Over the past few years, a certain bubble has arisen in the real estate syndication industry that causes many of us securities attorneys to worry. A new breed of sponsors self-labelled as “capital raisers” has come into existence, and their practices of raising capital in conjunction with the sale of securities is looking increasingly more like multi-level marketing than the tightly-regulated activity it is required to be. In other words, many of the capital raising activities we’re seeing probably violate securities laws.
Over the past few months, I’ve seen or heard about the following suspect practices:
- — Capital raisers getting paid for raising capital from acquisition or asset management fees
- — Deals with over a dozen individuals in the sponsor team
- — “Deferred equity structures” where a capital raiser is rewarded with a slice of the management or sponsor entity depending on how much is raised
- — Capital raisers claiming to be “part of the General Partnership” when they’re not mentioned anywhere in the PPM or Investor Summary/Deck
- — Investors being presented with the same deal from multiple different people claiming to be part of the Sponsor
- — And more.
What’s a Broker Dealer?
The federal activity-based definition of “broker” in Section 3(a)(4) of the Securities Exchange Act of 1934 is straightforward:
BROKER. — (A) IN GENERAL. — The term “broker” means any person engaged in the business of effecting transactions in securities for the account of others.
The definition’s operative terms are “engaged in the business” and “effecting transactions” and both are broadly construed by the SEC.
Borrowing from a speech by David Blass, Chief Counsel of the SEC Division of Trading and Markets, (https://www.sec.gov/news/speech/2013-spch040513dwghtm):
The test for broker-dealer registration is broad and depends on various activities a person performs in one or more securities transactions.
Some examples of activities, or factors, that might require private fund adviser personnel to register as a broker-dealer include:
- — Marketing securities (shares or interests in a private fund) to investors,
- — Soliciting or negotiating securities transactions, or
- — Handling customer funds and securities.
The importance of each of these activities is heightened where there also is compensation that depends on the outcome or size of the securities transaction — in other words, transaction-based compensation, also referred to as a “salesman’s stake” in a securities transaction. The SEC and SEC staff have long viewed receipt of transaction-based compensation as a hallmark of being a broker. This makes sense to me as the broker regulatory structure is built, at least in large part, around managing the conflict of interest arising from a broker acting as a securities salesman, as compared to an investment adviser which traditionally acts as a fiduciary and which should not have that same type of conflict of interest.
When we talk about “compensation,” we mean more than a mere commission. The SEC has a broad view of compensation–it can be a commission, cash, equity, warrants, options, cryptocurrency, etc. The important factor is whether the compensation is “transaction-based” or based on the success of a transaction. For example, an algorithm defining the percentage allocation of a syndication GP or manager based off the amount of capital each sponsor member brings in would probably be considered transaction-based compensation. However, a scenario where John Doe will get 5% of a manager entity for a variety of duties, including capital raising, even if he is unable to raise a single dollar, is less likely to be considered transaction-based compensation. The operative question here is whether the compensation is dependent on a successful transaction. Only registered broker-dealers licensed with FINRA can be paid transaction-based compensation–and I have yet to come across a ‘capital raiser’ holding such licensure.
If It Walks Like a Duck
Despite the above, many individuals seem to have fostered their own interpretations, or designed fancy agreements or loopholes around the transaction-based compensation rule. I’ve seen this happen before in other industries. However, the answer is always the same—it doesn’t matter what you label the activity or how creative you try to be about it. It really comes down to what is actually happening—does the scheme look like transaction-based compensation or not? When the SEC looks at the situation, if it looks like transaction-based compensation is going on, that is probably what they will label the activity. In other words, ‘if it walks like a duck, quacks like a duck, and swims like a duck, it’s probably a duck.”
While there is no formula to say what is transaction-based compensation and what it not, generally I tell clients that if they are going to bring a business partner into the sponsor role, that person had better be a true sponsor. Conservatively, this means that they bring value or a unique skill set to the offering, have duties and responsibilities throughout the lifetime of the deal—not just during the capital raise—and those duties should include activities that don’t involve raising capital (or investor relations or anything else relating to investors). Additionally, it means that any compensation an individual receives should not be tied to how much capital they raised—whether that compensation is in cash or equity.
