Capital raising for any kind of venture, but especially niche initiatives like qualified opportunity funds (QOF), is challenging enough and even more so when navigating the federal securities laws. However, recent regulatory developments and the burgeoning offering mechanisms have the potential to significantly expand the pool of potential investors and reduce a fund sponsor’s burden. Fund sponsors should pay careful attention to the possibilities arising from changes to the traditional private placement exemptions and to general solicitation market leaders when structuring their offerings – whether for real estate or operating companies.
SEC ADOPTS NEW RULES IMPACTING THE OZ MARKET
In the late fall of 2020, the Securities and Exchange Commission (SEC) adopted final rules to implement significant changes to the common securities offering exemptions under “Regulation D,” including SEC Rule 506. This rule permits a company, or issuer, to raise an unlimited amount of money from an unlimited number of “accredited investors” and up to 35 non-accredited investors. But if any non-accredited investor is to participate in the offering, the issuer has regulatory-prescribed disclosure obligations that includes requirements like audited financial statements. However, those requirements are inapplicable to offerings exclusive to accredited investors (subject to general anti-fraud rules). For years, entrepreneurial founders, sponsors, and securities lawyers have been disappointed to learn that the potential to include non-accredited investors is practically a mirage. In many cases, it was simply uneconomical to comply with the disclosure obligations necessary to include non-accredited investors. Under the new framework, however, that may be less true.
Under the SEC’s final rule (which is expected to be effective early this spring), the financial disclosure requirements for offerings with non-accredited investors in the mix are harmonized with those available under other rules and regulations, particularly Regulation A. For example, an issuer need only include unaudited financial statements in offerings up to $20 million to meet its financial disclosure obligations. Together with the revised safe harbor for separate treatment (i.e., non-integration) of offerings, an issuer could now raise up to $100 million (and maybe even more) through multiple offerings during a single year, if structured appropriately, without paying for a financial statement audit.
An offering that starts more than 30 days after the conclusion of a prior offering, will be honored as a separate offering. That means that an issuer could do relatively back to back to back Rule 506(b) offerings, including up to 35 non-accredited investors in each one. To stifle the opportunity for abuse of this “non-integration” safe harbor, the SEC limits the number of non-accredited investors that could be included in a series of offerings to no more than 35 in any 90-day period. But even with that limitation, an issuer could still include up to 100 or more non-accredited investors in Rule 506(b) offerings in one year. That’s a significant expansion in the number of potential investors.
HOW TO RUN SIMULTANEOUS OFFERINGS UNDER NEW SEC RULE
In addition to sequential offerings, new SEC rules also now permit parallel, or simultaneous, offerings under certain circumstances that are not subject to integration (that is, being viewed as one and the same offering). This enables an issuer to raise money through a private offering that includes non-accredited investors potentially at the same time that the issuer conducts an offering that includes general solicitation, such as those under Rule 506(c) exclusively to accredited investors, or Regulation Crowdfunding to smaller dollar investors. Naturally, the new rules contain a healthy dose of nuance that an experienced securities attorney is best suited to apply, the general rule is that as long each offering complies with the rules applicable to that particular offering, it should not be integrated with another offering – even if conducted at the same time.
THE BENEFIT OF REGULATION CROWDFUNDING
Regulation Crowdfunding (or Reg CF), the particular form of offering that permits general solicitation of investors without regard to their accredited investor status, may also become notably more useful to fund sponsors beginning this year. Prior to the implementation of the new SEC rules, an issuer was limited to raising no more than $1.07 million over any 12-month period. Under the new rule, that cap will be raised to $5 million. Also, accredited investors participating in a Reg CF offering will not be subject to the same investment amount limitations that non-accredited Reg CF investors are subject to. By increasing the overall amount that an issuer can raise in Reg CF offerings, and the amount that can be raised from accredited investor participants, Reg CF is a much more vibrant option for project investments well suited to mass marketing. The new rules do not stop there – the SEC has also increased the amount an issuer can raise in offerings under Rule 504, a federal exemption available if the offering complies with state law, from $5 million to $10 million; and Regulation A Tier 2, an exemption with robust disclosure and reporting requirements, from $50 million to $75 million.
“FINDER FEES” MIGHT SOON BE LEGAL TO PAY
Encouragingly, it may also soon be permissible to pay so called “finders fees” to those who make introductions to capital sources without the finder or the issuer violating the broker-dealer registration laws. No rule on that subject has been adopted, but the SEC is seeking comments on a proposed framework that would allow finder’s fee payments if there are written agreements in place and adequate disclosures made to relevant parties. Entrepreneurs and their attorneys have long lamented the absence of a useful exemption for what many see as a crucial part of the entrepreneurial ecosystem. The proposed framework could finally give some well-received news.
