Regulatory Considerations in Real Estate Syndication
What are some of the common securities registration exemptions relied upon in real estate syndications
A real estate syndication involves the offer and sale of securities, and therefore, the securities being offered must either be registered under the provisions of Section 5 of the Securities Act, or, as is more common, rely on an exemption from registration. The most common Securities Act registration exemptions relied upon by real estate syndications are Regulation D, Rule 506(b); Regulation D, Rule 506(c); Regulation Crowdfunding; and Regulation A. Each exemption is discussed in greater detail in the FAQs that follow.
What considerations are relevant to choosing a securities registration exemption for my offering?
While there are a number of considerations that are relevant to determining which securities registration exemption is the best fit for a specific real estate syndication, there are a few key factors. These include: (i) how much capital is being raised, (ii) who the investors are expected to be, (iii) whether the offering will be marketed through general solicitations and advertisements, and (iv) the sponsor’s budget/financial stability leading up to the real estate syndication offering and property acquisition.
In general, depending on which of these considerations is most important to the real estate syndication/sponsor, the sponsor may have to compromise on certain factors to accommodate the driving criteria. For example, if the sponsor is set on raising a smaller amount of capital, say $1M, but also does not have an established network of accredited investor and is seeking to raise capital from investors of any sophistication level, the real estate syndication may rely on Regulation Crowdfunding, which would allow the sponsor to accept investments from the retail public (i.e., non-accredited investors), but would also require the sponsor to engage an SEC and FINRA-registered broker-dealer or funding portal. Alternatively, the real estate syndication may instead rely on Regulation D, Rule 506(b), under which the no licensed intermediary would be required, but the real estate syndication may only accept investments from investors with whom it has a pre-exsiting substantive relationship, of which up to 35 may be non-accredited investors.
What is a Regulation D, Rule 506(b) offering?
Regulation D, Rule 506(b) is a provision under the Securities Act, which provides exemptions for certain private offerings of securities from the requirement of registering the securities with the Securities and Exchange Commission (SEC). Rule 506(b) is one of the safe harbor rules that issuers can use to ensure compliance with the exemption. Under the terms of the safe harbor, an issuer may raise an unlimited amount of funds from investors with whom it has a pre-existing, substantive relationship. This means that an issuer must rely on its own, existing network of investors when raising funds. While 506(b) issuers are strictly prohibited from engaging in general solicitation, they are able to raise capital from an unlimited number of accredited investors and up to 35 “sophisticated” investors.
While issuers are not required to register the securities with the SEC, they are still obligated to provide investors with all material information necessary to make an informed investment decision. This may include providing financial statements and other relevant disclosures in the form of a private placement memorandum. An issuer that raises capital relying on Rule 506(b) is also required to file a Form D with the SEC and state blue sky notice filings in each state where its investors are domiciled. Securities sold under Rule 506(b) are restricted securities and may not be resold, unless the securities are subsequently registered or the resale complies with another registration exemption. For more information on Form D and blue-sky notice filings, please review the FAQ titled “What is a Form D?” and “What are state blue sky laws and how do I comply?”.
What are the disclosure requirements in a Regulation D, Rule 506(b) offering?
Rule 502 under Regulation D provides the general requirements for the content and manner of disclosure in private placements conducted under Rule 506 of Regulation D. Rule 502(a) requires issuers to provide “information that is material to an investment decision,” which includes information about the company, its business, management, financial condition, and other information necessary to evaluate the investment. Additionally, issuers must provide access to additional information upon request and use certain legends and disclaimers in their offering materials to ensure that investors understand the limitations of the investment. The disclosure requirements under Rule 502 are intended to ensure that investors receive sufficient information to make informed investment decisions and protect against fraudulent or misleading statements or omissions by the issuer. As such, all disclosed information must be clear and not misleading and provided to investors in a reasonable amount of time before they make an investment decision.
