Securities Laws and Compliance Considerations for your Reg D Debt Fund

Jennifer Young:

Welcome everyone. We are doing a webinar today on securities laws and compliance and considerations for your Reg D debt fund. Hello everyone. My name is Jennifer Young, my friends call me Jen. I am a partner at Geraci and I'm on the corporate and securities team. My team helps our clients with fund formation as well as licensing. So before we begin today, there are a couple of housekeeping items. First questions are going to be answered at the end of the webinar and to submit questions, you'll need to put those questions in the q and a box at the bottom, not the chat box. If any questions are put in the chat box, they're not going to be monitored and they won't be answered. So make sure you click the q and a box at the bottom for your questions. And third, the marketing team will be sending the recording and slides after this webinar. So with that, I am going to get started.

Alright, so we're talking about debt funds for the most part in this webinar, and there are securities filings that are going to be required once you have your funds stood up. The first one is a federal filing requirement, and that's the Form D. This is a notice filing to notify the SEC that you're selling securities, the membership interest or limited partnership interest in your fund. The general rule of thumb for the Form D filing is within 15 days of the issuer's first sale. And practically that means once you get back your first signed subscription agreement for the fund, for your first investor, you want to generally file that form D filing within 15 days of that. At Geraci, my team, we usually file it proactively before the 15 days so that you don't have to worry about that timing wise. But after the first initial filing, this filing is going to be required every single year that the offering is ongoing and that you're raising money.

It will also need to be renewed annually on the anniversary date or before of the first form D filing. For Form Ds you also want to keep in mind that you may have to make amendments as needed and these amendments need to be filed where there's a material change to the Form D filed or you need to correct any error and amendments can be filed any time as needed. So the second type of filing is blue sky filings. These are state filings and really what they are is state notices with the state that the investor resides. Timing wise, general rule of thumb is the same 15 day rule companies, the fund should file 15 days within the first date of sale of securities with that investor in who resides in that state. So residing in that state, what does that mean? Individuals? That's easy. It's where their primary residence is for LLCs or entities, their principal place of business.

The kind of more trickier one to remember is for any IRAs or 401k plans, this is where the state, the custodian is based. Now for state requirements, those specific requirements vary by state. Most of them is within 15 days, but there is a state like New York that does require advanced notice. Most of these filings are done online, but again, with New York, their filing is a little bit more tedious and they do require a little bit more time. Renewal wise, the timelines again vary by state and it's only one state filing that's required after the first sale in that state. Same with Form Ds, renewals and amendments and other annual filings might be required depending on the state. So check with us for ongoing compliance there.

Moving on. All right, so 5 0 6 B funds versus 5 0 6 C funds. The biggest difference is the accredited investors that you are allowed in or the non-accredited investors that you're allowed into 5 0 6 funds and marketing, right? Those are the two big kind of threshold considerations you want to think about if you're deciding whether to go with a B or a C. So for a 5 0 6 B fund, you don't need to verify that your investors are accredited investors, but you do have to have a preexisting substantive relationship with them. What that means is that you have this existing relationship prior to them receiving any information about your fund. Substantive means that you have gotten to know their professional background, their financial risk tolerance, and that you've established this relationship ahead of time. Best practice is if you're meeting somebody new, you can't market to them and you can't tell them anything about the fund and you have to take the time and the steps needed to establish this preexisting substantive relationship, and that usually involves three touches and emails, phone calls, those all count without discussing the investment.

During this kind of get to know period, you're really getting to know them, their risk tolerance, their financial history, professional background, what do they do, et cetera. For 5 0 6 B funds. When your investors come into the fund, they don't need to be verified. They can just self certified that they are accredited, but if you have any non-accredited investors coming in, you want to be very careful and keep track of how many there are because you are only allowed 35 non-accredited investors, and this is for the life of the fund. This means that if one unaccredited investor redeems or withdrawals fully out of the fund, you lose that slot for the rest of the fund's. A lifespan term, excuse me. Another thing to keep in mind when you have any, even one unaccredited investor, you need to get audited financials once your fund hits 20 million in a UM.

