Syndicators Beware — Your Livelihood and Reputation are On the Line if Fraud Occurs in Your Syndicate

Fraud is a constant risk in any kind of transaction but even more so in a real estate syndication, which involves pooling funds from multiple investors, many of whom are senior citizens. The Securities and Exchange Commission and state securities regulators are acutely aware that unscrupulous Syndicators (also called “Issuers,” as in issuers of securities) can quickly strip unsuspecting investors of their retirement funds. Thus, the sale of securities is strictly regulated with stiff penalties for non-compliance.

Penalties for fraud and securities violations can include jail, fines, civil lawsuits, damages, disgorgement of gains, and prohibition against ever participating as a manager in another Syndicate or dealing with investor funds again.

Whether you are an investor, or a member of a Syndicate management team, you have to constantly be on the lookout for illegal dealings relating to your Syndicate that can threaten your investors, your livelihood, and your reputation.

So, what are the illegalities you should watch for in a Syndicate?

Some of the most common forms are:

  • Violations of securities laws;
  • Embezzlement where members of the management team steal investors’ money out of company funds;
  • Ponzi schemes.

These and more are discussed below in further detail.

Violating Securities Laws

It’s best to steer clear of anyone who is violating securities laws, regardless of whether you are a passive investor or actively involved in management of a Syndicate where securities violations are occurring. Issuers who get in trouble with securities regulators are likely to use investor funds for their defense.

Following are some of the most common securities violations that Syndicators must guard against:

  • Paying Finder’s Fees

If you are an investor and someone introduces you to a Syndicator, ask whether they are being compensated and how. If you are an Issuer, don’t pay commissions to people who refer investors.

While an Issuer can rely on an exemption from registration to sell its own securities, the Issuer cannot pay “transaction-based compensation” (i.e., a commission based on the amount of securities sold) to someone without an appropriate securities license. Issuers need to pay close attention to how everyone in management is raising money and make sure that they are staying within the rules of their securities exemption.

Paying an unlicensed finder could cause the Issuer to lose its exemption, and the finder could be prosecuted for acting as an unlicensed securities broker.

  • Admitting Bad Actors to Management

It’s also essential for those in charge of a Syndicate to run background checks on all of the people they admit to the management entity. Certain “bad actors” who have been in trouble with securities regulators in the past are prohibited from participating in management of a company engaging in Regulation D, Rule 506 or other securities offerings.

  • Embezzlement

It’s a well-known fact among forensic CPAs and attorneys who prosecute fraud that three things lead to monetary fraud or embezzlement in nearly all cases (known as the “Triangle of Fraud”):

  1. “Opportunity,” or “Access to Funds” — Investor funds, funds in the Company’s bank account, company books, etc.
  2. An “Unsharable Need” — For example, “I need this money to live, to buy a new car, to buy a new boat, to pay medical bills, to cover my daughter’s wedding, to support the lifestyle I should be living,” etc. Often, this starts with good intentions: “I’ll pay it back, I’m just borrowing the money,” etc., and
  3. “Justification” — When they can’t pay it back, they justify why they deserve it: “I worked harder than everyone else; I should have been paid more,” etc.

By the time this process plays out, the funds have usually been spent and are irretrievable.

You need to pay careful attention to the bank accounts for your Syndicate and the people with access to them. When people experience financial stress like that caused by COVID-19, embezzlement increases. It’s important that Syndicate managers closely control who has access to the bank and also closely monitor bank transactions within the Syndicate.

Here are some protective measures you should be taking:

  • Make sure there are at least two people keeping an eye on your bank accounts, with no single person in charge.
  • Watch for unauthorized transfers or large expenditures, frequent ATM withdrawals, personal credit cards paid with partner funds, advances on future pay, or reselling interests in the company.
  • Watch for people living above their means – buying fancy toys, taking extravagant vacations, holding lavish parties, etc.

Knowing someone else is watching is the best prevention. If you discover embezzlement, you will need to remove that person from management – your documents should allow this, but you might have to hire an attorney to do so.

  • Ponzi Schemes

Ponzi schemes occur when new investors are recruited to pay previous investors. This is often done to cover up embezzlement by someone in management, or mismanagement of the investment. Before investing in an existing Syndicate, make sure you have a clear picture of why the funds are needed, and that the explanation makes sense.

Descriptions of additional types of investor fraud can be found on the SEC’s website at https://www.investor.gov/protect-your-investments/fraud/types-fraud.

Conclusion

If you are tempted to engage in fraud, remember that it never ends well. You will eventually get caught, and when you do, relationships will be burned, your reputation will be ruined, and you could be labeled a “bad actor” and prevented from ever raising money from investors again. Remember that previous job you hated? You’ll be lucky if you can get it back.

If you suspect that someone in your Syndicate management team is embezzling funds, contact a litigation attorney.

If you are a passive investor and you suspect fraud by the manager of your Syndicate, contact a securities litigation attorney or your state securities agency.

NOTE: This information is of a general, educational nature and may not be construed as legal advice pertaining to your specific offering, exemption or situation. Such advice must be sought from your own attorney, pursuant to an attorney-client relationship, after consideration of your specific facts or questions.

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