A Guide to Real Estate Crowdfunding Today

8/10/2019 A Guide to Real Estate Crowdfunding Today

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A GOODW IN PR O CTER P U BLICATION FOR THE REAL ESTA TE INDUSTRY

F A L L / 2 0 1 4 SOURCE

The Legal Landscapefor Peer-to-Peer

Lending

Accredited Crowdfunding:Real Estate Investing Goes

High Tech

Crowdfunding andAccredited Investor

Verication

Potential Pitfallsto Crowdfunding

The Summof Change

A Guide to Real EstaCrowdfunding Toda


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SOURCE

Fall / 2014

A GOODWIN PROCTER PUBLICATION

FOR THE REAL ESTATE INDUSTRY

Editor-in-Chief

Robert M. Haight, Jr.

Editors

Lewis G. FeldmanJohn M. FergusonJohn T. HaggertyDouglas A. PrawChristopher B. PriceAndrew C. Sucoff

Production

Jessica HekmatjahNathan G. Leonard

DesignJulie Napoleon Copyright 2014 by Goodwin Procter LLP.All rights reserved. Reproduction, in wholeor part, without permission is prohibited . This publication may be considered advertisingunder the ethical rules of certain jurisdictions

and should not be considered legal advice.

Goodwin Procter Advises Trulia in$3.5 Billion Sale to ZillowGoodwin attorneys recently advised Trulia in its $3.5 billion sale to Zillow. Thetransaction, which is expected to closein 2015, is a stock-for-stock transactionwhereby Trulia shareholders will receive0.444 shares of Class A Common Stock ofZillow for each share of Trulia, and currentZillow Class A and Class B Common Stockshareholders will receive one compa-rable share of the combined company.Zillow and Trulia were founded nearlya decade ago and have capitalized onAmericans increasing preference forresearching purchases, including homes,online, rather than relying solely on a realestate agent. Our Technology Companiesand Real Estate Practices are designedto accommodate our clients needs asthey grow and change. We bring a com-prehensive, coordinated approach thatinterconnects business, new technolo-gies and the law. We invite you to contactus to learn more.

www.goodwinprocter.com

GOOD DEAL

Lewis G. Feldman, Partner and Co-Chair of Goodwin Procters Crowdfunding Practice

A Guide to Real Estate Crowdfunding Today The idea of creating large scale syndicates to purchase real estate is a classic concept.

Large scale syndication traces its roots directly back to the 1920s, when Manhattan-based

real estate developer, Fred French, built the largest residential development in Midtown, usingthe French Plan. French solicited small investments from large groups of investors in newspa-per advertisements, promising a 6% return on their investment and a 50/50 split of any residualincome. His investors subsequently became shareholders in a corporation that nanced theacquisition and development of real estate.

The concept developed by Mr. French grew to dizzying heights, through the partnership ofHarry Helmsley and Larry Wein in 1961. Together, the two men led the formation of large scalesyndicates that owned more than 40 buildings worth over $16 billion today. Among the proper-ties syndicated by Helmsely and Wien were the Equitable Building, the Plaza Hotel, the GraybarBuilding, and the Empire State Building. To buy the Empire State Building, Wein and Helmsleyled a syndicate of over 3,500 investors contributing equity towards a $79 million purchase price

over $600 million in 2014 dollars.

While French, Helmsley, and Wein were each able to achieve great success with large scalesyndication, their approach ultimately proved to be too unwieldy. The expense and administra-tive burden of large scale syndication ultimately led to the approach being largely replaced bymore efficient mechanisms for pooling small individual investments such as insurance compa-nies, REITS, and private equity funds.

Today, however, revisions to the securities laws and technological advances have given mod-ern syndicators a decisive advantage against not only their own predecessors, but also againstother conventional aggregators of capital. By allowing greater efficiency and access to inves-tors, crowdfunding has changed the value proposition of large sector syndication, making it aforce to be reckoned with in the modern nancial environment.

