Tuesday, May 6, 2014

Crowd Funding and Rule 506(c)

I devoted a little bit of my book, Meet Wally Street. The Reason You're Stupid to Private Placements and Regulation D offerings. One of the main points that I wanted to get across is that you really have to keep your radar up when you are approached by people who want you to invest in their Regulation D offering.

As I mentioned in my book, there are several different ways for companies to raise money. Depending on the particular IRS Code Section, you might be able to raise $1,000,000, $5,000,000 or an unlimited amount from mostly accredited investors and a limited number of non-accredited investors.

The crowd funding people got out ahead of the regulators, specifically the SEC and were raising money without fully understanding the regulations. As a result, Congress passed a law, The JOBS Act of 2012 that basically allows crowd funding to continue. The crowd funding people were using the Internet and social media to raise funds for their ventures. However, it wasn't until The JOBS Act was passed and the SEC in turn in established a new rule named 506(c) that they were officially allowed to advertise their offerings. The private placements under this new rule 506(c) had to be made to only accredited investors. No non-accredited investors are allowed to participate in their offering on exempt securities.

The full details of the rule have not been fully implemented as the SEC is continuing to develop the final rule. They did however allow the rule 506(c) to go ahead. One of the things in the rule was that the issuer (the people promoting it and who want you to invest in it) had to "verify" that each investor was indeed an accredited investor. Well, what does "verify" mean as far as the SEC is concerned?

Verify means prove it with tax returns, bank statements, W-2's, 1099's, K-1's and the like. There is another way to "verify" a person or entity to be an accredited investor. You can obtain a written letter from a registered broker-dealer or an SEC registered investment adviser (RIA) to attest to the fact. As an alternative, you can also get an licensed attorney or a CPA to attest to the fact that you are an accredited investor. Some people are saying this is a little too much of a gray area. They rightly point out that the broker-dealer, SEC RIA, attorney or CPA would have an opportunity to fudge a little on the letter by saying someone is accredited when in fact they are not. Of course, I am not saying that all of these professionals would do this, but it leaves it open for conflicts of interest. For example, what if the issuer tells you this:

"If your attorney will not sign off on you being an accredited investor, then ours will."

Keep in mind that these people hawking these rule 506(c) Private Placements will exaggerate the merits of their offering, because they want your money. Some will say anything to get you to invest and if they are unscrupulous, they may "help" you get "verified" so you can invest. Now, I am not saying all these people are crooks or anything, but it certainly is a little bit of a gray area in my mind.

Recently, I came across one of these fresh and new 506(c) Private Placements.This particular one was in simplistic terms a Non-Publicly Traded REIT. As I mention in my book, there are plenty of Publicly Traded REIT's that you can buy any day of the week on the NYSE with full liquidity where you can get to your money in as little as three days. Conversely, these 506(c) REIT's are not liquid and in my opinion, are designed to benefit the issuer's executives above all else.

After a diligent review of rule 506(c), I was surprised to learn that you need no type of licensing whatsoever to offer this Private Placement. You would think that a REIT might have someone on the executive committee who is advising them from a securities perspective like a registered broker-dealer firm. You would be wrong, because it is optional. They can have a brokerage firm involved if they want to, but it is not necessary. Normally, you want a brokerage firm involved, because the brokerage firm tells all of their registered representatives to promote the offering to their customers. So, if they decide to fore go the use of a brokerage firm, then they are going to be relying more on advertising, seminars, web sites and social media to promote their rule 506(c) Private Placements.

The other thing that I noticed is that none of the executives have any real estate licenses. You would think people who are selling a Non-Publicly Traded REIT via rule 506(c) would have someone with a real estate license. At least I would think that way. This particular group not only did not have any real estate licenses, but they did not have any securities licenses either. Does that scare you a little bit? It does me.

It is difficult for most investors to find, but you can find information on the executives and their offering. It is much harder if they do not have any licenses. I was able to dig deep and find out that this particular Non-Publicly Traded 506(c) Private Placement was previously offered through a registered broker-dealer. Interesting. Once I found the brokerage firm, then I was able to pull up their information. Much to my chagrin, they had their broker-dealer licensed revoked. Revoked? Yes, revoked. That made me dig even deeper to find out why they got their broker-dealer license revoked. It turns out that this broker-dealer got their license revoked for misleading people about Non-Publicly Traded REIT's they offered. Whoa Nelly!

The first offer of this Non-Publicly Traded REIT was offered pre-rule 506(c). They had to use a broker-dealer the first time. Fast forward a couple of years and now because of rule 506(c), they do not need a broker-dealer. Who can blame them after their first experience with the now revoked brokerage firm?

Now, when I look at this I see a company promoting a Non-Publicly Traded REIT via rule 506(c) without a broker-dealer, without a SEC registered investment adviser, without any licenses of any type and wonder if the accredited investors did their homework like I did. I seriously doubt it.

So, what is an accredited investor to do if they want to "verify" the issuer or people promoting this offering? Full disclosure here as I have no financial incentive or involvement with this firm, but there is a firm called Crowd Check that runs a background check on the issuer and its executives for a fee. To me, it would be worth the fee to have this done if you are real serious about investing in a particular Private Placement. Their web site is http://www.crowdcheck.com. They have lots of great information about all the different Regulation D Private Placement rules. In addition, they think like I do. Their goal is to protect investors.

As for me, I am going to stick with the advice in my book. Never invest in a Private Placement in the first place and you will be better off. Why do you want to invest in something that is totally illiquid and has restrictions against selling, requires you to hold it for several years, if not a decade and you have to hope that you get your money back, not to mention with interest? Why would you invest in such a thing as a rule 506(c) especially when you can invest in liquid investments and not take those risks?

Of course, this particular rule 506(c) Private Placement that I reviewed will have no trouble finding accredited investors to plop down their hard earned money. We will see in about ten years how they did. My guess is it will be not so good.

Be careful out there. More rule 506(c) Private Placements are coming and you will hear about them, believe me. Hopefully, you will not be easily swayed by all their hype.