QUESTION: How can I solicit investors for a group real estate investment?
A securities offering claiming the “private placement” exemption from registration under Regulation D, Rule 506(b)—“Rule 506(b)”—per Section 4(2) of the Securities Act of 1933 is generally a good choice for many syndicators because it offers some unique benefits that other state or federal exemptions don’t share.
Rule 506(b) offerings pre-empt state law.
Many issuers of securities for real estate offerings (aka “Syndicators” or “Issuers”) are crossing state lines in that the properties, the investors and the syndicators are located in different states. A Rule 506(b) offering allows a syndicator to cross state lines while “pre-empting” separate state securities laws. This means that individual states cannot impose their own investor qualification, investment limitations (e.g., 10% of net worth) or state pre-approval requirements, etc., on the Rule 506(b) offering. However, most states require syndicators to file a notice of the sale of securities and payment of a notice filing fee before honoring the Rule 506(b) exemption.
An unlimited amount of money can be raised from an unlimited number of ‘Accredited Investors.’
The Rule 506(b) exemption allows a syndicator to raise an unlimited amount of money from an unlimited number of “Accredited” investors and up to 35 “Sophisticated” investors. Many syndicators wish to sell securities to investors who are not accredited but have some knowledge, education or experience with real estate investments, either by themselves or with the assistance of their financial adviser (who must be unrelated to the issuer), that would qualify them to understand the merits of the offering. Those individuals are considered “Sophisticated” investors. Unless they are a member of the issuer, investors who do not meet this definition are not allowed in a Rule 506(b) offering.
Other Requirements of a Reg. D, Rule 506(b) Offering
There are, however, further requirements to which an issuer must adhere in order to qualify for the Rule 506(b) exemption and to avoid a potential charge of selling unregistered securities. These requirements, among other things, include: a) determining “investor suitability;” b) a prohibition of any “general solicitation” or “advertising” in order to meet potential investors; and c) establishment of a “substantive pre-existing relationship” with an investor before offering a specific investment opportunity.
What does ‘Investor Suitability’ mean?
A syndicator has the obligation to determine whether an investor is suitable for the offering. Specifically, that means determining if the investment opportunity being offered: a) matches the investor’s investment goals, and b) whether the investor can afford to lose the money. If the answer to either of these questions is “No,” the syndicator should not take the investor’s money. At the 2010 annual conference of the Real Estate Investment Securities Association (REISA), one of the presenting attorneys suggested that investor suitability was the #1 source of recent securities litigation. Every issuer should have a written procedure for pre-qualifying investors to which it strictly adheres with every new investor.
What is a ‘Substantive, Pre-Existing Relationship’?
The SEC has indicated, through a series of “no-action” letters, what constitutes this relationship. In general, the commission has suggested that, among other things, the requisite relationship exists when a syndicator knows enough about a potential investor to understand the investor’s financial situation and that the syndicator has a recordkeeping system in place to show that the relationship had been established prior to the offer of securities having been made.
Per the SEC’s no-action letters, two elements appear to be key in establishing a “pre-existing relationship defense” to a charge of selling unregistered securities (which is precisely what a syndicator should be seeking to avoid). The first key element is a recordkeeping system, and the second is the “passage of time” between when the syndicator first met the investor and when an offer of securities was made.
What constitutes an ‘offer’?
An offer generally occurs when the syndicator states it is “looking for investors” (per the SEC, this is considered the “first step” in making an offer), whether for current or future offerings, or whenever the syndicator provides specific information to an investor about any current offerings it has available (such as a property information package/brochure, business plan) or discusses information about the offering (such as the amount of money to be raised, minimum investment amounts, projected returns, etc.).
What is considered ‘general solicitation’ or ‘advertising’?
Rule 506(b) contains an absolute prohibition on general solicitation or advertising, both of which are broadly defined. This is specifically what distinguishes a “private offering” from a “public offering.” The prohibition precludes general announcements regarding an offering in any group setting where the syndicator has not already established a substantive pre-existing relationship with each person receiving the solicitation or announcement. The safest route is to conduct discussions regarding the sale of securities pursuant to any private offering in a one-on-one setting.
Examples of improper solicitation include announcements: made in front of a real estate investment club or during a teleconference with multiple participants; posted on a bulletin board, blog, search-engine-optimized website or other electronic forum; mailed to lists of accredited investors obtained from list brokers; blasted via email to multiple recipients (whether you know them or not); and presented during seminars whose sole function is to talk about a specific offering or the syndicator and how it structures, or has previously structured group real estate transactions.
When trying to decide if your proposed activity complies with the rules, it might be helpful to ask yourself, “What would a jury think?” as those individuals may be the people deciding your fate if you do it wrong.
How to Comply
How do I establish a ‘Substantive Relationship’?
