The Legal Risks of Crowdfunding
By: John Amabile and Brian Cromwell, Parker Poe
Understanding the risks involved in crowdfunding will help real estate professionals make the most of the opportunities presented by this “engine of change.”
THE COMMERCIAL REAL estate business has experienced seismic shifts since the Great Recession. Among other things, the creation of new investment models, along with the growth of financial technology (fintech) and real estate technology, have the potential to change the entire industry. Crowdfunding, however, may be the foremost engine of change within real estate, granting even the most local company a national audience of prospective investors.
Indeed, crowdfunding in real estate is expected to grow from more than $3 billion worldwide in 2016 to over $300 billion in 2025, according to Forbes magazine. Used properly, crowdfunding can be a true asset. However, if it is used incorrectly, it could result in large fines or even incarceration.
What Is Crowdfunding?
Crowdfunding is simply defined as funding a project by raising small amounts of capital from a large number of sources, typically via the internet. Crowdfunding enables a company to sell an interest in a project by advertising an offering to people with whom the company does not have a pre-existing relationship. The true benefit of crowdfunding is that it creates a direct correlation between the number and types of disclosures required under the securities’ laws and the amount the offering seeks to raise.
“Regulation crowdfunding,” the best known of three types of federally recognized crowdfunding mechanisms – in addition to Regulation A+ and Rule 506(c) offerings – greatly simplifies what a real estate company must disclose as long as the company is willing to limit the total amount it seeks to raise via this method of funding to slightly more than $1 million in any 12-month period and limit the amount each individual or entity invests to certain specified limits.
Real estate companies must conduct crowdfunding offerings through registered intermediaries, such as broker-dealers or funding portals. While companies also must make initial and updated filings with the Securities and Exchange Commission (SEC) and must include specified financial statements in the offering disclosure documents, those disclosures are limited compared to the disclosures required of traditional (and less restricted) public offerings. Thus, regulation crowdfunding is considered very attractive as it limits the time and costs associated with required disclosures.
The primary advantage of crowdfunding, including regulation crowdfunding, is its ability to advertise an offering to a large number of potential investors who are otherwise complete strangers to the company. This, along with permitting an unlimited number of unaccredited investors, is what most distinguishes regulation crowdfunding from typical syndications. Real estate syndications remain subject to SEC disclosure and filing rules and regulations, which, unless you go the full public offering disclosure route, limits advertising and the number of unaccredited investors allowed.
In other words, with certain limitations, you can legally use the internet to sell your securities! To a real estate company seeking to raise funds, this opens a world of possibilities previously not available under federal securities laws. It is also where the legal risks begin to accumulate.
What It Is Not
First and foremost, it is important to recognize that crowdfunding is not an exclusion from federal or state securities laws. Instead, it creates an “umbrella” that offers specific protections. What cannot be ignored is that when a company raises money by crowdfunding, it is offering securities for sale. While the required disclosures may be limited, they must nonetheless be compliant with federal laws. In addition, there is the possibility that multiple states’ blue-sky laws – state laws that regulate the sale of securities on a local level in order to protect the public from fraud – could apply to crowdfunding offerings when investors from more than one state participate, a potentially unanticipated consequence of a crowdfunding offering.
As an alternative, many states permit similar offerings on a purely intrastate basis, often with much larger caps on the amount that may be raised. Georgia, for example, permits the sale of up to $5 million in securities if the offering company, which may be located outside Georgia, complies with the state’s regulation crowdfunding rules, which include restricting investors to Georgia residents. However, this also creates certain types of legal exposure. Specifically, the offeror is voluntarily subjecting itself to the laws and the jurisdiction of that state. State law claims under fair business practice act statutes, state blue-sky laws or myriad other local liabilities can vary greatly. What plays in Georgia may be frowned upon in Nevada.
Unique Risks and Opportunities
The unique nature of crowdfunding also raises unique risks. Internet advertising may become subject to analysis under federal and state securities laws. Existing material on your informational website that could be viewed as mere “puffing” in other areas may become the basis for a fraud claim under state and federal securities laws. Every public statement therefore requires the strictest of scrutiny.
Moreover, all of the above apply equally to both civil and U.S. Department of Justice or SEC liability. Anyone involved in the sale of a security subjects himself or herself to potential criminal exposure. Regardless of how careful you may be, being the person quoted in an internet posting used to sell securities puts the advertiser in the position of owning those words and subjects them to a wide array of criminal and administrative claims.
Crowdfunding offers tremendous opportunities for real estate companies. In many ways, it brings the offering of securities into the 21st century. However, like most things associated with emerging technologies, it also brings unique risks. One must be aware of those risks before leaping into the crowdfunding arena.
John Amabile (firstname.lastname@example.org), counsel, Parker Poe, Atlanta
Brian Cromwell (email@example.com), partner, Parker Poe, Charlotte