Other (Legal) Ways of Working With Capital Raisers
There are other ways to work with capital raisers. For example, once could start a fund of funds, or a sub-syndication that invests in a parent syndication. The capital raiser can raise capital for their own fund (and thus, become the “sponsor” of their own offering), which would then invest those proceeds in one or more other funds or offerings. In these scenarios, the fund generally charges the investor an administrative fee, carried interest, or other fees to compensate them for bringing the deal to investors and doing due diligence. It also helps smaller investors group money to be able to invest in deals that require high minimum investments. The downside of the fund of funds approach, though, is higher transactional costs (to create the sub-syndicate) and the additional burden of meeting possibility of needing to be a registered investment advisor, or RIA (or an exemption from RIA licensure).
I used to talk about other ways to folks could help others raise capital, such as specific types of consulting agreements that do not pay transaction-based compensation, but I’ve seen such an abuse of these methods lately that I’m less inclined to talk about them.
Why Haven’t People Talked About This Issue Before
While “capital raisers” have been around for a while, their arrangements looked far different from the multi-level marketing schemes we’re seeing today. Traditionally, capital raisers who joined a sponsor group would know exactly which deals of which they were a co-sponsor. The number of sponsors in an offering would be limited in number, and the capital raiser would get a small, fixed percentage of the sponsor’s share for fulfilment of all their duties, regardless of whether they succeeded in raising money for the offering.
Consequences of Non-Compliance
Violations of securities laws come with a number of consequences. I always explain to clients that they’re dealing with two different types of risk—regulatory risk and litigation risk.
Regulatory risk is in relation to risk that federal or state regulators (i.e., the SEC, FINRA, state securities agencies) come after you for violation of securities laws. The consequences range from rescission, fines and penalties, criminal charges, jail time, and being labeled a ‘bad actor.’ At the state level, some states have more draconian laws which allow the investor to require the capital raiser (if they are an unlicensed broker dealer) to repurchase all unlawfully sold securities.
While all of these are bad, I believe the most detrimental punishment for a real estate syndicator is the bad actor label, which means that that individual cannot be a director or officer of any company that is raising capital for a period of time (sometimes forever). Effectively, this means that if you are labeled as a bad actor, you cannot be part of the sponsor group for a real estate syndication (or any other private placement), and you are limited in your investments in real estate syndication (and other private placements).
Still, as scary as regulators seem, regulators are often civil servants mandated to uphold their agency’s mission. If you are cooperative, life will be easier.
That is not true, however, of the plaintiff’s bar. If your investors hire an attorney to sue you, the sponsor, you may be in for a world of hurt. Plaintiff-side attorneys sometimes work on a contingency (so are not motivated to settle for less than a large sum) and other times, bill by the hour (and thus are motivated to make the process long and painful). My plaintiff-side attorney friends often joke to me that they love it when sponsors get sued because they get to bill for 100 times the amount of money the sponsor would have spent to avoid the issue in the first place. Just remember—we live in the most litigious country in the world, and Americans love to sue.
You may be wondering why you haven’t heard of any sponsors getting sued over all this stuff. There are many answers. For one, I believe that ‘capital raiser’ problem has become big enough to attract attention from regulators—and that the axe hasn’t fallen yet (but will). Secondly, there are a lot of people running around who quite frankly have never talked to an attorney, and were trained by someone else who also hasn’t talked to an attorney. And third, people don’t tend to air their dirty laundry, so if they’re getting investigated by regulators or sued, they’re not going to advertise that fact. I can tell you though that I’ve gotten more concerned inquiries about capital raisers in the past few months than the past few years. And, I’ve gotten more calls from folks asking for referrals to a litigation attorney in the past few months than I have over the past few years.
Why This Is Important
This is important because of the ramifications that today’s non-compliance may have on future offerings. The rule of thumb in securities offerings is that you must disclose all material information that an investor would want to know when they invest—this includes any personal or business bankruptcies, litigation, criminal proceedings, and run-ins with regulatory authorities. Once you get a formal order or enforcement action by a regulatory authority or become embroiled in litigation on a past syndication deal, you must disclose that information in your future deals in writing. This may sound like nothing right now, but for clients who have been in this situation, it’s an uncomfortable and sometimes embarrassing feeling.
Many of you get into real estate syndication to provide for your families. If there is anything I can wish for my clients, it is for you and your families to avoid going through the stress and pain that regulatory action and litigation oftentimes bring. In some cases, the stress becomes too much and results in people losing their families. Please don’t let the reason you get into real estate syndication end up as the thing you lose.