Suitability and Title III
By: Tim L. Edgar
The Securities and Exchange Commission recently finalized rules to implement Title III of the JOBS Act and soon true crowdfunding will be legal in the United States.
Regulation Crowdfunding was created by the new Section 4(a)(6) exemption to the Securities Act of 1933 and for the first time it will allow Non-Accredited Investors to invest in primarily start-up and smaller companies through the purchase of private securities. Section 4(a)(6) also created a new intermediary called a registered Funding Portal that is allowed to issue these private securities as well as SEC/FINRA broker-dealers.
I have spent the last year speaking at various conferences in Chicago, Boston, Los Angeles, Phoenix and Miami explaining that securities offered through the Regulation D 506(c ) exemption to the Securities Act is really not “crowdfunding” because the offerings are only available to Accredited Investors as defined by the SEC. Even after the SEC enacted Title IV of the JOBS Act earlier this year, known as Reg A+, we at Hotel Innvestor have continued to utilize the Reg D 506 (c ) exemption even though Reg A+ provides for Non-Accredited Investors to participate in those offerings. For us, it’s more than just the onerous financial reporting and other requirements associated with both Reg A+ and Section 4(a)(6) exemptions, it’s about suitability.
We issue private securities secured by equity ownership in or debt instruments on high-quality hotel projects nationwide through our broker-dealer partner, North Capital Private Securities Corp. These private securities are illiquid and have no readily available secondary market in which to exit the investment. Obviously this is disclosed to our investors and there is a tremendous demand for these alternative investments as evidenced by $1.4 trillion + raised in just Regulation D offerings last year. The reasoning behind the limitation that only Accredited Investors can invest in these securities is primarily liquidity. Although there are multiple ways to qualify as an Accredited Investor, it essentially equates to being a millionaire passive investor. As such, the reasoning goes, you will not need the money invested in these illiquid investments returned to you in the foreseeable future, i.e. you are a suitable investor in these private securities.
Hotel Innvestor’s primary focus is select service, extended stay and premium limited service hotels with a minimum $75 REVPAR (revenue per available room.) As such, the investment capital required by these types of hotels is invariably in the multi millions of dollars. Section 4(a)(6) offerings are capped at $1 million, so the suitability of this exemption for the types of hotels that we focus on is certainly suspect. The initial and ongoing audited financial reporting requirements under this exemption make it virtually untenable.
Regulation D offerings have been in existence since 1984 and as I mentioned previously, it is a trillion dollar marketplace annually. The characteristics of all Reg D offerings are that Accredited Investors pay a fee to an SEC/FINRA broker-dealer to invest in illiquid private securities in start-up and smaller companies that do not have the capacity for an initial public offering. Section 4(a)(6) has created a new entity called a registered Funding Portal. These Funding Portals can act as an intermediary in offering these securities in reliance on this new exemption to the Securities Act, as long as they abide by certain regulations that include not promoting the sale of these securities and not offering investment advice or recommendations. Thus Funding Portals and their associated persons are not FINRA licensed and receive compensation for issuing securities that they cannot recommend or solicit. As a passive investor, I question the suitability of investing in a private security through such an intermediary and the conflict of interests in the prohibition of recommending or soliciting securities that you get compensated for selling.
Although many in the industry have hailed the enactment of Title III through the Section 4(a)(6) exemption, we feel there is a tremendous potential for legal liability in selling illiquid private securities to Non-Accredited Investors based on suitability of the investment. Hotel Innvestor will continue to utilize the Reg D 506(c )exemption in our offerings because of our belief that it is better suited for both the Sponsor and the Accredited Investors. We also feel these securities are better served being issued by knowledgeable, licensed professionals issued in an SEC/FINRA compliant manner through a broker-dealer.