You found the deal and it is in escrow… “Now what???” Now you need to put the investment itself together and get investors committed. You also need to do it the right way to avoid trouble with your investors and the SEC down the road…
- Making Sense of the SEC Alphabet Soup
We syndicators operate under a regulatory framework. The basic framework says that every security needs to be registered with the SEC and/or the state. However, there are exceptions that do not need registration. We have state rules and federal rules that govern what we do. When everything is within the state, we can choose between whether we operate under the state rules, also called the “blue sky laws,” or under the SEC’s rules.
Looking online, you’d think this was just an administrative thing that you do when you check a box, because it’s just one form. And it’s not really all that necessary. Well, coming from an attorney, it absolutely is. This matters. If something were to happen, or someone complains, everything you’ve built is suddenly in jeopardy. If you haven’t done everything right, you may be liable for civil and criminal penalties. That said, you can stay on the right side of the law, when you know where those boundaries are and you know how to stay within them.
Let’s go through those boundaries and talk about how to stay within them. This is the kind of thing where you do want to do some research and talk to an attorney either in your area or somebody who regularly practices in syndication for guidance on any risks you might be running. There may be certain jurisdictions where there are some nuances that change the rules.
In general, when we’re talking about these boundaries, we’re talking about what exceptions there are to the registration of a security. Under our federal system, as soon as you have an interstate transaction where you have somebody in one state and somebody in another state, then the federal government automatically is in control. So that automatically falls under the SEC auspices on what is covered. Now if everything is in the same state (i.e., you’re in Texas, the property is in Texas, and every investor is in Texas) you can go under the blue sky laws of Texas, doing your syndication there and not not even dealing with SEC rules, as long as that’s what your the blue sky laws of Texas say.
Almost every jurisdiction allows for its own internal interest state securities regulation, but as soon as you get interstate, then you need to follow what the SEC rules are. There are three SEC rules that we’ll speak specifically about.
Three SEC Rules
The SEC is the Security and Exchange Commission. They’re the regulatory body that oversees securities in the United States. There are three different exceptions. The first one and the one that you probably will use the most is Reg D. Then there are two others that aren’t used as much, but we’ll go through them because you probably will see them in passing: Reg CF and Reg A. And under Reg A, we have tier one and tier two.
Let’s talk about Reg D. There are three different exemptions under Reg D, and we’ll talk about those. We have 504, 506B, and my preferred one, the 506C. The things that we need to mostly consider are: How much money can you raise? Can you have non-accredited investors? And also what’s your advertising?
Under Reg D, rule 504, you can raise up to $10 million per 12 month period. You can have non accredited investors, but you cannot advertise at all, which means that every one of your investors must be somebody who you’ve had a pre-existing relationship with at a business level or they fall into some other category like a non-accredited or they’re an accredited investor. And as accredited investors they either meet certain income requirements or net worth requirements, or there’s a couple categories for people who have securities licenses even if they don’t meet the income requirements or the wealth requirements.
Reg D, Rule 506B doesn’t have a limit. You can have greater than or equal to 35 non-accredited investors. You also need to determine that those non-accredited investors are sophisticated investors that know what they’re doing when they invest. You still are not allowed to advertise, so these need to be people who you have that existing relationship with as long as they are accredited now. When the SEC says no advertising, they mean no advertising at all.
Under Reg D, Rule 506C, we also have no limit on how much money we can raise. We can not, however, have any non-accredited investors. Every single one of your investors should be accredited, and their accredited status should be verified by a third party verifier. It just gives you an extra level of protection that you don’t get by doing it on your own. The nice thing here is that we can advertise. This means the internet, social media, billboards, banners, anything.
There are two other categories of exceptions. Reg CF (which stands for crowdfunding) came out of the JOBS Act, and under Reg CF, you can now raise a maximum of $5 million per 12 month period. That’s up from just a million dollars earlier, so now suddenly we’re in the ballpark. You can also have non-accredited investors, but here’s the big caveat. If you advertise, everything must go through a registered portal. A portal is set up, then registered with both FINRA and the SEC. The portal will be doing the verification of the investors to make sure that they’ve received all of their disclosures and to make sure that they know what they’re doing, as well as set that dollar amount that they can invest. The SEC wants to police to make sure that people aren’t investing their life savings in your deal, only to put it at risk and potentially lose it.
Under Reg A, there are two tiers. Under tier one you can raise up to $20 million in a 12 month period. And tier two is up to $50 million in a 12 month period. And you definitely can have non-accredited investors, and you definitely can advertise.
However, Reg A takes forever, since you need to file it with the SEC, who then reviews it. They may suggest changes, then there’s an additional review, and then hopefully they approve. For this, you’re looking at well over six months, probably nine months to a year in order to get one approved. Now, if that’s the kind of deal you’re working on, go for it, but know that you cannot accept any money until after they approve it.
Now, let’s say you did something that was not quite right, like you did a 506B, you have unaccredited investors, but you did advertise on social media. What is going to happen? As soon as something goes wrong and you have an investor who gets mad, they are going to file a complaint in state court and maybe with the SEC initially. And then you are going to be under extreme scrutiny. If you are found to have done something wrong, then you are suddenly liable for all of the money, not just the money that you got from that one investor. That’s right, you are liable for the entire amount immediately. So if all of the equity was $3 million of equity that you raised that day one, you need to give that $3 million back right now. No waiting. This means your entire syndication has completely fallen apart, and you committed fraud. Now suddenly, we’re talking about criminal penalties as well, and people do go to jail for this.
This is why this process is so critical, not the kind of thing that we just read online about and select at random. It’s important to stay in compliance with those rules.