The content of disclosures in a Regulation D, Rule 506(b) offering varies depending on factors such as the size of the offering and whether the purchasers are accredited investors or not, among others. Disclosures of financial statements vary depending on whether the size of the offering is under / over $20 million. Tier 1 Regulation A guides the disclosure requirements for offerings under $20 million and Tier 2 Regulation A guides the disclosure requirements for offerings over $20 million. While there are no affirmative disclosure obligations for offerings to accredited investors, it is generally best practice, regardless of whether the 506(b) issuer’s investors are accredited or not, to have a private placement memorandum (PPM) in place to provide all investors with ample disclosures so as to be compliant with all applicable securities laws and regulations.
What is a Regulation D, Rule 506(c) offering?
Rule 506(c) under Regulation D, promulgated under the Securities Act, provides an exemption from the registration requirements of the U.S. federal securities laws. Under Rule 506(c), an issuer may market their real estate securities offerings using general solicitation and raise an unlimited amount of funds from accredited investors only. There is no requirement that the issuer have a pre-existing relationship with investors. The issuer must take reasonable steps to verify that all investors meet the “accredited investor” definition.
An issuer that raises capital relying on Rule 506(c) is required to file a Form D with the Securities and Exchange Commission and state blue sky notice filings within 15 days from the date of first sale in each state where investors are domiciled. Securities sold under Rule 506(c) are restricted securities and may not be resold, unless the securities are registered or comply with an available re-sale exemption. For more information on Form D and blue sky notice filings, please review the FAQ titled “What is a Form D?” and “What are state blue sky laws and how do I comply?”.
What are the disclosure requirements in a Regulation D, Rule 506(c) offering?
Because Regulation D, Rule 506(c) offerings are only available to accredited investors, the rule does not impose any affirmative disclosure obligations. Nonetheless, issuers generally provide a private placement memorandum or offering memorandum to disclose important information about the issuer and the investment opportunity being offered, such as:
- Information about the company (business, management, and financial condition);
- Information about the offering (terms of the offering including amount of securities, price per share, any conditions or restrictions on the offering);
- Information about the risks (risks specific to the issuer and its business and general risks associated with investing in securities);
- Information about the use of proceeds from the offering;
- Accredited investor verification;
- Tax consequences; and
- Transfer restrictions and limitations on resale (disclosure that the securities sold in the offering are restricted, meaning they cannot be resold without registration or exemption from registration).
What is an accredited investor?
Under both the Regulation D, Rule 506(b) and Rule 506(c) exemptions, the issuer may sell its securities to an unlimited number of accredited investors. Accredited investor status ensures that these investors are financially sophisticated and able to fend for themselves or sustain the risk of financial loss, considering Regulation D offerings are not registered and provide less investor protections.
An accredited investor is a person or entity that meets certain criteria outlined by Rule 501 of Regulation D. While there are a variety of different definitions of an accredited investor, the most commonly relied upon definitions include (i) individual natural persons who have: at least $1 million in net worth, together with his/her spouse or spousal equivalent, and excluding the value of their primary residence; (ii) an income of at least $200,000 individually per year or $300,000 joint income with his/her spouse or spousal equivalent for the past two years, with a reasonable expectation to earn the same or higher income in the current year; or (iii) obtained certain professional certifications, designations, or credentials and are in good standing, including a broker or other financial professional Series 7, 65, or 82 license.
In addition to individuals who meet certain income or net worth requirements, there are several types of entities that may qualify as accredited investors under rule 501, including: banks, savings and loan associations, and registered broker-dealers, certain types of insurance companies, investment companies registered under the investment company act of 1940, business development companies (BDCs), small business investment companies (SBICs), employee benefit plans with assets over $5 million, charitable organizations with assets over $5 million, certain types of trusts with assets over $5 million and knowledgeable trustee, entities in which all equity owners are accredited investors, and entities with total assets over $5 million that were not formed for the specific purpose of acquiring securities being offered.
What is a sophisticated investor?
A sophisticated investor is one who either individually or together with his/her purchaser representative, has sufficient knowledge and experience with financial and business matters, allowing him/her to evaluate the merits and risks of a contemplated investment. Accredited investors, institutional accredited investors, and qualified institutional buyers are all considered sophisticated investors.
