How to Keep Yourself Out of Jail: Legal Compliance in Syndications
What are some of the biggest items that syndicators need to keep in mind? How to raise a fund yourself under your company name? Mauricio Rauld, securities attorney of Premier Law Group and host of Real Estate Syndicator Live, shares his knowledge.
Tell us a little bit about you.
I am a securities attorney. People tend to say that I'm one of the few attorneys or few lawyers that actually speak English so, I have this knack for taking these kinds of complex esoteric terms and making them somewhat easy to understand. I've been doing this for quite a long time now.
I started practicing back in 24 years ago back in 1999 and started my law firm job with one of the top rate law firms here in Southern California I was doing a lot of securities work and a lot of litigation back then. I represented the brokerage houses, the JP Morgan's, the Merrill Lynch's American Expresses of the world when they got sued. I was a defense attorney, I would do all the fun stuff, depositions, motions, trials, arbitrations, and appellate work but I quickly realized that was not what I wanted to do luckily I came across a little purple book, Rich Dad Poor Dad book that led me to get introduced to the real estate guys because they were affiliated with the rich dad and he was actually promoting them for something. Luckily for me, I got introduced to the guys who allowed me to leave my firm and become sort of general counsel for Robin Ross over there, which was amazing. That's really where I cut my teeth on the syndication process itself, they were doing a ton of syndications and raising a lot of capital.
In 2007, I started my own firm, Premier Law Group, we help real estate syndicators, make sure that they are in full compliance with federal and state securities laws when they're out there raising money. I kind of semi-joke that my job is to make sure my real estate clients' real estate syndicators stay out of jail to the point where I've actually ended up writing a book called The Five Things Every Syndicator Must Know to Stay Out of Jail, I picked it on purpose because there are so many people who are raising money completely and blatantly ignoring securities laws that they know is non-compliant. They have the attitude of, everybody's doing it, who cares, what's the big deal, and it is a big deal and you're not going to end up going to jail unless you're doing something fraudulent or something crazy, for example, a Ponzi scheme, Bernie Madoff, he's no longer in jail, I guess he passed away, but it has some serious consequences. All of my colleagues are out there pounding the table about things they shouldn't be doing. And to be honest, we have given our own clients who kind of I will say, behind our back when we tell them not to do something, and then we find out later that they've been doing it anyway because they just want to go raise the capital that's why I wrote that book to talk about some of the ways and some of the things you should be concerned about. If you're raising capital, make sure you don't end up in a in a yellow jumpsuit or orange jumpsuit like Bernie Madoff did.
What are some of the biggest items that syndicators need to keep in mind that are easily forgotten?
Understand that you are in the business of selling securities, because a lot of times, especially new real estate syndicators, they don't quite understand that. I'm just buying real estate, why do I have to worry about the Securities and Exchange Commission or the SEC? I'm just getting a couple of my friends and we're going to go buy a single-family home or buy this building, why do we have to worry about all this stuff? People think of the SEC as the stock market, stocks, bonds, mutual funds, etc but it is much broader than that. TIC agreements, joint ventures, profit-sharing agreements, and promissory notes are potentially securities, I always joke that high fives and handshakes are securities but the structure itself doesn't matter. People try and get creative such as I'm going to structure it this way or that way, or it's just a loan, it's just my dad, but the reality is the SEC doesn't care about any of that, all they care about is whether you are raising money, where the returns are generated by your efforts. If you're raising money, and you're doing all the work, or you and your co-sponsors are doing all the work, and you have passive investors who are writing you a check, it doesn't matter how you structure it, and how creative you get structuring it, it's going to be a security and that's something that newbies forget. Some of the more established ones try and get creative with things, such as a promissory note, a ticket agreement, or a joint venture and the SEC does not care how you structure it. The most common mistake is a lot of people are doing structures out there as a joint venture when they're really just securities offerings. Whether it's a joint venture, or it's a security, you don't get to make that decision, it is what it is. People call me a lot and say, it's just a small deal or it's just my friends and family, I think I'm going to do this one as a joint venture instead of syndication and you don't get to make that choice, we are going to look at the facts of how you structure this deal and it's one or the other.
