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Crowdfunding provisions under the new Rule 506(c): new opportunities for real estate capital formation.

The Jumpstart Our Business Startups (JOBS) Act of 2012 heralded a new era of capital formation regulation in the United States. In the act, Congress directed the SEC to ease longstanding small business capital formation registration exemptions, viewed by many as unnecessary. Furthermore, Congress tasked the SEC with devising an infrastructure to make "crowdfunding"--that is, using social media websites, such as Facebook and LinkedIn, to raise small amounts of capital--a reality, all with the additional aspiration of creating new jobs through the engine of small business.

The SEC responded to the first directive with Rule 506(c), the most dramatic change to Regulation D since its inception. As of September 23, 2013, issuers of securities raising capital under Rule 506(c) can, for the first time, publicly solicit and advertise for "accredited" investors under an exemption from registration. For the second directive, the SEC released for comment in October 2013 long-awaited rule proposals that, once adopted, will enable crowd-funding for equity and debt investors. What will these new provisions mean for real estate developers, attorneys, syndicators, investors, brokers, and others trying to raise capital for real estate projects through the sale of securities? This discussion attempts to answer that question by examining both of the SEC's initiatives.

Two New Ways to Raise Capital

Since the earliest days of securities regulation in the United States, absent an exemption, securities issuers were required to register their offerings with federal and state securities regulators in order to raise capital publicly (i.e., offering and selling to the general public). Securities registration is a long and costly process; however, a few exemptions did exist, and there was a private alternative.

Relying on sections 3(b) and 4(2) of the Securities Act of 1933 and the SEC rules promulgated thereunder, issuers were permitted to raise capital privately (i.e., not using general solicitation or advertising to find investors). To qualify for these private placement exemptions, issuers generally had to know their investors beforehand and have a preexisting business or personal relationship with them. (For a broad discussion of these rules for real estate group investing, see Gene Trowbridge, It's a Whole New Business, Trowbridge and Associates, 2013). Furthermore, the investors had to be deemed, per the regulations, sufficiently sophisticated so as not to need the protections of the securities laws. Private issuers had to run a gantlet of both federal and (often more restrictive) state "blue sky" law exemptions to offer and sell their securities privately.

The New Rule 506(c)

Promulgated in 1982, the SEC's Regulation D was a collection of rules that gave some clarity and direction to sections 3(b) and 4(2), but the regulation of private offerings was still shared with the states. In 1996, under the National Securities Markets Improvement Act, Congress gave new meaning and focus to Rule 506 of Regulation D when it classified securities sold in reliance on rules adopted under the securities registration exemption for nonpublic offerings [section 4(2)] as "covered securities," thus preempting the states from regulating them. (In other words, the federal government "took over" this area of governance.) Rule 506 became the exemption of choice virtually overnight. Under the rule, issuers are permitted to offer and sell their securities to an unlimited number of (accredited) investors and to raise an unlimited amount of money; however, until recently, they were prohibited from publicly soliciting or advertising for investors.

The term "accredited investor" is defined in Regulation D, Rule 501, and includes, among other parties, a natural person who--

* earns $200,000 for the year, or $300,000 for the individual and spouse for each of the prior two years, and who reasonably expects the same amount of earnings for the current year; or

* has a net worth of $ 1 million, either alone or with a spouse, excluding the value of the primary residence.

In the authors' opinion, there have been strong indications "surrounding the SEC" that the "accredited investor" definition might likely be tightened in the not-too-distant future. (See also the SEC request for comments.)

For better or worse, things remained the same for the next 17 years, notwithstanding the annual recommendations from the SEC's Government-Business Forum on Small Business Capital Formation to allow public solicitation and advertising of Rule 506 deals. A prohibition on "public solicitation" seemed a central tenet for regulators, both on the federal and state levels, as well as consumer protection organizations. (See comments by the forum in "Breaking Down the 2013 Crowdfunding World Summit," by Charles Luzar, CrowdfunInsider.com, Jun. 27, 2013.)

This lasted until 2012, when this concern with the difficulty of raising capital for small businesses became a strong impetus behind the JOBS Act. (See the SEC Open Meeting notes from Jul. 10, 2013, where this broad issue of raising capital and the two new proposals were discussed.) Title II of the JOBS Act drastically amended section 4 of the Securities Act of 1933. The existing four securities registration exemptions were included as subsections of new section 4(a), with the addition of new section 4(a)(6), discussed later, and new section 4(b). Under section 4(b), Congress declared that offers and sales of securities by issuers made in reliance on (changes to come to) Rule 506 were not to be deemed public offerings; thus, they did not require registration "as a result of general advertising or general solicitation."