Its an extremely exciting time in the industry, but its important to keep in mind the potentialchallenges that come with these opportunities. In this special edition of REsource , we offer bestpractices for addressing issues in todays real estate crowdfunding market. Mark Schonbergerand David Perechocky give some background analysis on how crowdfunding sites appear tobe complying or pushing the envelope with respect to the SECs new and proposed rules;Lynne Barr, Ben Saul, and Matt Saunig cover the key regulatory considerations that peer-to-peerlending platforms must address; Charlie Alovisetti discusses the evolution of third-party verica-tion services; Steve Ellis and Nicole Tate-Naghi look at the sources of legal problems for aspiringcrowdfunding entrepreneurs; and John Ferguson and Lauren Lebioda address the legal issuesthat sponsors need to consider when raising capital from non-U.S. sources.

As the industry continues to receive media attention and gain acceptance from investors, itsexpansion and maturation will continue to accelerate and its impact on society will continue togrow. We look forward to continuing this exciting journey with all of you and hope you nd thisissue of REsource a useful guide.


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by Mark Schonberger and David Perechocky

New rules provide new opportunities. A range of newand varied companies are emerging, as developers,sponsors, entrepreneurs, and investors explore theforms of online real estate investing opportunities

through crowdfunding. This article provides a legal overview ofaccredited crowdfunding and highlights some companies thatare part of the real estate crowdfunding landscape.

Accredited Crowdfunding:Real Estate Investing Goes High Tech

Rule 506(b) vs. Rule 506(c) Offerings There are two primary methods of raising capital online: Rule

506(b) offerings, which permit raising capital from accreditedinvestors and up to 35 non-accredited investors, and Rule 506(c)offerings, which only permit raising capital from accredited in-vestors. (Generally, an accredited investor is someone whoseincome is greater than $200,000 (or $300,000 with a spouse) ineach of the prior two years and reasonably expects the same for


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the current year, or whose net worth is at least $1 million exclud-ing the value of the persons primary residence.) Both rules are

securities law exemptions that permit online sales of securitieswithout the requirement to register the securities with the SEC.

The key difference between 506(b) and 506(c) is that 506(c)permits the issuer to engage in general solicitation, whichmeans the issuer may engage in activities that drive traffic toits website in order to generate interest in an offering, such asadvertising or publishing articles. If an issuer wants to rely on506(b), it is only permitted to promote specic offerings to pre-screened investors, generally in a password-protected sectionof its website. Furthermore, permitted investors may not investfunds except after a cooling off period of approximately threeto four weeks.

In exchange for the ability to engage in general solicitation,506(c) issuers must perform a heightened verication process toconrm that investors are accredited. This process may requireinvestors to submit tax returns, bank statements and/or a creditreport if the issuer is relying on the safe harbors for verication(it is common for potential investors to be reluctant to submitthese documents). In contrast, investors in a 506(b) offering onlyneed to complete a questionnaire self-certifying that they areaccredited investors. Thus, visitors to websites that rely on 506(c)can easily access basic deal information because of general so-licitation, but nalizing the investment may be more burden-some for the investor (at least for the initial investment) becauseof the heightened verication process.

In a recent keynote address, Keith Higgins, Director of theSECs Division of Corporation Finance, observed that earlyadopters of online fundraising were reluctant to use 506(c) dueto the verication burden. However, 506(c) offerings have be-come more prevalent as the cost of using third-party vericationservices decreases and issuers move beyond the safe harbors

for verication and get more comfortable with the principles-based evaluation of accredited investor status highlighted by

Mr. Higgins in his speech, both of which methods are permittedunder 506(c).

Mini-Registered OfferingsAdditional rules have been proposed that permit non-accred-

ited investors to invest in online securities offerings (under theCrowdfunding rules pursuant to Title III of the JOBS Act as wellas Reg A+ which expands the current Reg A rules), but theserules have yet to be nalized by the SEC. It is only natural thatadditional crowdfunding sites will develop, and current siteswill expand once these rules are passed. A few sites, such asFundrise.com and Groundoor.us, sponsor smaller offerings fornon-accredited investors under Reg A or state law Blue Skylaws, but these companies will likely use the new rules once theytake effect. Of particular interest are the Reg A+ rules, which willpermit offerings of up to $50 million to non-accredited investors(effectively a baby IPO), while the Crowdfunding rules willonly permit raising $1 million per year. Both offering types willbe subject to heightened disclosure requirements including au-dited nancial statements and ongoing reporting obligations.