My good friend Tom Wheelwright, a tax CPA, is a rich dad advisor and likes to say, that if you want to change your tax, you have to change your facts and he's really well-known for that. He was a good friend of mine so I bought it from him. If you want to change it from being a security offering to a joint venture, then you've got to change your facts. You can't have a situation where you're doing all the work and your joint venture partners are just giving you a check and getting all the returns. In order for it to be a true joint venture, everybody in that partnership has to be actively involved and doing something so that the returns aren't generated by one or two people, but they're generated by everyone. Typically, you don't want to have too many people because if you have 8, 9, 10, 15 people in a joint venture, there's no way everyone there is actively participating in helping to generate the returns. So generally, limit that to maybe 4 or 5 partners, call them partners, not investors. Everybody has proportionated, voting rights, depending on how much money they brought in, and everybody has to be some level of expertise for example you’re doing the day-to-day management, I'm doing the due diligence, you're doing this, you're working with the lender, everybody has to be rolling up their sleeves because if you have one passive investor, it's going to cross the line and become a securities offering, whether you like it or not.
What would be a way to go around that, would it be to raise a fund yourself under your company name, and then invest in that deal if you don't want to participate fully on the operations side or other things?
That issue comes up in another big way people are sort of violating securities laws. Probably 5-10 years ago, this wasn't big of a deal but what's going on now is that people are really coming into syndications, people are raising money, a group of sponsors are legitimately doing a syndication, they're going to buy a piece of property, they're complying with securities law, but then you have one of the partners that comes in specifically to raise money for the deal. It's very common these days, especially because it's getting harder to raise money, that if you need to go raise 2 or $3 million, and you're out there raising and you're going to come up short a million, it's very tempting to bring somebody on to your team just to bring in that last 500,000 or last million dollars and that's one of the biggest issues we're seeing right now in the Security Center. Just as prevalent as joint ventures, all of these groups of syndicators that at least one if not multiple people on their team, and their sole role is to raise capital. And just like you can't practice medicine without a medical license, just like being a lawyer without a law degree, you cannot raise money for other people without a broker-dealer license. It's a licensed and regulated activity and of course, none of those general partners that come into syndication, they're not licensed brokers, they're literally coming in and acting as what we call unregistered brokers or unlicensed brokers because they're bringing in capital in exchange for compensation, it's usually in the form of shares in the GP or membership units in that in that company, it's not usually cash. I don't see too many people coming in and just getting a flat commission where they'll raise a million dollars and get an 8% commission, but they will come in and raise a million dollars and in exchange for that get 10% of the GDP or 20% of the GDP. And what's worse is that they'll even make a contingent like if I bring in 500,000, then I'll give you 5% at bringing a million, I'll give you 10%, all those kinds of transaction-based compensations, which are just blatant violations of broker-dealer rules.
What people forget is that all of those emails, and negotiations that are going back and forth, for example, hey, Stephanie, I got a bunch of investors over here, I can bring them into your deal, just give me 5% or 10% of GDP. And then you're responding, I'll give you 8%, I'll give you that, and then and I want this and I can bring this, and all those emails are not privileged whatsoever. If anything were to happen, if there was an audit done on your syndication, or most likely what is going to happen is your deal goes south and investors start to lose money so they start calling regulators and then they open audits, they're going to see all those emails, they're going to request all the documents, and they're going to see that these were negotiated purely for raising capital. They're going to nail the syndication team and the syndicator for using an unlicensed broker.
In order for somebody to come into the syndication group as a legitimate co-sponsor and bring in some capital, there are three things they need to fit into because there's an exemption. The general rule is you need a broker-dealer license, but we can find an exemption to registration and that would be what we call the issuer exemption which requires three things and most of these deals don't follow. Number one is no transaction-based compensation. This happens a lot, you have to be willing to say, I'm going to give you 10% of the GP even if you don't bring a single dime. I know you promised that you thought you were going bring half a million dollars from your investors and it turns out, you aren't able to bring any, you still have to get that 5% or 10% because you're giving that person that percentage, not for raising money, but for other things they should be doing like any other syndicator: due diligence, underwriting, asset management and all these little ton of things otherwise it's transaction-based compensation. Your primary role needs to be those substantial duties, it can't be raising capital and you have to show that you're doing more than that. If you're a real syndicator, you have two or three partners, you're part of the team, and you're all working hard to make this deal work, then you're going to fit into that exemption.
But what's happening now, which is really driving me crazy, is you're just seeing 7, 10, 15, 18 co-sponsors on a particular deal. Forget about one or two, probably the vast majority of those people that have been brought in to raise the capital, and they're doing very little work or really not doing any work once the deal closes. And if they are, they're just really trying to fit that square thing in the round peg or whatever that thing is called, where they're supposedly showing up to meetings, but they really aren't really materially participating in the deal.
