Recently, on a popular crowdfunding site, I noticed that someone was seeking funds to produce a recording of Bach’s music. There are probably thousands of recordings of Bach, but this one was different – the musician planned to perform the music on the accordion.
For those unfamiliar with it, the accordion is an instrument played by pumping a bellows, which forces air over a reed to produce a sound. At the same time, the musician plays the melody on a keyboard with their right hand while simultaneously producing an accompaniment bass sound with their other hand.
Bach did not write music for the accordion because it wasn't invented until 100 years after his death. Most people’s experience with accordion music is like mine -- polka and klezmer bands and other folk music groups.
Curious, I listened to the recording accompanying the crowdfunding request. The musician is an artist on the accordion. The accordion’s bass resembles the basso continuo used during Bach's time. The keyboard timbre (sound quality) resembles an organ. Not surprisingly, Bach was an organ virtuoso and wrote much of his music for that instrument.
I thought maybe this musician had used his highly accomplished playing innovatively to expand the accordion's repertoire – but I was wrong. Searching online, I found videos of at least ten accordion players performing Bach and a 2017 ClassicFM article about performing Bach on the accordion.
So, although the accordion player seeking crowdfunding was highly accomplished, his planned album wasn’t as innovative as I had thought. Although Bach sounded terrific played on the accordion, it’s no match for hearing that music on a pipe organ in a vaulted sanctuary for which it originally was composed.
Like the accordionist, real estate sponsors often seek to be innovative. Cutting-edge opportunities like crowdfunding and online selling platforms call to them.
However, based on statistics from the Securities and Exchange Commission (SEC) Small Business Advocacy Office (SBAO) Annual Report (SBAO Report) issued in December 2023, most sponsors stick with the more familiar securities exemptions when selling real estate securities. Further, changes to the accredited investor decision could limit future access to Rule 506(c) on online real estate securities platforms.
Securities Law Exemptions for Real Estate Securities
The Securities Act of 1933 (1933 Act) requires that securities offerings be registered with the SEC unless an exemption exists. Although there are numerous registered real estate offerings – like traded REITs and funds- registering securities is costly and time-consuming, which works best for large investment companies that own dozens or hundreds of properties. So, most real estate sponsors offer securities under an exemption.
Before the 2010s, most unregistered real estate securities used the private placement exemption under Rule 506(b) of Regulation D (Reg D). Rule 506(b) was adopted under Section 4(a)(2) of the 1933 Act, known as the private placement exemption. So, Rule 506(b) prohibits general advertising and general solicitation of investors.
Rule 504, also part of Reg D, allows general solicitation. Unlike Rule 506(b), Rule 504 imposes a dollar limit on how much a sponsor can raise in a 12-month period (the limit is $10 Million). However, the biggest drawback of Rule 504 is state securities law compliance.
Rule 506(b) preempts state securities laws, but Rule 504 doesn’t. So (except for offerings involving only a few investors), in addition to the dollar limit, Rule 504 offerings must undergo scrutiny by state securities regulations. Qualifying under state securities laws increases the cost and time involved in the offering process, making Rule 504 less attractive than Rule 506(b).
Rule 506(c), adopted in 2013, started gaining the attention of real estate sponsors by the late 2010s. Unlike Rule 506(b) offerings, Rule 506(c) offerings may be publicly advertised.
However, there’s a tradeoff for that flexibility. Rule 506(b) offerings permit up to 35 unaccredited investors – provided specific requirements are met. Rule 506(c) offerings may be sold only to accredited investors.
To be accredited, individual investors must meet specified requirements regarding their income, net worth, securities licensure, or relationship to the issuer.
Rule 506(b) permits investors to self-certify their accredited status. Rule 506(c) does not. Therefore, 506(c) offerings require more scrutiny into investors’ financial situations than Rule 506(b) offerings, making Rule 506(c) offerings less attractive for some high, very high, and ultra-high net worth investors.
Regulation CF (Reg CF), which allows equity crowdfunding, is the newest exemption. Reg CF can be used only to raise equity for operating companies and can’t be used for “blind check” companies. So Reg CF isn’t available to a blind real estate fund. This restriction poses a challenge for larger real estate investments, which may raise funds before identifying all the assets the fund will own.
Reg CF offerings must be sold only through an authorized investor portal, access to which can be competitive and which adds to the offering cost. Plus, like Rule 504, Reg CF limits how much the issuer can raise ($5 Million). There are also dollar limits ranging from $2,500 to $90,000 on how much unaccredited investors can invest.
The small investment amounts translate to a larger number of investors. Unlike corporations, real estate funds taxed as partnerships (as most are) must provide annual tax documents allocating profits and losses to their investors. So, having a large number of investors adds to the issuer’s administrative burden. Plus, issuers must file annual reports with the SEC for several years after their Reg. CF offering, adding to the regulatory burden.
Although some refer to Regulation A (Reg A+) as an exemption, it actually is a streamlined registration process. Sometimes called "mini-IPOs," Reg A+ provides two tiers of offerings under which companies can raise up to $75 Million in a 12-month period. Since Reg A offerings require SEC review, they generally take longer and cost more than Rule 506 offerings.
Although unaccredited investors can invest in Reg A+, like Reg CF, the amount they can invest is limited. Still, Reg A+ is getting attention from real estate developers and others who need to raise more than $5 M, want access to unaccredited investors, and can afford the time involved in an SEC review.