Proprietary Portals vs. Multi-Operator Marketplaces The chart on pages 6-7 highlighting a few of the websites sur-

veyed, is divided into two categories: sites where the site spon-sor offers its own deals (proprietary portals) and sites wherethe site sponsor acts as an intermediary for deals offered by thirdparties (multi-operator marketplaces).

Most, but not all, of the proprietary portals rely on the 506(c)exemption, permitting general solicitation: their offerings tendto be either co-investment opportunities with an active andknowledgeable sponsor or portfolio investments in a fund-likestructure with the sponsor as the manager. A perceived benetof proprietary portals is that the sponsor performs thorough


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Mark Schonberger , a partner in Goodwin Procters Real Estate CapitalMarkets and Crowdfunding Groups, specializes in corporate and securi-ties law, with particular expertise in REITs, real estate companies, realestate-related matters, and fund formation. Contact Mark at212.813.8842 or [email protected].

David Perechocky, an associate in Goodwin Procters Real EstateCapital Markets and Crowdfunding Groups, advises clients on variousreal estate and business matters. Contact David at 212.459.7368 [email protected].

diligence on the property and there is a relative alignment ofinterests because the site sponsor, often an established real es-tate investment company, is co-investing alongside the investorin every deal.

Multi-operator marketplaces are currently the more commontype of crowdfunding sites. The site sponsors involvement ineach third-party deal it lists on its marketplace varies: some offerdeal opportunities without claiming to do any diligence on the

property and some claim to perform extensive diligence; someprovide management and investor relations services for the is-suers; and a few create their own special purpose entities (SPEs)and/or co-invest in the deals.

The structuring method of the investment in multi-operatormarketplaces varies by site sponsor. Some site sponsors, likeGroundbreaker.com and CrowdStreet.com, structure the invest-ments directly into the issuer so that each online investor is adirect investor in the issuer. Others, like RealtyMogul.com andRealtyShares.com, aggregate the investors into an SPE managedby the site sponsor which in turn invests in the issuer. Other sitesponsors may acquire the property outright and syndicate aportion of it to online investors, the approach taken by sites likePatchofLand.com and iFunding.com.

Single Asset vs. Portfolio InvestmentsAlthough most of the crowdfunding investments thus far

have been for single assets, online general solicitation is alsosuitable for multi-asset investments and fund-like structures.An increasing number of fund sponsors may try to raise moneyfrom otherwise untapped online investors by incorporating acrowdfunding sleeve as part of their fundraises or raise moneyentirely online through 506(b) or 506(c). Two examples of multi-asset crowdfunding are Broadstone.com and FundingHamp-tons.com, both using 506(c). Broadstone allows investors toinvest online in two sponsored investment productsa privatenet lease REIT and a private single-family rental fund. FundingHamptons raises a partial blind pool to fund the development ofa portfolio of luxury residential homes in the Hamptons.

Size Limitations and Other ConsiderationsSome companies utilizing crowdfunding, particularly portfolio

companies or funds, may also need to nd an exemption from

registration as an investment company under the InvestmentCompany Act of 1940, which means, depending on various fac-tors, they would need to (i) limit the offering to not more than100 benecial owners (3(c)(1) exemption), (ii) meet the require-ments of the real estate exemption which generally requiresmeeting certain asset tests and holding real estate and realestate-related assets in majority-owned subsidiaries (3(c)(5)/(6)exemption), or (iii) restrict the offering to qualied purchasers(generally someone who owns $5 million in investments) (3(c)

(7) exemption). These limitations could be particularly restric-tive for fund-like entities and multi-asset portfolios that want toexpand their investor base because they may be limited to 100investors if they are unable to rely on other exemptions.

In addition, a private company will be required to register withthe SEC as a public company once it has 2,000 shareholders, or500 non-accredited shareholders. This limitation on the numberof shareholders could have implications on the effectiveness ofa crowdfunding raise, if, for example, the sponsor wants to set alow minimum investment amount or there is high demand forthe investment opportunity.

ConclusionAs these platforms continue to receive media attention and

gain acceptance from investors, the industrys expansion islikely to continue to accelerate. At the same time, this innovationraises questions regarding risks to market integrity, the need forinvestor education, and the importance of sound regulation.

This article is intended only to identify regulations and is not intendto provide detailed guidance on the steps required to comply with any particular law.

