The Legal Liability of Funding Portals: Update for TruCrowd Complaint

On By crowdfundattnyIn Crowdfunding, Crowdfunding Liabilities, Crowdfunding PortalsLeave a comment

A few weeks ago I posted about the potential legal liability of funding portals. Lo and behold, on September 20, 2021 the SEC brought an enforcement action against an issuer and its principals, and also against the funding portal, TruCrowd, Inc., dba Fundanna, and its owner, Vincent Petrescu.

Here’s a link to the Complaint. If you take the Complaint at face value – and readers should bear in mind that there are least two sides to every story – this is a lesson in how a funding portal can get into hot water with a questionable issuer.

The allegations against the issuer and its principals are straightforward:  they failed to disclose the criminal record of one of the principals; they used investor money for personal purposes; they misled investors about a purported real estate project.

More interesting for our purposes are the allegations against the funding portal and its owner. Calling TruCrowd and Mr. Petrescu “gatekeepers,” the SEC alleges, among other things, that:

  • TruCrowd and Mr. Petrescu allowed the offerings to proceed despite multiple warning signs of possible fraud or other harm to investors.
  • Mr. Petrescu participated in drafting the inaccurate Form C and offering statement.
  • TruCrowd and Mr. Petrescu failed to order a “bad actor” check.
  • Mr. Petrescu ignored warning from a securities lawyer.

It’s hard to walk away from a big commission. But this enforcement action illustrates that sometimes you have to.

Publicly-Traded Partnerships: The Trap for LLCs Traded on ATS

On By crowdfundattnyIn LLCsLeave a comment

One drawback of private companies is they’re not liquid, meaning you can’t sell your shares easily. That’s why lots of people are spending lots of time and money creating secondary markets for private companies. These secondary markets typically take the form of an “alternative trading system,” or ATS, owned and operated by a broker-dealer. More on secondary markets here.

If you’re raising money for an LLC it’s attractive to have the interests traded on an ATS because you can tell prospective investors they’ll have liquidity, in theory if not in practice. But there’s a drawback, too:  if interests of in the LLC are traded on an ATS then the LLC might be treated as a corporation for tax purposes, not as a partnership, with potentially bad consequences.

If you’re interested in the differences between partnerships and corporations you can read this, but suffice it to say that (i) if you’re an LLC you probably made that choice intentionally, and (ii) a corporation is subject to two levels of tax on exit, significantly reducing the anticipated after-tax return to investors.

Under section 7704 of the Internal Revenue Code, a partnership (including an LLC taxed as a partnership) will be treated as a corporation for tax purposes if either:

  • Interests in the partnership are traded on an established securities market; or
  • Interests in the partnership are readily tradable on a secondary market “or the substantial equivalent thereof.”

The interests in a private LLC typically aren’t going to be traded on NASDAQ or any other established securities market, so we don’t worry about the first rule. But we do worry about the second rule. Interests in a partnership will be deemed readily tradable on a secondary market or the equivalent if:

  • Interests in the partnership are regularly quoted by any person, such as a broker or dealer, making a market in the interests; or
  • Any person regularly makes available to the public (including customers or subscribers) bid or offer quotes with respect to interests in the partnership and stands ready to effect buy or sell transactions at the quoted prices for itself or on behalf of others; or
  • The holder of an interest in the partnership has a readily available, regular, and ongoing opportunity to sell or exchange the interest through a public means of obtaining or providing information of offers to buy, sell, or exchange interests in the partnership; or
  • Prospective buyers and sellers otherwise have the opportunity to buy, sell, or exchange interests in the partnership in a time frame and with regularity and continuity.

Focus on the third bullet point. The whole point of listing LLC interests on an ATS is to give investors a readily available, regular, and ongoing opportunity to sell or exchange the interest. Hence, listing your LLC’s interests on an ATS will automatically turn your partnership into a corporation for tax purposes – unless you satisfy one of the exceptions.

This is the Internal Revenue Code so there are exceptions and exceptions to the exceptions and so on. How else would lobbyists put food on the table?