What is a Form D?
A Form D is a type of SEC filing. An issuer of securities files a Form D with the SEC to provide notice that they are relying on one of the exemptions from registration under Regulation D. All issuers offering securities under Regulation D are required to file a Form D with the SEC no later than 15 days after the date it first sells securities in the offering. The first sale date is when the first investor is irrevocably contractually committed to invest in the security being offered. If the first sale date falls on a Saturday, Sunday, or holiday, the deadline is the next business day.
The Form D filing requires disclosure of basic information about the issuer, its management, any promoters or intermediaries, and some information about the offering itself including the type of security being offered, the amount of securities being sold, and the intended use of the proceeds from the offering. There is no filing fee for filing a Form D notice or amendment and it may be filed using the SEC’s Electronic Data Gathering, Analysis, and Retrieval system (EDGAR). The SEC provides Form D filing process guidance on its website.
What are state blue sky laws and how do I comply?
In the US, securities offerings are regulated at both the federal and state levels and are subject to the federal securities laws and any state securities laws applicable to the offering. “Blue sky laws” are state-level securities statutes and regulations and may be applicable in connection with an issuer’s real estate syndication. While the blue sky laws of each state differ from state to state, many states have enacted either the Uniform Securities Act of 1956 or the Uniform Securities Act of 2002, providing more uniformity and consistency among the states’ blue sky laws. In the context of covered securities issued in Reg D offerings, the notice process under most blue sky laws somewhat mirrors the Form D process under the federal securities laws. Generally, you are required to file a notice filing with the securities regulator in each state where your investors are domiciled. This typically involves a fee and is due within 15 days of the date of first sale in the particular state. The North American Securities Administrators Association (NASAA) filing system is a centralized electronic filing system used by many states for securities offerings to comply with blue-sky laws. The system allows issuers to file a single set of documents electronically, which are then forwarded to the appropriate state securities regulators for review and approval. This allows for a streamlined state filing process and reduces the time and costs associated with filing in multiple states separately. It is important to note that not all states use the NASAA filing system and may have their own separate filing systems and/or require additional filings beyond what is required by the NASAA system.
Whether the registration or notice requirements of a state’s blue sky laws apply to an offering depends in part on the type of offering you are conducting from a federal securities law perspective. Regulation A offerings and Regulation Crowdfunding offerings have their own, unique treatment under the blue sky laws. It is important to consult with an experienced securities attorney to ensure that you are meeting all state filing requirements.
What is a Regulation A offering?
Regulation A is known as the ‘mini IPO’ under our US federal securities laws. Regulation A was amended in 2015 pursuant to the JumpStart Our Business Startups Act (JOBS Act) of 2012. The amended Regulation A rules are frequently referred to as Regulation A+. In a Regulation A offering, an issuer is permitted raise up to $75 million dollars from the public with disclosure requirements comparable to those of a publicly reporting company.
Regulation A allows issuers to conduct their offerings under two different tiers. Under Tier 1, a company, or fund, can raise up to $20 million in any 12-month period. Financial statements must be disclosed, but do not have to be audited. The offering circular (the Regulation A equivalent of a PPM) under Tier 1 must be filed, reviewed, and qualified with SEC staff and the state securities regulators, and only then can the issuer accept payment for the sale of its securities. Under Tier 2, a company, or fund, can raise up to $75 million in any 12-month period. Financial statements must be disclosed and must be audited by an independent accountant. The offering circular under Tier 2 must be filed, reviewed, and qualified with SEC staff, but not the state securities regulators. Notice filings are required to comply with state blue sky laws.
While there are no limitations as to how much an investor can invest under a Tier 1 offering, in a Tier 2 offering, if you are not an accredited investor and the securities are not going to be listed on a national securities exchange upon qualification, there are investment limitations. Individual investors may invest no more than 10% of the greater of the investor’s, alone or with a spouse, annual income or net worth (excluding the value of the person’s primary residence).
What are the disclosure requirements in a Regulation A offering?
