Securities Exchange Commission

SEC Adopts Final Rules For Private Advisers And Stresses Fiduciary Obligations

On By crowdfundattnyIn Private Fund Advisors, SECLeave a comment

Last year the SEC proposed new rules for private fund advisers. After public comment the SEC just adopted final rules.

Some of the new rules apply only to investment advisers required to be registered with the SEC. Others apply to all investment advisers, including so-called “private fund advisers.” I’m going to focus on the latter set of rules.

NOTE:  The new rules apply more broadly than you might think:

EXAMPLE:  Nikki Chilandra forms an LLC of which she is the sole manager, raises money from her private network of investors (no more than 100), and uses the money to buy a limited partnership interest in one real estate deal. The LLC is a private fund, and Nikki is likely a private fund adviser subject to the new rules.

Here’s a chart comparing the proposed rules with the final rules:

TopicProposed RuleFinal Rule
Charging for Services Not PerformedAn adviser can’t charge for services not provided. For example, if an asset is sold, the adviser can’t charge for the advisory fees that would have been due over the next two years.The final rules do not include this explicit provision. But that’s only because, according to the SEC, advisers are already prohibited from charging for services not performed because of their fiduciary obligations.
Charging for Compliance CostsAn adviser can’t charge the fund for expenses incurred in a regulatory examination of the adviser.The adviser may charge for these expenses with majority consent, unless the investigation results in sanctions under the Investment Advisers Act.
Reducing Clawback for TaxesAn advisor can’t reduce her clawback by the amount of any taxes.The adviser may reduce her clawback for taxes if she notifies investors within 45 days after the end of the quarter in which the clawback occurs.
Limiting Adviser LiabilityAn adviser can’t limit her liability for a breach of fiduciary duty, willful misfeasance, bad faith, recklessness, or even negligence.The final rules do not include this explicit provision. But the SEC explains that, in its view, the provision isn’t needed in light of the fiduciary and anti-fraud obligations already imposed on advisers under the Investment Advisers Act which, according to the SEC, may not be waived by contract (e.g., in an LLC Agreement).
Allocation of Fees Among FundsAn adviser can’t allocate fees among funds on a non-pro rata basis.The adviser may allocate fees on a different basis if (i) the allocation is fair and equitable under the circumstances and (ii) before charging or allocating the fees, the adviser notifies investors, explaining why it is fair and equitable.
Borrowing from FundAn adviser can’t borrow money from the fund.The adviser may borrow money with majority consent.
Preferential Treatment for Redemptions and InformationAn adviser can’t give preferential rights to redemption or preferential information rights to some investors if it would have a material negative effect on other investors.Both are allowed if the same rights are given to all investors (which makes the treatment non-preferential).
Preferential Economic TreatmentAn adviser can’t give other preferential economic rights to some investors without full disclosure to all investors.Preferential treatment is allowed with full disclosure (i) before an investor invests, (ii) when the fundraising period has ended, and (iii) annually.

In my opinion, the most important feature of the new rules isn’t the new rules themselves but the SEC’s statements concerning the fiduciary obligations of investment advisers. The SEC believes that all investment advisers have a duty of care and a duty of loyalty that cannot be waived by contract and can be liable for their negligence, no matter what the contract says.

Questions? Let me know.

SPVs in Crowdfunding

SPVs in Crowdfunding

On By crowdfundattnyIn Investment Advisers Act of 1940 (IAA), Investment Company Act, SPVLeave a comment

When you’re raising money for a company, it’s tempting to group all your investors in an entity and have that entity, rather than the individual investors, invest in the company. We often refer to an entity like this as a special purpose vehicle, or SPV. 

The Cursed Investment Company Act

Because the SPV is in the business of owning a security – even if it’s only one security – it’s an “investment company” within the meaning of section 3(a)(1)(A) and/or section 3(a)(1)(C) of the Investment Company Act of 1940. That means, among other things, that the SPV can’t use Reg CF or Regulation A to raise capital.

NOTE:  In 17 CFR §270.3a-9, the SEC created a special kind of SPV called a “crowdfunding vehicle” that can be used to raised capital in Reg CF. I’ve written about those here and here and here but am not writing about them today. Today I’m talking about SPVs formed to raise money under an exemption other than Reg CF, e.g., Rule 506(b) or Rule 506(c).