These are the primary exceptions:

  • Exception for Private Placements:  Your LLC raised capital in a private offering (including Rule 506(c) and Reg CF) and has no more than 100 members.
  • No Actual Trading:  Interests in your LLC are listed on an ATS but no more than 2% of all interests are traded each year.
  • Exception for Passive Income and the Oil & Gas Industry:  At least 90% of your LLC’s income is from interests, dividends, rent, gains from the sale of real estate or capital assets, or the oil & gas business.
  • Qualified Matching Service:  Interests in your LLC are traded only through a “qualified matching service” and no more than 10% of the interests are traded each year. A qualified matching service is where:
    • The service consists of a system that lists bid and/or ask quotes in to match sellers to buyers;
    • Matching occurs either by matching the list of buyers with the list of sellers or through a bid and ask process;
    • The selling partner cannot enter into a binding agreement to sell the interest until the 15th day after the date information regarding the offering of the interest for sale is made available to potential buyers;
    • The closing of the sale does not occur prior to the 45th day after the date information regarding the offering of the interest for sale is made available to potential buyers;
    • The matching service displays only quotes that do not commit any person to buy or sell a partnership interest at the quoted price or quotes that express interest in a partnership interest without an accompanying price and does not display quotes at which any person is committed to buy or sell a partnership interest at the quoted price;
    • The selling partner’s information is removed from the matching service within 120 days after the date information regarding the offering of the interest for sale is made available to potential buyers and, following any removal (other than removal by reason of a sale of any part of such interest) of the selling partner’s information from the matching service, no offer to sell an interest in the partnership is entered into the matching service by the selling partner for at least 60 days.

Many real estate LLCs will satisfy the exception for passive income (real estate rent), although they should be careful with other sources of income, like income from a parking lot or laundry facility. Most LLCs in the oil & gas business will satisfy the same exception because it was written for them. An LLC formed to hold treasury bonds is obviously okay.

But the large majority of LLCs raising money in Crowdfunding conduct other businesses, everything from technology to baby wipes. These companies must weigh the benefit of trading on an ATS – theoretical liquidity – against the cost of being treated as a corporation for tax purposes.

NOTE:  You could list the interests of your LLC on an ATS but limit trading to stay below the allowed annual thresholds. But of course that limits liquidity for your investors, taking some of the air out of your marketing message.

Use A Third Party To Verify Investors Under Rule 506(c)

On By crowdfundattnyIn Rule 506, Rule 506(c)Leave a comment

An issuer raising capital under Rule 506(c) must take “reasonable steps” to verify that investors are accredited. Rule 506(c)(2)(ii) specifies several steps that will be deemed reasonable, like getting a letter from the investor’s accountant.

Looking to save money, some issuers are tempted to verify investors themselves rather than using a third-party service like VerifyInvestor. For most issuers I think that’s a bad idea.

Suppose a non-accredited investor gets into your deal by forging a letter from an accountant, whiting out the numbers on her tax return, or because someone in your office makes a mistake. The deal goes south, investors lose money, and a clever plaintiff’s lawyer learns about the non-accredited investor. “The offering was illegal!” he claims. “Investors get their money back!”

You say, “But the letter from the accountant!” The plaintiff’s lawyer says, “You should have called the accountant’s office!”

You say, “The numbers on the tax return were whited out!” The plaintiff’s lawyer says, “The new numbers are in a different font!”

You say, “Everyone makes mistakes!” The plaintiff’s lawyer says, “But this mistake wasn’t reasonable!”

What you have are (1) a big headache, and (2) a lawsuit that’s not getting thrown out on summary judgement. Sorry for all the exclamation points but that’s the tenor of litigation.

Now suppose you used a reputable third party to verify investors. The plaintiff’s lawyer, who is working on a contingency, writes his demand letter and you respond “Sorry, I used XYZ Corp., an industry leader in investor verification.” I suspect the plaintiff’s lawyer doesn’t take the case. I think there’s a very strong argument that by hiring XYZ Corp. you have automatically taken “reasonable steps.”

For $50 per investor or whatever it is, that seems to me about as close to a no-brainer as they come.

Three points.

One, I said this is true for most issuers. A large issuer with lots of investors and an established, professionally-managed investor relationship department might be able to absorb the new responsibilities with proper training.

Two, Rule 506(c) is the only offering exemption that requires verification. In offerings conducted under Rule 506(b), Regulation A, and Reg CF, issuers are allowed to take investors at their word.

Three, suppose an issuer using Rule 506(c) does nothing to ensure that investors are accredited but they’re all accredited anyway. The issuer can still be sued successfully by that clever plaintiff’s lawyer. The obligation to take “reasonable steps” is independent of the requirement that all investors must be accredited.

Questions? Let me know.

New Podcast – In-Depth Commercial Real Estate

On By crowdfundattnyIn Crowdfunding Real Estate, Real EstateLeave a comment

In this episode Paul speaks to Crowdfunding attorney Mark Roderick about Crowdfunding in real estate. They go in-depth how the JOBS act that created crowdfunding changed funding portals, advertising, and where the future of raising capital is and what sponsors should focus on and be careful with.

