Steve is a long time attorney who specializes in private offerings and securities. A huge insight he drops on this episode, state securities agencies are like profit centers for state governments, and one of the easiest ways for them to make money is go after anyone who didn’t follow security laws. That is an eye opener, and gives you a great idea of what you are up against. You may also be surprised to learn that a lot of investors are actually offering a security, not filing with the SEC, and could get in some trouble because of that. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
Best Ever Tweet:
“The consequences of violating securities law are astronomical” – Steve D. Rinaldi
Steve D. Rinaldi Real Estate Background:
- Attorney specializing in private offerings of securities
- Has handled private offerings of securities for 29 years
- Based in Bethesda, MD
- Say hi to him at http://stevenrinaldilaw.com/ or (240) 481-270six
- Check out his services for syndications & private placement deal sheet http://bit.ly/2UKSRo7
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TRANSCRIPTION
Joe Fairless: Best Ever listeners, how are you doing? Welcome to the best real estate investing advice ever show. I’m Joe Fairless, and this is the world’s longest-running daily real estate investing podcast. We only talk about the best advice ever, we don’t get into any of that fluffy stuff. With us today, Steve Rinaldi. How are you doing, Steve?
Steve Rinaldi: Very good, very good.
Joe Fairless: I am glad to hear that, and looking forward to our conversation. Steve is an attorney specializing in private offerings of securities. He’s handled private offerings of securities for 29 years now. He’s based in Bethesda, Maryland. His law firm – you can go check out their website, stevenrinaldilaw.com, and we’ll put that in the show notes as well, so you can just click the link.
With that being said, Steve, do you wanna give the Best Ever listeners a little bit more about your background and your current focus?
Steve Rinaldi: Yes. I’ve been focused on private offerings of securities, including but not limited to real estate syndications for over 29 years. I handle all the business law aspects of the syndication, including obviously the formation of the Delaware LLC, the writing of the operating agreement, the writing of the private placement memorandum, writing the subscription agreement and the filing of Form D. Recently in my practice I have gotten more and more into the formation of opportunity zone funds.
Joe Fairless: Yes, that is a hot topic, that’s for sure. So you’ve got 29 years of experience. Clearly, you’ve seen a whole lot in the industry… What has changed from what you do from a legal standpoint, over the last 15 or so years?
Steve Rinaldi: I think the biggest change is obviously Rule 505 is no longer there.
Joe Fairless: What was that?
Steve Rinaldi: Rule 505 was a rule that allowed the private offering of securities to 35 or fewer unaccredited investors with a dollar limit of five million.
Joe Fairless: Okay.
Steve Rinaldi: Not too many people made use of 505, and more people seemed to be using 506(b) anyway. So that’s kind of more of a technical change… 506(b) is superior in that it allows the same 35 or fewer unaccredited investors, an unlimited number of accredited investors, but an unlimited dollar amount.
We’re seeing a lot of 506(b) offerings. I am seeing the occasional 506(c) offering as well, which is an offering to accredited investors only, that permits some limited advertising.
Joe Fairless: How would you describe your client profile who chooses to do 506(c) versus 506(b)?
Steve Rinaldi: I would say 506(c) tends to be a much larger dollar amount, and they have relationships with people who are able to invest 200k, 300k, 400k, 500k. The 506(b) offerings tend to be 10-15 people investing about 50k, which gets you a total of 750k, and the project sponsor or the syndication is going out and getting a bank loan for 1,5 million. The 506(c) deals tend to be much larger, and they may be buying multiple multifamily complexes.
Joe Fairless: I know with 506(b) you need to have a pre-existing relationship with anyone who sees your opportunity… How is pre-existing relationship defined?
Steve Rinaldi: The SEC refuses to define it.
Joe Fairless: Isn’t that fun?
Steve Rinaldi: It’s kind of like the Supreme Court when they decided the pornography case in 1971 – they kind of know it when they see it.
Joe Fairless: Right, yup.
Steve Rinaldi: Most attorneys, and even if you ask the SEC people [unintelligible [00:05:11].10] if you talk to somebody in a REIA for a couple of months, that’s fine. If you’ve gone together with the person before, say as co-owners on a property, you bought it for, say, half a million dollars, you each put up 75k and you borrowed 350k from a bank – that’s fine. If you’ve done a transaction with somebody before, that’s fine. But they have not really defined it, and it is a murky, grey area.
