Crowdfunding: Disclosing Both Pros and Cons?

Crowdfunding has grown tremendously in the past few years, and with the recent finalization by the Securities and Exchange Commission of its rulemaking under a 2012 law, there may be an even greater expansion of investor opportunities.

Traditionally, large real estate equity and debt transactions are funded by large institutions such as REITs and life insurance companies that invest in companies or joint ventures with only one or two investors. At the other end of the scale, a local real estate developer or investor might gain funding from friends and family members by way of a limited partnership structure or "sidecars."

Crowdfunding uses the broad reach of the Internet to attract small individual investments from a wide range of investors, many of whom have never had access to direct real estate investments because of the large individual commitments required.

Until late 2015, sponsors of real estate investments were limited in their ability to raise funds from large numbers of small investors by securities regulations requiring time-consuming and expensive securities registration and prospectuses, unless the capital raise was limited to "accredited investors"—i.e., those having a net worth over $1 million or income over $200,000.

Now, a sponsor of real estate investments can raise up to $1 million in any 12-month period from investors with little or no income or net worth, as long as the investment doesn't exceed, for those with income below $100,000, the greater of (i) 5% of the lesser of income or net worth, or (ii) $2,000, and for investors with $100,000 or greater income and net worth, 10% of the lesser of income or net worth, capped at $150,000 for all such investments during a rolling 12-month period.

The new rules do require disclosures to investors, and the use of a broker-dealer or funding portal responsible for compliance with the offering and investment limitations and certifications, and annual reporting with the SEC. Still, this process is far more streamlined than a traditional registered offering or even the new smaller public offering now available under the securities laws.

The end result, of course, is a potentially important source of capital for smaller-end real estate investment companies, and a new and very quickly growing set of opportunities for average people to invest in real estate deals.

In creating and permitting this new source of capital and investment, the real estate industry and SEC are at the same time weighing the risks to small investors, most of whom presumably do not have a lot of experience investing in real estate deals.

Like the EB-5 program, which attracts investment to the United States from (wealthier) offshore investors with the lure of immigration status, crowdfunding will overwhelmingly appeal to very unsophisticated investors.

While some protection is provided by the limits on investment in the new regulations, it's not hard to imagine that when some of these investments inevitably fail, there will be a lot of shocked small investors. There will also be a lot of excited class action lawyers, as the new regulations do not reduce sponsors' liability for failure to adequately disclose the risks of these investments.

The recent articles on the use of crowdfunding for mezzanine debt highlight this, as most institutional lenders today will not touch mezzanine debt, still ruing the huge losses they suffered on those loans in the Great Recession.

For small real estate companies, crowdfunding represents a really promising new source of capital. But the unsophisticated nature of the investors mandates particular care in clearly disclosing both the pros and the cons of the deal.

http://www.jdsupra.com/legalnews/crowdfunding-disclosing-both-pros-and-22121/

Mentions

• UNITED STATES SECURITIES AND EXCHANGE COMMISSION

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• New York