If you are just starting out, a lot of the terminology can be confusing – blue sky laws, Reg D, 506c, Rule 144, etc…
But starting a real estate syndication company can be a great way to begin generating substantial wealth and participate in fantastic projects. Having experience in syndication will definitely give you an advantage. You have to spot good deals, create solid business plans, and know-how to attract investors. But here’s the biggest impediment for most syndicators – reading or speaking legalese and navigating the various regulations governing the sale of securities.
Therefore, the more money, the stricter the legislation. With that said, it’s crucial to inform yourself of the various requirements to pull off a successful syndication deal and get the investors you need when putting together a Reg D offering.
One area in which syndicators struggle is syndication documents. How should you draft them, what do you need to discuss, and who dictates what information you have to disclose? This is where we run into two terms that can be confusing if you have no experience with securities law – Regulation D and blue sky laws. Before we go ahead and define them, here’s some background you need to understand. There’s a good reason for the madness facing securities issuers and investors today.
A Brief History of US Securities and Financial Legislation
Let’s start with a bit of legislation history. Although today’s legal environment may seem difficult or unnecessarily complex, it’s important to recognize how we got here.
You see, for a very long time, the US didn’t exactly have strong and enforceable laws concerning matters of selling securities and offering financial investments. The lack of a proper legal framework to govern the industry eventually led to two significant events in American history:
- The Great Depression
- The Securities Act of 1933
While it’s difficult to pinpoint the actual moment when the reform began, what’s widely accepted is that a Kansas Supreme Court judge endeavored to protect investors from speculative and risky offerings back in the early 1900s. The judge referred to these ventures as having “no more basis than so many feet of blue sky.”
Therefore, the concept and terminology of blue sky laws have been around for quite some time.
As the years passed and the country was getting closer to the 1929 stock market crash, speculative ventures such as those referenced by the Kansas Supreme Court judge were still remarkably popular.
During the pre-market crash period, companies used to issue stocks, promote investment deals, and come up with real estate offerings that had no basis. The promises were often unsubstantiated and grand, luring in gullible and uneducated investors. Of course, the SEC wasn’t around back then, nor was there much regulatory oversight for the investment industry.
More often than not, companies sold securities without supporting any profitability claims. If that wasn’t bad enough, others engaged in downright fraud by giving investors false information and hiding essential facts regarding the risk factors of said offerings. Everything was geared towards attracting as many investors as possible by any means necessary.
Anyone who has read up on the 1929 stock market crash knows that the very nature of this hyper-speculative environment caused the gross inflation of the 1920s stock market and led it to collapse.
But what about those blue sky laws?
Some of these laws existed at the time, although they didn’t contribute much regarding regulation. Kansas passed the first recognizable blue sky law as early as 1911. Other states started doing the same. However, across multiple states, the blue sky laws of the 1910s and 1920s were poorly worded and were hardly ever enforced. Savvy business leaders could also avoid those laws by taking their ventures into different states.
Of course, this is still a popular practice today.
It was no surprise that the 1929 stock market crash was so damaging. But after the Great Depression hit, the United States Congress formulated a series of Securities Acts in an attempt to regulate the stock market and the entire financial industry. Nothing similar had been done before on a federal level.
This eventually gave birth to the Securities and Exchange Commission (SEC) in the summer of 1934. Two decades later, in 1956, another guiding framework for securities legislation was passed. This was called the Uniform Securities Act and was a model law that assisted states in creating and passing their own securities laws. To this day, the Uniform Securities Act is the foundation of securities legislation in at least 40 states. The Act was often nicknamed the Blue Sky Law.
Introducing NSMIA And Blue Sky Laws
Blue sky laws were enforced for decades but very differently across most states. As with everything else regarding state legislation, the compliance statutes varied. Whether it was on purpose, due to indecision, or lack of cooperation among states – it doesn’t matter.
What’s important is that in October 1996, the National Securities Markets Improvement Act (NSMIA) came along. It was passed in an attempt to fix the continuous failed attempts at uniformly regulating various national securities offerings. The same Act also introduced a class of securities, now known as covered securities, which aren’t subject to blue sky laws registration requirements.
These covered securities include but aren’t limited to the following:
- Securities listed on the Nasdaq, NYSE, and AMEX
- Mutual fund shares
- Securities sold to select but not defined qualified buyers
- Government and municipal securities exempt under Section 3(a) of the Securities Act
- Bank securities
- Securities exempt from the Act if sold in compliance with Regulation D Rule506(b)
NSMIA was an attempt to preempt the registration requirements of specific state securities. At the same time, it empowered states to still investigate and even prosecute fraudulent activities.
