By: Coni S. Rathbone, JD, CRE, Shareholder
Zupanic Rathbone Law Group, P.C.
2014 is ringing in one of the most fundamental changes to private financing since the creation of Regulation D. It will be interesting to see whether conventional or alternative financing arises as the predominant financing tool for 2014. The changes in private financing, triggered by the 2012 Jobs ACT, will finally, in 2014, create a significant impact in the private market and likely in the financing market as a whole.
During the last several years, particularly in 2013, the U.S. economy has continued a steady crawl out of the deep 2008 to 2009 financial recessions. The outlook for 2014 looks positive, with economists predicting continued “measured” growth.
One of the greatest challenges to the economy during the financial crisis was the unavailability of money from traditional sources. Moreover, private money was sitting on the sidelines awaiting some certainty in the recovery. In the current climate, money will be much more readily available, albeit under much more stringent underwriting requirements and guidelines.
Banks and life companies are making loans again; however, their underwriting criteria is considerably more onerous. This change is positive, in that, pre-2008, underwriting criteria seemed to be entirely missing in action. Loan-to-value ratios currently fall in the 60% to 80% range.
Completely absent for several years were “CMBS loans.” They are back in 2014 with a vengeance. Borrowers can often obtain 10% more loan proceeds from a CMBS loan than a Freddie or Fannie loan. CMBS lenders’ rates are competitive, so if the project can tolerate the substantial yield maintenance requirements, this form of lending may be a good option. It’s interesting that the CMBS market has recovered relatively quickly, given that is one of the primary drivers of the financial crisis.
In 2012, Congress passed the Jump Start Our Business Start Ups Act (“JOBS Act”) in an effort to provide better access to equity through securities offerings. Congress intended for the JOBS Act to provide a relatively immediate source of new financing for the country, as evidenced by the Act’s fairly aggressive 2012 and 2013 deadlines for proposed implementation rules. Unfortunately, the SEC missed each deadline, causing great delay of the JOBS Act. However, many of the rules are now in effect, or are at least proposed. This means that private money will now start flowing as the legislature intended when it passed the JOBS Act.
People regularly referred to most elements of the JOBS Act as “crowdfunding.” The common understanding of “crowdfunding” means bringing together projects and money on the internet.
Really, this is “crowdsourcing.” Crowdsourcing means raising money on the internet, typically through portals. I liken these portals to dating sites. Instead of boy meets girl, it is investment meets money. It will be interesting to observe over the next year whether the securities broker dealers will become the controlling influence over the portals.
There are three primary aspects of the JOBS Act within the “crowdsourcing” definition that will be of interest to real estate investors and issuers: (1) Crowdfunding; (2) Advertising and General Solicitation of Reg D offerings; and (3) Regulation A offerings.
Crowdfunding will be used primarily for start-ups. In a crowdfunding transaction, an issuer is allowed to raise up to $1,000,000 over a 12-month period.
It permits a private company to sell securities in small amounts to large numbers of investors that are not accredited investors. The offer and sale will be exempt from state registration, and there are no public reporting requirements.
There are two primary methods of crowdfunding: donation-based and investment-based. For years there have been internet sites, such as Kickstarter, that have promoted donation-based money raising. For example, I want to fund a new fancy hat business. If you like my idea, you donate money to my company and if I am successful I will send you a fancy hat.
With the JOBs Act, this system has evolved into a process for raising money with expected returns. Because of the $1 million limitation it is not likely that crowdfunding will be used any substantial amount for real estate transactions. This product is truly targeted to start-ups with low capital requirements.
A big concern with crowdfunding is whether one offering will be integrated with other offerings of related issues for purposes of exceeding the $1 million cap. The SEC has not yet issued proposed rules for crowdfunding. Once implemented, crowdfunding will be popular, but likely not huge in real estate financing arenas due to the $1 million cap.
The SEC, now, for the first time ever, allows advertising and general solicitation in Rule 506 offerings if sold only to accredited investors. This means that an issuer in a Rule 506 offering can run newspaper soliciting for investors for a particular private offering, or even more likely, list their offering in an internet portal set up for this purpose.
Currently, an accredited investor is a person that earns $200K annually (or $300K with their spouse) or has a net worth of $1 million, excluding the investor’s personal residence. In July of this year, the SEC will be determining whether to increase the accredited investor standards to make it available to less of the population.
One complication with an advertised offering is that the issuer must certify that the investors are accredited. This has raised significant concerns for issuers and in the broker-dealer community with respect to determining “what is enough” for purposes of providing a certification of accreditation of the investors. Moreover, registered securities’ broker-dealers are worried about being cut out of the sales process altogether.
Despite this certification issue, the ability to advertise Reg D offerings is a fundamental change in raising private capital through securities’ offerings and will have a dramatic effect on private financing all over the U.S.
Finally, the JOBS Act made Reg A much more attractive by raising the maximum offering amount from $5 million to $50 million in a trailing 12-month period. Reg A can be described as a “mini” Registered Offering. Previously, the $5 million limit made Reg A unattractive because of the transactional costs. Securities issued under a Reg A offering can be sold to accredited and non-accredited investors and are freely tradable on a secondary market. (Rules for Reg A were issued on December 18, 2013.)
One important element of the proposed rules is that offerings greater than $5 million would be exempt from State regulations. With the new limits, Reg A offerings are a much more viable source of financing into the future.
While these changes in law will allow money to flow much more freely, other basic elements of securities laws will remain applicable, the most important being the anti-fraud provisions. As with all securities offerings, offerings under the JOBS Act remain subject to the anti-fraud provisions, meaning that there will be liability for misstatements and material omissions.
All methods of crowdsourcing allow liability for material misstatements and omissions. An interesting evolution will be whether investors will be likely to bring actions against issuers for misstatements and omissions when they have invested a relatively small amount of money in a Reg A offering through an internet portal.
It appears that the long drought of financing is over. Although harder to qualify, loans and financing are again available. The products to watch are those made available by the JOBS Act.
Coni S. Rathbone, JD, CRE, is a shareholder of Zupancic Rathbone Law Group, P.C.
This article was published in the DJC Oregon on Friday, January 4, 2014.