Accredited Investor Rules Question

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Accredited Investor Rules Question

Brian P Carolan
Accountant · Rochester, NY · Member since 2018 · 7 posts · 2 votes

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

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Brian BurkePro Member
Investor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
7y

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. 

Podcast Guest on Show The Truth About Real Estate Investing in 2024 (What Investors NEED to Know)
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  • Taylor L.
    Rental Property Investor · RVA · Member since 2016 · 5k+ posts · 4k+ votes
    7y

    As a syndicator - if I found out one of my investors represented themselves as accredited then did a backdoor conversion to bring a nonaccredited person in, I would be sorely tempted to find a way to revoke their shares and give them their original funds back. 

    Shoot, I would bet the syndicator has a legal responsibility to do so once they find out. I'm not a lawyer so I don't know.

    I would encourage you not to do this. There are many 506(b) syndications out there if you want to get in as a passive investor. Just start building relationships with syndicators, get deals coming in to look at, and start investing. 

    It's not hard to invest in syndications as non-accredited & sophisticated, it just takes a few extra steps to stay in compliance.

    @Brian Burke what are your thoughts? Have you had this come up?

    0Reply
  • Brian P Carolan
    OP
    Accountant · Rochester, NY · Member since 2018 · 7 posts · 2 votes
    7y

    I am wondering if it would be legal if my Dad filed his own Form D under 506(b) once he purchased the investment and then sold to me under his exemption.  Not a securities law lawyer so definitely do not know if that can be done or if that is within the law.  Logically I feel like it should be allowed but if it was there would probably be people talking about it.

    0Reply
  • Brian P Carolan
    OP
    Accountant · Rochester, NY · Member since 2018 · 7 posts · 2 votes
    7y

    Building relationships is definitely a good option which I will most likely be pursuing because it will also allow me to gain more comfort with the sponsor as well as invest clearly within the current law (even though it sucks).  

    I am just curious if anyone on here knows of a legal way to do what I described above just because it would be easier if I were able to set up an LLC and have some way to get it to qualify on its own.  I just want to have the option invest in any deal no matter if it is 506(c) or 506(b) as many people just will not accept non accredited investors. 

    I have found a few things I can invest in as a non accredited investor which have done well for me but from what I have seen the offerings open to accredited investors typically have more favorable terms.  If I could have a legal way to qualify under the SEC rules it would cut through a lot of red tape and allow me access to many more deals without any extra hassle.  

    Not sure why the government thinks these rules based on income and net worth make you a good investor.  I think a more effective way would be to have some sort of education class/test that you could pass to bypass the rules and get some sort of certification that would allow you to invest.  The govt could probably make some good money charging for this to haha.

    0Reply
  • Brian BurkePro Member
    Investor · Santa Rosa, CA · Member since 2012 · 2k+ posts · 7k+ votes
    7y

    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. 

    Podcast Guest on Show The Truth About Real Estate Investing in 2024 (What Investors NEED to Know)
    8Reply
  • Lee RipmaPro Member
    Rental Property Investor · Prairie Village, KS · Member since 2015 · 2k+ posts · 2k+ votes
    7y

    @Brian P Carolan

    I'm also not seeing how you're going to get into this syndication without being accredited as

    @Brian Burke so thoughtfully laid out. Seems like you've got 2 options: 1) invest in a 506b or 2) become accredited. What about your Dad transfering some property into your name so you can meet the requirments? I have no idea if this is an option just trying to help you think of things. 

    I went to a talk by a syndication attorney and he said that more than 95% of syndications are 506b. So there has got to be out there for you! 

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    0Reply
  • Carl FischerPro Member
    Rental Property Investor · Ambler, PA · Member since 2015 · 2k+ posts · 1k+ votes
    7y

    @Brian P Carolan

    What about lending your father money and him paying you interest? Of course using 1099s etc. your father can do what he wants with the loan$$ even invest it in a 506 or go on vacation. 

    [email protected]215-283-2868
    0Reply
  • Trevor Ewen
    Rental Property Investor · Weehawken, NJ · Member since 2014 · 1k+ posts · 704 votes
    7y

    @Brian P Carolan

    I agree with @Taylor L., there are a large number of great 506(b) offerings out there. Plenty of great stuff to look at. On top of that, I've looked at some 506(c) offerings that had pretty bad terms, but had higher minimums. 