So that's expensive and it's a little bit time consuming, but to be honest, I think that getting audited financials is going to be really helpful and I really encourage that at the outset. It helps you get a line of credit. It helps you raise money. Serious investors, institutional investors, family offices, they're usually looking at funds with two to three years of audited financials. So it's definitely a positive for your fund to do. For 5 0 6 B funds again, you cannot advertise, you can't advertise anything funds specific. You can market to your preexisting relationships once you've had that substantive relationship established. But to the general public on social media, LinkedIn, you cannot advertise anything fund specific. You can discuss a business opportunity, you can talk about your company, but not the fact that you're raising money or any fund details. Perhaps just that there is an investment opportunity.

For 5 0 6 C funds, so this is where investors are all accredited, and 5 0 6 C funds allow the fund to be advertised publicly and you can generally solicit investors that you don't even know. The downside of that is the verification practice. So every single single investor that comes into the fund has to be verified that they are indeed accredited investors. That means 200,000 income or 300,000 joint husband and wife, or they have a million in assets excluding their primary residence. Now for the verification process, it can be as simple as getting a letter, a certified letter from their CPA, their financial advisor, their RA or bd or even their attorney just certifying that. Yes, they are indeed accredited investors. There are also third parties services like verify investor.com that some of my clients find helpful with marketing and advertising. You're free to do this, you just want to avoid certain language, be careful about projections and overstating values.

And we have a whole marketing slide that we'll go through in more detail later. So that's the difference between 5 0 6 B and 5 0 6 C and the types of investors in each of those funds. So, all right, ERISA rules. Everyone's favorite. So there's two buckets of investors that plans that come in and you want to kind of understand the difference between them. The first is employer sponsored plans. Now these are 4 0 1 Ks pension plans, anything with employees inside them, they're a little bit harder to get right. They often can't invest in alternatives, or at least they weren't, it wasn't as common for them to be able to before, and you also need to get clearance from their custodian to be on their platform. So those employer sponsored plans, those are governed by erisa. The second bucket is solo self-directed IRAs, solo 4 0 1 Ks. Those plans that are not employee sponsored have no employees in them, that those are governed by IRC 49 75, and there has been a common misconception that ERISA rules don't apply to planned assets, meaning these solo self-directed IRAs.

That's not true. The ERISA rules and the IRC 49 75 rules are identical with regards to prohibited transactions and they should just be treated the same. So you have potential or you do have some IRAs as investors in your fund. What do you need to think about? Well, the general rule is that you want to stay below 25% of the fund's equity with those investors. Once the fund reaches 25 or exceeds 25% of the total funds equity, then the fund can be treated as a plan and the fund, oops, the fund manager, sorry, and the fund manager are going to be considered fiduciaries. So then prohibited transaction rules kick in and for debt funds out there, this really affects third party compensation for services rendered to the fund. And that means your loan fees, your fee income points, servicing fees, any type of fee income that the manager may be getting, you're going to have to fix, play around with accounting for that. But the thing that you want to keep in mind, threshold is 25% of the fund's equity.

The last point on this slide is principles of the manager or the gp. So the gps should not have their own IRAs or 4 0 1 plans in the fund. It raises self-dealing issues and prohibited transactions, and it doesn't affect the fund, it affects your own ira. So with that in mind, spouses are also treated the same as principal. It's lineal descendants, so up and down the family tree, both the husband and the wife and the mother, fathers grandparents and children and grandchildren. Best practice is just to keep in mind if you want to invest in your fund, don't do it through your ira, do it through maybe your GP entity or some other entity that you might have. It will affect your own ira.

Alright, paying commissions and broker dealer issues. So I get a lot of questions about can I pay this person? I want to bring him in and pay him commissions and so he can help me raise some capital for my fund. Well, the biggest issue there is always that unless that individual is licensed with a FINRA or SEC, you cannot pay them transaction based fees. This means that the payment can be contingent or premised upon successful capital raise or investment into the fund. You can condition and say, okay, I'll pay you this amount and it's going to be based on how much that investor invests into the fund. That's a big no-no, and you can only do that if they do have a license. Now, the way to do it generally for most states is that you can pay a referral fee or a lead gen intro, and these are only, they are flat fees and you're only paying for introductions if the introductions are good or bad.

