“Do I need to register as an investment adviser?” Part 2

In Part 1 of this article discussing real estate syndicators’ obligations under the investment adviser laws, I provided you with the not-so-good news that the SEC and the state securities regulators really do want managers and general partners to real estate investment funds to register as investment advisers even though they are “only” providing advice with respect to real estate and not securities.  In this article, I discuss an important exemption to the Texas investment adviser registration requirements.

In Texas, Rule §139.23 of Title 7, Part 7 of the Texas Administrative Code is titled “Registration Exemption for Investment Advisers to Private Funds”.  TAC Rule §139.23 exempts advisers to “real estate funds” (among other types of funds).  Under § 139.23(a)(5), a “real estate fund” is defined by reference to the definition provided in the instructions to Form ADV.  The Form ADV instructions define a “real estate fund” as “any private fund that is not a hedge fund, that does not provide investors with redemption rights in the ordinary course, and that invests primarily in real estate and real estate related assets.”  TAC §139.23(a)(2) defines “private fund” identically to Section 202(a)(29) of the Investment Advisers Act of 1940, as amended, which is by reference to Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940, as amended (the “Investment Company Act”).

Sections 3(c)(1) and 3(c)(7) of Investment Company Act provide two exemptions from the federal laws regulating the registration of investment companies (e.g., mutual funds, exchange-traded funds (ETFs), real estate investment trusts (REITs), or unit investment trusts (UITs)).  A Section 3(c)(1) fund is any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons and which is not making and does not presently propose to make a public offering of its securities.  A Section 3(c)(7) fund is any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are “qualified purchasers”, and which is not making and does not at that time propose to make a public offering of such securities.  Under Investment Company Act Section 2(a)(51), a qualified purchaser generally is an individual having a net worth of $5 million, or a business entity having a net worth of $25 million.  Section 3(c)(7) funds generally limit the number of investors to fewer than 2,000 because upon accepting the 2,000th investor, the fund would become subject to the reporting requirements of the Securities Exchange Act of 1934, as amended, under Section 12(g) thereof.

To qualify for the Texas private fund adviser exemption under Rule 139.23 (described above), you must be advising a real estate investment fund that qualifies for the exemptions under either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act.  The clients I typically represent sometimes struggle to fund their deals solely with accredited investors, so this requires them to rely on the securities registration (as opposed to investment adviser registration) exemption found in Rule 506(b) of Regulation D, which allows sales to up to 35 non-accredited investors who are “sophisticated”.  Notably, Rule 506(b) does not allow the use of general solicitation or advertisement (which Rule 506(c) does).  Because some of the investors may not be accredited, the fund will not qualify for the exemption in Section 3(c)(7) because that exemption requires that investors be solely “qualified purchasers”.  A Section 3(c)(1) fund may rely on the exemption found in Rule 506(b), accept up to 35 non-accredited but “sophisticated” investors (see here for a discussion about what constitutes “sophistication”), and because there is no general solicitation or advertising, the requirement under Section 3(c)(1) that the issuer is not making a “public offering of its securities”.

Texas’ private fund adviser registration exemption requires the adviser to file Part 1 of Form ADV with FINRA and with the State Securities Board.  This is a fairly straight-forward and simple notice filing, but the filing of the Form ADV does require at least one of the adviser’s principals to be designated as an Investment Adviser Representative.  That individual will create an account with FINRA and will be assigned a Central Registration Depository, or “CRD” number issued by FINRA.  Thereafter, the adviser is subject to surprise examination and audit by the Securities Board.  Best practices would require the adviser to adopt policies and procedures reasonably designed to ensure compliance with the laws and regulations applicable to investment advisers, who, in similar fashion to general partners of a partnership and managers of a limited liability company, owe their investors fiduciary duties.

For more information about taking advantage of the private fund adviser exemption from the investment adviser registration rules, please contact me.

Rule 506(b)’s “sophistication” standard

If you read Rule 506(b) under Regulation D, you won’t find the word “sophisticated.”  The rule specifies that each of your investors that is not “accredited” must “have such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such purchaser comes within this description.”   The underlined text is Rule 506(b)(2)(ii) and is translated as “sophisticated” when people talk about who their investors may be if they are not “accredited”.  Remember, you may only have 35 non-accredited but “sophisticated” investors.  That is from Rule 506(b)(2)(i).

Here is a link to Rule 506.


When are debt instruments considered securities?

I have been needing to research this issue for a while, and found this excellent article.