As these platforms continue to receive media attention and gainacceptance from investors, the industrys expansion is likely to continueto accelerate. At the same time, this innovation raises questions regardingrisks to market integrity, the need for investor education, and the importanceof sound regulation.


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Company Business Model MinimumInvestment

Site Sponsor Provides

Direct or IndireInvestment inIssuer

DueDiligenceServices

Co-invest-ment

AdministrativeServices

PROPRIETARY PORTALS (Site Sponsor = Issuer/Property Owner)

BroadstoneRochester, NY

Industry Focus:Net leaseSingle-family rentals

Site sponsor managestwo fund-like

investment vehicles

Private REIT (net lease)

Private fund (single-familyhomes)

$250,000(net lease)

$50,000(single-family)

Yes Yes Yes Direct

The Carlton GroupNew York, NY

Industry Focus:General commercialreal estate

Site sponsor offersdeal opportunities.

JV investments throughoutU.S. and Europe.

$1,000,000 Yes Yes Yes Dire

MULTI-OPERATOR MARKETPLACES (Site Sponsor = Intermediary)

Patch of LandLos Angeles, CA

Industry Focus:Single-family rehab andother residential realestate debt

Peer-to-peer lendingopportunities offered

by issuers.Site sponsor funds loans andthen syndicates to investors.

$5,000 Yes

(3rd partydiligence

rm)

Yes Yes Direct

RealCrowdPalo Alto, CA


Deal opportunities fromvarious issuers.

$5,000 No No Yes Direc

Realty MogulBeverly Hills, CAIndustry Focus:General commercialreal estate; debt

Deal opportunities from

various issuers.

$10,000 Yes No Yes Online in

aggregated inLLC vehicle bsponsor.

RealtySharesSan Francisco, CA


Deal opportunities fromvarious issuers.

$5,000 Yes No Yes Online inaggregated in

LLC vehicle bsponsor.

The chart on pages 6 and 7 , highlighting a few of the websites surveyed, is divided into two categories: sites where the

site sponsor offers its own deals (proprietary portals) and sites where the site sponsor acts as an intermediary for deals

offered by third parties (multi-operator marketplaces).

*=Information not available.


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SecuritiesLawExemption

Deal Information ThatBecomes Available Upon Waiting

PeriodCompensation to Site Sponsor Paid By

Is Site Sponsoa Registered

Broker/Dealer?Website Access Name

RegistrationFull

RegistrationInvestors Issuer

506(c) - Intro Full dealinformation

No 1% asset management fee.

3% management fee. Additional fees for

single-family vehicle: 10% property management fee

3% acquisition fee3% disposition fee

N/A No

506(c) Intro - Full dealinformation

No * N/A No

506(c) - Full dealinformation

- 21 days None Monthlyinterest (9%-

18%) origina-tion pointsclosing fees

No

506(c) Intro Full dealinformation

- No None Upfront accessfee; monthlyfee for inves-tor managersoftware.

No

Originally

506(b)Now 506(c)

- - Full deal

information

21 days Management fee for admin.,

legal, ongoing reporting,communications.

Upfront fee

Ongoing fee4% promote

No

(partner withWealth-Forge

506(b)

Plans to use506(c) in

some futureofferings

- - Full dealinformation

* Management fee forongoing reporting and

communications.

Fee for legal,accounting,

and compliancecosts.

No


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by Lynne Barr, Benjamin Saul, and Matthew Saunig

Peer-to-peer (P2P) lending is a rapidly growing vehicle forconsumer and business purpose lending. It can providefast, efficient access to capital, particularly for small busi-nesses, and relatively attractive nancing to consum-

ers who may not otherwise qualify for traditional loans frommainstream lenders. Investors are also attracted by the businessmodel, because of the ease with which they can invest in loansand earn relatively high rates of return. Like all lending activities,however, P2P lending is heavily regulated. While some of the

regulatory burdens can be reduced by structuring the businessappropriately, regulatory costs both in dollars and time needto be factored into strategic planning. This article discussessome of the key regulatory considerations that P2P lendingcompanies must address.

