THE "JOBS ACT" - THE SYNDICATION REVOLUTION OF 2012 IN A NUTSHELL
Post Date: 7/5/2012
THE "JOBS ACT" - THE SYNDICATION REVOLUTION IN A NUTSHELL
BY: J. ROBERT ECKLEY
Real Estate and Construction Attorney
May 1, 2012
©2012 ECKLEY & ASSOCIATES, P.C.
REPRINTED FROM "COUNSELOR'S CORNER", Ed. 60
Current Circulation: 75,004 per Month
The JUMPSTART OUR BUSINESS STARTUPS ACT ("JOBS"), signed into law by the President on April 5, 2012, is nothing less than a revolution in deregulating securities laws, making the alternative development of capital through private funding more accessible to businesses, owners, sellers, investors, entrepreneurs, promoters and others, directly including the real estate industry. It allows the securitization of every form of asset, it can generate loans, and it can fund a future venture, cash out an old one, or create vulture capital pools. It can readily facilitate loans, acquisitions and dispositions such as REITs and REMICs and certainly generate capital unobtainable (or not reasonably obtainable) from conventional lenders.
The JOBS ACT is addressed to give access primarily to middle entry-point projects and promoters (those grossing less than $1 billion annually) all of the way down to the micro-projects (those seeking only $1 million annually). It streamlines paperwork, allows for new and wider promotional activity for the offering than ever permitted before. In sum, the JOBS ACT has been designed to be highly competitive with and in some cases even replace lending and capital activity which has traditionally been available only at or through institutional sources. It also "dis-intermediates" the need for tiers of required professionals and required paperwork from brokers, attorneys, accountants and other consultants which have in the past added so much friction cost--as much as 10%--and so much more time--1 year previously, now down to 30 days--to packaging and selling these funding sources as in the past.
Last, the JOBS ACT creates federal pre-emption over state laws which, for one of the more important examples, allow Reg. D, Rule 506 offerings (explained more below) to be exempt from merit reviews and from multi-state compliance reviews as the offer or sale or the funding source and placement destination passes across state borders. Solicitations can even be made on the internet! For the capital-starved commercial real estate industry and for businesses, the JOBS ACT could be salvation!
WHAT IS A "SECURITY":
Before the JOBS ACT features are discussed more in depth, it would seem appropriate to know what a "security" is under the law. Many professional entering this field for the first time are often surprised at how broadly that term is defined and sometimes try to contractually limit or remove securities laws as an issue by “disclaimers” that only succeed in getting them into more securities trouble. Just to make the point sharper, under prior and past-JOBS Act law, a recital in an agreement which in fact involves what the law will call “securities” which has the investor agreeing that “this investment is not a security and is not covered by securities laws and any application is waived by the investor” is, itself a per se violation per of securities laws!
Both federal and state law define a "security" and with minor variations the definition is always the same or very similar. Under the guidelines established by the U.S. Supreme Court, a security is "an investment of money in a common enterprise with profits to come solely from the efforts of others." SEC v. W.J. Howey Co., 328 U.S. 293, 301, 66 S.Ct. 100, 1104, 90 L.Ed. 1244 (1946). "The focus of the Acts is on...the sale of securities to raise capital for profit-making purposes ..." United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 849, 95 S.Ct. 2051, 2059, 44 L.Ed. 2d 621 (1975). The courts follow two distinct approaches to determine the existence of a security. One approach focuses on the nature of the instruments: What is being sold and how it is unitized? Tenancies in common (“TICS”) and LLC interests can certainly be deemed “securities” under this distinction as they are “unitized” like “shares” and are for risk-oriented purposes of investment. The other approach, if the first one does not clearly classify the offering as a “security”, focuses on the program or agreement involved to purchase the instruments, that is, whether such constitutes an "investment contract," which is also included within the definition of a security. The “investment contract” test is usually most dispositive and bears more examination.
THE INVESTMENT CONTRACT TEST:
The “investment contract test” is the one that is most often applied to offerings involving real estate or funding for real estate (purchase or sale of it, holding of it, forming a loan pool for financing it). The test, again, comes from both state and federal law, so quoting the federal rule is encompassing: The term "security" in both the 1933 and the 1934 Acts includes "any note... evidence of indebtedness, collateral-trust certificate ... [or] investment contract..." 15 U.S.C. ' 77b(1)”. Accord at 15 U.S.C. ' 78c(a)(10). Most states recognize even such things as the sale of single promissory note if for investment purposes as a “security “ and they all recognize the formation of TIC or an investment partnership or LLC as the generation and sale of a “security”. Those who sell the securities-- owner, issuer, promoter, other--usually need a license to broker securities.
The JOBS ACT does not change the rule that investment contracts will be “securities.” But it does make it easier to sell and solicit them to a much wider audience of prospective investors and by methods—the use of an internet funding portal--never used before.
