with QIs to establish rapport.
• Do refer the client to his tax, legal, and financial advisors for due diligence on vendors and to determine the most appropriate relationships for the client.
• Do offer contacts for multiple advisors or sponsors if a recommendation is requested. Many advisors and TIC/DST sponsors are members of the FEA.
Providing more than contact information or offering only one recommendation might be construed as investment advice.
• Do not accept any form of compensation from an advisor or TIC/DST sponsor without disclosure. Carefully consider whether this exposes the QI to securities violations for receiving compensation as an unlicensed person. Further consider the issue of agency in acting as the QI.

FEA supports DST and TIC sponsors as valuable resources for QIs
DST and TIC sponsors offer valuable options to QIs and their clients. FEA has supported relationships between QIs and DSTs, many of whom are Affiliate members, sponsors of 8 conferences and FEA events, and supporters of the 1031 and QI industries. Because of the nature of the QI's role as a third-party intermediary, FEA raises these important considerations and recommends these best practices to guide protections for all parties.

Julie Baird is Vice President, Counsel, and Western Regional Manager for First American Exchange Company and Chair of the FEA Ethics Committee.
Lucas Ecklund-Baker is Communications Manager for the FEA.
Goeff Flahardy is National Accounts Director for ExchangeRight Real Estate, LLC and Chair of the FEA Affiliates Committee