SEC Form 1-A, also known as an offering statement or offering circular, is the disclosure document that must be filed with the SEC by companies conducting Regulation A offerings, which includes comprehensive information about the company and the securities being offered. Specifically, the issuer must disclose the following information in its offering statement: information about the issuer and business overview (name & address of the company, detailed description of company’s business operations including history, products or services, market, competition, and any regulatory requirements); information about the key aspects of the offering (amount and types of securities being offered, proposed maximum offering price, use of proceeds, estimated expenses of the offering); risk factors (risks associated with investing in their securities related to company’s business, industry, or regulatory environment); management discussion and analysis (“MD&A”) (analysis of the company’s financial performance, including its revenues, expenses, and cash flows, as well as a discussion of any significant trends or uncertainties); management and ownership (information about executive officers and directors as well as beneficial owners of more than 20% of the company’s equity securities); dilution (the impact the offering will have on the ownership percentage of existing shareholders, as well as the per-share value of the company’s securities before and after the offering); plan of distribution (how the securities will be offered and sold, including any underwriters or selling agents involved in the offering); financial statements (audited by an independent accounting firm, must cover two most recently completed fiscal years, or if the company has been in existence for less, financial statements for a shorter period); and exhibits (must be attached with other information that is necessary to make the disclosure document not misleading, including legal opinions, material contracts, or technical reports).
These disclosure requirements are designed to ensure that potential investors have access to all information needed to make informed investment decisions.
It is likely that issuers who are already publicly reporting and remain current in their reporting obligations already meet the Regulation A ongoing disclosure obligations.
What is a Regulation Crowdfunding offering?
The Jumpstart Our Business Startups Act (JOBS Act) amended the Securities Act to add Regulation Crowdfunding as a new registration exemption. Under Regulation Crowdfunding, issuers may sell unregistered securities to the public, including main street non-accredited investors. Equity crowdfunding generally involves the use of the internet and social media to raise capital from a large number of people investing relatively small amounts. Under Regulation Crowdfunding, the issuer may raise a maximum aggregate amount of $5 million in a 12-month period and all transactions must take place online through an SEC-registered intermediary (meaning a broker-dealer or funding portal). While accredited investors are not limited in the amount they can invest, non-accredited investors are limited in the amount they may invest across all crowdfunding offerings in a 12-month period. The issuer must disclose information regarding the offering in filings with the Securities and Exchange Commission, to investors, and to the intermediary facilitating the equity crowdfunding offering. Securities purchased in a crowdfunding transaction generally cannot be resold for one year.
What are the disclosure requirements in a Regulation Crowdfunding (Regulation CF) offering?
SEC Form C is the disclosure document that must be filed with the SEC by companies conducting Regulation CF offerings, which includes comprehensive information about the company and the securities being offered. Some key disclosures include detailed descriptions of the company’s business and investment strategy, target market, competitive landscape, and intellectual property; management and ownership with information about its management team and their experience, compensation, and ownership in the company, and significant shareholders or related parties; use of proceeds explaining how the company intends to use the proceeds raised from the offering; financial statements for the two most recently completed fiscal years or for a shorter period if the company has existed for less than two years; offering details including terms of the offering; risk factors including risks related to competition, market conditions, regulatory compliance, and the company’s financial position; and a plan of distribution describing how the securities will be sold, any restrictions on resale, and how the proceeds will be distributed to the company from escrow.
What information do I have to file with the SEC about me and my syndication?
The SEC requires the issuer company to file certain informative disclosures depending on the exemption being relied upon.
An issuer offering securities under Regulation D is required to file a Form D including basic information about the issuer (name, address, industry), as well as information about securities being offered (amount of money raised, type of securities offered, and offering price). Issuers must also provide information about the offering itself (intended use of proceeds, number of investors already involved, whether any commissions or finders’ fees will be paid). Additionally, Form D requires disclosure of any significant legal or financial problems that the issuer or any of its officers or directors have experienced in the past.
