It all began almost 100 years ago with tracts of citrus groves in sunny Florida and W. J. Howey Co (“Howey”). Howey sold tracts of citrus groves to buyers in Florida, who would then lease back the land to Howey. Howey would tend to the groves and harvest, pool, and market the produce on behalf of the owners. Both parties shared in the revenue. Most buyers had no experience, knowledge, skills, or equipment needed in agriculture and were not involved in the day to day operations themselves.
What Howey had failed to do is register the transactions with the U.S. Securities and Exchange Commission (SEC) and so the SEC intervened in 1946. The court’s final ruling determined the leaseback arrangements qualified as investment contracts.
The case resulted in a test, known as the Howey test, a four-prong test used to determine whether an instrument qualifies as an “investment contract” for the purposes of the Securities Act: “a contract, transaction or scheme whereby a person (1) invests his/her money (2) in a common enterprise and (3) is led to expect profits (4) solely from the efforts of the promoter or a third party.”
And that is how syndications were born. For a long time, however, investments in syndications were limited for the super wealthy…until 2012 when the Jumpstart Our Business Startups Act, or JOBS Act, among other things, reduced barriers to capital formation, particularly for smaller companies. The JOBS Act requires the SEC to adopt rules amending existing exemptions from registration under the Securities Act of 1933 and creating new exemptions that permit issuers of securities to raise capital without SEC registration, which registration is not only costly and document intensive, but also takes a long time. In 2013, the SEC adopted amendments to Rule 506 of Regulation D and Rule 144A under the Securities Act to implement the requirements of Section 201(a) of the JOBS Act. Those exemptions, while applicable to business in general, were also beneficial for the real estate industry overall as they opened opportunities for the average person to participate in large real estate investments.
The two most common SEC exemptions are Rule 506 (B) and Rule 506 (C). They represent private offerings that are regulated differently from public ones (e.g. stocks)
Under Rule 506 (B), a sponsor can raise unlimited amount of capital from unlimited amount of accredited investors and up to 35 non-accredited but sophisticated investors.
The full SEC definition of accredited investor is more comprehensive. However, as it applies to individuals investing in syndications it captures either individuals making at least $200,000 in gross annual income in each of the two most recent years (or joint income, with a spouse or partner, exceeding $300,000) or individuals with net worth (individual or joint) exceeding $1,000,000, excluding the person’s (couple’s) primary residence.
A sophisticated investor does not meet the income or net worth hurdles of accredit investor noted above; however, possesses business/finance/investment knowledge and experience to properly evaluate the risks and benefits of the investment.
Under the 506 (B) exemption, the sponsor is not allowed to publicly advertise the offering, including via social media or e-mail blasts. The sponsor is only allowed to share the offering with individuals/entities they have a substantive pre-existing relationship with. Such substantive relationship is usually established over time.
When participating in a 506 (B) offering, investors self-certify their accreditation status.
Under Rule 506 (C), a sponsor can raise unlimited amount of capital from unlimited amount of accredited investors.
The sponsor is allowed to publicly advertise the offering and a pre-existing substantive relationship is not a requirement.
When participating in a 506 (C) offering, investors undergo a third party written verification process to validate their accreditation status. Such third party validation is usually performed by the investor’s CPA or investment advisor.
The rules and laws regulating the 506 (B) and 506 (C) offering have many more requirements that a sponsor is/should be well aware of and adhere to. However, herein we are only sharing the ones that a passive investors more commonly come across. We recognize this content is denser as usual. Nevertheless, we thought it was important to share and hope you found it helpful.
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Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.