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.