    It's definitely not true in all cases, but this is something you'll often find in mass-marketed offerings that are trading more on their ability to run broad communication than their relationship and track record with a tight-knit group.

    1Reply
  • Amy Wan
    Attorney · Los Angeles, CA · Member since 2016 · 284 posts · 314 votes
    7y

    It seems to be like you're going through a lot of work to try and get past accredited investor rules. In all likelihood, YOU probably wont get caught, but if you are, the one who would be liable would be your dad. Oftentimes PPMs have clauses in which an investor attests that they are buying for themselves and not with a view to sell to anyone else.

    But like other commenters here said, some 99% of the all private capital raised in the U.S. is raised under 506(b) and its the sponsor's discretion whether they want to accept non-accrediteds into those deals. There's no reason you should have to bend over backwards to pigeonhole into a 506(c).

    4Reply
  • Alina Trigub
    Rental Property Investor · Glen Rock, NJ · Member since 2015 · 3k+ posts · 2k+ votes
    7y

    @Brian P Carolan

    If you're so eager to get into syndications as an accredited investor, consider setting up a goal for yourself to become accredited. Set the timelines and determine how you can get there.  (Perhaps marring a wealthy woman with NW over $1MM excluding primary residence will be the quickest ...LOL).

    0Reply
  • Jillian Sidoti
    Professional · Murrieta, CA · Member since 2013 · 405 posts · 458 votes
    7y

    @Brian P Carolan

    Let me lay some facts on you. Since the JOBS Act, when 506(c) was passed, only 7% of all offerings are under 506(c). 

    Meaning - 93% of offerings are under 506(b). In other words - you just need to find the right 506(b). There are plenty of them out there. Good luck!

    1Reply
  • Brian P Carolan
    OP
    Accountant · Rochester, NY · Member since 2018 · 7 posts · 2 votes
    7y

    Thank you everyone for the replies, lots of great information.  I wasn't favoring 506(c) over 506(b) maybe I wasn't clear enough in my question.  I basically was looking to find a legal bypass to any accredited offering (b or c) without having to have the syndication allow me in as a non accredited investor.  I figured there was not really a legal way to do it but can't hurt to ask and see if anyone had uncovered something I had not in my previous research on the topic.

    I want to use the LLC structure with my father purely as a way to allow me to invest less than the minimums on each deal and diversify more as I have a lower net worth than him and want to keep the risk I am taking at an appropriate level in relation to my total investment portfolio. The 75%/25% structure for our LLC would also allow my father to diversify a little more as well. My net worth is around $300K and my Dad's is probably close to 4 Million so I have some time before I can reach the 1 million mark unless my income were to meet the threshold at some point.

    Based on all of my previous research and the replies above I think the best way for me to get our fund going is to go network and find opportunities that would accept our LLC and structure into its fund/deals. I know I could probably just check the box on some of the opportunities that are out there under 506(b) and never get caught which has crossed my mind but I figured I would't want someone doing that to my deal and possibly putting it at risk. Also as a CPA I wouldn't want to do anything that could possibly put my license at risk as I am sure doing that would be viewed as not ethical. Also it could come back to bite me at some point and people may not want to let me in their funds which would be worse than just doing a bit more work in the beginning. It is not like I am on a clock and need a deal now so I can be patient. I just wanted to try and eliminate the additional requirements if I could do so legally.

    I also have some initial investments I made as a non accredited investor that I will be transferring to the fund so that will probably be the start of it once we finalize the operating agreement and other details.  Once I contribute my current deals and my father contributes additional capital to bring his interest up to 75% based on the deals and cash I initially transfer in I will then start the process to find additional deals to fill our fund through networking as suggested.  

    Thank you again to everyone who replied above for all of your help! Any additional suggestions are always welcome as I love to learn new ways to doing things/investing.

    Thanks,

    Brian

    0Reply
  • Alina Trigub
    Rental Property Investor · Glen Rock, NJ · Member since 2015 · 3k+ posts · 2k+ votes
    7y
    Brian,
    You and your father can absolutely invest in 506(b)'s once you've met the pre-existing relationship rule for non-accredited investors. Your LLC can invest directly or if the deal allows as a fund. The latter will require legal involvement on your side. Also, I think the deal sponsors may only agree to accept the fund if the investment sum is significant enough. 

