Accredited Investor Rules Question

[Brian P Carolan]

Hi Everyone,

I am looking to invest in a syndication deal that is offering units in an LLC under Reg D 506(c) which is only open to accredited investors that are verified.

I am not currently an accredited investor and I was wondering if it would be possible to get around these rules by using the following strategy below:

1. My father (who is an accredited investor) would form an single member LLC and use it to purchase the units in the syndication that I want to invest in.

2. After his single member LLC closes on the deal and owns the units in the syndication he would then sell me 25% of his single member LLC that just closed on the syndication deal. This would leave him with 75% ownership and me with 25% ownership in the LLC that now owns and interest in the syndication restricted to accredited investors that I wanted to purchase but would not be able to since I could not be verified on my own.

I believe if my Dad and I formed the LLC together to start we would not be able to purchase the units in the syndication as 506(c) requires verification of all members in the LLC at the time of purchase.

My first thought is that this strategy wouldn't technically be allowed under the law because it is basically the same thing as the example right above but how would anyone ever really find out if my dad later sold me shares in his LLC? Does anyone know the legal risk of us doing this?

Or would there be a way around this if my dad purchased the deal as described above but then Filed Form D under 506(b) for his LLC which would allow up to 35 non accredited investors to invest in his LLC. After he files Form D under 506(b) for his LLC that now owns the syndication he would then sell me 25% of the units in his LLC using the exemption for 35 non accredited investors under 506(b). Has anyone ever tried this strategy or know if it would be allowed?

Does anyone have any ideas that would allow my Dad (accredited) and me (not accredited) to invest in a real estate syndication that is only open to accredited investors?  

I just think it is such B.S. that the government is telling me I am not allowed to invest in a deal like this when I have the necessary financial knowledge and understand the risks involved.  If anyone knows a legal way around these rules I would greatly appreciate it.

Thanks,

Brian

[Brian Burke]

I agree with you, Brian, the "income/net worth test" isn't the best test for eligibility to invest in private offerings.  There are plenty of people that can pass this test yet know nothing about what to look for in a private offering.  But governments lack creativity, instead favoring quantifiable and uniformly applied standards, and given our affinity to currency it's no surprise that the default yardstick to measure how much you know would be how much money you have.  Having said that, the test is relevant because people who have a lot of money can afford to lose some without severely altering their lifestyle.

To your question, I don't see a way to do what you are looking to do.  Not only from a legal aspect, but from a contractual one.  Let's start with the legal.  But before I do--understand that I am not a lawyer and this is not legal advice.  Please find a lawyer to give you legal advice and consider everything I say to be "streetsmarts" and not "booksmarts" nor legal advice.

An investor in a 506(c) is required to be accredited.  If an entity is the investor, the entity must be accredited.  There are two ways for an entity to be accredited.  If the entity was NOT formed for the purpose of investing in the offering, the entity is accredited if it has total assets in excess of $5 million.  The members of the entity don't have to be accredited in this case.  This doesn't work for you because you are forming the entity for the purpose of making this investment.

If the entity IS formed for the purpose of making the investment, the entity is accredited if all of the equity owners in the entity are accredited.  If you own it with your dad, and you aren't accredited, the entity isn't accredited either, so this fails.

Now, the contractual implications. Let's say that your dad forms an entity, and he is accredited, and he makes the investment. That's fine, he can do that. But he can't sell interests to you after the fact unless that transfer is approved by the syndicate's operating agreement. The reason is, most subscription agreements specify two things. One, that the subscription agreement is not transferable nor assignable without the Manager's written approval. If the subscription agreement says this, which is probably does, he cannot transfer the subscription to you. But what you are proposing isn't a transfer of the subscription, the same LLC remains the subscriber, so you're OK here.

The second thing the subscription agreement most likely says is that the subscriber agrees to be bound by and abide by the terms of the operating agreement of the syndicate. The operating agreement likely has an entire section dedicated to permitted transfers. There's a good chance that the transfer provisions prohibit transfers of the equity interests of entity investors without the consent of the Manager. This means that your scheme to insert yourself into the LLC after the fact could be a violation of the syndicate's operating agreement, and by extension, a violation of your dad's LLC's subscription agreement.

From a practical perspective I suppose the question as to what the sponsor would do if they found out, or even if they would find out is a reasonable question.  But that choice is between you and your conscious.  With some solid advice from your legal counsel...

Having said all that, I wouldn't assume that all 506(c) offerings are from better sponsors or that all 506(b) is less favorable.  In fact, the opposite could be true.  506(c) allows firms to advertise their offerings.  Newer firms that don't have a loyal following might be more likely to employ 506(c) to recruit investors because they need to advertise in order to find enough investors.  On the other hand, very experienced sponsors have probably built a large and loyal following by word of mouth, referrals, and performance, and might be less likely to use 506(c) because they don't need to.  Just something to think about.