ISSUES FROM RAISING EQUITY WITH CROWDFUNDING SOURCES
Over the past year, we have seen more sponsors approaching crowdfunding sources to raise capital gain equity. Crowdfunding, a term that is often informally used to describe offerings using general solicitation including Rule 506(c) and Reg CF. Crowdfunding, in its informal sense, is an alternative approach to funding a project or venture by raising small amounts of money from a large number of people using advertising or other marketing normally prohibited by more traditional exemptions. Investors in a crowd-funded fund may only be required by the issuer or regulation to contribute a minimum of, for example, $25,000 or less. For sponsors who are struggling to raise equity or are in a time crunch to do so, crowdfunding enables easier access to investor capital. Yet, crowdfunding can be stressful in that it requires additional marketing, different management strategies, potentially further scrutiny from investors during the 10-year holding period, potentially more complicated accounting mechanisms, and additional state blue skies filing costs and burdens.
Some qualified opportunity fund sponsors may be accustomed to raising funds from a smaller network of sources through a fund in a Rule 506(b) offering. Rule 506(b) is a safe harbor under Regulation D of the Securities Act that provides a way for companies to raise money without registering with the SEC. Essentially this means that sponsors in a Rule 506(b) offering cannot advertise to the general public. Solicitation is, however, permitted under a Rule 506(c) offering. Rule 506(c) permits issuers to broadly solicit and generally advertise an offering, provided that, except as noted above, purchasers in the offering are accredited investors, the fund sponsor takes reasonable steps to verify purchasers' accredited investor status, and certain other conditions in Regulation D are satisfied. Sponsors who raise equity through a crowdfunding platform would therefore need to do so pursuant to a Rule 506(c) offering.
CROWDFUNDING UNDER THE INVESTMENT COMPANY ACT
Another potential complication with crowdfunding arises under the Investment Company Act of 1940, which regulates the organization of companies that engage primarily in investing, reinvesting, trading in securities, and whose own securities are offered to the investing public. Qualified opportunity funds frequently qualify for an exclusion from regulation under the Investment Company Act, among other potentially applicable exemptions, under Section 3(c)(1), because they will typically have fewer than 100 beneficial owners, as calculated in accordance with the Investment Company Act. However, funds raising capital from crowdfunding sources are far more likely to have more than 100 beneficial owners.
It is critical for a qualified opportunity fund to maintain qualification for exemption as an “Investment Company” under the Investment Company Act, in order not to be subject to its regulatory regime. Generally, an “investment company” is a corporation, business trust, partnership, or limited liability company that issues securities and is primarily engaged in the business of investing in securities. Investment companies can be privately or publicly owned, and they engage in the management, sale, and marketing of investment products to the public. Among other reasons, qualified opportunity funds generally do not intend to invest in securities. Nevertheless, a qualified opportunity fund would typically need to maintain its qualification for one or more exemptions from regulation under the Investment Company Act, in the event that it would otherwise seem to apply. If it cannot qualify with the nuances of the mortgages-related exemption found in Section 3(c)(5), a qualified opportunity fund will ideally qualify for the “private fund exemption,” found in Section 3(c)(1) or 3(c)(7) of the Investment Company Act, so long as it has fewer than 100 beneficial owners. If relying solely on Section 3(c)(1), a sponsor or manager would therefore need to ensure that there are fewer than 100 beneficial owners.
As noted above, because funds utilizing crowdfunding sources are likely to subscribe more than 100 equity owners, it is not possible to rely on Section 3(c)(1). Fortunately, it may still be possible for such a fund to qualify for the exemption found in Section 3(c)(5)(C) and/or 3(c)(6) under the Investment Company Act because the Fund is not engaged in the business of issuing redeemable securities or periodic payment plan certificates, and is primarily engaged in the business of purchasing or otherwise acquiring mortgages, other liens on, and to interests in real estate, directly and/or through one or more majority owned subsidiaries.
Hopefully that recent regulatory developments have the potential to significantly expand the pool of potential investors and reduce a fund sponsor’s burden. As illustrated, there are a handful of securities pitfalls and issues to be mindful of when raising capital for qualified opportunity funds. This is especially true when incorporating crowdfunding into the mix. Fund sponsors should always consult counsel to help best ensure that you are steering clear of any potential securities pitfalls when structuring their offerings.
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