An issuer offering securities under Regulation CF is required to file a Form C including details about the issuer (name, address, website, description of company’s business and management team); offering terms (target offering amount, price per share or unit, type of security being offered; risks related to the investment; financial information about the company, including its financial statements; and information about the ownership and capital structure of the company. Other necessary disclosures include the deadline to reach target offering amount, right of investors to cancel their investment, the process for handling investor funds, ongoing reporting obligations of company, and risks associated with investing in securities sold pursuant to Regulation CF.
An issuer offering securities under Regulation A is required to file a Form 1-A, which contains robust disclosures akin to a public company and audited financial statements. For more information on Form 1-A, please review the FAQ titled “What are the disclosure requirements in a Regulation A offering?”.
Am I permitted to use a third-party online investment platform or build my own?
Internet based platforms are a trending forum for real estate sponsors to conduct their offerings. While some platforms are operated by registered broker-dealers or funding portals, helping to drive traffic to your syndication’s campaign page, others simply provide the technology suite for you to self-host your own offering. Bear in mind that platforms that are not registered with the SEC/FINRA are not permitted to act as unregistered finders or broker-dealers, and must not charge you transaction-based compensation (i.e. commissions).
What are some of the benefits of using an online investment platform to manage my offerings?
Using an online investment platform to manage a syndication offering may prove beneficial to a sponsor trying to procure capital for its real estate deals and gain committed funds from qualified investors. Credible online investment platforms provide increased efficiency by streamlining the investment process, making it easier for both issuers and investors to manage and track investments and reducing overhead by automating many of the administrative tasks associated with closing and investor relations. Moreover, many of these platforms serve as comprehensive hubs, acting as veritable “one-stop-shops” for all syndication needs. They often provide intermediary services like creating a campaign page to market to and attract potential investors in compliance with applicable advertising and solicitation regulations while providing an existing network of investors to broaden the scope of prospective backers and facilitate the actual capital raise. Additionally, some online investment platforms provide ancillary services that further enhance the syndication experience. Such services often include providing (1) templatized offering documents, like subscription agreements and private placement memoranda, which ease the costs of drafting and assist with compliance, (2) networks of third-party service providers (e.g. lawyers or accountants), (3) due diligence services including market research, financial modeling, and other tools to help assess the viability of a deal, and (4) investor accreditation to help syndicators ensure that their investors meet the necessary accredited investor requirements.
Can investors e-sign subscription documents?
Yes; in general, investors can e-sign subscription agreements. At the federal level, the Electronic Signatures in Global and National Commerce Act (the “E-SIGN Act”) establishes a framework where contracts generally cannot be denied legal effect due to the use of electronic signatures. At the state level, the Uniform Electronic Transactions Act (the “UETA” or “Model E-Sign Law”) was proposed by the National Conference of Commissioners on Uniform State Laws with the intention of formulating a uniform set of state-level rules that would formally validate and effectuate electronic signatures in commerce. A version of the Model E-Sign Law has been adopted by all states other than New York, though New York also enacted a substantively similar statute. These laws generally provide that electronic signatures in the context of a business contract will generally be given effect if certain elements are satisfied, which most electronically signed contracts do indeed satisfy.
There are many types of electronic signatures that will be given legal effect. The E-SIGN Act and many state laws based off the UETA outline that an electronic signature may be an “”electronic sound, symbol, or process, attached to or logically associated with a contract or other record and executed or adopted by a person with the intent to sign the record.” Under this flexible standard, courts have under certain conditions upheld the enforceability of contracts utilizing the following kinds of electronic signatures: scans of handwritten signatures, digitally created signatures, type-printed names, clicking an “I Accept” box, and even email confirmations. If the federal and state requirements are met, issuers can use a wide array of electronic signatures to effectuate their subscriptions agreements.
What are some common risks associated with investing in a real estate syndication?
Risks common to real estate syndications can generally be put into four categories: risks related to the company, management, and the securities, risks related to the property specifically, risks related to owning real estate generally, and risk related to taxation.