Because of NSMIA, states don’t have to demand the registration of covered securities from issues. But they are still allowed to request filings and fee payments for both offers and sales of covered securities.
Now that you’re up to speed on the most important financial legislation passed since the Great Depression, let’s look at two of the most frequently used terms in real estate syndication.
- Blue sky laws
- Regulation D
What Are Blue Sky Laws?
Blue sky laws make up the regulations that warrant brokerage companies, investment advisors, and even individual brokers to get licensed in order to offer securities in one or more states. The laws clearly state that any private investment fund has to register in its own state as well as all other states where it intends to do business.
For the most part, blue sky laws stand for an extra regulatory layer on top of the federal securities regulations imposed by the SEC.
With blue sky laws, it’s important to remember this – they may vary between states but they’re all designed to safeguard investors from fraudulent, speculative, and risky offerings.
As such, any entity that issues securities is obligated to reveal all the terms of the offering and create disclosure documents providing any material information pertaining to the security or asset in the offering.
Since blue sky laws are enforceable only at a state level, where each jurisdiction is responsible for creating and imposing its own filing requirements to register offerings. This process is overseen by state agents. They’re the ones who analyze each offering and determine whether it’s compliant and fair for potential investors.
Blue sky laws also feature various provisions that can create liability in certain situations. For example, not disclosing information to the investor or making fraudulent statements open up securities issuers against legal actions.
Core Purpose Of Blue Sky Laws
In essence, the blue sky laws were created and imposed as deterrents. They discourage sellers from taking advantage of individuals or businesses that lack enough experience or knowledge of a particular industry they want to invest in. State regulations ensure that investors receive vetted offerings, already assessed by state administrators and deemed fair and equitable.
Some exemptions will apply for specific offerings. One example of this is the category of securities featured on the national stock exchanges. Some offerings governed by Rule 506 of the SEC Regulation D can also be exempt.
Hopefully, you now have a better understanding of blue sky laws, how they originated, and their purpose concerning the securities and financial market.
However, many new syndicators have problems with the SEC Regulation D, or Reg D, and where it fits in the grand scheme of things.
So, let’s dive into that.
What Is the SEC Regulation D?
Reg D is a regulation imposed by the SEC that governs private placement exemptions. This means that it dictates the legal guidelines to follow when selling an offering or raising capital from a select group of investors, such as non-accredited or accredited investors, on the private market. Many industries use Regulation D for their capital raises.
They are often beneficial to entrepreneurs and even private companies that meet the legal requirements. Offerings registered under Reg D can typically raise funding faster and more economically than most public offerings. Thus, small to medium-sized companies and entrepreneurs tend to use this method.
It’s important to note here that the SEC Regulation D enables capital raising through selling debt securities or equity but doesn’t require registering those securities with the SEC. Of course, where Reg D ends, other federal or state regulatory legislation could begin.
When it comes to raising private capital for real estate, a Reg D investment imposes less challenging requirements than a public offering. Therefore, businesses can save time and sell more securities than when using other methods.
Such a transaction can be a private placement debt offering or an equity offering, but it doesn’t have to be hidden. Certain rules of this regulation can enable open solicitation of an offering to potential investors.
A Regulation D transaction may involve one or multiple investors. That said, regardless of how many investors or partners join the venture, the issuer (real estate syndicator) is still legally-bound to create a compliant framework for the offering along with disclosure documentation (private placement memorandum).
This document is called Form D. SEC mandates impose the Form D filing on syndicators or securities issues after selling the first securities. Compared to other documentation, Form D is much easier to draft as it doesn’t need exhaustive information like most public offerings. The following details are often enough:
- Issuer’s name and address
- Information on executives and directors
- Vital information on the offering
When you issue an offering under Reg D, you should remember that written disclosures are mandatory. Investors need to know of previous criminal convictions, poor investments, or other bad actor disqualifications as mentioned in Rule 506 of Regulation D in the Securities Act of 1933.
Naturally, if this wasn’t a requirement, there would be less accountability regarding private placement offers.
The Federal Register lists Reg D transactions as not exempt from civil liability, antifraud, and other federal securities laws provisions. Furthermore, this SEC regulation doesn’t always supersede the need to comply with applicable state laws concerning the sale of securities (like blue sky laws.)
In fact, even if under Regulation D the issue may not have to disclose certain information, state regulations can overrule this and impose the requirement. Things that usually qualify here are disclosures of sales notices.
