The 1930s stock market crash was caused by investment promoters, also known as sponsors or syndicators, who made lofty promises of returns that never materialized. In response to the catastrophe, the government instituted the Securities Act of 1933. This series of laws is designed to maintain market integrity and to safeguard investors from bad actors and significant financial losses in the future.

Among their stipulations, securities regulations mandate anyone selling a security to disclose all investment risks necessary for the investor to make an informed decision. Securities must also be registered unless an exemption is applicable.

For real estate syndicators, understanding the legalities of raising capital is crucial for compliance. Let’s break down those legal aspects to make it easier for you to ensure all your fundraising activities meet the necessary legal standards.

Defining the Concept of Security

In fundraising, a security is any financial asset that can be traded and holds value. For real estate syndicators, this means bringing together funds from various private investors who expect a return. The profits should come exclusively from the syndicator’s efforts and could include purchasing commercial real estate, buying and flipping foreclosure properties, or providing capital for the startup of a new business.

To qualify as a security, the arrangement must be covered by an investment contract, which may be referred to as a Syndication, Private Placement, or Group Investment.

Under federal and state securities laws, the sale of securities must be registered with the government as a public offering. However, the syndicator or the transaction can qualify for an exemption from registration.

Pooling Investor Funds in Real Estate

Properly organizing your syndicate can prevent unintentional legal violations. It requires careful legal structuring to ensure compliance with securities laws. Setting up the appropriate legal entities and agreements helps clearly define the relationship between you and your investors.

Using the funds you raise, you will acquire the property or start the business and manage it. If successful, your next responsibility is to provide the investors with an ROI from cash flow during operations and/or upon resale of the property or business. They may earn interest on their investment or receive a percentage of the cash flow or equity.

As a syndicator, you get reimbursed for startup expenses and earn a percentage of the cash flow and equity for finding, organizing, and managing the investment. You could also earn additional fees for facilitating the acquisition, refinance, or resale of the asset.

The Private Placement Exemption

Raising money from family and friends may seem simpler, but it still requires careful adherence to securities laws. The Private Placement exemption from registration can be particularly useful in this context, allowing you to avoid registering the securities if specific criteria are met. This is provided by the federal Securities and Exchange Commission (SEC) under Regulation D, Rule 506(b).

Qualifications

Both real estate syndicators and investors need to meet specific requirements. These are the provisions under this exemption:

  • An unlimited number of Accredited Investors can participate
  • An unlimited amount of money can be raised
  • Investors can come from any state
  • State securities rules are generally overridden if necessary notices are filed

Rules

The Private Placement exemption enforces the following regulations:

  1. A syndicator must not engage in general solicitation or advertising of the opportunity. Instead, they should establish a substantive, pre-existing relationship with any investor to whom they offer the securities. This differentiates a Private Placement from a public offering where general solicitation is permitted.
  2. Prospective investors must be qualified as Accredited or Sophisticated based on their income, net worth, financial or investment experience, or the assistance of their professional financial advisors before committing their funds to the syndicator in a Subscription.
  3. The syndicator must disclose all foreseeable investment risks in a Private Placement Memorandum using a format prescribed by the SEC (Guide 5), and is not allowed to guarantee returns.
  4. All funds must be promptly returned to investors if the minimum investment amount is not raised within the specified time frame or if the investment objectives are not met, e.g., the property is not purchased, or the company is not established.
  5. Notices of the sale of securities and applicable fees must be filed with the SEC and any states where securities have been sold within 15 days of the first sale of securities.

Application

The individual or entity responsible for the promotion of a Private Placement Offering may go by various titles such as syndicator, promoter, manager, or general partner. Irrespective of these, the exemption is applicable to the issuer, which refers to the individual, group, or organization actively engaged in selling the securities.

Investor Sources of Funding for Private Deals

Investors often use their personal savings or retirement funds to invest in Private Placement Offerings. This is the main reason the Securities Act exists. Numerous retirement accounts permit the account holder to employ a third-party administrator or custodian to establish a self-directed individual retirement account (IRA) or 401(k) account.

With this option, the account holder can instruct the custodian to release their retirement funds to purchase private placement interests, such as shares in a limited liability company (LLC) or limited partnership (LP).

Risks of Non-Compliance with Securities Laws

Ignoring securities laws can lead to serious consequences, including hefty fines, civil penalties, and even criminal charges. A syndicator who does not follow securities laws jeopardizes the entire investment. Regulatory bodies or other creditors might compel liquidation at an inopportune time, or the syndicator could expend investor funds on legal defenses.

Investors considering using personal funds or self-directed IRA funds for an investment opportunity that they believe qualifies as a security, must perform thorough due diligence. They should ask the syndicator questions to ascertain adherence to the rules of any applicable exemption, and ensure a securities attorney helped prepare the offering documents and compliance with securities laws.

Properly structuring your investments, maintaining transparency, and adhering to all relevant regulations can help protect your real estate ventures from these risks. It’s vital to take proactive steps to ensure compliance, particularly by seeking advice from legal experts who specialize in securities law.

Final Thoughts on Legally Raising Funds from Private Investors

Familiarizing with securities laws and ensuring compliance can protect your projects and build trust with your investors. With the right knowledge and approach, you can confidently pursue your real estate goals while staying within legal bounds. This diligence not only safeguards your ventures but also paves the way for lasting success in your fundraising efforts.

Always consider seeking professional legal advice to navigate these regulations effectively. Legal guidance can help you navigate these complexities, ensuring that your fundraising efforts are both effective and compliant. A professional is also qualified to assist you in structuring your transaction to avoid the creation of a security, qualify for an exemption, or register it as a public offering.

By approaching this process with diligence and clarity, you will be able to create a solid foundation for your real estate projects and build a reputation as a reliable syndicator.

Are you in doubt as to whether your fundraising from private investors is legal? Consult an expert real estate investment attorney! Shams Merchant is the leading real estate securities attorney, representing clients in real estate syndications and fund formations across the country. As a leading securities attorney, Shams specializes in real estate syndications, fund formations, securities law, and private placements for commercial property investments and development, Shams has been featured in publications like Law360, the The Business Journal, BisNow, and The Real Deal.

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