Signs on properties and billboards, as well as ads in newspapers, television or radio can now be bought by real estate companies looking to raise capital through the sale of securities.
“You can go out now and you can advertise. There’s no limit. Your face, your face can be on a billboard … There’s no limit on what you can say on the Internet. There’s no limit on what you can say on TV. The only thing you have to live by is, what you say has to be truthful,” said Darryl Steinhause, a partner in law firm DLA Piper’s Real Estate Capital Markets group.
Steinhause discussed changes to the Securities Exchange Commission's Rule 506 on general solicitation at an event hosted Tuesday by The Corky McMillin Center for Real Estate at San Diego State University.
As a result of changes to Rule 506, real estate companies may now use advertisements to seek investors — but with hurdles created by entities that did not want the changes to go through.
“This rule change came from the JOBS Act (Jumpstart Our Business Startups Act) back in 2012. … The SEC hated this law. The SEC did whatever they could to delay the start of this rule. Every state hates this law and FINRA [Financial Industry Regulatory Authority] hates this law,” Steinhause said. “You’re going to find that there are going to be bumps in the road because the states are going to try to slow you down, FINRA is going to try to slow you down and the SEC may try to slow you down. They have new pending rules that could potentially slow down the entire process.”
Under the old rules, it could take between $7 million and $12 million to take out a real estate investment trust (REIT), register it and get the sales force into play, Steinhause said. People would get money from family and friends, broker-dealers and institutions, and there were never advertisements. With the new rules, it could cost $200,000 to get the same REIT out, Steinhause said.
There’s no limit on how much money can be raised, and everyone who buys interest has to be an accredited investor. The new rules introduce more hurdles to proving that an investor is accredited, Steinhause said. Previously, investors would basically check a box that said they were accredited. Under the new rules, investors have to prove that they are accredited by past returns or financial statements.
This could create difficulty with individuals who, for privacy reasons, don’t want to send their financial information to a company they don’t know, Steinhause said.
Broker-dealer rules are an aspect “everyone has to be careful about,” Steinhause said. Those who complete one or two deals per year don’t have to worry about these rules, but those who complete more than that typically go through broker-dealers.
Steinhause said many people were violating broker-dealer rules for years without penalty, and the SEC had taken a position that if the company wasn’t doing anything fraudulent, it wouldn’t go after the company for violating the broker-dealer rules.
“This year they went after a venture capital fund up in Palo Alto,” Steinhause said, adding that the fund had been the most abusive of these rules. “[The SEC] did an enforcement action against the company and its employees because they violated these rules.”
After, the SEC said it was changing its rules, Steinhause said, choosing this year because “they can stop what’s going on with this public solicitation. It’s a way for them to control what takes place.”
The SEC can push these deals back into FINRA, which oversees all broker-dealers. It moves publicly offered deals into the broker-dealer world and outside “the unknown world,” which is being called “the wild, wild West,” Steinhause said.
There are exemptions to those who have to file as broker-dealers. However, under the recent SEC rulings, if someone is paid compensation based on a success, that makes the issuer a broker-dealer, Steinhause said.
The problem with broker-dealers raising money is the cost, with some charging 10 percent commission, Steinhause said. He discussed something called the “3 percent solution,” in which a broker-dealer is brought in to work with the issuer on all leads.
One of the company’s employees can work with the broker-dealer and become a registered broker-dealer and deals can go through them. They can sell the product and make sure the investor is suitable and accredited, Steinhause said. The 10 percent commission typically charged by broker-dealers includes 7 percent for a representative. With the 3 percent solution, that representative is eliminated, taking the 10 percent commission down to 3 percent.
The Bad Actor Disqualification, which also took effect Sept. 23, aims to keep felons from using Rule 506 to raise money, Steinhause said.
“If there’s a bad actor anywhere in the chain, you can’t use 506,” Steinhause said. That includes the issuer, affiliates of the issuer, officers or directors of the issuer, the broker-dealer selling securities and “the real killer” — the investor.
Any beneficial owner of 20 percent or more of the issuer’s outstanding voting equity securities can’t be involved with any of the disqualifying events, which include: a felony involving something that is a security, or fraudulent activity either with the SEC, the state, in a court, through a regulatory agency of a state or through FINRA, Steinhause said.
Companies may be able to use platforms such as funding clubs or angel lists, where accredited investors can search a website for Private Placements Memorandums from people offering securities, Steinhause said.
He added that he does not think these platforms will be successful because the platform charges a fee to the investor, so investors will be more likely to go directly to the company to get all the profit.
The SEC is proposing rules that are “a little painful,” Steinhause said. Those rules include requiring 15 days’ notice before the first advertisement, and losing the right to do securities offerings for five years if Form D isn’t filed.
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