Let’s Talk about the Real Estate Syndication ‘Capital Raiser’ Trend

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.

The Different Types of Regulatory Exemptions

What are the different types of regulatory exemptions people can use to raise capital?

When raising capital, entrepreneurs must generally register with the SEC, or fall under a regulatory exemption. Those who register with the SEC are the likes of public companies, such as the ones you see on the New York Stock Exchange or the Nasdaq. However, the vast majority of capital raised in the United States is actually raised privately, not publicly, and falls under a private placement exemption.

Of the $1.8 Trillion raised under Regulation D from 2009-2017, 99.9% of the capital was raised under Rule 506(b) and 506(c). There’s good reason for this–those exemptions are fairly easy to use and provide federal preemption, meaning issuers don’t have to deal too much with state laws.

The general rule of thumb when it comes to the various SEC securites regulations and rules is that the more the SEC allows you to do, the more they’re going to ask for in return.

Most issuers raise capital under Rule 506(b), which allows an unlimited raise amount and unlimited numbers of accredited investors, but limits you to up to 35 non-accredited investors. You should have a substantial, pre-existing relationship with these investors, and cannot generally solicit (or advertise). Investors can self-certify (or fill out a form) that they are accredited.

About 4% of capital raised under Regulation D is raised under Rule 506(c)–a newer exemption that became effective only in 2013 as a result of the JOBS Act. Much like Rule 506(b), this rule allows unlimited raises and unlimited numbers of accredited investors, but bars investments from an non-accredited investors. However, issuers are allowed to generally solicit (or advertise) the offering, meaning that they can announce it online through ads, social media, at meetups, through unsolicited email, via radio, etc. However, issuers must verify that their investors are, in fact, accredited (thus, no more self-certification process, as was the case in Rule 506(b)). This is a more probing investigation of the investor involving W-2s and tax documents, and a source of friction when closing an investor, so many issuers will not use a Rule 506(c) offering unless they have a well thought-out plan to take advantage of the advertising capability that Rule 506(c) offers.

The Difference Between Joint Ventures and Syndications

A joint venture and syndication may often look alike, but are governed by vastly different laws.

A joint venture primarily governed by contract law and involves a few business partners who, regardless of whether they invest in the deal or not, are all actively involved and each contribute unique skills to the overall success of the project. Unique skills may include, for example, construction management, property management, due diligence, underwriting, searching for financing, handling accounting and legal, etc. However, these must all be real significance skills. Getting a group of people together every Tuesday to drink wine and vote on the color of the paint for the building, for example, doesn’t rise to the level of a unique skill.

In a syndication, one or few people are part of the sponsor or managing team. They are responsible for the overall success of the project and they each bring a unique skill. Everyone else who contributes money but is not actively involved in the deal is considered a passive investor. Syndications are a type of securities offering.

A security, or investment contract, is defined by the Howey test, which is a four prong test. It defines an investment contract or security as:

  1. an investment of money due to
  2. an expectation of profits arising from a
  3. common enterprise which
  4. depends solely on the efforts of a promoter or third party.

In a joint venture, because all business partners are involved, they are not relying on a third party for the venture to be successful. In a syndication, passive investors rely on the sponsor or management team to realize an ROI.

This is what female founders want

This is a slightly longer explication of my medium post.

Female tech founders are definitely well aware of the conversations surrounding gender these days. And let’s not kid ourselves–tech isn’t the only industry with issues around gender discrimination, harassment, or implicit bias.

I had the opportunity to attend Jason Calacanis’ Founder University with 50 other female founders this past week (which was organized by his amazing staff, including Jacqui Deegan, and graciously hosted by Wilson Sonsini).

Towards the end of two days of intense, deep learning from industry experts, Jason brought up the fact that the topic of gender discrimination was a topic that was not discussed at all (or, at least, barely. Only one person made a slight reference to it). Jason explained that he and Jacqui debated about whether or not to bring up the topic, and ultimately decided to leave it up to attendees to bring it up:

“But you didn’t want to talk about it — you just wanted to talk about your companies.”

Continue reading “This is what female founders want”