“[U]nder the controlling U.S. Supreme Court ruling (Reves v. Ernst & Young, 110 S.Ct. 945 (1990)), federal law also sets up a rebuttable presumption that a promissory note with a maturity greater than nine months IS a security (as the statute requires) UNLESS it resembles one of a ‘family of notes’ generally not considered to be a security for federal law purposes. The Reves court found the following family of notes not to be securities, regardless of maturity:

  • Notes delivered in consumer financing.
  • Notes secured by a mortgage on a home.
  • Notes secured by a lien on a small business or some of its assets.
  • Notes relating to a “character” loan to a bank customer.
  • Notes that formalize an open-account indebtedness incurred in the ordinary course of business.
  • Short-term notes secured by an assignment of accounts receivable.
  • Notes given in connection with loans by a commercial bank to a business for current operations.

The court went on to hold that notes that do not fit cleanly in one of those categories can be evaluated for family resemblance using the following factors, in no particular order of importance:

  • Whether the borrower’s motivation is to raise money for general business use, and whether the lender’s motivation is to make a profit, including interest.
  • Whether the borrower’s plan of distribution of the note(s) resembles the plan of distribution of a security.
  • Whether the investing public reasonably expects that the note is a security.
  • Whether there is a regulatory scheme that protects the investor other than the securities laws (e.g., notes subject to FDIC regulation).

. . .

So, there is no bright line? The evaluation of a note not clearly within the ‘family of notes’ will be driven by the facts and circumstances of each situation. The presence or absence of any of the factors is not by itself determinative of whether the note sufficiently resembles one of the family of notes excluded from securities regulation.”

“Do I need to register as an investment adviser?” Part 1

(Editor’s Note: This is Part 1 of a two-part article, with Part 2 at this link.)

Texas and United States federal law requires that any person who for compensation gives advice with respect to securities is obligated to register as an investment adviser, either with the state securities regulator of the state where the adviser has its principal office or with the United States Securities and Exchange Commission (the “SEC”).

I frequently represent clients who syndicate offerings of private securities to finance real estate investments.  I also represent clients who syndicate offerings of private securities to finance their acquisition of private stock in operating companies (as venture capital or private equity investors) and clients who syndicate offerings of private securities to finance their acquisition of publicly-traded securities (as a hedge fund, for example).  If these clients receive compensation for their analysis of the value of the underlying securities in which they are investing their investors’ investment funds, these clients are acting as investment advisers.  Historically, however, attorneys have advised clients who syndicate private offerings of securities to fund real estate investments that because the underlying asset is real estate and not shares of stock or membership interests in an underlying business entity (a corporation, LLC, or limited partnership), the “advice” that the client is providing really regards real estate and not securities even though the client is selling securities in their syndicated offering and there is a value placed on those securities.

Registration as an investment adviser is an onerous process.  You must apply either with the SEC or the securities regulator of the state where you are doing business.  Our securities regulator in Texas is the Texas State Securities Board (the “TSSB”).  Under the Investment Advisers Act of 1940, as amended (“Advisers Act”), until you have $150 million under management, you will be required to register with the state securities regulator instead of the SEC.  Under the state registration rules, at least one of the principals of the firm must satisfy examination requirements (the principal must pass the Series 65, or have a combination of either the Series 1, 2, or 7, and the Series 66).  The registration process commences with completing and filing a Form ADV for the investment adviser.  The Form ADV requires you to disclose material information about your advisory business and how you address potential conflicts of interest.  Part 2 of the Form ADV requires extensive narrative disclosure about your business.  After you are registered, you are subject to ongoing record keeping and operational requirements and you are subject to a surprise audit by the TSSB.

So this is the bad news that I am going to leave you with as a cliffhanger for the good news that I will provide in the next installment of this series.  If you want to know the answer sooner, call me and I would be happy to discuss further!

The SEC’s Evolving Integration Doctrine

“Integration” is the SEC’s term for treating two or more securities offerings as a single offering. For example, an issuer theoretically could rely on the exemption found in Rule 506(c) and the exemption under Regulation A, and simultaneously conduct separate offerings relying on two different exemptions. This is a great article discussing how the SEC’s integration rules are evolving, and actually becoming more liberal and clear, which is good news for issuers of private securities


How would you like $2.5 million to invest in real estate?

As we all know by now, the Jumpstart Our Business Startups Act (the “JOBS Act”) created new exemptions not only from the registration requirements of the Securities Act of 1933, as amended, but also from the reporting requirements under the Exchange Act of 1934, as amended. These reporting requirements require issuers to file regular 8Ks, 10Qs, and 10Ks, and the compliance burden can be costly. Because of the costs of compliance, these reporting obligations traditionally are something that private issuers of securities have tried to avoid.