Because of the prohibitive regulatory burden, we don’t want our SPV to be an investment company. Therefore, having concluded that the SPV is an investment company within the meaning of section 3(a)(1) of the ICA, we look for an exemption.

If you’re raising money only from very wealthy people you find an exemption in section 3(c)(7) of the ICA, which allows an unlimited number of investors as long as each owns at least $5 million of investable assets. All the big hedge funds and private equity funds in Manhattan and Merchantville rely on this exemption. 

The Section 3(c)(1) Exception – 100 Security Holders

For the unwashed masses, the most common exemption – actually, the only other viable exemption for SPVs – is section 3(c)(1) of the ICA. The section 3(c)(1) exemption applies if the outstanding securities of the SPV are held by no more than 100 persons. A few points about the 100-investor limit:

  • The limit refers to the total number of security-holders, not the number of investors in a particular offering. If you’ve conducted one offering and admitted 72 investors, you can’t conduct another offering and admit 87 more.
  • “Securities” include equity, debt, and everything in between. An investor holding a promissory note or a SAFE counts.
  • In general, if an entity invests in the SPV the entity counts as only one security-holder, even if the entity itself has multiple owners. But the law will “look through” the entity, treating its owners as owners of the SPV, if either:
    • You formed the entity to get around the 100-security holder limit; or
    • The entity owns 10% or more of the voting power of the SPV and is itself an investment company.
  • Suppose your SPV has 98 security holders and P.J. Jankara is one of them. She dies and leaves her 100 shares of common stock to her five children, 20 shares each. Is your SPV now an investment company? No, the law provides latitude for involuntary transfers like death.
  • As long as you have no more than 100 security holders in one SPV, you’re allowed to have a separate SPV relying on the section 3(c)(7) exemption. In legal jargon, the two SPVs won’t be “integrated.”

Qualifying Venture Capital Funds – 250 Security Holders

The 100 limit is increased to 250 for a “qualifying venture capital fund.” That means a fund satisfying all six of the following conditions:

  1. The fund represents to investors and potential investors that it pursues a venture capital strategy;
  2. Other than short-term holdings, at least 80% of the fund’s assets must consist of equity interests in portfolio companies;
  3. Investors in the fund do not have the right to withdraw or have their interests redeemed;
  4. All investors in the fund must have the right to receive pro rata distributions;
  5. The fund may have no more than $10,000,000 in aggregate capital contributions and uncalled committed capital, indexed for inflation; and
  6. The fund’s borrowing does not exceed 15% of its aggregate capital contributions and uncalled committed capital.

The regulations don’t define the term “venture capital strategy,” but the SEC provided this explanation:

Under the rule, a qualifying fund must represent itself as pursuing a venture capital strategy to its investors and potential investors. Without this element, a fund that did not engage in typical venture capital activities could be treated as a venture capital fund simply because it met the other elements specified in our rule (because for example it only invests in short-term holdings, does not borrow, does not offer investors redemption rights, and is not a registered investment company). We believe that only funds that do not significantly differ from the common understanding of what a venture capital fund is, and that are actually offered to investors as funds that pursue a venture capital strategy, should qualify for the exemption.

Whether or not a fund represents itself as pursuing a venture capital strategy, however, will depend on the particular facts and circumstances. Statements made by a fund to its investors and prospective investors, not just what the fund calls itself, are important to an investor’s understanding of the fund and its investment strategy.

When asked to define pornography, former Supreme Court Justice Potter Stewart famously responded: “I know it when I see it.” (Contrary to some critics, he did NOT continue “. . . .and I see it a lot.”) The definition of “venture capital strategy” is like that.

Now, one of the high-volume Reg CF portals says this about using SPVs for Rule 506(c) offerings:

If you wish to consolidate all the investors into a single SPV or fund, the law places a limit of 249 investors if the offering is under $10M in investments. If the offering has more than $10M in investments, there is a 99 investor limit.

This is 100% wrong. By referring to a $10M limit, the portal clearly believes that an SPV can be a “qualifying venture capital funds.” But an entity formed to “consolidate all the investors into a single SPV” couldn’t be a qualifying venture capital fund because it doesn’t pursue a “venture capital strategy.” In fact, the SPV has no investment strategy at all. Investors themselves make the one and only investment decision at the time they invest. The SPV is simply a conduit between the investors and the team, used to simplify the team’s cap table.