State LicensingStates regulate lending practices principally through licensing

requirements. A range of licensing requirements for the originat-ing, brokering, and servicing of loans exists. Prior to engaging in

The Legal Landscape forPeer-to-Peer Lending

P2P lending, a company should make sure that it is appropriatelylicensed in the states in which it will be brokering, making, or ser-vicing loans. Licensing requirements vary from state to state, andwhether a particular states licensing requirements are triggereddepends on various factors, including the size of the loans beingmade, interest rates and fees, and whether the loans are securedby real estate or are made for business purposes. Further, moststates assert jurisdiction over out-of-state companies that makeloans to residents of the state, particularly consumer loans.

In an effort to minimize certain lender licensing requirements,some P2P lending companies have used bank sponsors to makeloans, as banks are generally exempt from state licensing re-quirements. Use of a bank lender, however, does not completelyrelieve a company from all state licensing requirements. For ex-ample, licensure as a loan broker may be required to the extenta company is arranging loans. Additionally, servicing the loanscan implicate certain loan servicer or collection agency licensingrequirements.

Moreover, there are often substantive staterequirements with which licensed entitieshave to comply. Licensees frequently haverecordkeeping, disclosure, surety bond, mini-mum net worth, and reporting requirements,among others. Licensees are also subject toexamination by the appropriate state regu-lators and may have to notify regulators ofsignicant corporate changes (e.g., addresschanges and changes in ownership). Statelicensing regimes may also impose certain re-strictions on the practices of licensees, includ-ing advertising restrictions.

Federal and State ConsumerProtection Laws

Federal and state laws also regulate theconduct of lending business by imposing sub-stantive requirements, such as usury ceilingsand anti-discrimination laws, and extensivedisclosure requirements, particularly for con-sumer loans, on lenders and brokers.


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P2P lenders generally must comply with state usury laws, butpartnering with a bank to act as the lender can be advantageousbecause a bank can export the interest rate and fees permittedto it under the laws of the state where it is located. There havebeen recent legal challenges to such arrangements, allegingthat they are schemes to circumvent state usury laws and thatthe non-bank company is the true lender.

The federal Equal Credit Opportunity Act and some state

laws prohibit creditors and others that regularly participate incredit decisions from discriminating against credit applicantsand borrowers (both consumers and businesses) with respectto any aspect of a credit transaction on prohibited bases, suchas race, color, religion, national origin, sex, marital status, or age. Therefore, even if a P2P lending company uses a bank sponsor tomake the loans, compliance with anti-discrimination laws is stillrequired.

The federal Truth in Lending Act and numerous state lawscontain substantive restrictions and disclosure requirements onconsumer purpose loans of all types, including mortgage loans.Substantive rules relating to mortgage loans have mushroomedin the years since the housing crisis began and regulate all as-pects of mortgage lending, from detailed tests to determinewhether the consumer has the ability to repay the loan to fore-closure and loss mitigation requirements.

Federal and state laws relating to nancial privacy, anti-moneylaundering and terrorist nancing, data collection, the validityof electronic transactions, data security, and real estate-relatedprotections (such as lead paint certications) may also be ap-plicable to P2P lending activities.

Secured LoansIn the event that P2P loans are secured by either real or per-

sonal property, there will be ling requirements that must becomplied with in order to perfect the lenders security interestin the collateral. Each state has its own version of the UniformCommercial Code, which governs the types of lings that needto be completed in order for a lender to make its security inter-est in the collateral property a matter of public record. The lingsafford the lender more protection in the event of a borrower de-fault on the underlying loan. With respect to loans secured by an

Lynne Barr , a partner in Goodwin Procters Financial Institutions Groupand chair of its Banking and Consumer Financial Services Practices,focuses her practice on banking and consumer nancial services law.Contact Lynne at 617.570.1610 or [email protected].

Ben Saul, a partner in Goodwin Procters Consumer Financial ServicesLitigation Group and an expert in the areas of consumer nancialservices enforcement and fair and responsible banking, represents

nancial services and individual clients in high-stakes administrativeenforcement and criminal matters, private civil and class actionlitigation, parallel proceedings involving private litigants and federaland state enforcement authorities, and regulatory examinations.Contact Ben at 202.346.4110 or [email protected].

Matthew Saunig, an associate in Goodwin Procters FinancialInstitutions Group and a member of its Banking and Consumer FinancialServices Practices, advises banks, bank holding companies, mortgagecompanies, and other nancial institutions on a variety of regulatoryand transactional matters. Contact Matt at 617.570.1517 [email protected].

interest in real property, the mortgage or deed of trust must berecorded in the appropriate local recorders office.

