Arizonia and the Series LLC

Led by Delaware, a number of states allow a “series” limited liability company. Think of the LLC itself as a building and each series as a cubicle within the building. If you follow the rules then the assets and liabilities in each cubicle are legally separate:  a creditor of one can’t get at the assets of another.

Thus, rather than forming a brand new LLC for each group of assets, a business can create separate series within one LLC, saving on state filing fees.

Apparently, Arizona really dislikes the series LLC. Arizona amended its LLC statute recently, and not only does the new statute not adopt the series concept for Arizona LLCs, it goes a step farther, refusing to recognize the concept even for LLCs organized in other states. Section 3901D of the Arizona statute provides that an Arizona resident who is a creditor of the series of a non-Arizona LLC can get at all the assets of the LLC, notwithstanding the laws of the state where the LLC was organized.

EXAMPLE:  NewCo LLC is formed in Delaware and has two series, Series X and Series Y, with Series X in the asbestos business and Series Y in the real estate business. Section 215 of the Delaware Limited Liability Company Act says that creditors of Series X can’t get at the assets of Series Y. But Arizona says they can, if they’re Arizona residents or the transactions took place in Arizona.

I wonder if that’s even constitutional. From law school I recall that states aren’t allowed to impose their own regulations on long-haul trucks if it impedes interstate commerce. This sounds similar.

But putting the constitutional question to the side, it’s hard to see the purpose of the law. NewCo LLC can keep the Arizona creditor away from its real estate assets by spending a couple hundred dollars more — in Delaware —and forming two wholly-owned subsidiary LLCs rather than two series. Just as likely, national companies using a series LLC will avoid doing business in Arizona, hardly a desirable outcome.

From the invention of the corporation hundreds of years ago to modern times, the history of commercial law is that governments accommodate the development of business. Here the Arizona legislature has done the opposite and it’s hard to see why.

Can an LLC Serve as a Crowdfunding Vehicle for a Corporation?

Crowdfunding doesn’t screw up the issuer’s cap table. Nevertheless, because many issuers and investors think it does, the SEC adopted 17 CFR §270.3a-9 earlier this year. This allows Reg CF issuers to use a “crowdfunding vehicle” to issue securities to investors while adding only one entry to its cap table.

The use of SPVs to own securities is common in the Title II (Rule 506(c)) world and the world of securities generally. Accordingly, we form a separate entity, typically a limited liability company, to own securities of the “main” company. Indeed, a variation of the SPV structure is required in securitized real estate financing.

But that’s not what the SEC has in mind with crowdfunding vehicles in Title III. The SEC has in mind an entity that is a mirror image; you might say an alter-ego of the issuer. For example, the crowdfunding vehicle:

  • Can have no purpose other than owning securities of the issuer;
  • Must have the same fiscal year-end as the issuer;
  • May not borrow money;
  • Must be reimbursed for all its expenses only by the issuer; and
  • Must “Maintain a one-to-one relationship between the number, denomination, type, and rights of crowdfunding issuer securities it owns and the number, denomination, type, and rights of its securities outstanding.”

What does that last requirement mean? To me, it sounds as if the “rights” associates with the issuer’s securities must be the same as the “rights” associated with the crowdfunding vehicle’s securities.

The “rights” associated with securities are defined in part by contract, which we can control, but in part by state law. Corporate laws vary widely from state to state, and even within a state, the laws of corporations are often very different than the laws of limited liability companies. This is intentional: limited liability company statutes were written to be different than the corresponding corporate statutes. For example, LLC statutes typically give members of an LLC far greater freedom of contract while corporate laws, for historical reasons, take a more paternalistic view.

