California AB 2081 would follow federal JOBS Act and permit advertisement of securities issuances. Could your hard money lending fund benefit?
Earlier this year, the U.S. House of Representatives passed the Senate version of the Jumpstart Our Business Startups Act (“JOBS Act”) and President Obama signed the bill into law. Among the most consequential provisions of the Act is the elimination of the prohibition on general solicitation or advertising contained in Rule 506 of Regulation D. People and businesses seeking to raise capital, including private or “hard” money lending funds, without enduring the burdensome process of Securities & Exchange Commission (“SEC”) qualification, most often rely on Rule 506 for exemption of their issuance. The Rule allows the issuer to raise an unlimited amount of money by selling securities to an unlimited number of investors as long as no more than 35 of the purchasers are non-“accredited investors,” as defined by Rule 501(a). In other words, Rule 506 exempts from SEC registration private securities offerings to investors with the sophistication and financial resources to make informed investment decisions and bear the risks thereof (for as a practical matter, offering securities to non-accredited investors involves disclosures so extensive as to defeat the purpose of the exemption).
Historically, the prohibition on general solicitation or advertising was a primary restriction aimed at limiting abuses of an otherwise liberal rule. Some welcome the freedom to advertise a Rule 506 offering as a further liberalization of the private securities market that heralds fundamental change in the nature of private fund offerings. To others, it amounts to a reckless abdication of the duty of governments to protect vulnerable individuals, especially the elderly and retired, from falling prey to unscrupulous fund managers who recently cost investors their life savings, in some cases, when the private money lending and housing bubbles burst.
It is important to note, however, that the JOBS Act permits general solicitation only if the securities are ultimately sold to accredited investors exclusively. This limitation may not affect a fund greatly if it is already selling only to accredited investors. But if a pool of investors includes non-accredited investors (up to 35 in number), then the prohibition on general solicitation remains in place.
And in fact, the prohibition remains in place for Rule 506 until the SEC adopts final rules regarding, among other things, the “reasonable steps” that a private securities issuer must take to verify that all purchasers are indeed accredited investors. Judging by the remarks of SEC counsel, it appears that the SEC will make the verification process deeper and more involved than the current checkbox questionnaire requesting unsubstantiated representations that the prospective investor meets certain rigid criteria. Such enhanced verification requirements would please critics who claim that the thresholds for accredited investor status are outdated in their focus on net worth, and thus correlate best with advanced age, not investment sophistication. Depending on what the SEC ultimately prescribes, though, fund managers may be able to advertise in various media, solicit through open websites, and conduct general investment seminars, so long as the ultimate investors are all accredited. That all remains to be seen, but in the meantime the new provision will allow professional placement agents in organized offerings to reach out to prospective investors more easily.
Amid the uncertainty surrounding the implementation of the federal JOBS Act, California State Assembly member Michael Allen has proposed to follow its substance on the state level by sponsoring AB 2081. This bill exempts from the qualification requirements of California Corporations Code section 25110 private securities issuances made in conjunction with general solicitation or advertising, as defined in Rule 502(c) of Regulation D. However, the state bill places greater restriction than its federal counterpart on the means of solicitation by forbidding unrequested telephone calls to the residence or mobile phone of a person unless reasonable inquiry leads the issuer and caller to believe that the target is an accredited investor.
A further condition on the availability of the state exemption is the accredited status of all securities purchasers at the time of sale, so here the proposed state law follows the federal. But AB 2081 goes beyond the JOBS Act in requiring also a reasonable inquiry into the “suitability” of the investment for each individual purchaser. It defines suitability to mean “that immediately prior to the sale, the offering is suitable for the person, based on the person's financial status, objectives, investment experience, time horizon, risk tolerance, and any other information the issuer deems relevant to determine whether the offering is suitable to the person.” While this standard may sound vague, California securities issuers have particular experience with suitability determinations, and if AB 2081 becomes law, you should consult with your attorney and financial advisor before advertising your hard money lending fund’s securities issuance.
California SB 978 would impose suitability and filing requirements on real estate-related securities issuers. Could your hard money lending fund suffer?
Opposite in spirit and simultaneously working its way through the California legislature is SB 978 sponsored by Senator Juan Vargas. This bill seeks to address perceived abuses in private securities issuances by hard money lenders by imposing certain filing and suitability requirements on issuers “engaged in the business of purchasing, selling, financing, or brokering real estate” and who sell securities to non-accredited investors. Specifically, the bill requires an issuer relying on an exemption from securities qualification to file a notice of transactions with the Department of Corporations. Mercifully, the proposed statute has been amended to eliminate the conditioning of the availability of the exemption on the timely filing of such notice. However, the basic requirement remains in place under threat of noncompliance penalties that are unclear.
The bill further requires the issuer “to make reasonable efforts to ensure that the investment is suitable for the investor, as specified, to provide the basis upon which the issuer shall make that determination, and to maintain the information used to make the determination for 4 years.” Likewise, it commands an issuer to ensure that: (1) all purchasers “have the capacity to understand the fundamental aspects of the investment, by reason of their educational, business, or financial experience”; (2) all purchasers “can bear the economic risk of the investment”; and (3) “the investment in the notes or interests is suitable and appropriate for the purchaser, given the purchaser's investment objectives, portfolio structure, and financial situation.” The SB 978 “basis upon which” the issuer determines suitability should be comparable to the standards described in AB 2081 or Rule 260.218.2, so again, consult with your attorney and financial advisor to ensure compliance should the bill become law.
Finally, SB 978 requires the securities issuer “to provide information regarding the nature of the proposed offering on a form prescribed by the commissioner.” As with so many aspects of these potential new laws, we will have to wait and see what the Commissioner hands down, but at a minimum the issuer will have to produce the disclosure documents given to prospective investors and the names of corporate officers and directors.
The tumultuous times in hard money mortgage lending continue, and thus so do the legislative changes. Stay tuned as the new laws develop.
By Andrew Woodruff, Esq., General Counsel, Golden Omega. Mr. Woodruff is In-house Legal Counsel for Golden Omega, LLC, a software provider of loan document preparation, loan servicing, fund management, trust accounting and other modules for the mortgage and construction industries. He can be reached at email@example.com or by calling (916) 939-7083. For information on the software products, please visit www.goldenomega.net.