A good place to start is with by having every prospective investor fill out a prequalification questionnaire in which the investor describes, in his or her own words, whether he or she is “Accredited” or “Sophisticated.” The investor should sign and date this form and return it to the syndicator. The syndicator should follow up with phone calls and/or face-to-face meetings (preferably more than one) over a period of time in which the issuer gets to know the investor personally and asks questions about the investor’s financial situation and investment goals. The syndicator should document each meeting/discussion with dates, times, participants and topics discussed.
A decision as to whether you have violated securities rules will likely hinge on a preponderance of evidence as to whether you have made effective, consistent and documented attempts to comply with the rules of the claimed exemption.
Make sure you like this investor before taking his or her money. You may be in an intimate relationship with this investor for many years to come—through good times and bad, for richer or poorer—you get the idea. “Nervous Nellies” are not good investors. They will call your home at all hours, conduct internet investigations into your personal affairs and will ultimately keep everyone who is involved awake at night.
When should I establish this relationship?
You should establish the relationship before you have anything to offer. The “rule of thumb” is that you should not offer someone an investment that was available or “contemplated” on the day you first met. If you think you want to be a syndicator, you should develop a database of prequalified investors with whom you have established a substantive relationship, before you have any “contemplated” deals to offer.
Whether a deal is contemplated is a subjective determination, but it’s a pretty safe bet to say a deal is contemplated when it’s under contract, you’ve conducted due diligence or you have drafted a business plan or prepared a property information package. As with all of these rules, there is no bright-line distinction.
How do I determine ‘Investor Suitability’?
Your follow-up conversations with investors should include candid conversations regarding the amount of money an investor is looking to invest, the investor’s overall net worth (which the investor may have to determine with his or her CPA), the types of properties that interest the investor, geographic areas he or she likes/dislikes, previous/other investments and their outcome/returns, the desired duration of an investment and the types of returns that are expected, etc. Any unrealistic investors should be ruled out.
Aside from financial qualifications, a smart syndicator will determine whether he or she “likes” the investor and whether they have compatible personalities.
When can I tell someone about my deal and what am I allowed to say?
Only after you have established a substantive relationship and determined that an investor is suitable for your offering (all of which has been carefully documented), may you legally send an advertisement, promotion sheet, Property Package, Business Plan or a complete set of Syndication Offering Documents (PPM, Subscription Agreement, Operating Agreement, etc.), or otherwise make an “offer” regarding a specific investment opportunity to an investor inviting his or her investment in a Rule 506(b) offering.
During the investor suitability and qualification process, the syndicator should also discuss his or her own qualifications, business goals, etc., so that the investor has enough information about the syndicator to know whether the investor would like to invest with the syndicator! This is your opportunity to discuss the type of training/coaching you’ve received, and who your mentors are.
What can’t I say?
You cannot say anything that is false or might be misleading, and you cannot offer any guaranteed returns. We recommend that an attorney review, in advance, any marketing, websites or other promotional materials that you plan to send to prospective investors. Any investors you obtain from improper advertising or general solicitation may become “fruit of the poisonous tree,” and you may be precluded from ever offering them an investment.
NOTE: Your mentors, coaches and attorneys should never be listed in your offering materials as part of your “team” without their specific, written permission and material participation (including some level of control over your transaction and additional compensation), as they could potentially be held liable for your actions if something goes wrong.
What if I don’t know enough suitable investors and I have a deal under contract now?
Find a team member who has experience and established relationships with investors and invite that person or entity to be part of the issuer; work with a registered investment adviser; pay a licensed securities broker/dealer to sell your securities or become one yourself.
NOTE: This article specifically pertains to requirements of Private Placement Offerings under Regulation D of the United States Securities and Exchange Commission (SEC). It is best read as a follow-up to “Legal Aspects of Raising Money from Private Investors,” available from Syndication Attorneys, PLLC. This discussion is of a general nature only and is not to be construed as specific legal advice, which requires the establishment of an attorney-client relationship and fee agreement. Furthermore, state and federal securities agencies and other securities attorneys may interpret these rules differently than presented herein. An issuer represented by securities counsel should rely on its own attorney’s advice with respect to the matters discussed herein. At Syndication Attorneys, PLLC, we will be happy to discuss your investing goals with you. You can schedule a free, 30-minute consultation by clicking this link.
 If the property, the syndicator and every investor will be from a single state, a less restrictive state securities exemption or limited public offering may be available.
 As of July 2010, an Accredited Investor is defined as having $1 million net worth exclusive of equity in his or her primary residence, or $200,000 income for the past two years and into the foreseeable future as an individual or $300,000 income as a married couple.
See the related article, “Legal Aspects of Raising Money from Private Investors.”
 Note, however, that in recent litigation, the SEC has suggested that email blasts to multiple recipients, even where the syndicator had already established the pre-existing relationship, was a prohibited general solicitation.