Now, suppose the issuer in a Reg CF offering is a Delaware corporation. Absent guidance to the contrary from the SEC, I think that for the “rights” to be the same, the crowdfunding vehicle must also be a Delaware corporation, not a Delaware limited liability company. Similarly, if the issuer is a Wyoming limited liability company, the crowdfunding vehicle couldn’t be a Delaware limited liability company. If the issuer is a Wyoming limited liability company, then the crowdfunding vehicle would have to be a Wyoming limited liability company. Even then, only if the Operating Agreement of the crowdfunding vehicle is identical to the Operating Agreement of the issuer, giving security-holders identical rights.

That’s all well and good except for the tax issue. If the issuer and the crowdfunding vehicle are both C corporations, then dividends paid by the issuer to the crowdfunding vehicle will be subject, in part, to double tax.

Maybe the SEC will issue guidance smoothing the edges of the “one-to-one relationship” rule, so to speak. Or maybe Congress will amend section 243 of the Internal Revenue Code to give issuers a 100% deduction for dividends paid to a crowdfunding vehicle. Until then, issuers that are corporations should either resign themselves to double tax or not use a crowdfunding vehicle, which they don’t need anyway.

Tax Alert for Sponsors and Fund Managers: IRS Issues Final Regulations for Carried Interests

Every real estate syndication and private investment fund involves a “carried interest” for the sponsor, also known as a “promoted interest.” The IRS just issued final regulations on how those interests are taxed.

A carried interest is what the sponsor gets for putting the deal together. For example, a typical waterfall might provide that on sale of the project investors receive a preferred return, then investors receive a return of their capital, then the balance is divided 70% to investors and 30% to the sponsor. That 30% is the sponsor’s carried interest.

For as long as anyone can remember the sponsor’s 30% carry has been taxed as capital gain. This favorable tax treatment has been the subject of considerable controversy given that the carry is paid to the sponsor not for an investment of capital but for the performance of services. Why should fund managers and deal sponsors be taxed at capital gain rates while hardworking Crowdfunding lawyers are taxed at ordinary income rates? Or so the issue has often been posed.

As a gesture in the egalitarian direction, the Tax Cuts and Jobs Act of 2017 – the same law that gave us qualified opportunity zones – added section 1061 to the Internal Revenue Code. Section 1061 provides that while carried interests are still taxed at capital gain rates, the threshold for long-term rates is three years rather than 12 months.

That means if an investment fund buys stock in a portfolio company and flips it at a profit after two years, the investors are taxed at long-term capital gain rates while the sponsor is taxed at ordinary income rates, a big difference.

IMPORTANT NOTE:  In the real estate world section 1061 applies to vacant land or a triple-net lease, but not to a typical multifamily rental project. (The issue is whether the asset constitutes “property used in a trade or business” under Code section 1231.)

The final regulations just issued by the IRS clarify a few points:

  • They clarify that the three-year holding period doesn’t apply to an interest the sponsor acquires by investing capital along with other investors.
  • They clarify that if the sponsor receives a distribution with respect to its carried interest and reinvests the distribution, the interest the sponsor receives as a result of the reinvestment is not subject to the three-year holding period.
  • They provide that if the sponsor sells its carried interest, you “look through” the partnership to determine the holding period of the partnership’s assets.
  • They provide that if the sponsor transfers the carried interest to a related party, the sponsor can recognize taxable phantom gain.
  • They deal with in-kind distributions of assets to the sponsor with respect to the carried interest.

Section 1061 is one more tripwire for deal sponsors and their advisors. Be aware!

Using a Transfer Agent Doesn’t Mean You Have a Single Entry on Your Cap Table

Many issuers are concerned that “Crowdfunding will screw up my cap table.” In response, several Title III funding portals offer a mechanism they promise will leave only a single entry on the issuer’s cap table, no matter how many investors sign up.

The claim is innocuous, i.e., it doesn’t really hurt anybody. But it’s also false.

The claim begins with section 12(g) of the Securities Exchange Act. Under section 12(g), an issuer must register its securities with the SEC and begin filing all the reports of a public company if the issuer has more than $10 million of total assets and any class of equity securities held of record by more than 500 non-accredited investors or more than 2,000 total investors.