     
    Originally posted by @Brian P Carolan:

    Thank you everyone for the replies, lots of great information.  I wasn't favoring 506(c) over 506(b) maybe I wasn't clear enough in my question.  I basically was looking to find a legal bypass to any accredited offering (b or c) without having to have the syndication allow me in as a non accredited investor.  I figured there was not really a legal way to do it but can't hurt to ask and see if anyone had uncovered something I had not in my previous research on the topic.

    I want to use the LLC structure with my father purely as a way to allow me to invest less than the minimums on each deal and diversify more as I have a lower net worth than him and want to keep the risk I am taking at an appropriate level in relation to my total investment portfolio. The 75%/25% structure for our LLC would also allow my father to diversify a little more as well. My net worth is around $300K and my Dad's is probably close to 4 Million so I have some time before I can reach the 1 million mark unless my income were to meet the threshold at some point.

    Based on all of my previous research and the replies above I think the best way for me to get our fund going is to go network and find opportunities that would accept our LLC and structure into its fund/deals. I know I could probably just check the box on some of the opportunities that are out there under 506(b) and never get caught which has crossed my mind but I figured I would't want someone doing that to my deal and possibly putting it at risk. Also as a CPA I wouldn't want to do anything that could possibly put my license at risk as I am sure doing that would be viewed as not ethical. Also it could come back to bite me at some point and people may not want to let me in their funds which would be worse than just doing a bit more work in the beginning. It is not like I am on a clock and need a deal now so I can be patient. I just wanted to try and eliminate the additional requirements if I could do so legally.

    I also have some initial investments I made as a non accredited investor that I will be transferring to the fund so that will probably be the start of it once we finalize the operating agreement and other details.  Once I contribute my current deals and my father contributes additional capital to bring his interest up to 75% based on the deals and cash I initially transfer in I will then start the process to find additional deals to fill our fund through networking as suggested.  

    Thank you again to everyone who replied above for all of your help! Any additional suggestions are always welcome as I love to learn new ways to doing things/investing.

    Thanks,

    Brian

    0Reply
  • Jerel Ehlert
    Attorney · Austin, TX · Member since 2014 · 890 posts · 759 votes
    7y

    You don't qualify as an accredited investor, as an individual, under the income or net worth (see Sec. 203.501 - Reg. D definitions).  There are limited ways to comply.  

    First, make sure you *really* don't qualify.  Check the value of all your retirement plans and other assets.

    Borrowing enough to qualify from your dad won't work.  Assets MINUS liabilities.  You get cash and corresponding debt.

    Forming a company to invest won't work either.  You basically just tried to form an unregistered investment company.

    What works: 
    You could get licensed as a broker/dealer.
    You and Dad could form a company, buy assets (rentals, etc) at half value => increasing your net worth to the minimum threshold.
    You and Dad could form a company that does business and pays a salary (including income tax) to put you over the threshold.  Requires 2 years minimum.
    Form a syndication (i.e., become an Issuer).

    Also, you can invest in a 506(b) that works for you.

    0Reply
  • John FortesPro Member
    Multi-Family Syndicator · Abington, MA · Member since 2017 · 603 posts · 347 votes
    7y

    I wouldn't try to skirt the law. The OA will detail exactly how the transfer of equity/shares will be distributed if ever there was a reason for someone wanting out. @Brian Burke was really detailed and explained it thoroughly. @Jillian Sidoti writes these offerings for a living. 

    0Reply
  • Joe Tomko
    Specialist · Easton, PA · Member since 2018 · 137 posts · 48 votes
    7y

    Hi, @Brian P Carolan I cannot answer your question per se as I am not a securities attorney.  I think you are best served by not skirting the laws.  It's never a good idea to get cute with the government with unlimited resources to make your life miserable.  I agree with Taylor L, below.  If it were my deal and an accredited investor brought in a non-accredited investor through the back door, I would likewise probably return his investment and force him out of the deal, as I wouldn't want the scrutiny of the SEC.  

    It may be better to approach the person with the deal and explain your situation.  Inquire about other deals that they or a colleague may have where you would qualify.  You can also inquire as to whether they would offer the same syndication in a fund whereby you would qualify.

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