In-Depth Commercial Real Estate

In-Depth Commercial Real Estate is an exploration of the people, ideas, strategies, and methods behind commercial real estate. In each episode, we’ll talk to an expert about a particular topic: from CMBS and cap. rates to innovation and hiring strategies, and everything in between.

Disclaimer: This real estate podcast is for informational and educational purposes only and does not imply suitability. The views and opinions expressed by the presenters are their own. The information is not intended as investment advice.For any inquiries or comments, you can reach us as info@indepthrealestate.com.

Questions? Let me know.

Crowdfunding web portal

The Legal Liability of A TITLE III Funding Portal

On By crowdfundattnyIn Crowdfunding Portals, Title III, Title III CrowdfundingLeave a comment

In this blog post I summarized the potential legal liability of issuers raising capital using Title II Crowdfunding (aka Rule 506(c)), Title III Crowdfunding (aka Reg CF), and Title IV Crowdfunding (aka Regulation A). Here, I’ll summarize the potential legal liability of a registered Title III funding portal.

To start, let’s distinguish between two kinds of liability:  liability to the government (e.g., to the SEC) for breaking rules; and liability to private parties. Most people think about the first kind of liability but often the second is more important. The government doesn’t know about most violations of securities laws and even if it knows must pick and choose which cases to prosecute. Conversely, private parties – issuers and investors – are likely to know about actual or potential violations and there are plenty of plaintiffs’ lawyers willing to take a shot.

Section 4A(c) of the Securities Act

Section 4A(c) of the Securities Act of 1933 makes an “issuer” liable to an investor where:

  • The issuer made an untrue statement of a material fact or omitted to state a material fact required to be stated or necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading;
  • The investor didn’t know of the untruth or omission; and
  • The issuer cannot demonstrate that the issuer did not know, and in the exercise of reasonable care could not have known, of the untruth or omission.

The statute defines “issuer” to include:

  • Any person who is a director or partner of the issuer;
  • The principal executive officer, principal financial officer, and controller or principal accounting officer of the issuer;
  • Any person occupying a similar status or performing a similar function, regardless of title; and
  • Any person who offers or sells the security in the Reg CF offering.

The SEC has declined to say one way or another whether a funding portal is an “issuer” for these purposes. Given the role of funding portals in presenting securities to the public, however, it seems likely except in unusual circumstances.

If a funding portal is an issuer and a Form C contains false statements or omits important information, the funding portal would be liable to private lawsuits from investors unless the funding portal can prove that it didn’t know about the false statements or omissions and couldn’t have learned about them by exercising reasonable care.

The language of section 4A(c) is very similar to the language of section 12(a)(2) of the Securities Act, which applies to public companies. But the playing field is different. The document used in a public filing – a prospectus – is typically subject to layer upon layer of due diligence, not only by the issuer and its lawyers but also by the underwriter and others. In contrast, many of the Form Cs we see on funding portals are prepared by people with little or no experience in securities, typically online. I expect to see lots of litigation under section 4A(c), as courts decide what “reasonable care” means for funding portals.

Private Lawsuits:              Yes

Rule 10b-5

17 C.F.R. §240.10b-5, issued by the SEC under section 10(b) of the Exchange Act, makes it unlawful, in connection with the purchase or sale of any security:

  • To employ any device, scheme, or artifice to defraud,
  • To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
  • To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.

Liability arises under Rule 10b-5 only with the intent to deceive, known in legal jargon as “scienter.”

The Supreme Court has held that only the person who “makes” a deceptive statement or omission can be liable under the second prong of Rule 10b-5 – not a person who merely disseminates the statement innocently. But that begs the question:  does a funding portal merely disseminate information from issuers, or does it “make” the statements along with the issuer? Given the role of funding portals in Reg CF, very possibly the latter, although that could depend on the facts of a given case.

But that question could be moot. Under recent court decisions, a funding portal that knows about the misleading statements or omissions and allows them on its website anyway could be liable under either the first or third prongs of Rule 10b-5.

Private Lawsuits:              Yes

Section 17(a) of the Securities Act

Section 17(a) of the Securities Act makes it unlawful for any person, including the issuer, in the offer or sale of securities, to:

  • Employ any device, scheme, or artifice to defraud, or
  • Obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or
  • Engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.