Accordingly, the SEC was required to create new Regulation D rules, which took effect on September 23, 2013. In reliance on the new Rule 506(c), issuers are now permitted to offer and sell private offering securities publicly, within the limits set forth. As securities offered and sold under a rule adopted under what is now section 4(a)(2), these Rule 506(c) securities remain covered securities, and thus state regulation of them is preempted.

Under the old Rule 506--now Rule 506(b)--issuers may raise an unlimited amount of cash from an unlimited number of persons whom the issuer has a reasonable basis to believe are accredited investors. A maximum of 35 nonaccredited, yet "sophisticated," investors [defined in Rule 506(a)(2)(ii) as one who "either alone or with his purchaser representative(s) has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making the sale that such purchaser comes within this description"] is also permitted, provided the issuer has a preexisting business or personal relationship with these persons and does not use public solicitation or advertising in offering or selling securities to them. (See "SEC Issues Final Rules Ending Ban on General Solicitation in Connection with Regulation D, Rules 506 Securities," CCH Federal Securities Law Reporter, CCH Blue Sky Law Reporter, Para. 35,600L, and "Eliminating the Prohibition against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings," SEC, Sep. 20, 2013.) Except for the new numbering and the advent of the "bad actor" disqualifications (discussed later), Rule 506(b) has not changed; it remains available to private-placement issuers.

Under the new Rule 506(c), issuers may also raise an unlimited amount of cash from an unlimited number of purchasers, but they must verify that the purchasers are accredited investors. The prohibition on general solicitation and advertising and the latitude to sell to nonaccredited investors no longer exist.

Verification. In a concession to those worried about the potential for fraud due to the allowing of public solicitation and advertising of such securities offerings, Congress and the SEC limited sales (but not offers) of Rule 506(c) securities to investors verified by the issuer as accredited investors. At the time of passage, no one knew exactly what "verification" would mean, but it was apparent that the SEC and Congress intended that it would constitute a higher standard than the old Rule 506 requirement that the issuer have a "reasonable basis to believe" its investors are accredited. Though not yet well defined, there is an important difference between the verification and reasonable basis standards.

In the final Rule 506(c), the SEC elected not to define how issuers were to verify accredited investor status; instead, it provided three examples of verification methods that would meet the requirement. The SEC made it clear that the traditional old Rule 506 "check-the box" format in subscription agreements, which established that the issuer has a reasonable basis, will no longer suffice. An issuer must do more under Rule 506(c). In the three nonexclusive examples given, the issuer could--

* obtain third-party documentation establishing the investor's income (e.g., bank statements);

* review documents establishing the investor's net worth (e.g., brokerage account statements); or

* obtain confirming information from a professional dealing with the investor, such as a lawyer, financial adviser, accountant, or stockbroker.

Investors who are already invested in the issuer's deals are grandfathered and thus not required to meet these new standards. In some instances, the scope of the investment itself might "self-verify" accredited status--for example, a minimum investment of $2 million.

Form D. Consistent with the old Rule 506, issuers are still required to file Form D with the SEC within 15 days of the first sale in the United States and with a state securities regulator (along with a fee) within 15 days after the first sale in that state. The disclosure requirements set forth in Regulation D, Rule 502, remain in place for Rule 506(c) offerings. As provided in Rule 503, although the filing of Form D is required, it is not a condition of any Regulation D exemption. In other words, an issuer does not lose a Regulation D exemption for failure to file Form D.

Intermediaries permitted. In a less heralded, but perhaps just as significant, change as allowing public solicitation and advertising, the new section 4(b)(1) of the Securities Act of 1933 was enacted. Prior to section 4(b)(1), the SEC's Division of Trading and Markets had taken a rather restrictive view of "Internet matching services." The concept was that websites could be established where prospective investors ("angels") could peruse business plans posted by entrepreneurs hoping to spur interest in their ideas. Because such embryonic issuers rarely had the means to afford to pay such web hosts a sizeable upfront fee for their services, the only way such hosts could be compensated would be to take securities in the proposed offering. In the eyes of the SEC staff, this turned the web host into a full-fledged broker/dealer, subject to the full panoply of brokerage regulation. Per new section 4(b)(1), such web hosts are now specifically excluded from broker-dealer registration, provided that the hosts perform only "ancillary services" with regard to the posting, receive no commission on sales, and are not statutorily disqualified from registering as a broker/dealer.