SALES OF SECURITIES AND DISCLOSURE:
Once again, to understand the revolution of the JOBS ACT, one should first review the rule governing sales and solicitation s of securities under prior law. Under 15 U.S.C. ' 77l (' 12 of the Securities Act of 1933) a civil liability is imposed on anyone who offers to sell or sells unregistered securities or fails to file appropriately for exempt securities or who makes any misrepresentation in that regard (whether licensed securities dealer or not). The licensure law also mandates that the statements made about materials facts are true and none have been withheld. The law has in the past held that:
“Any person who--
(1) Offers or sells a security in violation of section 77e of this title [which prohibits the use of interstate commerce or mails to sell an unregistered security], or
(2) Offers or sells a security (whether or not exempted ...), by the use of any means or instruments of ... communication in interstate commerce or of the mails, by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact...
Shall be liable to the person purchasing such security from him, who may sue either at law or in equity in any court of competent jurisdiction, to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon ...”
The JOBS ACT does not change anything above regarding the duty to be fair, open and truthful and to disclose all materials matters that might tend to affect an investor’s decision to pay or to pay or put at risk a given amount. But it does remove from coverage a great number of prior acts which would have been considered acts requiring licensure (does away with the practical need for a broker-dealer) and vastly expands how the securities can be offered as noted below.
In addition to the civil liability of rescission, damages or exemplary damages, as the case may be, it is also a crime to sell securities that are in violation of law. This rule remains in the law even under the JOBS ACT. Criminal sanctions can be levied in addition to civil ones for violations of the JOBS ACT, too. But the JOBS ACT streamlines or even removes sales and solicitation hurdles by widening who can be offered these and by what medium and expands the smaller offerings from in-state to national without the paperwork and glacial speed formerly required.
ANTI-FRAUD METHODS OF SALE:
In the past, the methods of sale and solicitation of lawful securities have been highly regulated and some regulations remain even after the JOBS ACT. For example, the JOBS ACT does not permit fraud: The existing 15 U.S.C. ' 77q(a) (' 17(a) of the Securities Act of 1933) remains and prohibits a great many techniques in the offer or sale of securities:
(a) It shall be unlawful for any person in the offer or sale of any securities by the use of ... communication in interstate commerce or by the use of the mails, directly or indirectly--
To employ any device, scheme, or artifice to defraud, or
To obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact...
To engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser?
Furthermore, 15 U.S.C. ' 78j(b) (' 10(b), Securities Exchange Act of 1934) provides:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails...
(b) To use or employ, in connection with the purchase or sale of `any security ... any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe as necessary or appropriate in the public interest or for the protection of investors.
There is also strict liability for aiders and abettors under Section 17 and 10(b). This obviously remains so under the JOBS ACT.
MORE ABOUT NON-DISCLOSURE AND FRAUD: THE “PROSPECTUS”
DISCOVERY AND DISCLOSURE: Any “security” must be generated, offered and sold with full and fair written disclosure of the risks and shortfalls, similarly to what disclosure law requires in real estate. The difference is that securities laws, both prior to and after the JOBS Act tend to set the disclosure bar a bit higher than the non-securities-oriented “minimums” for real estate. Due diligence must be used to discover, analyze and then to disclose in writing any material matters which may tend to affect the consideration an investor might pay, the assumptions and yields expected from the investment, and any other matter which may tend to affect the investor's over-all decision to make the investment and at the price offered. If all of the risks and downfalls are adequately disclosed and if the investment fails for any other reason than bad management or failure to follow the business plan set out in the securities, the owners, promoters and brokers are without liability for the failure. If it failed because of unsupported assumptions, non-disclosure or mis-disclosure or the avoidable failures and transgressions of management, it can be actionable against the offerors, promoters, intermediaries and, of course,
This written disclosure in securities law is called the PROSPECTUS and is governed by Rule 10b (5), et. al, in the federal securities rules and also by the principles of common law fraud. Unlike real estate, the level of due diligence and discovery is extremely high in securities work since it is the issuer and promoter who are crafting it and they thus are assumed by law to have intimate knowledge and control over it to assure quality and expectations. This does not mean it has to be a good or even a wise investment. Only that all disclosures and projections are as true and accurate as good analyses can make them. The securities lawyer's old adage is that the well-written prospectus is one that seems to "virtually assure the investor that the project cannot possibly succeed!" This is an exaggeration, but the more realistic fact is that investors do not buy anymore from people and projects that have shown themselves to be tricksters or losers, whether the Prospectus covered them or not. The offeror and promoters will want people to have such a good experience with the first offering that they come back again for the second, the third, the...(forever, amen!)...