Even if it is not the issuer, a funding portal participating in a scheme to mislead investor could be subject to section 17(a) of the Act just as it could be liable to investors under Rule 10b-5.

Private Lawsuits:              No

Crowdfunding and FINRA Regulations

A funding portal that violates the regulations issued by the SEC or FINRA could be sanctioned or, in the extreme case, have its registration with the SEC and/or its membership in FINRA suspended, effectively putting it out of business.

An investor who loses money and learns that the funding portal violated SEC regulations will probably claim that the regulatory violation gives rise to a private right of action – that is, that if she was harmed by the regulatory violation then she can sue the funding portal. Although we can never say never, her claim should fail.

Private Lawsuits:              No

State Common Law

A funding portal could be liable to investors under a variety of state “common law” (as opposed to statutory law) theories, including fraud and misrepresentation. In the typical case, the investor would try to show that (i) the issuer did something wrong, and (ii) the funding portal is responsible for it.

Private Lawsuits:              Yes

Liability to Issuers

Funding portals will be sued by issuers. Among the possible claims:

  • The funding portal made promises about the offering that proved false (e.g., “You’re sure to raise at least $2 million!”);
  • The funding portal conducted the offering ineffectively (e.g., failing to notify subscribers by email);
  • The funding portal made factual misrepresentations (e.g., the number of its registered users or the percentage of its successful raises); and
  • Actions by the funding portal caused the issuer to face lawsuits from investors (e.g., the funding listed the issuer’s year-over-year revenue growth as 1,300% rather than 130%).

Private Lawsuits:              Yes

Criminal Rules

If a funding portal really screws up, it could even be subject to Federal and state criminal penalties, including:

  • Criminal penalties for intentionally violating securities laws
  • Criminal penalties for mail fraud
  • Criminal penalties for wire fraud
  • Criminal penalties for violating the Racketeer Influenced and Corrupt Organizations

Liability of People

Entrepreneurs too often believe that operating through a corporation or other legal entity protects them from personal liability. For example, an entrepreneur on her way to a business meeting swerves to run over a gaggle of doctors and jumps from her car, laughing. “You can’t sue me, I operate through a corporation!”

No. She did it, so she’s personally liable, corporation or no corporation. If her employee did it, the story might be different (unless he was drunk when she handed him the keys).

The same is true in securities laws. To the extent you’re personally making decisions for the funding portal, all the potential liability I’ve described applies to you personally as well.

Reducing Your Risk

A funding portal can and should take steps to reduce its legal risk. These include:

  • Strong Contract with Issuers:  Funding portals should have a strong contract with issuers, clearly defining who is responsible for what and disclaiming liability on the funding portal’s part.
  • Training:  A junior employee of a funding portal once told my client to do something that clearly violated the securities laws. Recognizing that funding portals, like other employers, are liable for the acts of their employees, funding portals should have in place a strong training program. Among other things, employees should know about the funding portal’s potential liability and be familiar with its Manual of Policies & Procedures.
  • Due Diligence Processes:  Funding portals should have in place processes and policies for conducting due diligence. How much due diligence is required is an open question, but if a funding portal is sued for failing to discover a misstatement in a Form C, it’s going to be asked about its due diligence policies. The answer can’t be “None.”
  • Insurance:  Like any other business, funding portals should carry insurance. Even a very weak lawsuit can cost hundreds of thousands of dollars to defend.
  • Culture:  The sea at the tip of South America is among the roughest in the world, as two oceans collide. Crowdfunding is like that, sort of. On one hand, Crowdfunding is new and disruptive and attracts people who want to do something. On the other hand, the legal landscape in which Crowdfunding takes place is old and well-worn, developed before many American homes had radio. Leaping into the brave new world of online capital formation, eager to move fast and at least dent things, funding portals must nevertheless create a culture that takes seriously the often-tedious responsibility associated with selling securities.

Using Reg CF To Raise Money For A Non-U.S. Business

On By crowdfundattnyIn Title III, Title III CrowdfundingLeave a comment

To use Reg CF (aka Title III Crowdfunding), an issuer must be “organized under, and subject to, the laws of a State or territory of the United States or the District of Columbia.” That means a Spanish entity cannot issue securities using Reg CF. But it doesn’t mean a Spanish business can’t use Reg CF.

First, here’s how not to do it.

