Group Investing

Group Investing Update

Changes to securities laws may change your business model.

By Kim Lisa Taylor, Esq., and Gene Trowbridge, Esq., CCIM |

CCIMs and other commercial real estate professionals are often involved with raising money from groups of investors to purchase income-producing properties. Since this activity generally means working under the federal securities laws, the ability to advertise and solicit investors has historically been restricted. However, the Jumpstart Our Business Startups Act, known as the Jobs Act, has dramatically changed the way group investment money is going to be raised.

What Changed?

In its July 10, 2013, meeting, the Securities and Exchange Commission adopted the new Regulation D, Rule 506(c) as authorized by the Jobs Act (Title II), which became effective September 23, 2013. (See SEC Release No. 33-9415, Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings.) Under the new rule, persons such as issuers, sponsors, syndicators, or promoters selling “securities” to private investors to fund their companies or real estate transactions will be able to advertise their private-investment opportunities under certain conditions.

Anyone who is raising money from multiple investors is probably selling securities. Securities include promissory notes or investment contracts between a manager and passive investors. Under the Securities Act of 1933, sales of securities must be registered with the SEC unless exempt.

By far the most common exemption has been the Rule 506 private offering exemption. As much as $898 billion may have been raised in Rule 506 offerings in 2012, according to the SEC. From 2009 to 2012, the average offering size was $30 million and the median offering size was $1.5 million.

The Old Rule 506

Under the original Rule 506, which will now be known as Rule 506(b) and is still in effect, issuers of securities are exempt from SEC registration as long as they follow the rules for the exemption. Rule 506(b) allows issuers to raise an unlimited amount of money from an unlimited number of accredited investors and up to 35 “sophisticated” investors, but issuers cannot make any offers or sales of the securities by any means of general advertising or solicitation. To prove they didn’t solicit investors, issuers must be able to demonstrate a pre-existing relationship with an investor that predates any current or contemplated offer to sell securities. For issuers relying on Rule 506(b), investors may self-certify that they are accredited or sophisticated by checking a box on a prequalification form the issuer provides.

For real estate syndicators who want to issue their own securities, the pre-existing relationship and nonsolicitation provisions of Rule 506(b) have been a source of great confusion, misinterpretation, and a significant impediment to funding their real estate transactions. The new Rule 506(c), which allows syndicators to advertise their real estate offerings, eliminates that obstacle and provides new opportunity for CCIMs and other commercial real estate professionals.

The New Rule 506(c) Solution

Under Rule 506(c), real estate syndicators can advertise to anyone as long as they only accept accredited investors in their offerings and comply with the rest of the Rule 506(c) provisions.

However, there are strings attached. Issuers of Rule 506(c) offerings must demonstrate that they are “reasonably assured” that all investors are accredited. The SEC has offered some nonexclusive methods to verify an investor’s accredited status, which include:

• reviewing filed tax forms for the past two years and written assertions from the investor(s) that the income is expected to continue;

• reviewing brokerage house or bank statement balances or tax assessments and third-party appraisals of real estate holdings and liabilities through an investor’s credit report;

• obtaining a written confirmation from a securities broker-dealer, registered investment adviser, licensed attorney, or certified public accountant, who asserts having taken reasonable steps to verify an investor’s accredited status within the past three months; and

• using repeat investors: there is an exemption for investors who have previously invested with an issuer as an accredited investor.

“Bad Boy” Prohibitions

The SEC also adopted amendments to existing rules 501 and 506 to implement Section 926 of the Dodd-Frank Act, also effective September 23, 2013, to be known as Rule 506(d). These amendments disqualify certain convicted felons and other “bad actors” from claiming a Rule 506 exemption. Bad actors are defined as persons who have been convicted of, or are subject to, a cease-and-desist order, injunction, or disciplinary order issued by certain federal financial regulatory agencies or the Postal Service. If these events occurred before the effective date of September 23, 2013, these individuals may still operate under Rule 506, but mandatory disclosure of such disqualifying events is required.

The SEC has proposed other amendments to Rule 506(c) offerings, including requiring additional Form D filings for presale, first sale, and closing notices of securities; filing of additional information about the issuer, marketing methods to be used, additional legends, and disclosures; and temporarily submitting written ads to the SEC prior to use. The SEC is taking public comment on these amendments and the final rule could be issued by year-end.

Clarifying Crowd Funding

However, none of these rulings should be confused with crowd funding, which is completely unrelated to Rule 506. Crowd funding is a different funding scenario authorized in a separate part of the Jobs Act (Title III). The premise is that investors will be able to invest as little as $1,000 for offerings advertised through SEC-authorized funding portals. To further confuse matters, the media and certain promoters have hijacked the term crowd funding to describe Rule 506(c) offerings conducted on the Internet.

Despite Internet and news reports to the contrary, the SEC has not approved crowd funding. On October 23, 2013, the SEC met and the commissioners voted to submit for public comment the proposed rule that will authorize crowd funding. The public comment period is 90 days. After that, the SEC will determine if revisions to the proposed rule are required and vote on a final rule. The rule becomes effective 60 days after it is published in the Federal Register. Crowd funding will probably become a reality during first quarter 2014. However, according to the SEC’s own website, until the final rules are effective, all crowd funding offerings are unlawful.

While the changes authorized in the Jobs Act are exciting, many have yet to be implemented. Commercial real estate professionals involved with group investing should proceed with caution and verify information heard in the media and on the Internet through the most reliable source: www.sec.gov.

Kim Lisa Taylor, Esq., is a California and Florida licensedattorney with practice areas in real estate investment and securities law. Contact her at kim@syndicationlawyers.com. Gene Trowbridge, Esq., CCIM, is a California licensed attorney, senior CCIM instructor, and author of “It’s a Whole New Business,” on real estate syndication. Contact him at gene@genetrowbridge.com. A version of this article previously appeared in Personal Real Estate Investor.