What we’re seeing in the 506(b) realm is intended to be family and friends, or people in the same investment group, who have been pursuing different deals, but they’ve been talking about deals among themselves for years. I’ve never really ran into a red flag, even though it’s very ill-defined.
Joe Fairless: What about if someone who runs in your circle — or let’s even go one step further; what about if it’s your second deal, and you have investors from your first deal who are very pleased about what you’re doing, and they say “Hey, I’d like to refer my best friend Kim”, and they copy Kim on an e-mail with you… Is that a pre-existing relationship? I don’t think it is, but if it’s not, then how do you establish that with Kim?
Steve Rinaldi: If you’ve been talking to Kim over a course of about two months or so about your deals, what you’re doing, “This is what I’ve done in the past”, then at that point you might be able to argue there’s something.
Joe Fairless: What are some errors you see investor make from a legal standpoint? Of course, they’re not your clients, so if they were, then they wouldn’t be making them, but… When you just shake your head and you’re like “Oh my god, seriously? They did that? They didn’t know they couldn’t do that?”
Steve Rinaldi: The biggest mistake I’ve seen somebody make is saying something is not a security when it is. That is probably the most colossal blunder you can make, because the consequences of violating securities law are astronomical.
Joe Fairless: What are they?
Steve Rinaldi: Well, even if you’ve raised less than a million dollars, the state securities agencies will come in and they will demand that you refund money to all the investors, whether you have it or not. And obviously, if you don’t have it, they will go after your house, your bank accounts and everything you have. And it’s an obligation owing to the state, so the state comes first in line, not your mortgage company. So the moment your mortgage holder on your primary residence sees the state securities agency coming after you for something, they’re gonna panic, like crazy. That’s for starters.
It is a fraud action, it’s non-dischargeable in bankruptcy. And obviously, actions filed against you by the state are not dischargeable in bankruptcy either, so you have to pay the money back… And in addition to that, the state is going to fine you. That fine will easily be in the amount of their attorney’s salary, healthcare, pension, 401K contributions related to that time period…
Joe Fairless: Paid vacation…
Steve Rinaldi: Yup. State securities agencies are very much profit centers for state governments… And one of the easiest ways for them to make money is go after anybody who didn’t follow securities laws. To be a security, you have to have four things – an investment of money, a common enterprise (which it obviously is) with the expectation of a profit (nobody invests money unless you expect a profit) and to be derived in whole or substantial part from not the investor’s effort, but rather from the promoter’s effort. And obviously, derived in whole or substantial part meaning if the promoter is the one negotiating the mortgage with the bank, if the promoter is the one leasing the apartments or leasing the office space or leasing the warehouse space, the promoter is the one talking to the attorneys; he or she is the one opening and closing the bank accounts, talking to the real estate closing attorney… Then you’ve definitely got a security. At that point, you have to comply with one of the various private offering exemptions.
Joe Fairless: So that gets violated tons, because tons of people who I talk to, they bring on investors and they’re not registering the security. I agree with you, that’s something that happens. For the record, all of our deals are registered, just so I get that out there.
With a security, when you register it, there are costs involved in order to register it. If you can, think of yourself as a real estate investor for a moment. You don’t have a specific deal yet; you are looking at deals. And you need to decide when does it make sense financially, knowing that there will be costs involved in order to register a security – when does it make sense financially to bring in investors passively, so it would be a security, and I need to go to register, versus doing a joint venture with some other business partners, and it is not a security that needs to be registered?
Steve Rinaldi: I would say it’s not so much the money, it’s the psychology, and the dynamics between the people. If you’re bringing on five or six people and you’re gonna give them the type of control that would be in a joint venture, where every single person has the right to veto a lease, every single person has the right to veto the refinancing of a bank loan, or any single person has the right to veto the plumber coming and making $1,000 in repairs… Basically, if starts to become a cackling henhouse, you’re better off spending the money on a securities attorney to go through a full-blown registration.