This is the same high-volume Reg CF portal that uses a series LLC as crowdfunding vehicles, despite this. 

Whether the exception for qualifying venture capital funds is flexible enough for a bona fide venture capital fund is a different story. But unless you live in Manhattan or Merchantville, assume that your SPV can have only 100 security holders.

Questions? Let me know. 

Escrow account crowdfunding portals

By Itself, An Escrow Account Won’t Stop Sponsors From Stealing Investor Money

On By crowdfundattnyIn Crowdfunding Portals, Crowdfunding Real Estate, Portals, Real Estate2 Comments

As reported everywhere, CrowdStreet investors recently suffered very large losses when a sponsor apparently absconded with their money. It’s a very bad thing, not only for those investors but for the real estate crowdfunding industry. You’d almost think this were crypto! 

In the aftermath, many have called for crowdfunding sites to use escrow accounts. My point today is that escrow accounts by themselves aren’t enough.

CrowdStreet hosts offerings under Rule 506(c), where escrow accounts aren’t required. On the other side of the street, in the Reg CF world, funding portals must use an escrow agent. Rule 303(e) even specifies who can serve as the escrow agent (a broker-dealer, a bank, or a credit union) and directs which instructions the funding portal is required to give to the escrow agent under what circumstances. If and when the issuer reaches its target amount the funding portal must instruct the escrow agent to release the funds to the issuer, while if the investor cancels his, her, or its investment commitment or the offering is terminated, the funding portal must instruct the escrow agent to return the funds to the investor.

Now let’s assume exactly such an arrangement had been in place for the doomed offering on CrowdStreet.

The offering would have stipulated a “target amount” of $63 million, with the money held securely in escrow. With the target amount raised, CrowdStreet would have given the escrow agent instructions to release the money to the sponsor, following the regulations to the letter. And the sponsor would have stolen it.

By itself the escrow account wouldn’t have prevented the theft. Extrapolating to Reg CF, the escrow accounts used by funding portals do not prevent theft. They just make the unscrupulous sponsor wait until reaching the target amount to steal the money.

To prevent the theft you have to layer something on top of the escrow agent. In the CrowdStreet offering you could have prevented the theft by wiring the money not to the sponsor but to the title company conducting the closing, with instructions that it would be used only to acquire the property. In a typical Reg CF offering, where the money is being used by the issuer for marketing or other general business purposes, it’s much harder.

This is another reason why the “bad actor” rules are odd. They catch people who have violated the securities laws but not people who have robbed strangers at gunpoint. 

Questions? Let me know. 

Reinvigorate American Capitalism Through Crowdfunding

Reinvigorate American Capitalism Through Crowdfunding

On By crowdfundattnyIn Podcasts1 Comment

In this episode, we dive into the world of crowdfunding and see how it can reinvigorate American Capitalism with our special guest Mark Roderick. Crowdfunding is an exciting and transformative concept that simplifies capital formation through the Internet. Mark, a corporate lawyer with extensive experience in helping entrepreneurs raise capital, shares his insights on how crowdfunding has the potential to revolutionize investment opportunities.

With the internet expanding opportunities in raising capital, similar to how it revolutionized the retail and dating industries, Mark explains how crowdfunding can connect entrepreneurs with investors in unprecedented ways. Specifically, he delves into the Jobs Act of 2012, which created different types of crowdfunding, including the highly successful Rule 506 C that allowed real estate professionals to advertise and raise billions of dollars. With Mark’s guidance, we also explore the three essential documents in real estate deals that are vital for legality and protection against potential challenges. Join us for this enlightening episode as we uncover the power and potential of crowdfunding with the knowledgeable and experienced Mark Roderick.