A Spanish entity wants to raise money using Reg CF. Reading the regulation, the Spanish entity forms a shell Delaware corporation. All other things being equal, as an entity “organized under, and subject to, the laws of a State or territory of the United States,” the Delaware corporation is allowed to raise capital using Reg CF. But all other things are not equal. If the Delaware corporation is a shell, with no assets or business, then (i) no funding portal should allow the securities of the Delaware corporation to be listed, and (ii) even if a funding portal did allow the securities to be listed, nobody in her right mind would buy them.

Here are two structures that work:

  • The Spanish business could move its entire business and all its assets into a Delaware corporation. Even with no assets, employees, or business in the U.S., the Delaware corporation could raise capital using Reg CF, giving investors an interest in the entire business.
  • Suppose the Spanish company is in the business of developing, owning, and operating health clubs. Today all its locations are in Spain but it sees an opportunity in the U.S. The Spanish entity creates a Delaware corporation to develop, own, and operate health clubs in the U.S. The Delaware corporation could raise capital using Reg CF, giving investors an interest in the U.S. business only.

NOTE:  Those familiar with Regulation A may be excused for feeling confused. An issuer may raise capital using Regulation A only if the issuer is managed in the U.S. or Canada. For reasons that are above my pay grade, the rules for Reg CF and the rules for Regulation A are just different.

Questions? Let me know.

Arizonia and the Series LLC

On By crowdfundattnyIn UncategorizedLeave a comment

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?

On By crowdfundattnyIn Title II, Title II Crowdfunding, Title III, Title III CrowdfundingLeave a comment

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, providing that a Reg CF issuer may use a “crowdfunding vehicle” to issue securities to investors, thereby adding only one entry to its own cap table.

The use of SPVs to own securities is common in the Title II (Rule 506(c)) world and in the world of securities generally. 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.

When the regulations were proposed, CrowdCheck (Sara Hanks) submitted the comment pointing out that because of the differences in laws among types of entities and states, it would be difficult or impossible for the rights associated with owning an issuer to be identical to the rights associated with owning a crowdfunding vehicle. When the final regulations were issued, the SEC had not changed the language of the regulation and responded to comment as follows:

“As one commenter pointed out, because investors are investing in the crowdfunding vehicle, and not directly in the crowdfunding issuer, there may be slight differences in the rights in the crowdfunding vehicle that investors receive. However, we do not believe these slight differences in rights should in any way affect the ability of the crowdfunding vehicle to issue securities with rights that are materially indistinguishable from the rights a direct investor in the crowdfunding issuer would have [bold added].”

The differences in rights described in the CrowdCheck’s comments were not “slight.” To the contrary, the differences in rights between, say, a New Jersey corporation and a Delaware limited liability company would be “material” in any other area of the securities laws. Having filed a registration statement that identified the wrong type of entity and the wrong state, I can imagine a lawyer arguing to the SEC staff “Who cares? Those are only slight differences!”

How should we interpret the SEC’s response? Why didn’t the SEC just change the language of the regulation, rather than pretend the differences in state laws aren’t “material”? Can issuers and funding portals do whatever they want?

There are two issues:

  • The first issue is just cost. Issuers and portals want to automate SPVs, using the same type of entity, the same state, and the same contracts for all of them.
  • The second issue is taxes. If the issuer is a corporation and the crowdfunding vehicle is also a corporation, then dividends paid by the issuer to the crowdfunding vehicle will be subject, in part, to double tax.

The question is more than academic. When investors lose money they’re unhappy and often look for someone to blame. If a Mississippi corporation uses a Delaware limited liability company as a crowdfunding vehicle and an investor loses money, a clever plaintiff’s lawyer (no jokes here) won’t find it hard to argue that the Delaware LLC failed to qualify under 17 CFR §270.3a-9 and that the offering was therefore illegal, giving his client the right to get her money back from the issuer and its principals and possibly from the funding portal and its principals as well.

As readers know, I think the SEC has done a terrific job with Crowdfunding, going out of its way to support the industry time after time. For that matter, the SEC introduced crowdfunding vehicles only because of the mistaken impression that Crowdfunding “screws up your cap table.” As crowdfunding vehicles become more widely-used, however, I think more straightforward guidance is required, if only to dissuade clever plaintiffs’ lawyers. For example, the SEC could say explicitly “Differences in rights arising solely from state laws governing corporations, limited liability companies, limited partnership and other legal entities will not be taken into account for these purposes.”

Until that happens, I would be cautious and bear in mind that issuers don’t really need a crowdfunding vehicle in the first place.

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

On By crowdfundattnyIn TaxLeave a comment

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

On By crowdfundattnyIn Title III, Title III Crowdfunding, UncategorizedLeave a comment

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.