Earlier this month I had the pleasure of being interviewed by Reed Goossens, who speaks with a strange accent but knows a heck of a lot about real estate. During the program, the third installment in Reed’s series on U.S. real estate syndication, I talked about raising capital from non- U.S. investors and other more general issues that face syndicators and investors.
If you’re interested, you can listen to the podcast here.
On March 4th I had the pleasure of co-presenting a workshop on Regulation A (Title IV Crowdfunding) in Mountain View, California, at an event organized by Crowdfund Beat. My co-presenter, Jillian Sidoti of SyndicationLawyers.com, is a terrific person, an engaging speaker, and one of the country’s leading authorities on Regulation A.
I hope you enjoy our conversation and get a sense of the real-life practicalities of preparing and filing a Regulation A offering.
CrowdFund Beat Media International is an online source of news, information, events and resources for the crowdfunding industry. Currently we cover the USA, Canada, the UK, Italy, Germany, France, and Holland, and soon we’ll be expanding to Spain, Australia, Japan and China. We think of our work as an educational and informative service to the crowdfunding community, and appreciate your suggestions.
Guest Co-Author: Benjamin L. Roderick
What Is Blockchain?
Blockchain is the term given to a highly sophisticated database tool that allows “distributed verification.” Most of us heard about blockchain because it is the technological backbone of Bitcoin, the alternative currency, but the possible applications go far beyond that.
To understand what “distributed verification” means, let’s look at a typical Bitcoin transaction, where Franchesca uses her Bitcoin currency to buy a TV from Herb.
On the surface, the transaction is simple: Herb gives Franchesca his TV and Franchesca gives Herb some Bitcoin. But how does Herb know that Franchesca actually owns Bitcoin? And how does he get it from her? The answer is the blockchain. Distributed all over the world, the blockchain verifies that Franchesca owns Bitcoin, and then records the transfer from Franchesca to Herb, so Herb can use the Bitcoin to buy groceries from Janet.
Benefits of Blockchain
The primary benefits of the blockchain are:
Here’s a table illustrating where and how blockchain technology can add value:
Blockchain technology isn’t perfect yet; some might say it’s not even ready for prime time. Today, the primary drawback is how long it takes to authenticate transactions. A transaction today in Bitcoin takes about 10 minutes to clear, and Bitcoin is a microscopic market compared to, say, credit card transactions. Indeed, the Bitcoin community is engaged in a civil war as to how, or even whether, to change the technology to speed up transactions.
Application of Blockchain Technology
But you can understand why blockchain technology is attracting so much interest from government and private industry. For example, the music industry is plagued by uncertainty over ownership of rights. The title industry exists because of uncertainty as to the ownership of real estate. Credit card issuers spend tens (hundreds?) of millions of dollars processing and authenticating transactions. Airlines have yet to find a way to ensure that every plane is late.
Everyone wants a secure, decentralized, efficient network that can authenticate transactions or information, as long as the FBI gets a back door (no joke).
Here are some possible applications in the Crowdfunding industry:
Crowdfunding and blockchain are both pieces of the FinTech industry. We’re going to see blockchain startups raising money using Crowdfunding, and we’re going to see Crowdfunding companies using blockchain technology. A blockchain startup using a Crowdfunding company that uses blockchain technology – that’s not far down the road.
Ben Roderick is currently working on blockchain applications for his MBA Capstone project at Carnegie Mellon University, graduating in May 2016. His email address: Broderic@tepper.cmu.edu.
Questions? Let me know.
Title III requires all these disclosures, reported on the new Form C:
As I write this, a lot of very smart entrepreneurs and software engineers are working to automate these disclosures. They have to: to make money running a Title III portals, you’re going to have to automate everything that can be automated.
Now look at Title II. As a write this, the disclosures for almost all Title II deals are prepared the old-fashioned way, with a lawyer writing an old-fashioned Private Placement Memorandum. The PPM for Deal 1 on Portal X might or might not include the same information as the PPM for Deal 2 on Portal X, and almost certainly doesn’t include the same information or look the same as the PPM for deals on Portal Y. An investor trying to compare apples to apples would go, well, bananas.
That situation is ripe (sorry) for change and I think it will change as Title III comes online, for three reasons:
Questions? Let me know.
Most Title II and Title IV portals will also want to operate Title III portals, and vice versa. Can they do it?
The Title III regulations issued by the SEC appear to contemplate that a Title III portal – a “funding portal” – will do more than operate a Title III portal. For example, 17 CFR §227.401 provides that “A funding portal. . . .is exempt from the broker registration requirements of section 15(a)(1) of the Exchange Act in connection with its activities as a funding portal.” If a Title III portal couldn’t do anything else, that extra language at the end wouldn’t be necessary.
The same is true for of the regulations issued by FINRA. FINRA prohibits Funding Portals from making false or exaggerated claims, implying that past performance will recur, claiming that FINRA itself has blessed an offering, or engaging in other misconduct, but a well-behaved Title II or Title IV portal would have no trouble meeting those standards.
What about the platform itself? The Title III regulations (17 CFR §227.300(c)(4)) define “platform” as:
A program or application accessible via the Internet or other similar electronic communication medium through which a registered broker or a registered funding portal acts as an intermediary in a transaction involving the offer or sale of securities in reliance on section 4(a)(6) of the Securities Act.
Nothing there would prohibit Title II, Title III, and title IV securities from appearing on the same website.
