Last week, the Securities and Exchange Commission (“SEC”) adopted final rules that will make it easier for real estate firms to pursue capital raises of up to $50 million in a 12 month period.
The rules, commonly referred to as Regulation A+, permit eligible companies to conduct securities offerings without the onerous requirements of full securities registration. What’s more, companies can solicit funds from individuals who are not accredited investors. In other words, companies can promote their investment opportunity to any investor with an internet connection, although unaccredited investors will be limited in the amount they can invest. It’s no surprise why Regulation A+ has been called the private company’s mini-IPO law.
Silicon Valley’s legal community seemed to shrug and yawn when asked about the fundraising opportunities for startup tech companies, according to a recent article in The Recorder. Time will tell if they are right. However, in the real estate investment and development community, $50 million can help fund a very attractive real estate opportunity.
Overview of Regulation A+
Of course, the new regulation is not without its process and procedure, so real estate project sponsors need to proceed carefully. The exemption cannot be used for a “blank check” real estate business model. In addition, the new rules establish two tiers of offerings that can be made:
Tier 1: Annual offerings of up to $20 million, including no more than $6 million on behalf of selling security holders that are affiliates of the issuer. There are no minimum investor qualifications and only reviewed, but not audited, financials are required. However, Tier 1 offerings are subject to both SEC and state review.
Tier 2: Annual offerings of up to $50 million, including no more than $15 million on behalf of selling security holders that are affiliates of the issuer. A company making a Tier 2 offering must provide audited financial statements, annual reports and engage in ongoing reporting. Tier 2 offerings will be exempt from registration and full Exchange Act reporting and may list their securities on a national securities exchange by filing a short-form registration statement. Unaccredited investors can purchase no more than (i) 10% of the greater of annual income or net worth (for natural persons) or (b) 10% of the greater of annual revenue or net assets at fiscal year end (for non-natural persons). Tier 2 offerings are subject to SEC, but not state review.
Real estate companies can “test the waters” with, or solicit interest in a potential offering from, the general public either before or after the filing of a Regulation A+ eligible offering statement so long as certain conditions are satisfied. This can be an important tool for real estate developers who want to gage interest in their particular project before launch.
Some Issues Unique to Real Estate Related Offerings
Unlike a typical startup company offering, structuring a real estate offering properly is crucial to take advantage of the new regulation.
For example, asset backed securities are excluded from the list of eligible securities that can use Regulation A+. The definition of an “asset backed security” under the Securities Exchange Act is “a fixed income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset, including (i) a collateralized mortgage obligation, (ii) a collateralized debt obligation, (iii) a collateralized bond obligation, (iv) a collateralized debt obligation of asset-based securities, (v) a collateralized debt obligation of collateralized debt obligations, and (vi) a security that the Commission, by rule, determines to be an asset backed security for purposes of this section.” The important take away from this definition for real estate companies? Regulation A+ cannot be used if a company’s offering is selling participation interests in real estate secured debt, in a long term ground lease, or other similar real estate secured receivables.
A more difficult question is whether Regulation A+ would allow an offering of mezzanine debt. Most commonly, a mezzanine loan is secured by membership interests in a limited liability company or limited partnership interests in a limited partnership that holds title to a real estate asset. Is the ability to enforce a pledge of such equity interests through a Uniform Commercial Code sale or foreclosure an example of a “self-liquidating financial asset”? As of the date of this writing, it appears that no federal court has had an opportunity to explain the meaning of this term. In a withering critique of the lack of clarity in the defined terms in the Exchange Act amendments, Professor Jonathan Lipson in his article Defining Securitization points out that the terms “self-liquidating” and “financial asset” could describe a wide range of things. He points out that the term “financial asset” is not defined in the Exchange Act at all and is defined very broadly in Article 8 of the Uniform Commercial Code to include an “interest in . . . property . . . which is recognized in any area in which it is issued or dealt in as a medium for investment.” This latter definition is obviously overbroad and ambiguous, which does not provide comfort to real estate companies.
Nevertheless, the definition of an “asset backed security” in the Securities Exchange Act does have an exception that may be helpful to real estate project sponsors. An “asset backed security” does not include “a security issued by a finance subsidiary held by the parent company or a company controlled by the parent company, if none of the securities issued by the finance subsidiary are held by an entity that is not controlled by the parent company.” What this language suggests is that structuring a real estate investment transaction so that a finance subsidiary is the party involved in the capital raise may provide a path forward that has the comfort of being an exception that appears in the Securities Exchange Act itself rather than in the SEC’s rules. But again, one should proceed with caution in structuring the opportunity.
Finally, another alternative that should be considered is structuring a Regulation A+ offering with preferred equity in a limited liability company. This mechanism is likely outside the definition of a “self-liquidating financial asset” because its features are similar to a typical equity investment in a startup company, which was the focus of the SEC’s action and the federal JOBS Act. That being said, it is important think through the structure from a legal and economic perspective before moving forward. One important consideration would be review of SEC rules at the time of the offering, because the SEC has the flexibility to adopt new rules as to whether a particular offering strategy involves an “asset backed security.”
Other structuring options may be available. The good news is that one more tool will soon be available to help real estate project sponsors raise funds in the capital stack. Regulation A+ will take effect 60 days after its posting. We will see how the real estate community reacts to this new financing tool.