Crowdfunding: Disclosing Both the Pros and the Cons?

Crowdfunding has grown tremendously in the past few years.  Recent finalization by the Securities and Exchange Commission of its rulemaking under a 2012 law may provide for even greater expansion of investor opportunities. Those thoughts are from Tom Muller , co-chair of land use and real estate practice at Manatt, Phelps & Phillips LLP , who reviews more about crowdfunding in the exclusive commentary below. The views expressed below are the author’s own. Large real estate equity and debt transactions are traditionally funded by large institutions such as REITs and life insurance companies investing in companies or joint ventures with only one or two investors. At the other end of the scale, historically a local real estate developer or investor might attract funds from a handful of friends and family members, using a limited partnership structure or “sidecars.” Crowdfunding uses the broad reach of the internet to attract small individual investments from a wide range of investors, many of whom have never had access to direct real estate investments because of the large individual commitments required. Until late 2015, sponsors of real estate investments were limited in their ability to raise funds from large numbers of small investors by securities regulations requiring time consuming and expensive securities registration and prospectuses, unless the capital raise was limited to “accredited investors”— i.e. , those having a net worth over $1 million or income over $200,000. Now, a sponsor of real estate investments can raise up to $1 million in any 12 month period from investors with little or no income or net worth , as long as the investment doesn’t exceed, for those with income below $100,000, the greater of (i) 5%  of the lesser of income or net worth, or (ii) $2,000, and for investors with $100,000 or greater income and net worth, 10% of the lesser of income or net worth, capped at $150,000 for all such investments during a rolling 12 month period. The new rules do require disclosures to investors, and the use of a broker-dealer or funding portal responsible for compliance with the offering and investment limitations and certifications, and annual reporting with the SEC. Still, this process is far more streamlined than a traditional registered offering or even the new smaller public offering now available under the securities laws The end result, of course, is a potentially important source of capital for smaller-end real estate investment companies, and a new and very quickly growing set of opportunities for average people to invest in real estate deals. In creating and permitting this new source of capital and investment, the real estate industry and SEC are at the same time weighing the risks to small investors, most of whom presumably do not have a lot of experience investing in real estate deals. Like the EB-5 program, which attracts investment to the US from (wealthier) offshore investors with the lure of immigration status, crowdfunding will overwhelmingly appeal to very unsophisticated investors. While some protection is provided by the limits on investment in the new regulations, it’s not hard to imagine that when some of these investments inevitably fail, there will be a lot of shocked small investors. And a lot of excited class action lawyers, as the new regulations do not reduce sponsors’ liability for failure to adequately disclose the risks of these investments. The recent articles on the use of crowdfunding for mezzanine debt highlight this, as most institutional lenders today will not touch mezzanine debt, still ruing the huge losses they suffered on those loans in the Great Recession. For small real estate companies, crowdfunding represents a really promising new source of capital.  But the unsophisticated nature of the investors mandates particular care in clearly disclosing both the pros and the cons of the deal.