New licensees, seasoned real estate professionals, and investors are all faced with similar challenges when it comes to funding deals. Whether you are facilitating the procurement of purchase money financing for a first-time homebuyer or arranging a multiple tranche capital stack for a larger commercial acquisition, financial architecture is often the single most important aspect of the long-term viability of a real estate investment. For those trying to acquire a first investment property, it is the primary gating issue.
This article focuses on investment property financing. It covers historical trends, present day investment financing tools, and the utility, mechanics, opportunities, and constraints of crowdfunding as it relates to the gathering and deployment of this type of debt or equity for use in the acquisition of investment property.
Historical Structures and the Evolution of Entity Structure and Fundraising Methods
The Uniform Limited Partnership Act (ULPA) was codified originally in 1916 and revised in 1976 (RULPA). RULPA, as subsequently amended in 1985 and 2001, governs the use of limited partnerships throughout the United States. It was promulgated by the National Conference of Commissioners on Uniform State Laws (NCCUSL) for national governance of business partnerships within the United States.
Before the use of limited partnerships for the acquisition of investment real estate (and non-real property investments), general partners shared all benefits and burdens of combined investing jointly and severally. While the benefits could (and can) be adjusted by agreement, the third-party liability remained absolute for each partner. Specifically, if one partner incurred 100% of a third party-obligation by, for example, pledging partnership property to secure a loan, the creditor could, under most circumstances and at its discretion, pursue either partner singularly or jointly in whatever proportion the creditor selected.[1] This was and remains true even if the other party was unaware of the obligation having been incurred. This joint and several liability was and remains problematic for many investors who prefer to invest passively, earn returns, not manage the ownership entity or its assets, and remain protected from and against liabilities beyond the sum invested.
The Limited Partnership. Limited partnerships were created to afford the investors the protection of a corporation with the tax benefits of a partnership. Assuming the investor who receives, for cash or other consideration, a limited partnership interest as a limited partner (LP), agrees to refrain from engaging in management activity, his, her, or its exposure (corporate entities, trusts, and individuals may be limited partners) shall remain limited to the amount invested by the LP. Every limited partnership requires at least one general partner (GP) and one LP. The GP(s) have no asset or liability protection in this structure and are often the promoters of the investment.
The Limited Liability Company. California adopted the Beverly-Killea Act (California Act) in 1994 to mirror what, at the time, many states were already doing relative to investment and operational entity structure.[2] Unlike the limited partnership structure, limited liability company members are entitled to engage in management activities without endangering the sanctity of the entity, they are protected from liability similar to the protection afforded corporate shareholders, and they receive the benefits of avoiding double taxation as do most in pass-through entities.
Syndication and the Law
Syndication is nothing more than fundraising through more than one source for a common investment. As already discussed, structures over time have ranged from unincorporated associations, general partnerships (joint and several liability), limited partnerships (joint and several liability for the GPs and limited liability for the LPs), and corporations (shareholder liability typically limited to the sum invested absent a finding of alter ego) to tenants in common arrangements, that for a period of time, were (or should have been) securitized. When fundraising, your threshold inquiries are:
- Am I soliciting the investment in and sale of securities?
- Am I allowed to solicit the investment in and sale of securities?
- If the answer to the first two questions is yes, do I need to ensure the securities are registered, or alternatively, are they exempt from the state and federal securities laws, including the Securities Act of 1933 and the Securities and Exchange Act of 1934, as amended (collectively, the Securities Acts)? Every state provides certain exemptions from registration, and federal exemptions likewise exist.
Is it a Security?
The Investment Advisers Act defines a security as:
“...any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security (including a certificate of deposit) or on any group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a security, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guaranty of, or warrant or right to subscribe to or purchase any of the foregoing.”[3]
States have adopted similar statutes defining securities and regulating their offer and sale.
Am I Allowed to Sell the Securities Represented in the Syndication?
Those soliciting the investment in and sale of securities are required to register as Investment Advisors or maintain other designations depending upon the nature of the securities offered unless, in certain circumstances, they are fundraising for an entity they are specifically affiliated with. For example, the Chief Executive Officer and majority shareholder of a corporation can, in limited circumstances, fundraise and sell shares in the corporation without registering the securities. However, doing so must fit within one or more enumerated exemptions from the registration requirements, as in the sale of any securities.