Securities RegulationsAs part of their business model, P2P lending companies usu-

ally sell payment-dependent notes to investors. Under thefederal Securities Act of 1933, these payment-dependent notesare considered securities. In connection with these notes beingtreated as securities, P2P lending companies should consider

whether any other federal or state securities laws apply. Theserequirements may include registration, disclosure and conductobligations. Such requirements should be considered prior to theissuance or sale of any payment-dependent notes to investors.

ConclusionGiven the signicant regulatory oversight of P2P lending, the

structure of the business needs to be inuenced by a companystolerance for supervision and the costs of compliance. Althoughcertain regulatory obstacles can be avoided by structuring lend-ing operations in certain ways (e.g., through the use of a banksponsor as the lender), any company seeking to engage in theP2P lending business needs to implement and maintain a legalcompliance structure that addresses the myriad federal andstate requirements applicable to lending and securities.


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by Charles Alovisetti

New regulatory regimes often create new businessopportunities and the Jumpstart Our Business Start-ups (JOBS) Act is no exception. About a year ago, onSeptember 23, 2013, issuers were permitted, for the

rst time and subject to certain restrictions, to use general so-licitation in connection with private placements of securitiesunder the newly created Rule 506(c), something that had beenprohibited since the enactment of the Securities Act of 1933. Ifan issuer takes advantage of this new exibility, it is required totake reasonable steps to verify that all of the purchasers are ac-credited investors, in addition to meeting the other applicablerequirements of Regulation D of the Securities Act. The verica-tion requirement is separate and independent of the conditionthat sales be limited to accredited investors, and it must be satis-ed even in an instance where all of the purchasers are accred-ited investors. Verication is a new requirement and remains anobligation only when general solicitation is employed.

Historical BasisInstead of providing a strict list of rules to follow, the SEC set

forth a principles-based verication process, together with anon-exclusive list of acceptable verication methods. The SECalso permitted issuers in certain circumstances to rely on third-party verication of a persons status as an accredited investor.For example, the non-exclusive list of acceptable vericationmethods deems an issuer to satisfy the verication requirementin Rule 506(c) if the issuer obtains a written conrmation from aregistered broker-dealer, an SEC-registered investment advisor,a licensed attorney, or a certied public accountant that suchperson or entity has taken reasonable steps within the priorthree months to verify that a purchaser is an accredited investor.

CROWDFUNDING AND ACCREDITED

INVESTOR VERIFICATION

These third parties satisfy the verication requirement in Rule506(c) and since they are already subject to regulatory or licens-ing requirements, the issuer can rely on their work without anyindependent verication efforts. An issuer, however, may also beentitled to rely on the verication of accredited investor statusby a person or entity other than one of the explicitly listed thirdparties, provided: (i) such third party (a) takes reasonable stepsto verify that the purchasers are accredited investors, and (b) hasdetermined that such purchasers are, in fact, accredited inves-tors, and (ii) the issuer has a reasonable basis to rely upon suchverication.

While the SEC accepted that it may prove costly to pay for theverication services of a lawyer or accountant due to profession-al liability concerns, it did note that because uniform vericationmethods were not required and a conceptual approach wasadopted, issuers and entrepreneurs could benet from the regu-latory exibility to adopt innovative approaches to verication,including the development of reliable third-party databasesof accredited investors and verication services. In a prescientfootnote to the nal rules, the SEC noted that new services maydevelop to verify accredited investor status.

Evolution of Third-Party Verication ServicesAs the SEC anticipated, a number of new businesses emerged

that provide accredited investor status verication. While theseplatforms seek to streamline the verication process, they arenot without their critics. The Angel Capital Association hasvoiced concerns regarding privacy and the verication process,given that purchasers would be asked to provide sensitive nan-cial documentation to unfamiliar online businesses. Concerns

The verication requirement is separate and independent of thecondition that sales be limited to accredited investors, and it mustbe satised even in an instance where all of the purchasers areaccredited investors. Verication is a new requirement andremains an obligation only when general solicitation is employed.