The fly in the ointment is 17 CFR §227.300(c)(2)(ii), which provides that a Title III portal may not:
What does that mean, in the context of a portal offering both Title II and Title III securities? What it should mean is that a Title III portal cannot offer investment advice or recommendations concerning Title III securities, and cannot solicit purchases, sales, or offers of Title III securities. The idea of Title III is to protect Title III investors. Why should the SEC care whether the portal is offering investment advice concerning Title II or Title IV securities?
But we can’t be 100% sure that’s what it means. If it means that a Title III portal can’t offer investment advice about any securities and can’t solicit offers to buy any securities, then we need to steer clear.
I’ve spoken informally with the SEC and they’re not sure how to interpret 17 CFR §227.300(c)(2)(ii). They suggested I submit a request for a no-action ruling and I guess I will, unless one of my Crowdfunding colleagues already has.
Pending that guidance, there are several ways to operate a Title II portal, a Title III portal, and a Title IV portal on the same platform:
Finally, FINRA is a wonderful organization, but I’m not necessarily eager to have FINRA looking at everything my clients do. All other things being equal, I might choose option #3 just to keep a degree of separation between the regulated entity and my non-regulated activities. But that’s not necessarily the end of it – FINRA will want to explore the relationship between the funding portal and its affiliates.
Questions? Let me know.
Why has Home Depot made local hardware stores a thing of the past? Partly price, but mainly selection. And I think the same forces will require most Crowdfunding portals to offer investments under Title II, Title III, and Title IV, all at the same time.
Crowdfunding portals are like retail stores that sell securities. They have suppliers, which we call “sponsors” or “portfolio companies,” and they have customers, which we call “investors.” They pick the market they want to serve – hard money loans, for example – then try to stock their shelves with products from the best suppliers to attract the largest number of customers. Think of DSW, but selling securities rather than shoes.
Now consider these situations:
Those of us in the industry see Title II, Title III, and Title IV as separate things, but to the suppliers and customers of the industry they’re all the same thing. The differences between Title II and Title IV are nothing compared to the differences between sneakers and 6-inch heels! Yet DSW sells them both and everything in between because in the eyes of customers, they’re all shoes.
It doesn’t matter to suppliers and customers that Title II and Title III require different technology and business models. It doesn’t matter that one is more profitable than the other. Mercedes might lose money selling its lower-end cars but doesn’t mind doing so because customers who buy the lower-end Mercedes today buy the higher-end Mercedes 10 years from now. The Vanguard Group probably loses money on some of its funds but sells them anyway to keep customers in the fold. As the Crowdfunding market develops, I think the same will be true of the interplay with Title II, Title III, and Title IV.
For portals that have achieved success in Title II, it might be unwelcome news that Title II isn’t enough. But on the positive side, Fundrise has managed to leverage its reputation in Title II into a well-received REIT under Title IV. In any case, I think it’s inevitable.
Questions? Let me know.
Last Thursday I joined Jack Miller, the host of “Down to Business” on 880 AM The Biz in Miami, for a discussion about Crowdfunding and what it means for entrepreneurs and investors. Jack is a terrific interviewer and an entrepreneur himself, and brings a great perspective to the subject.
We had a lot of fun and might have even shed some light on this brave new world for Jack’s listeners.
Caution: material not appropriate for all ages.
Questions? Let me know.
In the Crowdfunding world, almost every equity investment involves a limited limited liability company. Because (1) limited liability companies are treated as partnerships for tax purposes, and (2) Congress has just turned the law governing tax audits of partnerships on its head, all those LLCs will need to revise their Operating Agreements. And all new LLCs will have to follow suit.
Until now, tax disputes involving partnership were conducted at the partner level. That means the IRS had to pursue partners individually, based on each partner’s personal tax situation. With its budget cut and manpower reduced, the IRS was unable to pursue everybody.
Seeking to streamline partnership audits and ultimately collect more taxes, the (bipartisan) law just passed reverses that rule. Now, the IRS conducts audits at the partnership level and no longer has to argue with all those partners and their accountants. In fact, even though partnerships are not normally subject to tax, under the new law the partnership itself must pay any tax deficiency arising from the audit, unless it makes a special election.
EXAMPLE: NewCo, LLC owns an apartment building. The IRS decides NewCo used the wrong method of depreciation, and adds $1 million to NewCo’s taxable income. Under the new law, NewCo itself is liable for tax on $1 million, calculated at the highest possible tax rate. However, NewCo may elect to make its members personally liable instead.
Under old law, every partnership had a “tax matters partner” with broad administrative responsibilities. The new law creates a much more powerful position, the “partnership representative,” with the power to bind the partnership and all of its partners on tax matters. The partnership representative doesn’t even have to be a partner, just a person or entity with a substantial U.S. presence: an accounting firm, for example.
The law becomes effective in 2018. Between now and then, all existing limited liability companies should revise their Operating Agreements to:
Obviously, all new limited liability companies should deal with those issues at the outset.
Questions? Let me know.
The JOBS Act was signed into law by President Obama on April 5, 2012. The SEC was supposed to issue regulations under Title III 270 days later, by December 31, 2012. Instead, the SEC issued final Title III regulations last Friday, which will become effective around May 1, 2016, or about 1,466 days after enactment.
But better late than never! In its final regulations the SEC has again bent over backward to m
ake Crowdfunding easier, for example:
Hat’s off the to the SEC staff for doing excellent work with a flawed statute! I’ve written a Title III Primer: Outline for Portals and Issuers.
This is a brave new world, the transformation and democratization of the U.S. capital formation industry. I am very, very interested to hear what all of you think.
Thanks for reading.
Questions? Let me know.
Markley S. Roderick
Lex Nova Law
10 East Stow Road, Suite 250, Marlton, NJ 08053
P: 856.382.8402 | E: mroderick@lexnovalaw.com
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