Tread Carefully When Raising Capital

October 22, 2008
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Real estate developers who plan to seek commercial loan financing for the bulk of acquisition and development costs may hope to raise part or all of the equity needed from investors. In doing so, they should take care in the manner in which they offer and sell interests in a new development company.

Both federal and state securities laws will impact the capital financing. Failing to comply with those laws can result in severe personal consequences for the developer. He can be subject to regulatory or even criminal proceedings by state, SEC or other regulatory bodies. He also can find himself personally liable for a refund of the investors’ money plus attorney’s fees and interest, generally at 6 percent.

This can be the case even if the developer’s noncompliance is inadvertent and the project is unsuccessful for matters outside of his control.

Under federal and state securities laws, the offer and sale of all securities must be registered or an exemption from registration must be satisfied. Stock in a corporation is a security, and membership interests in a limited liability company are almost always deemed securities. Registration of the securities will not be an appealing alternative for the developer. As a result, he will need to work with counsel to identify federal and state exemptions from registration for what he is offering.

Exemptions From Registration

Most likely, the developer will seek to rely on the federal exemptions from registration provided by Regulation D, adopted under Section 4(2) of the Securities Act of 1933. That exemption permits the private offering (i.e., there can be no general solicitation or advertising) of interests in his new entity that meets the requirements of Regulation D, which have to do with the information provided to offerees, the requirement of a fairly simple notice filing with regulators, the financial standing and sophistication of offerees, and the manner of offering, among other things.

One of the principal concerns for developers is the prohibition on any general solicitation. To be safe, developers should offer interests only to people with whom they have a pre-existing relationship sufficient for them to have an understanding of the investor’s financial standing and business and investment sophistication.

For a private offering like this, the developer cannot seek investors at seminars, distribute flyers, or even mention his capital-raising process in press accounts of the overall project. Any publicity about the capital raising will likely cause the developer to lose the availability of a private offering exemption for some time.

In addition to identifying an exemption at the federal level, the developer will need to work with counsel to identify and comply with exemptions at the state level. For most Regulation D offerings, his compliance will be limited to making a notice filing (which is the same filing to be made with the SEC) and the payment of what is usually a fairly nominal fee.

Disclosure Rules

In addition to identifying and satisfying exemptions at the federal and state levels, the developer must be certain that he discloses all material information about the potential investment to investors.

This requirement is separate and distinct from the exemption requirements, some of which also require specified disclosure. The material information requirements, sometimes called the anti-fraud rules, means the developer must disclose to prospective investors all information that a reasonable investor would want to consider in evaluating the investment.

Certain items are almost always deemed material, such as any compensation the developer is taking as the promoter of the investment or manager of the company and any conflicts of interest he may have in the project (for example, if the developer’s construction company will likely be the general contractor for construction work).

Compliance with the anti-fraud rules would usually be accomplished by the developer preparing a disclosure document and sharing it with potential investors. In this way, there is a reduced chance of later disagreements about what was disclosed.

There are other federal and state securities laws and rules that often impact the offer and sale of securities in these types of projects. For example, if there is a minimum amount of equity that must be raised or if there is some other contingency (for example, zoning approval) that must be met before an offering is completed, special rules apply to the handling of investor funds pending satisfaction of raising the minimum or satisfying the contingency.

Close consultation with securities counsel would be a wise move for developers to ensure compliance with the exemption, disclosure and other applicable rules.

Failure to comply can result in real pain for developers.

Loren Andrulis is an attorney with Warner Norcross & Judd LLP in Grand Rapids. He concentrates his practice in real estate, securities and business services.


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