The risks related to the company, management, and the securities involves risks associated with investing in a company that has no track record (i.e., because most real estate syndication vehicles are newly formed), risks associated with the success of the investment being primarily dependent on the manager and its ability to generate income, and consequently, distributable cash for investors, and risks associated with the investor’s equity interests having limited to no voting rights.
The risks related to the property specifically involve risks associated with a seller’s failure and/or due diligence not uncovering all material information about the property prior to the real estate syndication issuer’s acquisition and risks associated to leveraging the property for additional capital.
The risks related to owning real estate generally involve risks associated with insured versus uninsured losses, risks associated with liability for environmental issues, and risks associated with state or local law considerations.
Finally, the tax-related risks involve risks associated with sponsors not obtaining an IRS ruling despite intending to be taxed as a partnership and risks associated with tax liability potentially exceeding distributable cash.
Does the Investment Advisers Act or any state law equivalents apply to my GP?
In general, no, the Adviser’s Act, does not normally apply to the GP of a real estate syndication, nor do state law equivalents. While, at first glance, GPs may think the Advisers Act applies to them because under Section 202(a)(11), an “investment adviser” is anyone that (i) for compensation; (ii) is engaged in the business of; (iii) providing advice to others or issuing reports or analyses regarding securities. Fortunately, a person who is in the business of advising others only as it relates to assets that are not deemed ”securities” is not an investment adviser. That said, while the definition of a “security” under the Adviser’s Act is broad, real estate is not included within the definition, and the SEC has explicitly stated that fee simple ownership of real estate is not a security. Therefore, GPs will falls outside the scope of the Adviser’s Act if they are only advising an entity who owns real estate in fee simple, as most real estate syndications do. The state law equivalents of the Adviser’s Act also generally adopt the same or a similar position on real estate as the federal law, with some minor variations.
Am I required to register as a broker-dealer or engage a broker-dealer for my offering?
While GPs of a real estate syndication do generally conduct what is commonly considered “broker-dealer activity,” (i.e., soliciting investors, participating in the securities offering , and receiving transaction-based compensation) which would require GPs to register with the SEC as a broker-dealer, there are certain exemptions from broker-dealer registration that GPs may rely on. One notable exemption, and the most commonly relied upon exemption for real estate syndication GPs/sponsors, is the “issuer exemption” under Rule 3a4-1 of the Exchange Act. This exemption allows issuers of securities, and by extension, the issuer’s manager (more accurately, “persons associated with an issuer or its affiliates), to offer and sell securities without registering as a broker-dealer, as long as certain conditions are met.
Are there any state broker filing requirement considerations for the GPs?
There are certainly state broker filing requirement considerations for GPs. While many states emulate the broker-dealer registration/filing requirements and exemptions provided by the federal law, every state has its own requirements for a person conducting business as a broker or dealer in that state. Consequently, GPs should be cognizant of the state’s regulation of broker-dealers in the state from which they operate.
Does the Investment Company Act of 1940 (the “ICA”) apply to my syndication?
The ICA generally does not apply to real estate syndications. In general, under the ICA, a company who is engaged in the business of investing or trading in securities is considered an “investment company” and must be registered as such with the SEC. While similar to the definitions of a “security” set forth under the Adviser’s Act, the Securities Act, and the Exchange Act, the definition of a “security” under the ICA does not include fee simple interests in real estate. Therefore, because real estate syndications are not engaged in the business of investing or trading in “securities,” the ICA most often does not apply to real estate syndications.
However, the framework of the ICA is implicated when a fund-of-funds model (the “FOF”) is utilized by real estate sponsors and GPs, adding a layer of regulatory complexity. A FOF is an investment strategy where an investment fund invests in other funds or syndications. FOFs are considered investment companies under the ICA, imposing certain regulatory requirements on FOFs and their managers, especially regarding diversification. For example, under Section 12D-1, a fund cannot invest over 5% of its assets in a registered investment company or over 10% of its assets in registered investment companies, and cannot acquire more than 3% of an investment company’s voting shares. Therefore, real estate managers utilizing a FOF structure must adhere to these regulatory requirements and strategically map out and balance their investments across the underlying funds.