17 CFR §240.12g5-1 defines what it means for securities to be held “of record.” For example, under 17 CFR §240.12g5-1(a)(2), securities held by a partnership are generally treated as held “of record” by one person, the partnership, even if the partnership has lots of partners. Similarly, under 17 CFR §240.12g5-1(a)(4), securities held by two or more persons as co-owners (e.g., as tenants in common) are treated as held “of record” by one person.

With their eyes on this regulation, the funding portals require each investor to designate a third party to act on the investor’s behalf. The third party acts as transfer agent, custodian, paying agent, and proxy agent, and also has the right to vote the investor’s securities (if the securities have voting rights). The funding portal then takes the position that all the securities are held by one owner “of record” under 17 CFR §240.12g5-1.

Two points before going further:

  • Title III issuers don’t need 17 CFR §240.12g5-1 to avoid reporting under section 12(g). Under 17 CFR §240.12g6(a), securities issued under Title III don’t count toward the 500/2,000 thresholds, as long as the issuer uses a transfer agent and has no more than $25 million of assets.
  • 17 CFR §240.12g5-1(b)(3) includes an anti-abuse rule:  “If the issuer knows or has reason to know that the form of holding securities of record is used primarily to circumvent the provisions of section 12(g). . . . the beneficial owners of such securities shall be deemed to be the record owners thereof.”

But put both those things to the side and assume that, by using the mechanism offered by the funding portal, the issuer has 735 investors but only one holder “of record.”

Does having one holder “of record” mean the issuer has only a single entry on its cap table? Of course not. At tax time, the issuer is still going to produce 735 K-1s.

The fact is, how many holders an issuer has “of record” for purposes of section 12(g) of the Exchange Act has nothing to do with cap tables. The leap from section 12(g) to cap tables is a rhetorical sleight-of-hand.

As I said in the beginning, the sleight-of-hand is mostly harmless. Except for some additional fees, neither the issuer nor the investors are any worse off. And the motivation is understandable:  too many issuers think Crowdfunding will get in the way of future funding rounds, even though that’s not true.

Even so, as a boring corporate lawyer and true believer in Crowdfunding, I’m uncomfortable with the sleight-of-hand. When SPVs become legal on March 15th perhaps the market will change.

Crowdfunding Real Estate

PODCAST: The Storage Investor Show

Real Estate Crowdfunding in 2021 with Mark Roderick – episode 9

In This Episode:

  • Updates to Accredited Investor qualifications
  • Who qualifies as a “Finder” of capital?
  • Title III crowdfunding changes
  • How can sponsors and investors take advantage of recent changes
  • Why crowdfunding is a marketing business

Guest Info:

Mr. Roderick concentrates his practice on the representation of privately-owned and emerging growth companies, including companies in the technology, real estate, and health care industries. Mark specializes in the representation of entrepreneurial, growth-oriented companies and their owners.

List OF Accredited Investors for PPMs

Every Private Placement Memorandum includes a list of accredited investors, summarizing 17 CFR §230.501(a). With the new definitions coming into effect on December 8th, I thought it might be useful to post a summary here.

“An ‘accredited investor’ includes:

  • A natural person who has individual net worth, or joint net worth with the person’s spouse or spousal equivalent, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person;
  • A natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse or spousal equivalent exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year;
  • A natural person who holds any of the following licenses from the Financial Industry Regulatory Authority (FINRA):  a General Securities Representative license (Series 7), a Private Securities Offerings Representative license (Series 82), or a Licensed Investment Adviser Representative license (Series 65);
  • A natural person who is a “knowledgeable employee” of the issuer, if the issuer would be an “investment company” within the meaning of the Investment Company Act of 1940 (the “ICA”) but for section 3(c)(1) or section 3(c)(7) of the ICA;
  • An investment adviser registered under the Investment Advisers Act of 1940 (the “Advisers Act”) or the laws of any state;
  • Investment advisers described in section 203(l) (venture capital fund advisers) or section 203(m) (exempt reporting advisers) of the Advisers Act;
  • A trust with assets in excess of $5 million, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person;
  • A business in which all the equity owners are accredited investors;
  • An employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
  • A bank, insurance company, registered investment company, business development company, small business investment company, or rural business development company;
  • A charitable organization, corporation, limited liability company, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets exceeding $5 million;
  • A “family office,” as defined in rule 202(a)(11)(G)-1 under the Advisers Act, if the family office (i) has assets under management in excess of $5,000,000, (ii) was not formed for the specific purpose of acquiring the securities offered, and (iii) is directed by a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment;
  • Any “family client,” as defined in rule 202(a)(11)(G)-1 under the Advisers Act, of a family office meeting the requirements above, whose investment in the issuer is directed by such family office;
  • Entities, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that were not formed to invest in the securities offered and own investment assets in excess of $5 million; or
  • A director, executive officer, or general partner of the company selling the securities, or any director, executive officer, or general partner of a general partner of that issuer.”

This list doesn’t try to capture every detail of every definition. For purposes of a disclosure document it’s plenty.

WHY I’M GRATEFUL THIS THANKSGIVING

My 10th great-grandfather was William Bradford, the leader of the Pilgrims, so I have a special fondness for Thanksgiving. Feeling a little out-of-sorts that COVID-19 kept family members away — and then realizing how little that meant relative to the real suffering of so many — I made my annual list of things I’m grateful for:

  • I’m grateful that while we couldn’t get together on Thanksgiving Day, my family is safe and healthy.
  • I’m grateful for my new law firm, Lex Nova Law, and partners I admire and trust. Character really does matter.
  • I’m thankful to live in a dynamic, capitalist country. All things considered, capitalism has done a terrific job during the pandemic, delivering goods and services through channels invented on the fly.
  • I’m grateful for Zoom and the other technologies that have allowed me to work during the pandemic without missing a beat.
  • I’m grateful for the nurses and doctors working on the front lines, putting their own lives at risk to save others, showing a kind of dedication those of us in the white collar world don’t see often.
  • I’m grateful for governors and elected officials around the world who acted courageously to save lives and for Anthony Fauci, an American hero.
  • I’m grateful for American entrepreneurs, with their unquenchable faith that things can be done better.
  • I’m grateful to the SEC for trusting American entrepreneurs and ordinary citizens, as it lays the foundations for the Crowdfunding ecosystem.
  • I’m grateful for the hundreds of thousands of investors who have expressed faith in that ecosystem with their hard-earned dollars.
  • I’m grateful that American democracy survived its greatest threat since the Civil War and that, despite some creaking of the old timbers, the machinery of our democracy worked again. Maybe blockchain or some other technology will make future elections easier, but until then we rely on the integrity of thousands election workers of both parties working together despite their ideological differences. Because of their hard work and decency, on January 20, 2021 our country will enjoy the miracle of another peaceful transition of power.
  • I am thankful to live in a diverse, changing, sometimes-chaotic country where it often seems we disagree about everything (we don’t). Like others, I worry that so many Americans have chosen alternative realities and conspiracy theories, but I have faith that these afflictions, like others in our history, will prove temporary.
  • Most of all I’m grateful for my clients, a diverse, energetic, endlessly-creative group of entrepreneurs who are making America better and in the process making my life infinitely more rewarding.

Perhaps 2021 could be a little less. . . .interesting? No matter how that turns out, let’s all step into the future with thanksgiving and hope.

Thanks for reading.

MARK

Why Everyone Benefits from the SEC’s New Crowdfunding Rules

To the delight of both issuers and investors, the SEC continues to make crowdfunding better as they have announced major changes to their crowdfunding rules. In this podcast, crowdfunding attorney Mark Roderick and Co-Founder of Lex Nova Law goes over what he believes are the most important and impactful changes including raising the limits for Regulation A and Regulation CF deals as well as the ability of “finders” to legally accept commissions for bringing deals to the table. And perhaps most importantly, the changes regarding accredited and non-accredited investors are a complete game changer! In this podcast, you’ll find out why that is.