It doesn't matter if the investor ultimately invests into the fund, it doesn't matter. You're paying them for the introduction period and it should be a flat fee with capital raising. I get a lot of questions of what are some other ways or successful ways that people have had good outcomes with for capital raising? And from what I've seen, it's usually the investor advisors or registered RIAs. They are great as a partner because they're licensed. The harder part is that you need to get on their platforms, but ultimately the investor pays their commissions. So if you have any good wealth managers, investment advisors, I would encourage you to start some conversations there. Now with broker dealers, bds, they're a little bit different. Managing broker dealers, placement agents, whatever you want to call them. They're a little bit more on the expensive side usually, and if you're actually working with one, I would suggest you reach out to us to help negotiate terms of that agreement. We've had issues and some of our clients have had bad experiences with some landmines in those agreements, so feel free to reach out to us. If that does come across your way, I'm happy to help there.

Next slide. All right, so fund activities. This really has to do with what offering docs say, right? The big rule is called the four corners rule, and that just means you want to stay within the four corners of your PM document. So the funds, activities in general, the funds should just run in accordance with the PPP M, your fund. For these debt funds, they are just making and purchasing mortgage loans or loans secured by real property. In our documents, we have making or purchasing mortgage or loans secured by real or personal property, but that doesn't mean that you can just go out and make car loans or something like that. The personal property part is added on there as an equity pledge for additional collateral for those mortgage loans or deeds of trusts.

Something to keep in mind is that these ppms are specifically drafted in a way so that the 40 Act, the Investment Company Act and the Investment Advisor Act doesn't apply. And going outside of any of those specific laid out fund activities in your PM could raise 10 B five causes of actions, meaning fraud and misrepresentation. So things to keep in mind for your fund's activity. You're only buying mortgage loans and in our view, the Investment Company Act, the 40 Act and the Investment Advisor Act, they don't apply so long as the fund doesn't get involved in buying and selling securities, marketable securities or investing in debt funds, other debt funds, anything like that. Marketable securities, obviously stocks, bonds, treasury bonds, de bills, muni bonds, R-M-B-S-C-M-B-S fund to fund investing. Also, debt funds is what I'm talking about for marketable securities. When that happens, or if the fund does conduct that type of activity and invest in any of that list, the manager can be viewed as an investment advisor and then would need to be registered. I also have a lot of questions about managing dry powder and what can I do with that money for the temporary time being and money market depository accounts. Are they okay? Yes, they are, but money market funds are not. Okay. So there's a difference there. The depository accounts savings, those are all fine, but if it's a money market fund, that's a big no-no.

Something to keep in mind for these debt funds. As you guys are collecting fees and selling, maybe even selling loans when you sell a mortgage loan via a whole or fractional loan sale, that loan sale can become a security if you don't have independent underwriting on the other end, or you're selling to a high net worth investor or trustee deed investor, and that can trigger the investment advisor or investment company act. So really you want to think about for whole or fractional loans, co-leading, how much reliance is there on your expertise? Right? For high net worth trusted investors, there's usually no independent underwriting. They don't evaluate these loans themselves. There's someone who is relying on your diligence, your underwriting, they're passive, right? And so because of that, it'll be considered a sale of securities.

Same with co-leading and liquidating loans for capital, additional capital. The 40 act will kick in. So you want to definitely think about who you're transacting with and stay away from trust deed investors or high net worth investors. Now, selling to professional loan buyers or aggregators, that's a different story. They have their own credit guidelines. They do their own underwriting evaluation, they do their own due diligence. I've seen in their documents, they also have reps and warranties and covenants, so totally different story. They're not relying on your expertise. It wouldn't be considered a sale of securities. So when you're dealing with whole or fractional sales, think about how much reliance on your expertise they are relying on and whether or not they're doing it, their own underwriting and due diligence.

Something else in the PPM that a lot of, at least our clients have the capability to do is side letters. So side letters usually offer the investor a reduced fee or enhanced economics or maybe liquidity. A lot of times these are offered at the early stage at the seed stage for seed investors. The only thing I want you guys to remember and to keep in mind is that you're consistent in your approach. You don't want to offer these side letters with the same enhanced economics to just a $5 million investor versus a hundred million dollars investor. You want to be consistent and you want to have an underlying justifying reason for these side letters. So maybe quite often it's the amount that's invested. A lot of times with these seed investors, it's a cutoff timeline based, but just in general, you want to be able to justify your basis for offering these side letters.