Do Appropriate State and Federal Exemptions Exist?
The most common exemption from registration under the Acts is Regulation D. The substantial majority of the states, including California, have adopted similar legislation exempting certain offerings of securities from registration.[4] The gravamen of these exemptions afford, in intrastate and in some instances interstate transactions, exemptions from registration if:
- the number of those to whom the securities are offered is limited;
- there is no general solicitation that translates to an existing business or personal relationship with those to whom the securities are offered;
- there is a limited number of non-accredited investors (typically 35 or less); and
- there is a much larger number of accredited investors.
Accredited Versus Non-Accredited Investors
An accredited investor is an individual (or certain entities that transcend the scope of this article) or individuals with a net worth in excess of $1,000,000 without inclusion of the value of their primary residence (a 2013 amendment) and a household income of $200,000 for an individual and $300,000 for a couple or more.[5]
Crowdfunding and the Law
Crowdfunding is defined as “the practice of funding a project or venture by raising monetary contributions from a large number of people, typically via the internet.” Crowdfunding was responsible for approximately $5.1 billion during 2013 alone.[6] This innovative approach to fundraising is deployed across investment opportunities, and the law in this area is dynamic and in its infancy. Further, since the majority of the investing is online, the issues such as choice of law, conflicts of disparate laws, and jurisdiction remain ethereal.
Crowdfunding and the Securities Acts
The House [H.R. 3606 – April 5, 2012] recently enacted rules governing crowdfunding for investment purposes. Specifically, sponsors of crowdfunding projects characterized as securities are limited to an aggregate funding of $1,000,000 per 12-month period. Further, non-accredited investors are limited personally in the amount they may invest ranging between 5% and 10% of the greater of their annual income or net worth.
The portal or source through which the investments are made must likewise comport with a myriad of rules and laws in the event the crowdfunding is deemed related to the solicitation and sale of securities. Specifically, the Acts, as amended by the JOBS Act, require the following:
- Intermediaries and portals must register with the SEC and FINRA as a portal or broker-dealer.
- All SEC disclosures must be provided before accepting invested funds.
- Investor privacy must be maintained.
- Compliance with investor limitations across all crowdfunding sources must be adhered to.
- Finder’s fees are proscribed.
- The foregoing proscriptions may, in certain circumstances, redound to the detriment of officers and directors of the sponsor entity.
- Company transparency, disclosure, a business plan, tax returns, and financial statements, in some instances audited depending upon scale, are likewise referenced. Specifically, those raising between $100,000 and $500,000 are required to have their financial statements reviewed. Audits are required for fundraising above those sums during a 12-month period.
- Prices and ownership structure, including capitalization, must be defined and disclosed.
Crowdfunding and the JOBS Act
The JOBS Act raises from 499 to 2,000 people, or 500 non-accredited investors, the aggregate number of investors an offering of securities may accept. It also excludes from these numbers those who receive equity securities pursuant to an employee compensation plan in an exempt transaction.
The JOBS Act modified Regulation D of the Securities Act to allow advertising and general solicitation to accredited investors. While the JOBS Act opens the fundraising door much wider for small investments in securities, some of the changes do not apply relative to professional investment entities.
State securities laws remain a challenge in some jurisdictions as they are not automatically preempted by the new law.
Conclusion
Crowdfunding is here to stay as one of several viable ways to finance real estate. With the right structure, advisors, and an understanding of the myriad laws and forthcoming regulations governing this growing piece of the investment continuum, appropriately sized real estate investments are an interesting and appropriate method for real estate investing if your business model comports with the laws and salient economic and operational conditions.
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Scott A. Chaplan, Esq. is a founding partner in Greene, Fidler & Chaplan, a real estate and business law boutique firm (Greene Fidler & Chaplan) and Managing Director of Del Rey Urban Capital, LLC, a national real estate fund management and advisory firm with affiliated entities in real property investment, brokerage, and management.
- [1]California Corporations Code, Section 15904.04.
- [2]California Corporations Code, Sections 17000-17656.
- [3][\202(a)(18); SEC v. Howey Co, 328 U.S. 293 (1946).
- [4]California Corporations Code, Sections 25102(f) and (h)
- [5]The Securities Act, Regulation D, Section 230.500
- [6]http://en.wikipedia.org/wiki/Crowdfunding, accessed 11/18/14