Listen to “Why Everyone Benefits from the SEC's New Crowdfunding Rules” on Spreaker.

We can’t elect a President, but there’s certainly a preponderance of positive energy being circulated in the crowdfunding industry with respect to these rules revisions from the SEC! By increasing the raise limit of Reg.A and Reg.CF offerings, the entire process has become much more realistic in terms of making everything successful on just about every level and aspect of the industry. Now, accredited investors can have whatever stake of a project they want, and non-accredited investors can participate in ways unimaginable just a short time ago. And what’s an accredited investor? That rule has changed too!

One of the biggest changes the SEC has implemented is the legality of “finders” receiving commissions or payments for brokering deals and introducing investors to issuers, syndicators, developers, etc. Before this change, only broker-dealers were allowed to receive compensation for such deals. With the new changes, these finders can now legally receive these commissions and other transaction-based compensation from issuers. The ability to legally monetize your connections is something many have been waiting for for quite a long time!

There’s no question that crowdfunding still has its growing pains. However, one thing’s for sure: finders, investors, and issuers alike should all be jumping for joy after listening to the information Mr. Roderick goes over in this podcast. Broker-dealers, maybe not… But regardless, it’s a new world for crowdfunding and doors continue to open. The industry is definitely heading in the right direction.

SEC (Finally) Approves Crowdfunding Changes

With uncanny precision, I predicted the SEC would approve the Crowdfunding changes no later than August 31, 2020. I was right on target except for the month and year.

The SEC Commissions just voted 3-2 to adopt the changes effective 60 days after they’re published in the Federal Register.

It looks as if there were no significant changes to the proposals made on March 4th, but I’ll let you know shortly. You can read the full text and SEC explanations here.

Beneficiary Designations by Crowdfunding Issuers and Portals

Some Crowdfunding portals and issuers allow investors to designate a beneficiary, i.e., a person who will take ownership of the security (the LLC interest, debt instrument, whatever) should the investor die. Just be careful.

Most states (not Texas) allow the owners of securities, including privately-held securities, to designate a beneficiary outside the owner’s will, under a version of the Uniform TOD (Transfer on Death) Security Registration Act (the Delaware version is 12 DE Code §801 et seq). For the investor, the advantage of designating a beneficiary is that the security doesn’t go through the probate process but instead passes directly to the designated beneficiary.

For the Crowdfunding issuer or portal, there is a benefit to making life easier for investors. And it’s pretty straightforward to create a beneficiary designation form on your website.

Nevertheless, adding convenience for investors carries some risks. For example:

  • Suppose an investor wants to designate her cousin Jacob as the beneficiary of her LLC interest. She uses Jacob’s name on the beneficiary designation form but mistakenly uses her husband’s social security number, out of habit. What happens?
  • The investor correctly designates Jacob on the form but later changes her mind and designates her husband as the beneficiary of the LLC interest in her will. Unfortunately for her husband, the beneficiary designation made using your form cannot be undone by the will. Your form didn’t make that clear.
  • The investor property designates Jacob as the beneficiary of her LLC interest and doesn’t change her mind, but she lives in a community property state and your form didn’t tell her she needed her husband’s consent.
  • The investor property designates Jacob as the beneficiary of her LLC interest but he dies before she does, and she hasn’t designated a successor beneficiary.
  • Your site crashes and the investor’s beneficiary designation is lost.

What’s your budget for legal fees this year?

Designating a beneficiary on your site isn’t the investor’s only option. She can sign a simple will or codicil (if she already has a will) designating a beneficiary for her LLC interest and any other securities or other property, which probably makes more sense than designating beneficiaries security-by-security. And if her cousin and husband end up arguing over the codicil, you’re not involved.

If you’d like a sample of a Beneficiary Designation Form let me know.