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Charles Alovisetti , an associate in Goodwin Procters Private Equityand Crowdfunding Groups, represents private equity sponsors and theirportfolio companies, as well as public companies, in a range of corpo-rate transactions, including mergers, stock and asset acquisitions anddivestitures, growth equity investments, venture capital investments,and debt nancings. Contact Charlie at 212.459.7272 [email protected].

regarding privacy, especially in the context of newly-formedonline businesses, will need to be addressed in the future byissuers, crowdfunding portals, and verication platforms. In re-sponse to these concerns, crowdfunding portals have begun toprominently display and discuss their data security and privacypolicies on their websites.

The role of third-party verication services is not likely to ex-pand in scope once the proposed rules regarding retail crowd-funding under Title III of the JOBS Act and Regulation A+ comeinto effect. Under the proposed crowdfunding rule, purchasersdo not need to be accredited investors. But a purchasers invest-ments cannot exceed certain thresholds based on income andnet worth. The SECs proposed rules regarding retail crowd-funding permit an issuer to rely on an intermediary (all retailcrowdfunding transactions must be conducted through a regis-tered intermediary) to verify the limits regarding the aggregateamount of securities purchased. The issuer does not need a rea-sonable basis to rely on such verication, as long as the issuerdoes not know the purchaser has exceeded, or would exceed,the investor thresholds as a result of purchasing securities inthe issuers offering. An intermediary may reasonably rely on apurchasers representations of their annual income, net worth,and the amount of the purchasers other investments unless theintermediary has reason to question the reliability of the repre-sentation. Similarly, pursuant to the proposed offerings underRegulation A+, the amount of securities a purchaser can acquireis limited to a certain percentage of a purchasers annual incomeand net worth. Issuers can rely on a purchasers representationsof compliance with the proposed investment limitation unlessthey knew, at the time of sale, that such representations werefalse. Absent a change to the proposed rules upon enactment,

there will not be any need for third-party verication services inconnection with the nal part of the JOBS Act.

As crowdfunding changes the nancial landscape, third-party veriers will continue to provide an important service.However, as the Angel Capital Association notes, third-partyverication is not without its risks. Issuers and crowdfund-ing portals must be careful to do their diligence before out-

sourcing critical compliance functions. Prior to engaging athird-party provider, issuers or crowdfunding portals shoulddiscuss the third-party providers policies and practices with aqualied attorney. Two key areas of concern are privacy andthe method used for accredited investor verication. Since ac-credited investor verication by its nature requires disclosureof sensitive nancial information, it is crucial that the thirdparty take appropriate measures to maintain the privacy of anydisclosed materials. The internal process of accredited investorverication should also be reviewed and compared with theSECs non-exclusive list of methods. This may be as simple asreviewing the description of services on a third partys website.

While third-party verication services offer certicates certify-ing to an investors accredited status, reliance on such a certi-cate alone, without any knowledge of the third partys process,may not be enough to establish a record that the issuer hada reasonable basis to rely upon the third party. Third-partyverication services allow issuers and crowdfunding portals toavoid costly and time-consuming accredited investor verica-tion, but they cannot be used blindly. Issuers should be awareof the need to have a reasonable basis to rely on these services.

Barriers to Entry The crowdfunding third-party verication sector is still new

and continuing to evolve quickly. Currently, as a result of verylow barriers to entry, there are a large number of new third-party veriers. And although the future is uncertain, it seemslikely that purchasers will prefer to entrust sensitive nancialinformation to a reputable company and, once comfortablewith the procedures of a particular verication service, crowd-funding portals are also likely to be repeat customers. Thesefactors, combined with the easy scalability of verication,should result in the emergence of clear winners sooner ratherthan later.


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by Steven Ellis and Nicole Tate-Naghi

The Jumpstart Our Business Startups (JOBS) Act was ex-pected to create and expand opportunities for peopleto invest directly in a wide variety of commercial proj-ects through what is known as crowdfunding. The Act

attempts to reduce and streamline the statutory and regula-tory barriers that apply to the operation of online crowdfunding

platforms. But crowdfunding, while exciting, poses risks. As thepopularity of investments through this burgeoning industry in-creases, businesses should keep in mind the risks and avoid po-tential pitfalls, such as liability for failure to register and liabilityunder federal securities laws, state securities laws, and generallyapplicable common law principles and statutes.