Prospectuses disclose sources and applications of funds, anticipated risks not just in the investment economics or dynamics, itself, but also in the entire investment climate, make projections of the returns based upon good math and sound principals, discuss the strengths and weaknesses to the principals, discloses their anticipated involvements and their expected returns and the like. These should be well-written, thorough and unvarnished, as if they are all of these things and, as noted above, the investment is run as projected and yet fails, there is no liability for the issuer, promoters, principal or affiliates other than the practical one noted above, i.e. they will likely never be taken credibly by the investor groups again and they may even have to disclose their prior offer failure.
Disclosure and prospectuses remain in the JOBS ACT, but the rules have cut back on the depth of the disclosures and width of them. See below. The author of this paper suggests, though, that a lower “rules minimum” is not always the best protection for offerors, promoters, brokers, participating professions and salesmen. The fact is that if a fact is “materially adverse” it needs to be disclosed in writing whether or not the strict wording of the old and new rules directly mandate it, since there could always be a plethora of “after the fact” arguments in investor lawsuits or regulator complaints over what was “truly material” and the outcome on that debate is a crapshoot before a regulator, judge or jury that one should want to enter.
Here is where the JOBS ACT makes some big differences. Another critical factor to a regulated offering is in determining the investor profile sought—deciding who may qualify to invest and if those investors will suit the offering. The regulators know that potential investors have varying analytical and business talents and varying susceptibility to sales talk, even after being provided a prospectus which, in fact, many tend not even to read, and that they have varying abilities to absorb the loss that a failed investment might present. Regulators want to protect the investors from bad decisions in both categories. Thus, under former law, the regulators have established tiers of investor “sophistication” and have regulated who may purchase how much without the assistance of a “purchaser representative.” Loosely explained and trying not to use trade jargon, at the top of the “investor tier” is the investor who, either by being an institution or by having a certain higher net worth, is considered sophisticated enough to qualify for any securities purchase (and able to take the hit if the security fails) without consulting a skilled investment consultant for consultation and representation in sizing up and purchasing the security. Next down are those investors who may have lesser money accesses (income and net worth), but are deemed still significant enough to be capable of making evaluations on their own and able to suffer a loss of their investment. There are all—institutions on down to those who are deemed by income and net worth standards to be financially able to “take the hit”—are called “accredited investors”. At the end of the tier is the investor who meets none of the foregoing criterion of sophistication or loss-capacity and should only buy with the assistance of an authorized purchaser representative—usually a stock broker, CPA or an attorney who is deemed sophisticated enough to be able to explain the risks adequately to the investor. Those not meeting this criterion are considered “unaccredited investors.” There is also an exception for the one who can, without any of the “safe harbor” qualifications above, still demonstrate great economic and securities sophistication in some other way. For example, investors who are real estate brokers, lawyers and accountants—even without the net worth—can often demonstrate the required sophistication by their licensure and experience, alone. Qualification is usually established by an “Offeree Questionnaire” by which the would-be investor is asked the key qualification questions, scored for compliance with the criterion of the offer, and then qualified to go forth or disqualified as unaccredited and required to see an Offeree Representative who is expert enough to advise of the risks and values. The Offeree Representative then certifies to the offeror that he or she is such and that the potential investor has been adequately advised and is prepared to make an investment. All of this structure still remains, but the thresholds for eligible investors are lowered under the JOBS Act.
The JOBS ACT has reduced the criterion for buyer entry by reducing the net worth’s required to the potential investor and thus qualifying more potential investors and it has also expanded Reg D., Rule 506, to allow for unlimited offers and the ability to sell unlimited securities to unlimited numbers of accredited or sophisticated investors across state lines from the state of the offering, entirely unlike the old rules which narrowly restricted all of the foregoing. See more, below.
Under the now current law, to qualify as an accredited investor without being a large institution, one has to be a natural person who has a minimum net worth of (including spouse if buying jointly) of at least $1 million (Reg. D., Rule 501 a.5) or a natural person who has income in excess of $200,000 in each of the last two years or joint income in conjunction with spouse in excess of $300,000 both of the last two years and has a reasonable expectation of reaching the same within the same year as the purchase (id. at a.6.). Natural person entities with this kind of base net worth (living trusts, IRAs, 401k) also qualify and small business entities with high net worth also qualify. Foreign investors of those obtaining funds from outside of the U.S. would likely have to jump through the “anti-laundering” hoops, but that is a “how-to” subject for a future article.
Under the JOBS ACT, Rule 506 is substantially expanded on this and has created a new class of investor qualification and funding. Particularly notable under the JOBS Act is the dynamic ability to make the offering through the massive potentials of worldwide marketing through “portal crowd funding,” without the need (even if wisest) for an owner/promoter, securities broker or dealer license in the loop. That’s a “first” and a mighty one for offerors and promoters. See below.