In the investment fund world, managers limit sales of securities solely to “accredited investors” (to sell securities under the old Rule 506 exemption from the registration requirements of the Securities Act), but also sometimes would limit the persons who could invest to “qualified purchasers” (defined in Section 2(a)(51) of the Investment Company Act of 1940 as individuals with a net worth of at least $5 million, or business entities having a net worth of at least $25 million (or owned solely by other qualified purchasers)). Investment funds relying on the Section 3(c)(1) exemption from the definition of “investment company” in Section 3(a) of the Investment Company Act of 1940 could sell interests in the fund to a maximum of 100 accredited investors without regard to the investor’s status as a “qualified purchaser”. Section 3(c)(7) provided a very similar exemption to Section 3(c)(1); provided however, that if the only purchasers of securities were “qualified purchasers”, the fund could accept up to 500 investors before being subject to the reporting obligations under the Exchange Act.

The JOBS Act amended Section 12(g)(1) of the Exchange Act to require an issuer to register a class of equity securities if the issuer has total assets of more than $10 million and a class of equity securities “held of record” by either (i) 2,000 persons, or (ii) 500 persons who are not accredited investors. The prior threshold (before the JOBS Act) had been 500 holders of record without regard to accredited investor status, and that provision created the 500-investor limit on Section 3(c)(7) funds. Now, Section 3(c)(7) funds (funds selling interests solely to qualified investors) can accept up to 2,000 investors without having to be subject to the Exchange Act’s reporting requirements. Unfortunately, the limit in Section 3(c)(1) (100 accredited investors) remains unchanged.

For a real estate fund, other exemptions from the definition of “investment company” exist. Under Section 3(c)(5) of the Investment Company Act, a person who is primarily engaged in purchasing or otherwise acquiring mortgages and other liens on, and interests in (i.e., fee simple), real estate are also exempted. In that case, a real estate fund relying on the Section 3(c)(5) exemption could accept up to 2,000 investors (all of whom are accredited), or 500 if they are not accredited investors, and remain exempt from the Exchange Act reporting requirements.

There are limits on the number of non-accredited investors that may invest if the issuer is relying on Rule 506(b), but there is another exemption created by the JOBS Act, namely, the exemption found in revised Regulation A, that allows for

• advertising and general solicitation in connection with the sale of securities, and

• sales to up to 500 non-accredited investors.

While there are limits on the amount a non-accredited investor could invest, the minimum under Regulation A is always at least $5,000. How would you like $2,500,000 raised from non-accredited (and accredited) investors through a Regulation A “mini-IPO” for an open-end REIT?

Selling Private Securities To Foreign Investors

A client recently asked whether a foreign (i.e., non-U.S.) person could invest in private securities offered by a United States domestic issuer (such as a Texas limited liability company).  In this context, “private” securities are securities sold and issued to an investor under an exemption from the registration requirement of the Securities Act of 1933, as amended (the “Securities Act”).  Private securities are contrasted with “public” securities that are registered with the SEC and freely-tradable in a public market, like the Nasdaq stock exchange.

The exemption most frequently used by my clients to sell securities to US investors is Rule 506 of Regulation D under the Securities Act, that allows a company to sell its private securities on a largely unrestricted basis provided that the company is selling the securities solely to “accredited” investors.  This is relevant because the question about the foreign investor always comes from a client who already is conducting an offering of their securities to US investors.  There are other exemptions than Rule 506 that my clients might use, but for purposes of this article, we are going to assume that my client already is conducting a sale of its Texas LLC interests to investors residing in the United States (mostly in Texas) under Rule 506 (and this could either be Rule 506(b) with no advertising/general solicitation, or Rule 506(c) which allows advertising).

Regulation S is an additional set of rules promulgated by the SEC under the Securities Act that provides for a separate exclusion from the registration requirements of the Securities Act for offerings by a US issuer to foreign investors (like my Texas LLC client described above who wants to sell some of its interests to an investor from Mexico).  The basic requirements of Regulation S are that the offering must be made in an “offshore transaction” and that no “directed selling efforts” to US investors may be made by the issuer.

To be an “offshore transaction”, no offer may be made to any person in the United States.  Further, at the time the investor wires their money to purchase the securities, the investor must be (or must be reasonably believed by the issuer to be) physically outside the United States.

The term “directed selling efforts” is defined as “any activity undertaken for the purpose of, or that could be reasonably expected to result in, conditioning the U.S. market for the relevant securities.”  Very basically, the issuer may not advertise the Regulation S offering in places where the advertising will reach persons in the United States, and then turn around and rely on Rule 506 to sell the same securities to the US persons.  At the time that Regulation S was adopted, of course, no advertising or general solicitation was permitted for Rule 506 offerings, but now of course, the new Rule 506(c) exemption in fact permits general solicitations and advertising.

To comply with Regulation S contractually, my client must require the investor from Mexico to certify that the investor is not a U.S. person and the investor is not acquiring the securities for the account or benefit of any U.S. person.  Additionally, the foreign investor must agree not to resell the securities other than in accordance with applicable U.S. securities laws.  Finally, they must agree not to engage in hedging transactions with regard to such securities unless in compliance with the Securities Act.

