How to Pool Investor Funds Without Running Afoul of the SEC

Since commercial real estate often requires a larger down payment than most individuals can come up with, investors usually pool their funds in order to raise sufficient cash to cover the down payment and other acquisition costs. Doing this incorrectly can lead to huge fines from the SEC, not to mention potential liability from lawsuits.

Anytime money is pooled with the expectation of making a profit, a security is created. After the Great Depression, the Securities Acts of 1933 and 1934 were enacted to protect the public against fraudulent securities. It was at this time that the Securities and Exchange Commission (SEC) was created to oversee the implementation of these laws.

The person who pools investor funds creates a syndication and is known as a syndicator or a promoter. This person must be very careful to follow all the SEC regulations because the fines for violations are very stiff. The laws are not difficult to understand and follow, but claiming a lack of knowledge about them will not be a suitable defense.

The syndicator must ensure that all the potential investors are given enough financial and other important information regarding the security being offered for sale so that they can make an informed decision about the suitability of this particular deal.

In 1946 the Supreme Court heard a case called SEC v WJ Howey. The Howey Company sold land in citrus groves in Florida and also offered to plant, harvest and sell the fruit for the new landowners, who were mostly out of state people looking for a passive investment. When things went bad, it ended up going through the courts, and resulted in what became known as the Howey Test. This test determines what qualifies as a security and has four main points, all of which must be true.
1. There must be an investment of money, and
2. There must be a common enterprise, and
3. There must be the expectation of profit, and
4. This will be managed soley through the efforts of the promoter.

If all four of these are true, a security has been created which falls under the SEC guidelines. The most critical part of the law for our purposes is called Regulation D, usually just called Reg D. Reg D describes a private offering made only to accredited or sophisticated investors. When this is done correctly, it allows full exemption from registering the security with the federal SEC. Since registration can cost upwards of $250,000, avoiding it is a worthy goal for most of us.

An important definition to bring in at this point is that of an “accredited investor.” There are two tests, either of which is sufficient for someone to be so labeled. Anyone with a net worth, with their spouse, of over $1 million (less any equity in the primary home), qualifies as accredited. Otherwise, anyone who has received income in excess of $200,000 ($300,000 if married filing jointly) for the last two years, with the expectation of that level of income in the current year, is accredited. The SEC assumes that an accredited investor has the financial acumen to make smart investing decisions without its oversight.

Investors who do not qualify as accredited can be labeled as “sophisticated investors” by the syndicator and still accepted into the pool. This will require the syndicator to know this person well enough to think they can invest in the project without harm to their financial standing.

There are three main rules of Reg D that offer the exemption from filing. The least onerous of these is called Rule 506. This rule does not have a cap on the investment size, which the other two do. In addition, it allows a syndication with an unlimited number of accredited investors, and up to 35 sophisticated investors. No general solicitation or general advertising is permitted. The promoter must have an already established relationship with any investors brought into the pool.

Anyone considering becoming a promoter in order to buy commercial real estate will absolutely need to have an attorney who specializes in SEC work to draw up all the documents involved in creating the syndication. The fees charged will be significant, but don’t rely on your regular real estate attorney for this work.

In the interest of full disclosure, you need to know I am not an attorney, and this report should not be considered legal advice. While I believe it to be accurate, it is for informational purposes only. Be sure to solicit the proper legal advice whenever pooling investor funds to achieve your real estate goals.

Be sure to read our newer post called, “Do I Really Need a PPM (Private Placement Memorandum)?”

 

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One thought on “How to Pool Investor Funds Without Running Afoul of the SEC

  1. Pingback: HUD 221 (d)(4) Loan Program - Right for You? | The Colorado Springs Apartment Investor

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