You can use the Rule 504 exemption, which is still somewhat costly. You can use 506(b), you can use 506(c)… You could even use crowdfunding, but that’s the most costly and the most restrictive.
Joe Fairless: Good point. This is a little fuzzy in my mind, but I believe I heard this once from someone… I think they did a joint venture, and I don’t think I’m getting it exactly right, but maybe you can talk about the concept of this. They did a joint venture, they said in the operating agreement that such and such management company would handle those decisions, and then either they owned that management company, so really it was this one partner was handling the decisions, and they had full authority over management decisions, or they were overseeing the management company… So basically it was a roundabout way of saying “All you other partners, you don’t have to weigh in on these decisions, nor do you have the ability to, because it’s this management company, and then I’m the one person who has control over that.”
Steve Rinaldi: That’s a security, because that sounds awfully lot similar to the Howey case. Howey was leasing orange groves in Florida, and it was actually Howey’s management company who was operating them. The SEC and the Supreme Court saw right through that and said “No, the control is coming from Howey and Howey’s management company.” These people out in New York, and in Ohio, and wherever, who bought into these orange grove interests, what control do they have? They’re not deciding when to fertilize the ground, when to water, when to pick the oranges… So there’s no control.
Joe Fairless: Yeah. And it’s just common sense. You said the Howey case, but does it pass the sniff test? [laughs]
Steve Rinaldi: Exactly.
Joe Fairless: Yeah, it didn’t pass the sniff test.
Steve Rinaldi: The moment a state securities agency sees the term “management company” and sees the management company making all the day-to-day decisions, that’s a total red flag.
Joe Fairless: Cool. What are some other things that you’ve seen people do to either violate security law, or any other interesting things that you’ve come across?
Steve Rinaldi: The misdefinition deciding something isn’t a security when it is is number one. The other thing I’ve seen is people try to hire someone to be a finder to go get investors, and the person is not a licensed broker-dealer, and they offer to pay that person a commission based on the money raised; that starts to run afoul of the Exchange Act of ’34, because the only person who can get a commission on the sale of a security is a licensed broker-dealer. And that one’s really easy to remedy – you can just make the person your director of investor relations and you can just give him 1% or 2% profit stake. You’ll be completely in the clear if you went that way. But I see that a lot.
Sometimes I’m starting to see now in the case of funds you have to do an investment advisor filing with about 35 to 45 of the states, depending on how the private fund is structured. I see that a little. The penalties for that one aren’t as astronomical as the first two. State agencies will just say “Okay, go ahead. You did everything else in compliance with the law. Just get yourself an investment advisor and file Form ADV.”
Joe Fairless: Okay. With doing a fund compared to doing a one-off 506(b) offering, what are the costs involved in each of those?
Steve Rinaldi: Well, the fund is gonna be more expensive, because if you look at the federal laws and regulations you’re gonna be okay, because invariably a lot of the private funds that you and I are talking about have less than 100 investors. Far less. They’re down below 35 in almost all cases. So you’re not gonna be running a mutual fund; you don’t have to worry about compliance with that whole area of law. But you do have to comply with the state laws and the state regulations, which means in addition to all the work I mentioned earlier – forming a Delaware LLC, writing the operating agreement, writing the private placement memorandum, writing a subscription agreement and filing Form D, you’re also gonna have to have an investment advisor agreement, and you’re going to have to have that investment advisor file Form ADV.
Now, there are exceptions. Some states, if there are fewer than 5-6 investors and they’re all accredited, you don’t have to go through that whole rigmarole. Some go as high as 15. One exemption – New York will let you go up to 115 million without having to file. But most states, if you’re doing a fund, you’re looking at an investment advisor and having to file Form ADV. You’re probably looking at about another $1,000 in costs.
Joe Fairless: So all-in, what’s the range to do the legal work for a 506(b)?
Steve Rinaldi: 506(b) all-in is probably about $8,500, maybe a little higher if you have investors in a lot of different states.
Joe Fairless: Okay. And all-in, what’s the range for doing a fund?
Steve Rinaldi: Closer to $10,000.
Joe Fairless: That seems really cheap. So when you’re saying $8,500 for 506(b), what does that include?