Key Points from This Episode:

  • Crowdfunding has the potential to revolutionize real estate investment opportunities.
  • The Internet greatly expands opportunities for raising capital and connecting with investors, similar to how it has revolutionized retail and other industries.
  • Mark has extensive experience in helping entrepreneurs and real estate professionals raise capital.
  • Mark is knowledgeable and experienced in navigating the complexities of crowdfunding laws and helping real estate professionals comply with new regulations.
  • The Jobs Act of 2012 created three types of crowdfunding, including the most successful one, which was a change in the previous rule that prohibited the advertising of real estate syndications.
  • Rule 506 C allows for advertising and requires verification of accreditation for investors.
  • This change enabled real estate professionals to raise billions of dollars of capital, making it a spectacularly successful source of funding.
  • As a corporate lawyer, Mark can provide legally sound and easily understandable documents to ensure compliance and avoid legal troubles in the crowdfunding process.
  • While Mark can assist with legal aspects, he is not able to directly help with raising funds. Established real estate crowdfunding sites like RealCrowd or CrowdStreet may be a viable option for experienced individuals to access an existing investor base.
  • For those starting out, crowdfunding requires active digital marketing efforts. Simply creating a website is not enough to attract investors; it is a marketing business that requires proactive efforts to generate interest and secure investments.
  • Three essential documents in real estate deals – the subscription agreement, limited liability company agreement, and the disclosure document (PPM) – play a vital role in keeping the process legal and protecting against potential legal challenges.
  • Crowdfunding thrives in spaces where limited information is available and can make deals more efficient and known to a broader audience.
  • Crowdfunding is not well-suited for fully efficient markets like single-family home mortgage loans or large-scale development projects where most major investors have access to in-depth information about the deal.


About Mark Roderick

Since the JOBS Act of 2012, Mark Roderick has spent all of his time in the Crowdfunding space, and today he is one of the leading Crowdfunding and Fintech lawyers in the United States. He writes a widely-read blog, which offers a wealth of legal and practical information for portals and issuers. He also speaks at Crowdfunding events across the country and represents industry participants across the country and around the world.

Series A Preferred Stock

Owning Securities Won’t Make Your Funding Portal An Investment Company

On By crowdfundattnyIn Crowdfunding Portals, FINRA, PortalsLeave a comment

Funding portals are allowed to receive part of their compensation in securities of the issuer, as long as the securities are of the same class being offered to investors. For example, if an issuer raises $2M selling Series A Preferred Stock and the funding portal charges a 7% commission, it may take all or any part of the $140,000 as Series A Preferred Stock rather than cash.

Before long, the value of these securities might exceed the value of the funding portal’s business. Inquiring minds would wonder whether owning all those securities will turn the funding portal into an “investment company” within the meaning of the Investment Company Act of 1940.

It’s a good question, but fortunately the answer is No. Section 3(c)(2) of the Investment Company Act provides an exception for:

Any person primarily engaged in the business of underwriting and distributing securities issued by other persons, selling securities to customers, acting as broker, and acting as market intermediary, or any one or more of such activities, whose gross income normally is derived principally from such business and related activities.

Funding portals are engaged in the business of distributing securities issued by other persons (issuers) and should therefore fall within that description.

Two related issues.

Effect of Upstream Distribution: The owners of the funding portal would like to protect the pool of securities from the potential liabilities of the funding portal business (e.g., if the portal has been using a series LLC as a crowdfunding vehicle). Their first thought might be to distribute the securities upstream to the parent company and then put them into a new, wholly-owned subsidiary. But be careful. The new subsidiary might cause the parent to be treated as an investment company.

Effect on Option Pool:  Suppose the funding portal continues to own the securities, either directly or in a wholly-owned subsidiary. On one hand, the potential value of the securities would be attractive to employees and others holding options in the funding portal. On the other hand, the fair-market-value rules of section 409A of the tax code would require the funding portal to place a value on the securities frequently and, as the value of the securities climbs in relation to the value of the funding portal’s business, the value of the options would be less and less correlated with the success of the business, defeating the purpose.

Questions? Let me know. 

audience asking questions by raising hands

The Series LLC And Crowdfunding Vehicle: A Legal Explanation And A Funding Portal WSP

On By crowdfundattnyIn Crowdfunding Portals, Crowdfunding Vehicles, Series LLC2 Comments

Lots of people have asked for a legal explanation in response to my previous post about crowdfunding vehicles and the series LLC. Plus, many funding portals will want a Written Supervisory Procedure (WSP) addressing the issue.