Under former law, generally speaking, there are “registered” securities and “exempt securities.” Registered securities are commonly what are seen on Dow-Jones. “Exempt” is commonly on the pink sheets. “Registered” calls for governmental filings and often some due diligence review by governing authorities, “exempt” do not, but even the “exempt” ones call for filing a Notice of Intent to Sell an Exempt Offering with the government, actually a sort “back-door registration” though the exemption calls only for a several page disclosure of the offering and identifies the specific exertion section claimed. Exempt securities generally are not merit-reviewed by Regulators unless there is a complaint, though they are compliance-reviewed from the face of the Notice of Exemption to assure the exemption qualification is proper, and in compliance to the exemption form and content, the proposed and actual method of sales and for proper qualification of the investors group to be solicited. The registered offerings are usually large. Reg. D., the favorite place for many smaller offerings, runs from $1 million to $5 million under Rules 504 and 505, covers exempt securities. Reg. D, Rule 506, as amended by the JOBS Act can be unlimited in amount.
The JOBS ACT now also shortens the registration for federal “Reg. A” securities (usually larger offerings), creates a new category of securities offeror called an “Emerging Growth Company” (herein “EGC”, which is an entity having a gross annual revenue of up to $1 billion) and exempts the EGC from former investor limitations and accounting regulations and elevates a JOBS Act Reg... D, Rule 506 offering to the status of a federally-allowed security which then permits it to be offered on an interstate basis (when prior law limited it to in-state or multi-state only upon application with each state).
Rule 506 of Reg. D. is one of the places where the JOBS Act has done a great deal of helpful and very profitable expanding and liberalizing work. A local offering can now act almost like a Reg A. federal offering. Where in the past it was highly limited in how it could be offered and offering it even across state lines was hampered by local rules in each state, that is gone under “federal supremacy”. Where in the past it was tightly regulated how many potential and actual investors could be promoted and sold to and the type, cutting out a lot of smaller investors, the “high-roller requirement” is for the most part gone under the JOBS Act. See the attachments.
Some venturers, entrepreneurs and real estate licensees have put their clients into investments which clearly qualify as “securities”, but which are not registered, not exempted, do not comply with any regulations and they are not securities-licensed broker-dealers. This class of professional needs to realize this and correct it and the JOBS Act makes that easier by removing some securities licensure rules—but not all. It is a relatively clear malpractice to have no securities license where one is required. Example: TICS are securities. Consider rolling TICs over into a Reg. D Rule 506 project, now that it is much cheaper and easier. It could head off a securities prosecution and a malpractice claim. Example: LLCs between unaffiliated persons holding investment properties. The LLC interest is a security. Avoid hearing “who was the crook who put us in that disaster (?)” when the investors lose their hides on the investment you put them into! Roll this into a new JOBS Act Reg. D. 506 and legitimize it, now!
Warning: There is no real estate professional (or law or accounting) malpractice insurance for this—all standard policies exclude coverage for issues like this. Hence, correction is not merely the best remedy; it is the ONLY good one!
THE JOBS ACT:
With the above background one can now appreciate better the JOBS Act. See the information feature panels in this handout, starting at page 12, et. seq., below.
The highlights learned:
Design your own LLC, REIT or REMIC to buy or sell property, get finance or refinance for targeted projects or even to establish vulture funds or funds to facilitate a sale or buy—bypass the banks. If your project or client is at the $1 billion point (and did not offer any securities before November, 2011), consider the EGC options and an IPO.
the Act simplifies what was once a brick wall of paperwork making sense only to stock analysts, securities brokers and attorneys...Yes, kids, you actually CAN “do THIS one at home.”
You can use the Internet and social media to raise up to $1 million every 12 months per project. Wow!
Even without portal or crowd funding, the amount one can raise under the Reg. D Rule 506 exemption is unlimited.
The Act dynamically reduces regulatory requirements for securities development, soliciting and sales – Reg. D. Rule 506 is a “fast track” process that can get these out in a month or less, one after another!
The Act permits widespread, effective public advertising of private equity and money placements and the use of passive “funding portals” to reach small-end investors which were virtually never capable of being reached before.
“Crowd funding” securities offerings is made lawful
Can roll over previous holdings to solve the “TIC” and other investment securities violations problems of yesteryear
Permits you to seek investors for your local project nationally without having to comply with 50 state laws or complete a costly and Reg. A national offering!
Requires no registration as a broker or dealer and the payment of no broker dealer commissions!
Even permits on-line sales to those would not qualify under Reg D. as accredited investors
Creates more investors by liberalizing investment qualifications
There is no worth-while deal the Act cannot make EVEN MORE worth-while!
AND THE BEST PART:
IF THE OFFERING IS DONE CORRECTLY AND YET THE BOTTOM STILL FALLS OUT, UNLIKE COMMERCIAL AND OTHER LOANS, THERE IS NO PERSONAL LIABILITY!
DOES IT GET ANY BETTER?!