Are You Complying with SEC Rules on Syndications?

Did you know that it is illegal to receive compensation for referring an investor to a syndicator who’s raising money if you are not an SEC licensed broker-dealer? If you are a syndicator planning to raise funds for your syndication deal or a real estate investor helping a syndicator, you should know that private equity fundraising is heavily regulated and that there are many legal and regulatory requirements you must adhere to in order to be in compliance with securities laws. And you might be wondering why the securities laws are involved when you are buying a piece of property. 


We should all be aware that syndicators are selling securities every time they take money from investors where there’s an expectation of returns. As a general partner that takes an active role in generating profits, you are dealing with securities and therefore need to comply with securities laws. Mauricio Rauld and I talked about this at length in a podcast interview. As the founder and CEO of Premier Law Group, an internationally recognized securities firm focused on real estate syndication, Mauricio educates syndicators and investors on navigating the complex but critical legal component of the syndication process and capital raising. Mauricio himself has actively raised capital and built real estate companies and has advised the nation’s top real estate experts. 


I’d like to share with you some crucial legal information that we in the real industry must know as we raise capital for our syndication business in a lawful manner. As Mauricio jokingly says, “I’m here to make sure you stay out of jail.” Click here if you want to listen to the full episode.


Why it’s important to comply with SEC rules

Breaching SEC rules is serious business. The Securities Act says that any person (in our case, the syndicator) who sells or offers to sell securities in violation of the Securities Act or the Exchange Act by employing manipulative or deceptive devices or contrivances is subject to criminal and civil penalties, and purchasers (passive investors) of such securities may either rescind their purchase (investments) or sue for damages. Violators of state securities laws are subject to additional penalties and liabilities depending on state law.


The SEC regulators take this compliance very seriously and there are no excuses when violations are found. So, it is in the syndicator’s best interest to always comply with the federal and state securities laws lest you commit a felony, be sued by disgruntled investors, and bear the astronomical cost of settling liabilities. 


Illegal Ways of Helping a Syndicator Raise Funds

#1 Referrals with compensation

 A person who is not a licensed broker-dealer but makes introductions, recommendations, and referrals to sponsors and then receives compensation is committing a violation of the SEC laws.

“The first thing you have to recognize is that anytime you’re receiving compensation for helping others to raise money, you’re most likely acting as a broker-dealer. The rule is you cannot pay anybody a commission or transaction-based compensation unless that person is an SEC licensed broker-dealer,” explains Mauricio. An unlicensed broker can’t give advice or receive compensation for referring people just as medical professionals can’t practice medicine without a medical license and attorneys can’t dispense legal advice without a license. 

“The problem with the syndicator’s side is that they are concealing it because it’s an illegal payment. You’re doing an illegal offering because you’re not giving them the full set of disclosures. When you’re paying a referral fee, that can have a material effect on a prospective investor, “Are you referring it to me because you’re getting the compensation, or are you referring to me because you do think it’s a good deal?” That’s the number one obvious mistake,” says Mauricio. 


#2  Setting up side-agreements

Bringing in capital from a big contributor and then hiding it under a marketing agreement or a consulting agreement that is compensated by hefty fees is another common way people try to get around the SEC rules. If you have a consulting agreement or a marketing agreement, it will be your responsibility to prove that consulting services were indeed provided and the compensation for that service should be commensurate and reasonable to the actual work completed. In order to justify the marketing or consulting fees, pieces of evidence such as minutes of meetings, records of calls and meetings, marketing materials, marketing campaign projects, or some other proof that you actually did that consulting are crucial. Otherwise, if you lack proof and the SEC regulator conducts an investigation to find that you are only responsible for bringing in $1 million of equity for the deal, you’ll be charged for committing a violation.

“You can call it a marketing agreement or a consulting agreement or an independent contract agreement, it doesn’t matter. The SEC is going to look straight through your documents and look at the underlying facts. If you’re suddenly getting a $1 million check for doing a little consulting work, that will not make sense.  If anything, including those agreements and fees, is probably a red flag,” explains Mauricio. 


#3  Giving GP roles to money raisers

As you do syndication deals, at some point, you might run out of investors to raise fund from and need to connect with more people to find sources of investors. And if you can’t advertise, where would you get the money from?

