Reg D Exemption In Jeopardy Using JVs To Capitalize Development Deals?

Question

As our east-Austin-based development organization ramps up we are taking in additional cash from partners.  We already have a fund set up to take money from accredited investors and would like to organize marketing materials for a diverse set of potential investors.

What we would like to do is to have non-accredited investors loan money to partners in the east Austin development because they can't invest in our fund.  The fund and each of the partners will JV on each project according to how the capital breaks out at any given point in time.  The investor that procured the capital would borrow money from non-accredited investors without clouding title and that money along with the JV partner's equity would capitalize their portion of the equity in each project.  Each partner will be capable of investing up to 25% of the equity in order to optimize dollars out of each project instead of ROE given that the cost of capital from the fund is far less than the AROI for the project.

Has anyone done something like this before?  If there was a fund involved did you ever get a legal opinion about whether or not this is an issue with the Reg. D exemption for your fund?

Steven Hamilton II · Answer

I haven't looked at the illustration yet; but in my thinking provided these groups were put together and investing in other projects, I don't see a problem; but if it is just structured to get more investors, that is where I'd question.

Jeff S. · Answer

Ok Brian, if I was a potential investor I would be happy if I felt everything was transparent and well thought out.

I would be scared if I thought things weren't as they seemed and I would be scared if I felt the decision makers didn't have any experience.

If I made more than I was promised I'd be happy, if less than not as much.

If timelines were kept as promised it would be good. This can be difficut when dealing with gov't agencies.

Bryan Hancock · Answer

I could see how subscribers would call this "dilution" when it really isn't.  This could be claimed if the fund invested in any opportunity where one of the principals was also a principal in the JV with various other parties.

The best answer is to start a new class of shares for these types of opportunities and to pay these shareholders only when the money is at work.  They would subscribe to this arrangement and all would be out in the open.  That is how I am pushing the conversation, but I am not sure what is going to happen.

The dilution argument is very valid though and it isn't really something I considered.  Thanks for bringing it up.  I'll try to push the other 2 JV partners into being principals in the fund instead.  We have already accounted for principal dilution in this scenario and all of the principals know the rules of engagement and should be fine with the arrangement if we drag in additional LPs.

Jason S. · Answer

Then that is how I would do it.

The thing is that it does not matter what your intent was if the Grand Jury / Prosecutor sees it differently.  That is my point.  Never do anything that could possibly be misunderstood.

People make a plan that is great, but if it can be looked upon as breaking the rules, then you should assume it will be.  That is how you protect yourself.

I assume also that those in the Fund, the subscribers, are aware of the dilution of their earnings due to additional participation of the principals?  It could be interpreted that the principals are looking to make more money than allocated to them by the fund.

In the end.  I really do not know.  I have been involved with several funds and even have co-written them with a partner that used to teach how to create syndication's and funds on the college level.

What I do know is that you need to be very careful on every single little issue or you are creating an unnecessary long term liability where, should anyone complain, or heaven forbid not be satisfied with the return and put your fund under a microscope - how will it look to them?

Always act with the worst case in mind when dealing with the SEC & other people's money.  Reduce liability & risk to zero whenever possible

Bryan Hancock · Answer

That is the trouble Steven...how do we "prove" that it wasn't structured to circumvent the rules.  My thinking is that if we make the same disclosures to the non-accredited investors as we would with them investing directly in the fund and we keep the quality to fewer than 35 we should be okay.  That makes logical sense to me.

Note that I found a few typos in the illustration....but you should get the point if you check it out.

Bryan Hancock · Answer

The structure actually wasn't constructed to circumvent the rules Jason.  We could easily take 35 non-accredited investors in our fund and beef up the filings, disclosures, etc.

The structure is really to allow 2/4ths of the principals in the development to not participate in the fund if they so choose.  This isn't easy to do and it smacks of a conspiracy to circumvent rules when it really isn't.

We have a securities attorney and will get an opinion about this and some other constructs to accomplish what we want to accomplish soon.  I just wanted to get more opinions from people knowledgeable about things.

Jason S. · Answer

Bryan,

I looked at the picture and it frightens me more than what I read.  There is a direct link, a direct methodology to circumvent the rules.  That is trouble.  Do yourself a favor, ask a Federal white collar criminal defense attorney.  Yes, criminal.  Because that is the likely violation, criminal first with civil following.  Your regular attorney can tell you what they want, but the criminal attorney will tell you what the Grand Jury/Prosecutor will see in your plan.  Organized conspiracy to circumvent blah blah blah.

Maybe I am completely wrong. But I know a guy who was running a $100MM fund prior to the bust - let me tell you , they went through his fund and every aspect with a fine tooth comb - and this is not just because of lost money, they were trying to take the fund away from him and control it.

There are so many ways you can get into trouble.

Of course, this is all my opinion.  But it looks scary.  Find a Federal Criminal Defense Attorney that specializes in this type of crime and ask them what they see.  It may cost you $400 for 30 minutes, but it is likely worth it.

Once again, this is my opinion.  I may be 100% wrong. But I would ask my regular attorney and then the criminal attorney first - and you know what they say......

If you have to ask. You probably should not do it.

Bryan Hancock · Answer

I figured this was rather confusing and hard to follow in a thread so I threw together a picture this evening that hopefully clarifies what I am hoping we can do.  Here is a first cut:

East Austin Development Capitalization

If anyone knows of weaknesses with this approach or a better way to do things I would love to learn about your experience.  Random commentary is certainly welcome as well.  Think about how you would react if you were a potential investor.

Bryan Hancock · Answer

Yeah...that is why I am worried Jason.  Our exemption allows for up the 35 non-accredited investors anyway, but the group managing the projects really is separate and distinct from the fund.  The trouble is that 2 of 4 members of the fund also participate in the partnership doing the development so there is a bit of a conflict and I could see how a disgruntled investor would claim things were constructed to somehow circumvent the rules.

What we really desire is for each of the 4 principals in the development venture to be able to find both accredited and non-accredited investors and have them invest in our projects.  Some of the principals won't be involved in the fund so the situation is a bit dicey as-is.

Any additional thoughts or insight is appreciated.

Jason S. · Answer

Be very careful.  It is this type of circumvention that is frowned upon by regulators.  You never want to be caught "structuring" - that is bad and you will be looking over your shoulder forever wondering when a Grand Jury is thinking of looking into your practices. There is simply too much money already available to put your organization at risk. IMHO.

I did read recently that there are some in Govt considering for relaxing some of the current rules.

Reg D Exemption In Jeopardy Using JVs To Capitalize Development Deals?

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