Small Business Advocacy Office’s Report
The SBAO Report provides data on small companies raised capital. Although the report focuses on small businesses generally, real estate businesses are included. The report combines all real estate into one category, so there’s no breakdown among development, single-asset, blind fund, and other real estate offerings.
According to the SBAO Report, Rule 506(b) remains the overwhelming choice for capital raises among small businesses, with a total offering of $2.7 Trillion and a median raise of $1.2 Million. Once again, the aggregate amount raised under Rule 506(b) far outstripped the amount raised via initial public offerings (IPO), which raised only $17 Billion. Regulation A offerings, often called “mini-IPOs,” raised $1.5 Billion.
The next most popular exemption, Rule 506(c), was used to raise only $169 Billion, with a median raise of only $750,000. Although the aggregate dollar amount raised increased for both Rule 506(b) and Rule 506(c) offerings, both also experienced a reduction in the median raise. Only 12% of the money raised in Reg D offerings was for operating companies, although those offerings represented 55% of offerings.
Rule 504 and Regulation CF offerings raised $258 Million and $352 Million, respectively. The average investment under Reg CF was only $1,578, with the average total raise being $428,486.
Other exempt offerings (such as Regulation S and Rule 144A) raised $1.3 Trillion. Another $8.8 Trillion flowed into funds registered under the Investment Company Act of 1940.
In the real estate industry, there were $75 Billion in Regulation D offerings (the report doesn’t distinguish between Rules 506(b) and 506(c)) and $29 Billion in public offerings. Once again, the real estate industry had more Regulation D offerings than any other industry.
The SBAO Report compared the use of Reg D, Reg A+, and public offerings for the real estate and other industries. For real estate offerings, Reg D was by far the most popular option, with $75 Billion raised (there isn’t a breakdown between Rule 506(b) and Rule 506(c). Public offerings followed, with $29 Billion raised, and only $557 Million was raised using Reg A+.
Why Rule 506(b) Offerings Still Dominate
Although Rule 506(b) offerings can’t be advertised, they enable an issuer to raise an unlimited amount of money at a reasonable cost without SEC or state review or annual filings. Upfront costs for a Rule 506(b) offering include preparing a placement memorandum and filing Form D and state notice filings. Although Rule 506(b) offerings cannot be advertised, they can work well for an issuer raising funds from friends and family, some of whom may not be accredited.
Rule 506(c) offerings also are among the least expensive. Although Rule 506(c) offerings can be advertised, they can be sold only to accredited investors. Yet, verifying accredited status can add to costs and discourage investors who wish to keep their financial situation private.
Established sponsors with existing investor relationships that need not advertise may favor Rule 506(b) offerings. However, from a practical matter, Rule 506(b) limits solicitations to prospective investors to telephone, mail, email, investor portal, and other private communication methods.
While these methods may work well for many investors, as Millennials make up more of the investor base, sponsors may want to migrate to social media and other communication methods with which they are most comfortable. To use public-facing communication to solicit investors, sponsors must move to Rule 506(c).
Why Rule 506(c) is Increasing in Popularity
Rule 506(c) offerings enable sponsors to build a base of accredited investors through advertising without SEC review or an ongoing reporting requirement. The tradeoff is that sales can only be made to verified accredited investors.
However, the number of accredited investors is increasing. In another December SBAO Report (Accredited Investor Report), the SEC estimated that 24,254,049 households, representing 18.5% of US households, qualified as accredited investors in 2022. In 1983, only 1.51 Million households, representing 1.8% of US households, were accredited.
Part of this increase is due to inflation. The net worth and net income dollar amounts have stayed the same for 40 years (although a rule removing home equity from net worth was implemented in 2011).
However, inflation doesn’t explain the entire increase. Applying the CPI-U to the 1983 numbers, the Accredited Investor Report calculated that 5.7% of US households would be accredited – still more than triple the 1983 percentage.
The Accredited Investor Report notes that changes in retirement benefits from defined benefit plans to defined contribution plans and individual retirement accounts (IRA). With a defined benefit plan, the plan manages the retirement plan assets. However, with defined contribution plans and IRAs, the employee manages and owns the assets and can include them in their net worth calculation. According to the Accredited Investor Report, 12.5% of households are accredited based on net worth. However, only 8.8% of US households would meet the $1 Million net worth threshold if retirement assets weren’t included.
The Accredited Investor Report notes that the National Association of State Securities Administrators (NASAA) has expressed concerns that many newly accredited investors aren't “capable of protecting their own assets.” Therefore, NASSA has recommended increasing the net worth thresholds to reflect inflation and excluding defined contribution plan assets from the net worth calculation.
The SBAO Report recommends maintaining the current accredited investor net worth and income thresholds and expressed concerns that increases could adversely impact access to capital for women, racially and ethnically diverse, and rural populations. The SBAO Report also recommends expanding the accredited investor definition to include additional professional criteria as an alternative for net worth and income.
Returning to the Bach example, Bach played on a massive pipe organ in a venue with a vaulted ceiling will produce the most authentic performance. However, people need access to such a venue to hear the performance. On the other hand, accordions are portable, so they can perform Bach almost anywhere, giving more people access to this beautiful music.
The SEC has a similar dilemma. It can follow NASAA’s recommendations and tightens the accredited investor definition to better conform to the original idea to limit access to Rule 506(c) offerings primarily to very high net worth individuals. Or, the SEC can expand the definition of accredited investor to provide more people with access to those offerings. Whether Rule 506(c) offerings continue to increase in popularity – and the number of individuals who can purchase fractional interests in real estate through funds -- is likely to depend on the SEC’s decision.
This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.