Proposed rules that would restrict Rule 506(c). The SEC created some confusion when, along with the announcement of the final Rule 506(c), it released several proposed rules for comment that, if adopted, would change the complexion of Rule 506(c) dramatically. With any or all of these requirements and restrictions, the SEC would essentially take away what it had offered in the new latitude for offering under Rule 506(c). The simultaneous announcements caused some to believe the proposed rules were part and parcel of the new Rule 506(c), but that is clearly not the case. In fact, it is highly questionable that the proposals will be adopted in their current form, given the many negative comments received by the SEC to date.

The release contained proposals under which issuers hoping to sell under Rule 506(c) would be required to file Form D and their solicitation and offering materials with the SEC before commencement of the offering. The failure to file Form D and the documents would, under the proposals, preclude the issuer's reliance on any Regulation D exemption for a year. SEC Rule 156, which governs the advertising of mutual funds, would, as proposed, be extended to Rule 506(c) offerings, and prescribed legends on offering materials would be required. Finally, as proposed, more restrictive and heightened standards would be set for accredited investor status.

If implemented, there is no question that these rules would significantly alter the new, less restrictive landscape created by Rule 506(c); however, the new rules are far from certain, especially given that the initial comment period was extended.

Accredited investor. The definition of an "accredited investor" has not been changed (with one minor exception as to the "net worth" calculation) since its adoption in 1982. The effect of inflation since that time has served to reduce the thresholds for an individual's annual income and net worth relative to prices. In section 413 of the Dodd-Frank Consumer Protection and Wall Street Reform Act, the SEC was charged with reevaluating the accredited investor parameters every four years, beginning in the fourth year after the measure was signed into law (July 21, 2010).

Whether and how the SEC will change the qualifications for accredited investor status is unknown at this point. Each aspect will be carefully debated and considered. It is a fair bet that the definition will become more exclusive. If such a change occurs, how will it be implemented? Will there be a rush to recruit legacy-accredited investors to investments before new thresholds set in? Only time will tell.

Crowdfunding

On a parallel course with the new Rule 506(c) and public solicitation and advertising came an even greater change, the crowdfunding phenomenon. In Title HI of the JOBS Act, Congress set forth the outlines of a crowdfunding system for capital formation. The crowdfunding title is where most of the reaction to the fears and warnings of consumer groups and securities regulators about potential fraud and investor abuse from relaxed regulation were directed. (For example, members of the SEC, state commissioners' offices, and professionals have expressed concern about this issue. For an overview, especially with regard to fraud against investors on the Internet, see Luzar 2013.)

The SEC was charged with creating the rules necessary to put flesh on the crowdfunding bones enacted by Congress. The novelty and complexity of the new process proved daunting. The SEC had to act in coordination with the Financial Industry Regulatory Authority (FINRA), because the new system entailed the creation of a new class of securities registrants, called "funding portals," along with an array of new procedures. Proposed rules were finally announced and released for comment on October 23, 2013--all 285 pages of them (not including the FINRA release). As of the date of this article's publication, it is unclear exactly what crowd funding for securities investments will look like after the SEC and FINRA act.

New system. Although the enabling federal rules have yet to be put in place, the contours of what the crowdfunding system will most likely look like when finalized are apparent. In trying to appease so many disparate interests, the statute grew in unusually granular detail. (For an overview of developing crowdfunding rules, see "Equity Crowdfunding--Transforming Customers into Loyal Owners," by Jonathan Frutkin, Cricca Funding LLC, 2013, and "Crowdfunding: Offerings of $1 Million or Less," in Venture Capital and Small Business Financings, by Robert Haft, 2013.)

Crowdfunding offerings will be capped at $1 million in a given trailing 12-month period. They must be made via the Internet, through independent broker/dealers or funding portals, which will constitute a new brand of FINRA registrants, though subject to lesser burdens than full-fledged broker/dealers. Investors will be limited in how much they can invest in any year in any crowdfunded deals based on their income or net worth. Furthermore, crowdfunding issuers will be required to provide fundamental disclosures to prospective investors. Funding portals and crowdfunding broker/dealers will be required to inform investors of the generic risks of crowdfunding investing. The funds raised will have to be escrowed until a previously determined and disclosed milestone is reached.