It’s also important to understand that the SEC Regulation D has some limitations too. Its benefits are extended only to the issuer of securities, or in your case, the syndicator. These advantages don’t transfer to affiliates or securities resellers. Simultaneously, the regulatory exemptions apply to transactions and not securities or assets subject to sale or investment.
Reg D Rule 506 and Its Interaction With Blue Sky Laws
The SEC is the main regulatory body that oversees and governs the securities and financial industry. As a result, its legislation is used as a baseline and applied country-wide.
However, each state is allowed to create and enforce its own regulations, which is where blue sky laws come in. Depending on the specific registration rules followed by securities issuers, they may have to adhere to one or both – federal statutes and state laws.
What Is Rule 506?
In the simplest terms, Rule 506 is a section of the SEC Reg D that offers securities issuers two well-defined exemptions regarding the registration of offers and sales. In the case of real estate syndication companies, this means that being compliant with Rule 506 allows syndicators to raise unlimited capital.
This rule has two variations – b and c.
Rule 506(b) Example
Here’s an example of an offering registered under Rule 506(b) of Regulation D. Companies and entrepreneurs (e.g., syndicators) are allowed to raise unlimited capital and sell securities to as many accredited investors as they want.
With that in mind, the Reg D 506(b) requirements state that issuers aren’t allowed to participate in general solicitation or advertise their securities on the public market. Furthermore, there’s a cap on the maximum number of non-accredited investors. Issuers can’t raise funds from more than 35 non-accredited investors per offering. Of course, those investors should also generate proof of having adequate investment experience and knowledge in the space to be deemed capable of analyzing and understanding the risk vs. reward of a potential investment.
Should the non-accredited investors join accredited investors on the same offering, then the issuer is obligated to provide the former with the same documentation and information presented to the accredited investors. That essentially means making non-accredited investors privy to financial statement information as indicated in Rule 506. It’s also necessary for the issuers to be available and clarify any questions regarding the investment.
In this example, the SEC Regulation D can act as a federal preemption. It can invalidate requirements for state registration and qualification. However, states may still exercise their authority and collect state fees while also requesting notice filings.
Rule 506(c) Example
This variation still allows for unlimited capital raising. However, issuers are also allowed to solicit investors on the open market and even advertise their offerings. But they need to meet two requirements to remain compliant and exempt.
As a syndicator filing under Rule 506(c), you can’t solicit non-accredited investors. Therefore, you’re only allowed to present your proposal and sell securities or equity to accredited investors.
Furthermore, you’re tasked with verifying the accredited status of potential investors. This usually involves reviewing tax returns, doing credit checks, and analyzing W-2s, among other documents.
As you can see, securities legislation can get complicated even when dealing with private placement offerings. Raising private capital for real estate is arguably easier, faster, and cheaper, hence why many opt to go into real estate syndication. But because each state has its own blue sky laws and the SEC governs at a federal level, navigating these legal fields isn’t easy.
That’s why the safest approach for a syndicator, and their investors, is to enlist the services of an experienced real estate syndication attorney.
The Need to Understand the Legal Environment
Deciding to build a career or business around real estate syndication isn’t something to take lightly. While profitable and exciting, this field is much harder to navigate, even if you’re well-versed in all aspects of real estate.
Syndication means having the potential to raise unlimited capital. We’re talking about pooling millions of dollars from multiple investors, building and managing multi-property portfolios. But since syndication is mostly done on the private market, there are certain legal aspects you have to navigate perfectly to enjoy the benefits of private offering exemptions.
Consulting a real estate syndication lawyer may be necessary, even if you’re only operating in a single state. It’s highly recommended if your business spans several states as you will have to adhere to different requirements everywhere you go.
Even if the statutes differ slightly, you’re liable to your investors, the federal government, and the state you operate in as a syndicator. Therefore, it’s essential to have the best guidance when creating real estate syndication documentation and presenting an offer to prospective investors. Getting expert legal help will help you create a compliant proposal and minimize your risk.
State Blue Sky Laws
Tilden Moschetti, Esq., is a highly sought-after syndication attorney with nearly two decades of experience. His clientele ranges from real estate developers and startups to established businesses and private equity funds. Tilden’s expertise in syndication law comes not only from his knowledge of syndication and securities law but from real, hands-on experience as an active syndicator himself in every real estate product type and nearly all markets in the US. His knowledge and experience set him apart and established him as the Reg D legal services leader.