Business Management

BREAKING NEWS: General Solicitation of Accredited Investors is Now Legal… Who are the Winners and Losers?

Expertise: Real Estate News & Commentary, Business Management, Personal Development, Mortgages & Creative Financing
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SEC Ruling

“Devotion to the truth is the hallmark of morality; there is no greater, nobler, more heroic form of devotion than the act of a man who assumes the responsibility of thinking.” Ayn Rand

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Real estate syndicatiors, hedge funds, and start up companies received the long awaited blessing from the Securities Exchange Commission (SEC) to begin advertising for accredited investors on Wednesday, July 10th. The vote lifted an eighty year ban for general solicitation and some clear winners and losers are sure to emerge with the change.

This will affect accredited investors witch means the eight million or so Americans with a liquid net worth of $1,000,000. This is impressive crowd for the record. Some estimates suggest that 1.4 TRILLION will be raised under the new rules.

To fully grasp the magnitude of the change consider this crash course in securities law. A prospective investment is a security (The Howey Test) if it is:

  • investment of money due to
  • an expectation of profits arising from
  • a common enterprise
  • which depends solely on the efforts of a promoter or third party

Therefore, if a promoter is making the business decisions for the venture then its a security. Other structures that are not a security include a member managed LLC, a Tenet in Common ownership structure, and a debt obligation that is not fictionalized.

Registration of a securities is extraordinarily expense (Accounting, Lawyers). For a single asset purchase is not cost effective. However, the private placement rules permit a much less costly avenue for promoter under three provisions: regulation D rules 504, 505, and 506. Rule 506 is the most popular with sponsors because it has no dollar limit being raised and lower disclosures required because it is targeted at accredited investors.

The protection scheme of 506 is supported by the policy that accredited/sophisticated investors are wise enough to not need hand holding. Up till now however the process of meeting new investors was to say the least a lot like dating. You had to meet the investor and create a per-existing relationship before you could pitch your specific investment. (These rules still apply to 504 and 505).

The JOBS act has taken away the “courtship” aspect as to rule 506. Its on like Donkey Kong! Direct mail is fired up and ready to go all across the land. An interesting question is how much will actually change. The promoter will still need to gain the trust of the investor. Will someone invest on the basis of a postcard alone?

This change is not without some concern. Here are the winners and possible losers under this change:

Winners:

  • Real Estate Syndicates perhaps the biggest winners. It will permit a much more aggressive marketing model.
  • Small fry hedge fund managers: This will permit the mom and pop hedge funds to aggressively seek a larger capital base
  • Existing commercial real estate owners looking to sell. The flood of liquidity coming to the market price will bid up. Its going to be very intriguing to see what markets and asset classes will bear the brunt? Will multifamily overbuilding get pushed into overdrive?
  • Accredited Investors: more choice is a good thing in almost every circumstance. This change will permit a greater exposure to opportunities
  • Ponzi schemers: somewhat joking here. This will possibly permit a scheme to to run a lot longer before it crashes.

The need for taking responsibility of education: it will now be even more incumbent upon the investor to be critical of the offerings.

Losers:

The overly trusting, keep up with the Jones, invest because my doctors neighbors said he was great guy investor is officially doomed and the clock is ticking.

Tips for Protecting Yourself in the New Era if You Are an Accredited Investor:

  • Gravity is real….investment returns of far greater than ten percent or returns that are consistent in spite of market fluctuations demand scrutiny
  • Stay diversified. Don’t place too large a percentage with one promoter or opportunity.
  • If you don’t understand how they are proposing to generate the returns…trust on the axiom a confused mind must say no!
  • How much access will the permit to ongoing books and records? The truth is found in a paper trail….always
  • Trust your gut: our flight instincts will protect us if we listen
  • Watch American Greed on CNBC. The key theme I draw from the show occasionally demand your capital to be returned. Note single asset real estate deals generally will not permit this option.
  • Read The Intelligent Investor by Benjamin Graham
  • Read The Snowball: Warren Buffett and the Business of Life by Alice Schroeder

Overall, the changes in the securities rules will have a tremendous impact and I believe mostly positive in the real estate world. The dangers do exist for the unwary. That’s the truth.

Photo: Scrambled Squash

Douglas Dowell J.D. is a commercial and multifamily investor. His blog will focus on legally raising private money, risk mitigation with due diligence and management science. He is also an avid stu...
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    Curt
    Replied over 7 years ago
    I think this article made a huge statement that my research into Reg D did not find to be true. “Other structures that are not a security include a member managed LLC, a Tenet in Common ownership structure, and a debt obligation that is not fictionalized.” I’m assuming that spell check screwed up again and what was meant was: “not fractionalized” meaning pooling of investors onto one note. This is a complete surprise to me and my Reg D understanding. I was under the impression that even putting a lender onto a mortgage and a note was selling a security. Can we offer regulation passages that validate that one investor one mortgage does not need an SEC Reg D filing? tnx curt
    Douglas
    Replied over 7 years ago
    Fictionalized Notes are a problem haha….thanks Curt. I will have to check spelling more closely. The best place to look for the answers on weather a debt obligation should be treated as a security is found in Reves v. Ernst & Young, 110 S. Ct. 945 (1990) and the cases the flow from it. Their alot of confusion about what is and is not a security because the court elected to use form over function. The following factors seem to be the most relevant: 1. Is their collateral? 2. The number of participants in the obligation? 3. How is repayment structured? 4. What is the reasonable expectation of the investor? A great example is Bass v. Janney Montgomery Scott, Inc., 210 F.3d 577 (6th Cir. 2000). The bridge loan note was not a security because there was only one investor and the note was collateralized. Again please seek legal counsel before acting on this information.
    Curt
    Replied over 7 years ago
    Hi Douglas, I think this is a huge revelation! And think it’s not well understood where the dotted line is for the real estate investor and borrower. This could be the topic of another blog. 🙂 I’d like the scoop of that blog now though. 🙂 Douglas can you give the laymen’s description of how to borrow from a passive cash lender that is NOT an SEC regulated activity? IE 1 lender onto 1 property with 1 mortgage note. Does a personal promissory note in addition to the mortgage note make it a security? How one might accidentally structure a JV or deal to BE an SEC regulated activity? Sorry for taking your help and asking for all of court law to be boiled down into a few sentences. LOL but thanks. This is a huge area that needs more horn blowing for REI folks to learn where the dotted line is. curt
    George Foster
    Replied over 7 years ago
    I would agree with Curt. Could you breakdown what is an allowable structure vs. one that would raise the eyebrows of the SEC.
    Douglas Dowell from Olathe, Kansas
    Replied over 7 years ago
    Sorry I missed this comment George. Stay tuned…I am def. going to tackle that in not next Fridays…but the following.