Here’s the legal reason why a “series” of a limited liability company can’t serve as a crowdfunding vehicle.

Rule 3a-9(b)(1) (17 CFR §270.3a-9(b)(2)) defines “crowdfunding vehicle” as follows:

Crowdfunding vehicle means an issuer formed by or on behalf of a crowdfunding issuer for the purpose of conducting an offering under section 4(a)(6) of the Securities Act as a co-issuer with the crowdfunding issuer, which offering is controlled by the crowdfunding issuer.

You see the reference to the crowdfunding vehicle as an “issuer” and a “co-issuer.”

Now here’s a C&DI (Compliance & Disclosure Interpretation) issued by the SEC in 2009:

Question 104.01

Question: When a statutory trust registers the offer and sale of beneficial units in multiple series, or a limited partnership registers the offer and sale of limited partnership interests in multiple series, on a single registration statement, should each series be treated as a separate registrant?

Answer: No. Even though a series of beneficial units or limited partnership interests may represent interests in a separate or discrete set of assets – and not in the statutory trust or limited partnership as a whole – unless the series is a separate legal entity, it cannot be a co-registrant for Securities Act or Exchange Act purposes.

Note the conclusion:  “. . . .unless the series is a separate legal entity, it cannot be a co-registrant for Securities Act or Exchange Act purposes.”

A “series” of a limited liability company is not a separate legal entity. Under section 218 of the Delaware Limited Liability Company Act and corresponding provisions of the LLC laws of other states, if you keep accurate records then the assets of one series aren’t subject to the liabilities of another series. That makes a series like a separate entity, at least in one respect, but it doesn’t make the series a separate legal entity. A motorcycle is like a car in some respects but it’s not a car.

That’s the beginning and end of the story:  a crowdfunding vehicle must be an “issuer”; a series of a limited liability company can’t be an “issuer” because it’s not a separate legal entity; therefore a series of a limited liability company can’t be a crowdfunding vehicle.

Maybe someone will challenge the application of the C&DI in court. Until that happens the result is pretty clear.

A couple more things.

First, this same C&DI is the basis of many successful offerings under Regulation A. Suppose, for example, that you’d like to use Regulation A to raise money for real estate projects (or racehorses, or vintage cars, or anything else), but you don’t want to spend the time and money to conduct a Regulation A offering for each project. This same C&DI allows sponsors to treat the “parent” limited liability company as the only “issuer” in the Regulation A offering even while allowing investors to choose which project they’d like to invest in and segregating the projects in separate “series” for liability purposes. If each series were a separate issuer that wouldn’t work.

Second, suppose a funding portal creates a new series for each offering and has conducted 25 offerings (that is, 25 series for 25 crowdfunding vehicles), each with a different type of security (one for each offering). Because we know that only the “parent” can be an issuer:

  • They’ve violated Rule 3a-9(a)(3) because the parent has issued more than one class of securities; and
  • They’ve violated Rule 3a-9(a)(6) because there is no one-to-one correspondence between the securities of the parent and the securities of the crowdfunding issuer.

To quote Simon & Garfunkel, any way you look at this you lose.

If you’re a funding portal, you’ll probably be asked by FINRA to add a WSP dealing with crowdfunding vehicles. Here’s an example.

Questions? Let me know. 

Reinvigorate American Capitalism Through Crowdfunding

How Can Sponsors Raise More Money When A Deal Goes South?

On By crowdfundattnyIn PodcastsLeave a comment

When a real estate deal goes bad as many are doing now, should limited partners have the right of first refusal to invest rescue capital on the same terms as anything the sponsor can bring in to save the deal?

My podcast guest today, attorney Mark Roderick, calls it ‘pre-emptive rights’ and, as you will hear, he explains it can make the best of a bad situation.

But what does that look like in reality?

Here’s the script:

***

Email #1: From Sponsor to Limited Partners (Investors):

Subject Line: We’re stopping distributions and need more money from you

Sorry investors, we screwed up because we [select from the following]

  1. Didn’t manage the property aggressively enough to account for a downturn.
  2. Underwrote debt levels to eternally low interest rates on variable rate terms and now can’t afford the doubling of our debt costs.
  3. Our original loan is maturing, the value of the property has gone down, debt costs have skyrocketed, rent growth is not what we assumed in our proforma, and the bank will only lend us 60% of our original loan amount.
  4. Cap rates are now nearing 6% not the 4% we projected.
  5. Thought this time was different.

