Talk to any serious real estate investor and you will probably hear the same complaint – I have more deals than I do money or credit. Some investors have solved this issue through simultaneous closings or with hard money lenders. Others have taken a different approach by actively soliciting people with cash to invest in their deals. The allure for these cash laden souls is the promise of higher returns from real estate. Unfortunately for many of these investors, they are trading one problem for another and it is not a trade I would make – lack of cash for potential civil and criminal liability. However, if the investor’s fund raising activities are properly structured, then liability is greatly diminished. This article will examine the various ways to navigate the raising of private capital from a securities law perspective.
Occasionally an investor asks me why his local real estate attorney refuses to discuss the raising of capital or will flat out discourage such activity. The answer is simple. The federal government requires every company (corporation, limited liability company, trust, or limited partnership) in the United States seeking to sell an interest be “registered” at both the federal level (with the Securities and Exchange Commission – the “SEC ”) and with each state in which the securities are offered or sold. This registration can be an extraordinarily complex and expensive endeavor, which, if done wrong carries significant penalties. As the reader, you might be thinking how investors who are short on capital are able to raise money. Are they violating the law? In some instances the answer is yes, although most have educated themselves on the various exemptions and in turn operate their business within the constraints of the law.
Both federal and state law base their exemptions around the following criteria:
- The number of investors solicited;
- The type of investor solicited;
- The amount to be raised; and/or
- The manner of solicitation
For real estate investors, understanding and staying within these exemptions should be your primary concern, but always bear in mind that an exemption does not necessarily make your offering “legal”. Each exemption takes us down a different regulatory path and knowing these paths will be key in preventing you from becoming lost.
From a federal securities law standpoint we have one playbook. However, each state has it’s own set of rules, therefore exempting your fund raising under federal law will not relieve you of state securities issues commonly called the “Blue Sky Laws”. Further, if you plan to invest in multiple states and raise money, then the number of playbooks you must consult will increase accordingly. I assure you I am not trying to deter you from fund raising. My aim is in arming you with the right information so you can begin your raising of capital on solid footing. Think of it as follows – every solicitation for capital is subject to federal law unless covered under an exemption. Even if you are covered under a federal exemption, you must still consult state law unless the federal exemption specifically preempts state law (currently rule 506 and crowd funding).
Rule 506 – The Exemption Regulation
Rule 506 is the preferred exemption for those investors looking to save time, money and to reduce the complexity of fund raising activities. Moreover, the rule preempts state law. Thus, with the exception of certain abbreviated state notice filings, you can raise capital without worrying about state Blue Sky Laws. Here are the basics of Rule 506:
- No limit on the amount of capital you can raise;
- No restrictions on who can use Rule 506 to raise capital;
- You can raise money from an unlimited number of “accredited investors” (defined below) and up to 35 non-accredited investors. (Note: all non-accredited investors, must be “sophisticated investors” (defined below), that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.); and
- Only a Form D must be filed with the SEC and the state where funds will be raised.
You cannot engage in general advertising or general solicitation to market the securities i.e., no seminars, flyers, advertisements, etc.. (NOTE: Under the JOBS act the SEC released its proposed rule to amend Rule 506 to eliminate the general solicitation prohibition provided all purchasers are accredited investors. However, under this new rule, 506(c), you must take “reasonable steps to verify” that your investors are indeed accredited investors, whereas the current Rule 506 contains not such requirement.)
An “accredited investor” is anyone with a net worth of $1 million excluding the value and debt of their personal residence, or an individual whose gross income for each of the past two years was $200,000 or more (or $300,000 jointly with a spouse), and who has reasonable expectations of meeting that income level the following year.
A “sophisticated investor” is any investor who has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.
Rule 504 – Regulation D
For investors who would like to advertise, Rule 504 is an option because the SEC basically takes a “hands off” approach to any offerings under $1,000,000 within a 12 month period. Although Rule 504 allows the investor to use general advertising and general solicitation to raise capital, you must still meet state registration requirements (this assumes the state in which your registering permits solicitation and registration). Under Rule 504, an unlimited number of investors are permitted, and there are no sophistication or experience qualifications placed on investors. Finally, you are not obligated to provide investors any disclosure materials regarding the offering. This rule will most likely fall out of favor given the new changes to Rule 506 discussed above.
Rule 147 – The Intra-State Offering Exemption
If you plan to raise capital in only one state, your business is organized in the state where you are raising the capital, all of the investors live in the state, and you will use the capital in the same state, then Rule 147 grants an exemption from the SEC, but not state, registration. Under Rule 147 an investor can solicit for capital and there is no federal limit on the amount that can be raised. Generally speaking, the SEC leaves regulation up to the state where you are raising capital. The main advantage to Rule 147 is the solicitation, however, most states impose restrictions on raising capital when solicitations are involved.
If you are planning to raise capital for your real estate endeavors, I recommend you find the path of least resistance and make the appropriate filings. Keep in mind this article assumed you will not be working solely with a few friends and family which, in most instances, does not require registration. If you have any questions regarding any of the matters contained herein, do not hesitate to contact me.