Creating your own fund and then investing in somebody else, is one way or another way to kind of avoid that issue, I did a video on this and a blog, it's called The Six Ways to Legally Raise Money, but if you are really great at raising money, you just have a great audience, you add value to them, and it's relatively easy for you to go raise 500, or a million, or 2 or 5 million. One option is getting the appropriate license and being able to do it legally or you could set up your own syndication, write your own fund, raise money into your fund, fully comply with all the rules set up your PPM, and talk to the Security attorney, raise all the money into your own fund that you manage, and then go out and allocate a piece of that fund into different deals that you like. You're not a co-sponsor or CO GP, you're literally a fund manager and you're saying, hey, Stephanie, over here has got a great deal. She's raising a couple million dollars and I really liked that deal. Let me put 500k into her deal and my fund will be an LP and her deal. Then, I go over here, oh, Bronson's got another great mezzo here, I'm going to put in a million dollars over there. You start allocating capital of the money that you've raised and that's what you're really getting compensated now. Now, you're going into each of these deals, evaluating them, and making decisions because passive investors are busy, they don't have time to go meet with all, they don't have time to go underwriting or look at your operations and so that's the value that you bring as a fund manager of putting your own syndication together.
Do funds pay interest until they allocate all of the funds, is that optional?
That's the beauty of syndications in general and certainly, with funds, you can be as creative as you want to be. I would usually recommend not making it super complicated because then you start losing investors. Some people decide to give a flat fee, almost like a coupon rate. I'm just going to give you an 8% or a 10% return every year and I'm going to pay you monthly and I'm going to do what I'm going to do with the money and then I'm just going to pay you, it's almost like a promissory note although they are technically equity owners, they do get some depreciation benefits.
Other people just do straight splits, it's like, hey, I'm putting this fund together and whatever we invest in, we're going to split the profits at 80-20. I'll take 20% for running the fund and we'll give the remaining 80% to investors. Some people do different classes, if you're in this type of class, you're just going to get a flat fee, and I'm just going to pay you 8%. You're going to be almost like a loan so, you're ahead of everybody else, but you're only going to be capped at 8 or 10 or 12 % and then everybody else is going to be 70-30 or 80-20, or whatever the splits are.
There are some nuances in funds that don't show up in a regular syndication that people should be aware of, for example, if I go raise $10 million, do I collect all $10 million now? What if it just ends up sitting in my bank account for the next six months and not deploying it? How am I generating a return, you've given me your money that's sitting in my bank. The bank accounts these days are paying 5%, I can put it in the money market accounts, it's not the end of the world but a couple of years ago, when your interest rate was half a percent, that was an issue, that's something you need to work with. Do you want to take all the money upfront? Do you want to just take soft commitments, which you probably don't because then people change their minds?
Most of our clients would like to take a deposit so that kind of hooks them a little bit. Let's say they invest 100,000, maybe instead of wiring you 100, they wire you 10% or 10,000. And then, you can cash all the rest when you need it. And then withdrawal provisions, that's another thing that usually doesn't show up on a specific deal product, or whatever the length of the deal is, which usually 5 to 7 years. But in the fund, does it go on forever, how do I get in and out, those are the questions you have to ask and answer for the investors. This might be a fund that is going to last to 10 years, some investment doesn't want to be tied up for 10 years so how do I get out of it and you're 5 or 4 or 7? There have to be some provisions in the fund documents that allow the investor to be able to give you notice. Then, you have to figure out what's the price that you're going to get out so those are little things you've got to work through in a fund that usually isn't an issue in syndication, which is one of the reasons funds tend to be a little bit more complicated and a little bit more expensive.
I don't usually recommend funds for first-time syndicators or newer syndicators because it's much harder, and a lot of our clients are realizing this, a lot harder to raise money for a fund than it is to raise money for a product specific. From the sponsor standpoint, it's great, I get all the money in the fund, I get to decide what to invest in, I may even have economies of scale because I can go buy something for cash when I'm competing with other people, I can close faster because the money's sitting in my account. But on the flip side, it's tougher for the investors because they don't see anything, they don't know what you're investing in, they don't have the pretty pictures or the specific business plan, or pictures of the property or what market you know exactly where it is in the state. So, I'm really trusting you, and basically just saying, I'm going to give you $100,000, I trust you to go do whatever you're going to do with it and that's harder. If you don't have a track record, and you haven't done this for a while, you don't have a really solid base of investors, that is going to be harder for you to do.
If you're a first-time syndicator, I would argue that it's almost impossible unless you have a huge following. You can start off with funds from day one because they make a post and 500,000 people see it or they do a video and they've got a million followers. For all the rest of us mere mortals, we're probably starting with a project-specific deal for the first couple of 3,4,5, and at some point, you get that traction and you've got 50 investors that are super happy with you and they're going to give you money and just go do run with it.