In sum, we need you to pony up more equity so we can avoid losing the property to the bank.

***

Email #2: From Sponsor to Rescue Capital fund (pref equity, mezz debt, whatever)

Subject Line: Have we got a deal for you!

Our offering docs allow us to bring in additional capital under any terms. Our bank will only lend us 60% of the original loan amount so we need to shore up the difference. Can you help us.

***

Email #3: From Rescue Fund to Sponsor

Subject Line: We’re in!

Sure. We’ll come in with the 40% you need. We want second position behind the bank (ahead of your existing LPs) and if you miss proforma targets or fail to pay us on time, we’’ll remove you as GP and wipe out your LPs’ equity.

***

Email #4: From Sponsor to Investors

Subject Line: Great news! We’ve found some rescue capital.

You get first right of refusal on the terms we just got to protect your investment.

Terms are that your new capital will come in ahead of your old [or dilute it out completely], and if we screw up again, you get to remove us as GP.

Please accept these terms or someone else gets them.

Oh, and by the way, the Rescue Capital wants all or nothing so we need unanimous agreement from all Investors or we go with the Rescue Capital.

***

Is this an ‘offer’ or a ‘threat’?

Or is the dialogue different somehow?

At the end of the day, does having pre-emptive rights (right of first refusal) really mean anything?

Advocating for Intellectual Honesty in the Legal Sphere With Mark Roderick

On By crowdfundattnyIn Crowdfunding Interview, Crowdfunding Interviews, PodcastsLeave a comment

In this episode… Why is intellectual honesty important for lawyers? By prioritizing what is morally correct over personal gain, lawyers strengthen the lawyer-client relationship and contribute to a fair and just society. Upholding the integrity of the legal profession and ensuring that justice is served depends on attorneys’ commitment to ethical principles — even when they don’t benefit from what they advocate.

As a math major, Mark Roderick was exposed to the world of math proofs and abstract thinking. Realizing he desired to work with people and help solve problems in the real world, he applied to law school. Unlike other professionals in the industry, Mark has a passion for doing what is right at all times — and seeks out others who value intellectual honesty over financial gain. Respecting your integrity, both in your profession and personal life, strengthens your relationships as individuals grow to trust you have their best interest in mind.

In this episode of 15 Minutes, Chad Franzen sits down with Mark Roderick, Principal Partner at Lex Nova Law, to discuss how sharing the same values impacts your work environment. Mark also talks about what inspired him to pursue a career in law, how his background in math has contributed to his career, and how he started his crowdfunding blog.

Resources mentioned in this episode:

Chad Franzen on LinkedIn – https://www.linkedin.com/in/chadfranzen

Gladiator Law Marketing – https://gladiatorlawmarketing.com

Mark Roderick on LinkedIn – https://www.linkedin.com/in/markroderick/

Lex Nova Law – https://www.lexnovalaw.com/

Crowdfunding & FinTech Law Blog – https://crowdfundingattorney.com/

Caution: Don't Use Series LLC As A Crowdfunding Vehicle

FINRA: Don’t Use Series LLC As A Crowdfunding Vehicle

On By crowdfundattnyIn Crowdfunding, FINRA, Series LLC2 Comments

At least one high-volume Crowdfunding portal once used a “series LLC” for each crowdfunding vehicle and used a crowdfunding vehicle for almost every offering. Maybe that portal and others still do.

In a post that has yet to be picked up by the Associated Press, this blog once explained why that was a bad idea from a legal liability point of view. Now FINRA has chimed in.

The Series LLC

Some states, notably Delaware, allow a single limited liability company to be divided into “series,” the way an auditorium could be physically divided into cubicles. If operated correctly, Delaware provides that the creditors of one series can’t get at the assets of another series. So if one series of the LLC operates an asbestos plant and is hit with a giant lawsuit, the plaintiffs can’t get at the assets of the real estate owned by a different series of the same LLC.