The states will be preempted from imposing regulations on crowdfunded offerings that differ from those that exist on the federal level, but they will be permitted to pursue antifraud investigations and remedies. Issuers of crowdfunded offerings are subject to strict liability private civil remedies set forth in section 12(a)(2) of the Securities Act of 1933. Given the proposed SEC and FINRA rules, many are beginning to wonder if crowdfunding will be more trouble than it is worth (Kendall Almerico, "Has the SEC Made Equity Crowdfunding Economically Unfeasible?," Crowd fundlnsider.com, Nov. 21, 2013). That is, if one is restricted to raising a smaller amount of funding (e.g., $1 million), do the controls, timing, costs, exposure and efforts warrant the use of crowdfunding to raise capital?

Current crowdfunding. Although much has been written and said about the current state of crowdfunding, whatever is being (legally) undertaken today either does not involve the interstate offer or sale of securities, or is being offered and sold in reliance on the new Rule 506(c), perhaps utilizing crowdfunding (social media/Internet) techniques to find verifiable accredited investors. One should not confuse congressional and SEC crowdfunding with the use of this same term in other settings. Crowdfunding as a tool to seek individuals to put forth money for a project or venture has existed and continues to exist, notwithstanding the crowdfunding portion of the JOBS Act. Many of these prior contributions were not investments or ownership interests; in many cases, they were monies given to the entrepreneur to further the development of an idea. As noted, some of the funds were raised from "crowds" of people who were willing to support the idea, even without necessarily gaining a material interest in whatever resulted (e.g., the online platform Kickstarter or the raising of funds by entrepreneur Eric Migicovsky for the Pebble smartwatch).

For an overview of this area of crowdfitnding, see "Some Simple Economics of Crowdfundingby Ajay Agrawal, Christian Catalini, and Avi Goldfaib, NBER Working Paper Series, issued by the National Bureau of Economic Research, June 2013. In this working paper's abstract, the authors noted the following:

   The recent rise of crowdfunding--raising
   capital from many people through an
   online platform that offers little opportunity
   for careful due diligence and involves
   not only friends and family, but also many
   strangers from near and far--is initially
   startling.


Whatever it may be, this is not the crowdfunding regulated by the SEC under the new sections 4(6) and 4A because both sections can be implemented only by rule, and those rules are not even finalized--let alone effective--yet. Impatient with the federal process, several states have enacted intrastate crowdfunding legislation. Such legislation has already been adopted in Georgia, Indiana, Kansas, Maryland, Michigan, and Washington; it is pending in Florida. In reliance on section 3(a)(11) of the Securities Act of 1933, the federal exemption for intrastate offerings (offerings made solely in one state), crowdfunding is permitted to one degree or another under each state's securities act, usually through some form of state-sanctioned funding portal.

On April 10, 2014, the SEC's Division of Corporation Finance issued three new Compliance and Disclosure Interpretations (CDI) on the subject of intrastate crowdfunding (http: //www. sec. go v/di visions/ corpfin/guidance/securitiesactrulesinterps.htm#141-03). In short, the SEC staff advised that they would not recommend enforcement action for sale of unregistered securities on offerings made by means of intrastate crowdfunding, provided it was conducted through some sort of funding portal, but not by the issuer itself, and stayed within the bounds of the safe harbor under section 3(a)(11) (i.e., Rule 147).

Limits on Both Rule 506(c) and Crowdfunding

One-way street Relying on either of the new rules is a one-way street. Once an issuer starts offering or selling in reliance on Rule 506(c) or using crowdfunding, there is no other exemption to fall back on if the issuer wants to change directions. Under Rule 506(b), if an issuer sells to more than 35 nonaccredited investors, fails to comply with a disclosure requirement, or perhaps publishes an ad in error that no investor relied upon, while the exemption might not be viable, an argument can still be made that, notwithstanding the gaffe, the offering nevertheless qualifies as exempt under the more general section 4(a)(2) of the Securities Act of 1933, in that it still does not constitute part of a "public offering." That fallback argument is eliminated when an issuer undertakes a Rule 506(c) or crowdfimded offering and fails to meet the requirements under Rule 506(c) or the crowdfunding exemption under section 4(6). Not only is there no fallback position, but an issuer of a botched or failed Rule 506(c) or crowdfunded offering is required to he fallow for six months before it is eligible to rely on Rule 506(b) or any other exemption for another offering.

New bad actor rules. Another new limitation to consider [under Regulation D generally and Rules 506(b) and (c) and crowdfunding specifically] is the bad actor provision under new Rule 506(d). Essentially, if anyone connected with the issuer has been the subject of a variety of final law enforcement or regulatory enforcement judgments or orders after the effective date (September 23, 2013), the issuer is precluded from relying on Rule 506(b), Rule 506(c), and the crowdfunding exemption for any offering. This preclusion is not retroactive, except in the sense that an issuer that would have been disqualified from relying on these exemptions had the judgment against the related party been rendered or the order issued after the effective date is required to disclose the adverse judgment or order to prospective investors. Such disclosure would almost certainly be required under general antifraud principles in any event.