Steve Rinaldi: It includes forming the Delaware LLC and all the Delaware filing fees, plus your state qualification fee. It includes the operating agreement, it includes the private placement memorandum, it includes the subscription agreement, and it includes filing Form D in every state in which you have investors.
Joe Fairless: And then once you close on the deal, don’t you have to file it with the SEC?
Steve Rinaldi: 15 days from the day you raise your first dollars from an investor.
Joe Fairless: Okay. That is included in this?
Steve Rinaldi: Yes, that is included.
Joe Fairless: What you were just saying, all those things – what part is that part of?
Steve Rinaldi: That’s the Form D part.
Joe Fairless: The Form D, got it. Form D in every state. Got it. And then the 10k for the fund – what does that include?
Steve Rinaldi: That includes all the above services that I just mentioned, plus the investment advisor agreement, and usually the investment advisor will go ahead and file Form ADV, which they’re doing on their own anyway. So that extra amount reflects one more agreement that I have to write.
Joe Fairless: Did I hear you correctly with the fund, that you’re saying usually there are under 35 investors?
Steve Rinaldi: Yeah, I’m saying in a private fund under 35. Now, remember, with a fund you’re gonna have to meet not only the 506(b) exemption, or 506(c) exemption if they’re all accredited, but 506(b) exemption has 35 or fewer unaccredited investors… But you also have to meet the standards of the Investment Advisor Act and the exemptions of the Investment Company Act.
Joe Fairless: Yeah, I would think that for a 506(c) it would be the opposite… I’m thinking about our business – I’ve always done 506(b), and if I did 506(c), the only reason why I would do it is to be able to publicly advertise an opportunity; that way it would bring in more investors, and likely at a lower amount… So that means I’d have even more investors in a fund, or like a 506(c), so I would have 100, or 200, or 300 investors, versus if I was doing my normal 506(b).
Steve Rinaldi: Well, you just hit a big [unintelligible [00:18:39].19]. You just hit a couple rocks. If you go at or over 100 in your fund, you now become a mutual fund.
Joe Fairless: Wow, okay.
Steve Rinaldi: The Investment Company Act. You don’t go over 100.
Joe Fairless: Huh.
Steve Rinaldi: You don’t wanna go over the 3(c)(1) exemption. There’s also a 3(c)(7) exemption for real estate funds, but most of those as a back-up tend to stay under 100. Private offering securities for 29 years – anytime it’s been a fund type situation, I’ve never had someone even come close to 100.
Joe Fairless: Okay. Because they don’t wanna–
Steve Rinaldi: Don’t wanna be a mutual fund.
Joe Fairless: Because then – tons of red tape, and…
Steve Rinaldi: In addition to complying with the exemptions under the 33 Act, the 506(b) and (c) or 504 exemptions, you also have to comply with the Investment Company Act as well. So now you’re throwing — basically, yeah, it’s all securities law, but it’s too radically different areas of securities law. You’re just complicating your life tremendously.
Joe Fairless: [laughs] I don’t wanna do that. Okay, that’s helpful. That’s new information. As you might be able to tell, I’ve never done a fund before; we always have done 506(b)–
Steve Rinaldi: Yes, that’s why you’ve had no issue.
Joe Fairless: Right. Interesting. Okay. One question that comes up with 506(b) is if you choose not to take on non-accredited investors… So no sophisticated investors, no non-accredited, even though you could take up to 30-35, if you choose not to take on any, does that benefit you from a regulatory standpoint in any form or fashion, if you’re only taking on accredited investors in 506(b)?
Steve Rinaldi: Where it can really benefit you is under the fund, if you’re doing a fund. That’s where it can really benefit you, because in about 15 states you can argue you don’t need an investment advisor.
Joe Fairless: I’m talking about just 506(b).