The foregoing description vastly over-simplifies ALL of the requirements of Regulation S, but is accurate for the specific facts described above.  In many ways, compliance with Regulation S is easier than compliance with Regulation D because there is no requirement that the foreign investor be “accredited”.  The other requirements can be satisfied by imposing restrictions on transferability that my clients would include in their offering documents in any event.

An important legal question that should be considered by my client taking money from a foreign investor is anti-money laundering (AML) compliance.  Unless my client is an investment adviser, though, the burden for AML compliance will largely rest on the shoulders of the bank where my client has their account.  If the investor is allowed to wire the money to my client’s account, that means that the transfer of funds has cleared the bank’s AML compliance requirements, and my client should be in the clear.  This will be the case unless my client has specific knowledge that the investment proceeds are derived from illegal means.

Escrow Services For Crowdfunding Transactions

It [almost] goes without saying that issuers of private securities in any equity financing transaction must address each step of the transaction in detail.  This is true whether the financing is crowdfunded or whether it is distributed using more traditional means.  One such important detail is how investment proceeds are paid to the issuer.  (If you want to read a FINRA release on this topic instead, click here!)

If I am selling $1 million of my LLC’s membership interests to 10 investors, the first investor sending me his $100,000 might wonder what happens if I don’t raise the other $900,000 I told everyone explicitly in my offering memorandum I needed for my financing.  My offering memorandum provides that if I do not raise the entire $1 million, I will return any investor proceeds received without interest.

The investor may be concerned that if I can’t raise the entire $1 million, I might take his $100,000 and use it for some other purpose.  Of course, that would be fraudulent on my part, but practically, the investor’s only recourse would be a lawsuit to recover his money.  To ensure that I raise the entire $1 million in offering proceeds, some investors insist that the issuer establish an escrow where an independent third party evaluates whether the issuer has received minimum investment proceeds to close the financing round.

Historically, these escrow services could be and were performed by broker-dealers and banks (usually acting through their trust department).  This is the case because the Securities Exchange Act of 1934 makes it illegal for anyone to accept compensation for facilitating a securities transaction (“effecting transactions in securities for the account of others”) unless you are registered with FINRA and the SEC as a broker-dealer, or you are a nationally or state-chartered bank.  Interestingly, as noted in the FINRA release linked to above, in certain instances, state-chartered trust companies qualify as “banks” for purposes of Section 3(a)(6) of the Exchange Act.  In that event, a trust company may perform escrow services in a private securities transaction without violating the Exchange Act.

Importantly, § 227.303 of Regulation CF (the SEC crowdfunding regulations applicable to Title III crowdfunding portals) requires that a funding portal direct investment proceeds to an escrow established by a broker-dealer or a bank.  Unlike the language from the Exchange Act, Regulation CF also allows for credit unions to serve in this capacity.  There is a question in the crowdfunding industry whether FINRA and the SEC will allow trust companies to serve in this manner.  If they don’t, the new JOBS Act exemptions are worthless because as this article suggests, issuers inevitably must engage a broker-dealer (or a bank or credit union) to comply with this provision.  Giving issuers the option of using a broker-dealer OR a funding portal was the original intent of this exemption.

Finding a bank to serve in this way has proved to be challenging.  Banks themselves are skittish of engaging in these types of transactions because of the litigation risk.  Because of their historically conservative nature, banks philosophically oppose the new.

Broker-dealers are not good options because of the expense.  Operating a broker-dealer or a bank is an expensive proposition generally.  A great deal of that expense is paid toward compliance costs and those costs must be paid by the issuers (and ultimately, investors).  Because banks and broker-dealers engage in many types of transactions that are not crowdfunded sales of securities, their compliance programs must address many transactions that have no relevance for equity crowdfunding.  A limited-purpose trust company formed for the specific purpose of Title III compliance and handling proceeds in Title II (i.e., Rule 506(c)) raises may be the most cost-effective option for issuers needing escrow services, because the compliance program of a trust company solely performing these functions could be vastly simplified relative to that of a bank or broker-dealer.  Most important will be adopting procedural safeguards to make sure that the escrow agreement is read correctly and money is wired to the issuer only if the minimum offering conditions are satisfied.  If not, the money is returned to the investors.  These compliance functions theoretically could be built into software so that procedurally, the need for human intervention could be reduced.

For more information about escrow services for equity crowdfunding or private securities offerings generally, please contact me.

Texas issuer exemption

Rule 139.19 is a uniform exemption from the securities registration requirements of the Act for the sale of securities by an issuer to accredited investors. The exemption is not available to an issuer that is in the development stage that either has no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person.