Why Not to Use a Series LLC

I argued that it would be foolish to use a series LLC as a crowdfunding vehicle because:

  1. The series LLC concept has never been tested in a bankruptcy court, so we’re still not 100% sure the walls between cubicles will hold up.
  2. Some states, like Arizona, don’t even recognize the series LLC concept. So if an Arizona resident invests in a series LLC that goes bad, she can theoretically get to the assets owned by every other series of the same LLC. When you have a high-volume portal using a new series over and over, that could be a nightmare.
  3. Using a series LLC rather than a brand new LLC saves less than $200.

FINRA Chimes In

According to a recent statement by FINRA, a series LLC would not satisfy 17 CFR §270.3a-9(a)(6), which requires a crowdfunding vehicle to “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.”

FINRA is saying, in effect, that while one series of an LLC might be protected from the liabilities of a different series under Delaware law, the series is not itself an “issuer.” The “issuer” is the LLC itself, i.e., the “parent” limited liability company formed by the portal. Because the securities of that parent do not reflect a one-to-one correspondence with the securities of any particular company raising money on the platform, it doesn’t qualify as a crowdfunding vehicle – it’s a plain vanilla investment company. And investments companies aren’t allowed to use Reg CF (they’re also subject to a bunch of other rules).

For what it’s worth, FINRA’s position about who can be an “issuer” is consistent with SEC practice.

The Upshot

If FINRA is right, it probably means that every offering that used a series LLC as a crowdfunding vehicle was illegal. 

Some possible ramifications:

  • Any investor who lost money can sue the issuer and the funding portal, and possibly their principals.
  • Every issuer can sue the funding portal.
  • Funding portals might be sanctioned by FINRA.

In short, a bonanza for plaintiffs’ lawyers and a black eye for the Crowdfunding industry.

Questions? Let me know. 

chess board raising capital

Improving Legal Documents In Crowdfunding: Give Yourself The Right To Raise More Money

On By crowdfundattnyIn Crowdfunding, Crowdfunding LawsLeave a comment

Interest rates have gone up, real estate valuations have gone down, banks have disappeared, and investors have become more cautious. Many real estate sponsors, faced with looming loan repayments, wonder how they’re going to raise more equity.

They might be surprised when they check the Operating Agreement. Too often, Operating Agreements prohibit the sponsor from raising more equity without the consent of a majority of the LPs or even a single large investor. And getting that consent might not be easy or even possible, for several reasons:

  • Existing investors might not agree that new money is needed.
  • Existing investors might be unrealistic about market conditions, thinking the new equity can have the same terms as the existing equity.
  • Existing investors hate being diluted.
  • Existing investors might prefer to contribute the new money themselves on terms the sponsor believes are exorbitant.
  • A large investor might be angling to buy the property for itself at a fire sale price.

When times are good and the Operating Agreement is signed those possibilities seem far-fetched. Then you get to an April 2023.

Knowing that an April 2023 is always on the horizon, sponsors should negotiate hard at the outset for the right to raise more equity. They won’t always get it because people who write very large checks usually get what they want (that’s why we call it “capitalism”). But in my experience, too many sponsors give away the right too easily or don’t even think about it.

If the sponsor has the right to raise more equity, how do we protect the original investors? What’s to stop the sponsor from raising equity from her own family or friends on terms very favorable to them and very unfavorable to existing investors, even if the equity isn’t needed? 

The answer is “preemptive rights.” If the sponsor wants to raise more equity, she must offer the new equity to existing investors first. Only if they don’t buy it may she offer it to anyone else.

Preemptive rights aren’t perfect. The main flaw is that Investor Jordan, who had money to invest when the deal was launched, has fallen on harder times and doesn’t have money to participate in the new round. Or Mr. Jordan does have the money to participate but is no longer accredited and therefore can’t participate. 

Even with the flaws, preemptive rights generally allow for the equitable resolution of a difficult situation, much better than the alternatives most of the time.

You can see my form here. Let me know if you think it can be improved.

NOTE:  Sponsors might also consider “capital call” provisions, i.e., provisions allowing them to demand more money from investors if needed. In my opinion, however, they typically do more harm than good, driving away investors at the outset while not providing enough cash when it’s needed. And in practical terms, a large investor who would balk at allowing the sponsor to raise more equity certainly won’t agree to an unlimited capital call.

Questions? Let me know.