Some operators will try to partner with other people entirely for the money that they can bring in without providing other substantial work or assuming active roles in the syndication. The tactic is to bring money raisers into a deal and give them a general partner position. But, it is critical in syndication that every person considered as a general partner has a substantial role and duties to be considered a legitimate cosponsor. 

“When an SEC regulator asks, “I see this person is a 5% or 10% GP in this deal. What did he do to earn that 5% or 10%?” Your answer cannot be, “He helped me raise money.” It has to be something else. When you’re coming in as a GP, you have to be doing real work. You can’t be just getting a percentage of the deal in order to get a percentage of the GP,” explains Mauricio.


The key is to be doing substantial work beyond just raising money. All general partners have to be involved in active duties and do the typical work that syndicators do.


Legal Ways That You Can Help Raise Funds  

#1 Fund of Funds (FOF)

A fund of funds (FOF) is a pooled capital from multiple investors which is invested in other types of funds. 


“In theory, you could raise money into your own fund and syndication. If you raise $1 million into your syndication, you turn around and invest that $1 million into somebody else’s deal. You get compensated with an acquisition fee and management fee at your level. You split it 80/20. You can negotiate with the company that you’re investing in for a little bit of preferential treatment because you’re coming in with a huge million-dollar investment,” explains Mauricio. 


The caveat in doing a fund-to-fund is that you’re no longer raising money and investing in real estate because you are now investing in a security that is similar to buying stocks. As you will now be giving advice on securities as opposed to real estate, do you now need to be a registered investment advisor in order to do that? Mauricio says that registration as an investment advisor is a state-by-state issue, with some states requiring it while others do not. It’s best to seek advice from your state regulator or securities attorneys to comply with state regulations.


#2 Become a Licensed Broker-Dealer

While becoming a licensed broker-dealer will bring legitimacy to accepting compensation from syndicators for making referrals, Mauricio maintains that this may not be practical. “The last time I looked at it many years ago, it was a six-month process and it’s expensive. You have to go through a series of exams and compliance obligations. It’s cheaper and easier to buy a broker-dealer firm. For $500,000 or something like that, you can go buy one but there is still a ton of compliance so it’s probably not realistic, but I wanted to throw it out there.”


#3 Bring in fund contributors as a legitimate co-sponsor

“When I say legitimate, I do not mean, “Come in and go help us raise money. We will give you 5% or 10%,” or the worst one, which is, “Depending on how much money you raise, we will give you a percentage of the deal.” That’s truly a transaction-based compensation, which is the hallmark of being an unlicensed advisor or broker-dealer,” cautions Mauricio.


Bringing in a money-raiser to become a legitimate general partner in a syndication deal means they will assume and maintain an active GP role and perform substantial duties in the syndication. Active roles in syndication that members can be involved with on an ongoing basis include, among others: acquisition and finding a deal, underwriting the deal, performing due diligence, financing and signing on the debt, putting the business plan together, asset management, marketing, and investor relationships.


“All that stuff that everybody else is doing, they have to do that as well. If an SEC regulator challenges you and says, ‘You are in 10% here. You didn’t put any cash into this deal. What did you do?’ You cannot say, ‘He helped me raise money.’ You’ve got to list all of the other items. If you’re doing investor relations where you’re spending a couple of hours a quarter and you’re getting 25% to 30% of the deal, it’s a hard sell. Your share should be commensurate to the amount of work you’re doing,” advises Mauricio.


As co-GPs, they will also assume all the liability and fiduciary responsibilities that come with the deal. In case the deal fails, all co-GPs will assume the burden and will bear the onus of settling all liabilities and obligations. 

“If the deal goes south, they’re going to go south with them because they are part of the deal,” cautions Mauricio. 

Nonetheless, Mauricio advises that bringing in your fund contributors as a legitimate co-GP is the main legal way to do it. 


Final Thoughts

While navigating the whole legal side of syndication is full of pitfalls, you shouldn’t let these regulations scare you. Multifamily syndication is still one of the best investment vehicles for wealth creation. You just need to educate yourself on the subject and find a reliable and trustworthy attorney to help you do it the legal and right way.


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