You also definitely want to avoid family side letters, so let us know if you have any questions and we can walk you through that and prep these side letters for you. The last item on this slide is amendments. So amendments are often needed for funds. This occurs when there's a change in business activity or any change in investor economics or management fees and comp. Depending on what you are trying to amend or update in your fund, you may need to get investor or member consent. Best practice is also to review and refresh your fund PPM every couple of years, and we're happy to review for you if you want to make some changes or update and let you know if you do indeed need any member or investor consent or if it's just simply a notice that needs to go out to all the investors.

All right, marketing the fun part. Okay, so fun. Marketing materials are always very important and we want to spend some time to review these and make sure that they're accurate. So the first thing we always look for is does the marketing material have its securities disclosures and disclaimers? And this is not just the pitch deck or PowerPoint slide or whatever it is that you use. It's also LinkedIn posts or social media posts and email blast. They should have some sort of security disclosures and disclaimers on them, and a lot of people forget about that when it's just like a simple little LinkedIn post about the offering. The second thing is that the information that's presented should be accurate and not misleading. You definitely don't want to overstate your values and you want to be accurate in listing fees and management fees especially, or returns accurately at Lee.

You don't want to use, there's certain terms that you want to avoid, and some of those terms would be guarantee or guaranteed returns or risk-free investments. Never use those words. Don't imply no risk or low risk. That's a big no. The last one to keep in mind is certain marketing materials that I've seen lately have given they where you hold yourself out there as giving investment advice. That's definitely something to keep an eye out for and avoid because that language, that type of language or putting yourself out there is licensable activity, and you need to have a license to hold yourself out there as giving investment advice.

The last thing I want to bring up is the difference between 5 0 6 B funds and a 5 0 6 C fund. So of course, with advertising, this comes into play and 5 0 5 0 6 C funds are allowed to advertise. BS cannot for bs. You can't advertise anything fund specific. You can discuss business investment opportunities, and again, you can't talk about the new investment opportunity, but you can talk about the company and what it does for C, there's not really anything that you can't discuss. You can give the fund details, what does this waterfall look like? What is its pref, what are the management fees, projections, et cetera. But all of that, of course is premised with needing to have the securities disclosures and disclaimers out there on your marketing materials. All right, let's move on. And this is our last slide. So we made good time, which means you guys will have a lot of time for questions, but this is the last compliance kind of related item.

For funds for fund managers, you want to make sure that your fund is appropriately licensed. So depending on where the fund is going to be making loans, where those properties are, you may or may not need to be licensed. Now for business purpose loans, and this business purpose loans means loans not for personal family or household purposes. For business purpose loans, there are six states that need licensing. If you're going to be lending in that state, regardless of the collateral, that's California, Arizona, Nevada, North Dakota, South Dakota, and Vermont. Hands down, even if it's commercial, five plus, you need to be licensed in those states to be able to lend. Now, if the loans are secured by a one to four, there's an additional four states that will need to be licensed, and that's Utah, Oregon, Minnesota, Idaho, and Virginia. And last, which it doesn't come up as often, but sometimes business purpose loans can be secured by owner occupied properties, and those three states are Iowa, Kansas, and Washington.

So keeping in mind that you do need licensing in certain states, there are certain states that kind of have different, not licensing, but for example, North Carolina requires a registration with the Secretary of State, and what that registration looks like is really just a disclosure statement, a financial statement of the company, and a 10 K surety bond. With that, it's an annual kind of filing and it allows you to broker or make loans in North Carolina. Now, Florida is one of those states that doesn't require licensing for most funds, it's a little bit flip flopped. North Carolina is also a little flip flopped. North Carolina, you need to be registered if you make less than $1 million in loans in the prior year. Florida, you don't need a license for one to fours or if the borrower is an entity. So that means that if you're making commercial property loans or you're lending to an individual, then you will need to be licensed. Now, there are a lot of, not a lot, but there are certain exemptions for certain states that will exempt you from licensing. For example, in California, if you have a DRE licensed broker, that's the California Department of Real Estate broker license, that broker can broker or arrange a loan for your unlicensed fund to lend for California loans.

Oregon also has something similar where if you have a licensed broker who arranges the loan, then you don't need to have a license in Oregon to loan. For Arizona, there is a pretty specific exemption where if it's a five plus or commercial property and it's 250,000 or more loan size, then that's an exemption from licensing and if you can make that loan without a license, another Arizona license exemption is that if a loan is arranged by an Arizona broker, you're fine to lend without a license so long as you don't have an office in Arizona.

