Securities Exchange Commission

SEC Adopts Final Rules For Private Advisers And Stresses Fiduciary Obligations

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.

Escrow account crowdfunding portals

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

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

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

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

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?

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

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

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

Watch Out For Oregon’s Securities Laws

Oregon is a beautiful state and its people among the friendliest and most caffeinated in the country. But watch out for its securities laws.

A New York law firm found out the hard way in a case called Houston v. Seward Kissel, LLP. The firm prepared offering documents for a company that was later sued by an Oregon investor claiming fraud. The unhappy investor sued the law firm under ORS 59.115(3), which imposes liability on anyone who “participates or materially aids” in the sale of a security. The judge allowed the case to go forward without even requiring the plaintiff to show the law firm knew about the alleged fraud. 

In another case under the same statute, Ainslie v. Spolyar, the court granted summary judgment against a junior associate in a law firm that prepared offering documents, where the issuer allegedly violated the terms of the offering documents.

How dare they sue lawyers!

But lawyers aren’t the only ones potentially on the hook. Other potential targets include finders, agents, funding portals, accountants, financial advisors, employees of the issuer, even banks that extend financing to investors. If you touch the offering, you’re potentially liable. And under the statute, everyone is “jointly and severally” liable, meaning everyone, even the lowly associate in Ainslie v. Spolyar is liable for 100% of the damages.

The only defense is to show that you didn’t know of the facts underlying the claim (e.g., the fraud or violations of Oregon’s securities laws) and couldn’t have known of them “in the exercise of reasonable care.” That’s a very tough burden for two reasons:

  • Suppose the issuer has committed fraud. Proving that you didn’t know about it is one thing. Proving that you couldn’t have discovered it is extremely difficult because there it is, in broad daylight today.
  • Because the burden is on the defendant, these cases will rarely be dismissed on summary judgment. That means you’re in for a long, expensive fight.

The Oregon statute doesn’t matter too much for issuers because issuers are always liable for fraud and other wrongdoing and know all the facts. But for third parties, including websites and funding portals, at least consider excluding Oregon investors from your offerings, if possible.

Questions? Let me know

Don't Use Lead Investors and Proxies in Crowdfunding Vehicles

Don’t Use Lead Investors And Proxies In Crowdfunding Vehicles

Some high-volume portals use a crowdfunding vehicle for every offering, and in each crowdfunding vehicle have a “lead investor” with a proxy to vote on behalf of everyone else. This is a very bad idea.

Lead investors are a transplant from the Silicon Valley ecosystem. Having proven herself through  successful investments, Jasmine attracts a following of other investors. Where she leads they follow, and founders therefore try to get her on board first, often with a promise of compensation in the form of a carried interest.

A lead investor makes sense in the close-knit Silicon Valley ecosystem, where everyone knows and follows everyone else. But like other Silicon Valley concepts, lead investors don’t transplant well to Reg CF – like transplanting an orange tree from Florida to Buffalo.

For one thing, Reg CF today is about raising money from lots of people who don’t know one another and very likely are making their first investment in a private company. Nobody is “leading” anyone else.

But even more important, giving anyone, lead investor or otherwise, the right to vote on behalf of all Reg CF investors (a proxy) might violate the law. 

A crowdfunding vehicle isn’t just any old SPV. It’s a very special kind of entity, created and by governed by 17 CFR § 270.3a-9. Among other things, a crowdfunding vehicle must:

Seek instructions from the holders of its securities with regard to:

  • The voting of the crowdfunding issuer securities it holds and votes the crowdfunding issuer securities only in accordance with such instructions; and
  • Participating in tender or exchange offers or similar transactions conducted by the crowdfunding issuer and participates in such transactions only in accordance with such instructions.

So let’s think of two scenarios.

In one scenario, the crowdfunding vehicle holds 100 shares of the underlying issuer. There are 100 investors in the crowdfunding vehicle, each owning one of its shares. A question comes up calling for a vote. Seventy investors vote Yes and 30 vote No. The crowdfunding vehicle votes 70 of its shares Yes and 30 No.

Same facts in the second scenario except the issuer has appointed Jasmine as the lead investor of the crowdfunding vehicle, with a proxy to vote for all the investors. The vote comes up, Jasmine doesn’t consult with the investors and votes all 100 shares No.

The first scenario clearly complies with Rule 3a-9. Does the second?

To appreciate the stakes, suppose the deal goes south and an unhappy investor sues the issuer and its founder, Jared. The investor claims that because the crowdfunding vehicle didn’t “seek instructions from the holders of its securities,” it wasn’t a valid crowdfunding vehicle, but an ordinary investment company, ineligible to use Reg CF. If that’s true, Jared is personally liable to return all funds to investors.

Jared argues that because Jasmine held a proxy from investors, asking Jasmine was the same as seeking instructions from investors. He argues that even without a crowdfunding vehicle – if everyone had invested directly – Jasmine could have held a proxy from the other Reg CF investors and nobody would have blinked an eye.

When the SEC issues a C&DI or a no-action letter approving that structure, terrific. Until then I’d recommend caution.

Questions? Let me know