The biggest complication with the bad actor provisions is that they do not only apply to the immediate principals of the issuer; board members, affiliates, and their principals also are included. Significant due diligence into the background of anyone even tangentially involved on the issuer side is now essential before proceeding in reliance on any Regulation D exemption as a result. (For interpretive guidance from the SEC staff on the bad actor rule, see "Compliance and Disclosure Interpretations," Questions 260.14-260.27, Dec. 4, 2013.)

Prognosis for Real Estate Projects

The important changes brought about by Congress and the SEC to Rule 506 may prove to be watershed developments. In attempting to predict the effects of these two changes on raising funds for real estate projects, there are some thoughts to consider.

In the past, entrepreneurs were restricted in offering their securities exclusively to persons with whom they had a preexisting business or personal relationship, but that restriction is gone for Rule 506(c) issuers. How important will this new regulatory latitude prove to be? It might be the case that the only investors likely to consider investing with any small business issuers are those who know the business owners, making the ability to publicly solicit and advertise of little consequence.

Absent a national reputation or connections, real estate investments are generally local in nature; thus, will this new approach to seeking capital prove fruitful when most of the capital will be from local sources? General ads are unlikely to reap much benefit. Realistically, what reasonable investor is going to invest thousands of dollars on the basis of a television spot or newspaper ad from across the country?

The development of trusted and well-performing websites might be more promising if they gain reputations for hosting "good deals." In other words, a good track record remains an important element of success in most cases; usually, the best opportunities will be offered by such websites. As word spreads, interested investors will be attracted to the more successful sites and the projects that they feature.

As for crowdfunding, what can anyone in real estate do with a maximum of $1 million? Such a small gross sum will quickly be depleted by costs and fees within the crowdfunding. Perhaps "flippers" will be able to use crowdfunding on a per-house basis, but that is a great deal of risk and effort to undertake just to purchase and renovate a house or two.

Information on the Internet about prospective investments will help entrepreneurs to see the types of transactions and terms offered in the market and, thus, to understand the deal elements that appear to be most attractive to investors and fashion their deals accordingly. Of course, this works both ways; investors will be able to see the same information and have better knowledge about the most current terms being offered.

Many prospective private issuers have concluded that it is hard to succeed in raising capital without bringing potentially expensive broker/dealers on board to find investors. Furthermore, given concerns about some fraudulent private placements marketed by some broker/dealers in recent years, broker/dealers might be a bit more reluctant than usual to undertake such offerings. Even so, given that they are now free to publicly solicit Rule 506(c) deals on behalf of issuers, it remains to be seen if broker-dealers will take advantage of the new latitude.

The format and media for public solicitation and advertising will likely emerge after the waters are tested to determine which forms of solicitation are most successful. Attempts to raise funds via advertisements and cold calls might identify the issuers running the advertising as the promoters of investments that could not raise funds by traditional means (i.e., from investors they know and who know and trust them). On the other hand, even though advertisements for professionals (e.g., attorneys, physicians) have become more common, there was a time when such promotional efforts would not have been considered, even if allowed by law and ethical standards. In weighing whether to take advantage of these new methods of promotion, issuers should ask themselves what would attract them to an investment opportunity. If the idea of widespread advertising or contact by social media does not come to mind, these avenues might not be appropriate.

Looking to the Future

Notwithstanding all the statutory and regulatory complexities, Rule 506(c) public solicitation and advertising and the new crowdfunding provisions might hold promise as a new means for small businesses to raise capital. Some organizations have already explored how these new opportunities might be utilized to raise capital for real estate projects (Haft 2013).

This is a subject that will surely be reviewed and revisited on a regular basis in the coming years. It is hard to know if these new approaches will prove to be a boon for small business or, as some consumer groups fear, a Pandora's box of fraud, abuse, and incompetence that was best left shut.

Mark Lee Levine, JD, PhD, is a professor and chair holder in the Franklin L. Burns School of Real Estate and Construction Management and the Daniels College of Business, University of Denver, Denver, Colo. Philip A. Feigin, JD, is a senior partner in the Denver, Colo., office of Lewis Roca Rothgerber LLP.
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Title Annotation:Finance: corporate finance
Author:Levine, Mark Lee; Feigin, Philip A.
Publication:The CPA Journal
Date:Jun 1, 2014
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