For those of you guys out there who are also brokering if your fund is also brokering, the general rule of thumb is that all of the states that I listed on this slide will require you to have a broker license in order to broker and collect a fee. But there's additional states where you don't need a lender's license, but you will need a broker's license. And those are New York, Michigan, I think New Jersey, Pennsylvania, they're more on the East coast. You don't need a lender license, but they do require a broker license. I think that's about it for me. I know we went through those pretty fast. Before I open it up for questions, I wanted to let you guys know that we do have an upcoming webinar. It's on July 9th at 1130, California time, nema Geraci's own Nema, and Sean Morgan for CASA is going to be holding a webinar for private lending, deep data dive markets and market share. So that should be really interesting and very, very informative. Again, that's July 9th at 1130.

So I am going to open it up for questions and I will start answering them here. Give me a second as I open this. Okay, so there was one question. Can selling and purchasing partials be considered factional loans? Can it be a security issue? Can you please give an example? I think it depends on the fact presented and who you're dealing with. But again, and let's go back to my slide. Oh, okay. I don't have information. Sorry about that. Oops. Yeah. So the things that you want to think about for whether or not it's a securities issue is how much reliance they are to the buyer. Are they relying on you? Are they relying on your expertise? Did they do any due diligence on their part and basically underwriting and analysis, or are they just wholly kind of relying on you and you are the one that said, this is a good deal. I did my underwriting and I made this loan, so now I'm selling it to you and they're relying on you. That would be a securities issue. Feel free to reach out to me. You guys should have my email address. It's j.young@geracillp.com if you have any questions. But generally, that's what you always want to think about in any sale, loan sales and fractionals and co lending and multi Benny situations.

Can you please explain the ERISA IRA portion? Again, what kinds of IRAs fall under erisa? Yeah, so for erisa, it's really all kinds of plans. Employer sponsored plans, so that's pension plans 4 0 1 KS for the company as well as ira, solo self-directed IRAs and solo 4 0 1 KS, although they're govern separately. One is under ERISA and one is under the IRS code. They are exactly the same in the way that you want to look at them, and they should be treated the same. They have prohibited transactions come in, kick in. Once your fund hits 25% of the equity from these plans, from these IRAs, and with prohibited transactions, the fund is going to be viewed as a plan. The manager gps are going to be seen as fiduciaries and with prohibited transactions. You want to think about your third party compensation. You can't pay managers fees sometimes for services rendered. This will affect your origination points, your servicing, other certain aspects of fund accounting. Might have to be kind of finagled a little bit, but reach out to us if you're getting close to that 25% threshold and we can kind of take a look at where you are and figure out how to solve for this. It's not the end of the world. We just need to focus some time on it and figure out how to be compliant.

Are there any special considerations for an unrelated feeder fund? Say a B, C real estate fund takes money from investors and invests in X, Y, Z real estate fund. Okay, X, Y, Z makes commercial real estate loans for business purpose. Yeah, so the consideration there is that anytime you are taking your fund, if you're managing your fund, you don't want to invest, you can't invest in another fund. It doesn't matter what kind of fund, because that becomes securities purchase, right? Buying interest in another fund managed by another gp that is securities purchase and it'll make the investment advisor have to register as a RIA with the SEC. So that doing something like that is the same as investing in stocks or bonds for the fund. I hope that answered your question. Feel free to reach out to me if you want to talk more about that.

I don't think that there are. Yeah, so I think that we have all the questions that were put into the q and a box. Feel free to reach out to me, happy to talk to you, answer any other questions that you may have. We've been doing this for a very long time and we are happy to speak with you about structuring your fund or maybe restructuring your fund or any of the points that I brought up here. If you haven't been filing your form. ds, which is something that a lot of our fund managers forget. Our team sends out annual reminders to our fund clients, but everyone else, sometimes they don't know it falls off their calendar. So happy to help with form d filings and state filings as needed. But again, reach out to me if you guys have any questions and I'd be happy to help and chat. So that's going to be a wrap for this webinar today, and I thank you guys all for joining. My email address is j.young@geracillp.com. I look forward to hearing from you guys and I hope you guys enjoyed this presentation. Thank you.