Steve Rinaldi: You still wanna give people the same private placement memorandum. If you look at the black-letter of the regulation, it says “Unaccredited investors have to get a private placement memorandum”, but if you look at the securities act itself, or the authority where the regulations come from, it says all investors have to receive all material information. The practical matter – if you have to give all investors all material information, you’re not saving yourself any time or money by saying “Oh, I’ll limit this to accredited only, and not pay for writing a PPM.” Because if the deal goes sour, the accredited investors will sue you anyway under the securities act, saying “You didn’t disclose all material information to me. You didn’t tell me what the rental rate was, you didn’t tell me that you had to pay pre-payment penalties on the mortgage, you didn’t tell me that the inspection said you needed a new roof…” They’ll find something, anything, and it’s pretty easy in real estate investment for a judge to say “Yeah, something is material, and you didn’t tell them that.” You don’t derive much benefit.
Joe Fairless: Okay. So if you are doing 506(b), assuming that you have the disclosures in there – which you should, if you’re doing 506(b) – you don’t really have an additional benefit from a regulatory standpoint by only bringing on accredited investors. You could also fill in some of the non-accredited spots.
Steve Rinaldi: No, none at all.
Joe Fairless: Oh, sophisticated.
Steve Rinaldi: Right.
Joe Fairless: Yeah, sorry. I forgot I was [unintelligible [00:22:04].10] Sophisticated investors – you can fill in those 35 spots of sophisticated investors.
Steve Rinaldi: A trick on that is sophistication has never clearly been defined.
Joe Fairless: [laughs]
Steve Rinaldi: What my practice has been – if a person knows something about real estate investing, they’ve done some flips before.
Joe Fairless: Yeah, but how do you qualify someone… If you have a 506(b) offering and they say “Hey, I’m a sophisticated investor”, how do you qualify them?
Steve Rinaldi: Okay, are you an attorney who’s dealt with either business law or real estate law in the past? Are you an accountant who’s had business or real estate clients? Do you have any investment properties? Have you participated in any investment in the past? Have you at least gone to a REIA actively, openly, and gone through all their educational sessions the last couple of months?
Joe Fairless: Does it have to be recent? Or if they’re like “Yeah, I went to one 2-3 years ago.”
Steve Rinaldi: Developments change. I would feel more comfortable with recent.
Joe Fairless: Okay.
Steve Rinaldi: Usually, what I’m encountering is most of the people who are investors in these deals have invested in past deals, or if they haven’t, they own investment properties.
Joe Fairless: Sure.
Steve Rinaldi: They’re basically looking to up their game.
Joe Fairless: Yeah. Because most of the attorneys I come across are accredited, and accountants… Well, most of the investors I come across are accredited, because they know we only work with accredited investors, but I’d say owning investment properties – that’s gonna qualify a whole lot of people to be sophisticated… Because usually, from my experience, you don’t wanna passively invest in an apartment community or some other 506(b) offering unless you have some sort of real estate experience, because you won’t know what the heck that is… If you don’t have some sort of real estate experience, you won’t even be having the conversation with the syndicator… From my experience.
Steve Rinaldi: Exactly.
Joe Fairless: Cool. Well, this has been so informative… Anything else that you think we should mention as we close out here, that we haven’t discussed?
Steve Rinaldi: Yes, the new development in opportunity zones. I’m starting to see people coming in, requesting that I set up opportunity zone funds. That is obviously — you’ve got in addition to securities law you’ve got the tax law [unintelligible [00:24:22].08] as well. I’m starting to see that more and more, getting more and more questions.
Joe Fairless: Yeah, and that will keep on coming at you, I’m sure. So you do set that up, for anyone who’s looking to create a fund, or something…?
Steve Rinaldi: Absolutely. If you wanna go the opportunity zone fund direction, I can definitely assist them.
Joe Fairless: Well, how can the Best Ever listeners learn more about what you’ve got going on and get in touch with you?
Steve Rinaldi: Obviously, they can e-mail me at my e-mail, stevendrinaldi@msn.com. An even better way is to go on my website, StevenRinaldiLaw.com, and look at the private offerings of securities page, and see all the work I’ve done. My recent deals are on there.
And definitely, another thing is obviously to call me directly at 240-481-2706.
Joe Fairless: Great stuff, I learned a lot. I loved this conversation. I’m sure anyone who is passively investing or actively putting together deals got something from this, probably many things. Steve, thank you so much for being on the show. I hope you have a best ever day, and we’ll talk to you soon.
Steve Rinaldi: Thank you very much, Joe.