Failure to RegisterSeveral years before the JOBS Act, peer-to-peer (P2P) lend-

ing sites Prosper Marketplace (Prosper) and Lending Club weretwo of the early players in crowdfunding. In P2P lending, privatelenders and borrowers (individuals or small businesses) cometogether to make loans without an intermediary (such as a bankor broker). Prosper and the Lending Club took the position thatthese lending transactions did not involve the sale of securi-ties under federal law and therefore did not require registrationwith the SEC. The SEC, however, did not agree and issued cease-and-desist orders in 2008 that shut down these crowdfundingplatforms. Although both platforms ultimately obtained properregistration and reemerged, the message from the SEC was clear:crowdfunding may be a new and technologically innovative wayfor people to make investments and for businesses to obtaincapital, but the old rules still apply; if crowdfunding platforms areselling unregistered securities without satisfying the registrationexemption requirements, the SEC will exercise its power and au-thority to investigate these platforms and shut them down.

Other Federal Securities LawsNotwithstanding the passage of the JOBS Act, crowdfunding

currently is subject to a variety of federal statutes and regula-tions. For example, under Rule 506(b), which predates the JOBSAct, online sites may come within the private offering exemp-tion, but they cannot engage in general solicitation and mayaccept investments only from (self-certied) accredited inves-

Potent ialPi tfal ls to

Crowdfunding

tors. Under Rule 506(c), promulgated in 2013, crowdfundingplatforms may engage in general solicitation but they must takereasonable steps to verify independently that the investors areaccredited, and all solicitation materials must be led with theSEC. Title III of the JOBS Act permits non-accredited individualsto invest through crowdfunding platforms, but issuers may not

raise more than $1 million per year, various registration and dis-closure statements must be led with the SEC by the issuers andthe platforms, and other implementing regulations contem-plated by the JOBS Act have not yet been nalized. In addition,the SEC has proposed Regulation A+ rules that would furtherrelax restrictions on crowdfunding platforms and investments,but these rules have not yet been nalized either.

Navigating through the existing hodgepodge of applicablefederal statutes and regulations is no easy task. Companies look-ing to raise money through crowdfunding (as well as companiesconsidering the launch of new crowdfunding platforms) mustcarefully consider which statute or regulation to proceed underand carefully monitor compliance. Although the potential re-wards of crowdfunding are great, companies that fail to complywith the governing federal law face the very real risk of unwel-come scrutiny, and potentially even more unwelcome adverseaction from the SEC.

Even if all requirements are met for the issuance of these new se-curities, there remains a risk of liability if the opportunity that wasfunded through crowdfunding fails. Its not uncommon for lawyerswho specialize in suing on behalf of large classes of shareholders toallege violations of section 10(b) of the Securities Exchange Act of1934 and SEC Rule 10b-5 regarding fraud, fraudulent misrepresen-tations, deceptive practices, or omissions in the sale of securities.Defending against such lawsuits, even if the companys defensesare strong, can be very costly, and settlement is often the only vi-able option because of the crushing burden of preparing for trial.

State Securities LawsUnder current law, crowdfunding entities are also gener-

ally subject to scrutiny under state securities (Blue Sky) laws. There is widely publicized tension between federal and state


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securities regulators on the subject of crowdfunding. It islikely that Blue Sky regulators will monitor closely those whoparticipate in this area and in some cases will rely on creativearguments under state law if they see perceived abuses, eventhough federal regulations may preempt state law. In one re-cent highly publicized case, the Ohio State Department of Com-merce, Division of Securities, led a cease-and-desist action

against SoMoLend Holdings and its principal, alleging that thecompany, operating through two crowdfunding platforms, hadsold more than $2 million of unregistered securities throughgeneral solicitations, outside of any exemption, in violation ofOhio law. According to Ohio, SoMoLend sold these securitiesthrough false statements regarding, among other things, pastand current performance and future projections. In addition,Ohio alleged that SoMoLend continued to provide a platformfor the sale of unregistered securities not covered by any ex-emption for almost two years after Ohio warned SoMoLend notto engage in such conduct.

Generally Applicable Common Law Principles and StatutesAll states have common law principles and statutes that pro-

hibit fraud, false or misleading advertising, and other forms offalse, misleading, or deceptive business practices. These aregenerally applicable laws, not based on or tied specically to thesale of securities, but potentially applicable in the crowdfundingcontext. These laws may provide state officials, even those whoare not charged with enforcing Blue Sky laws, with opportunitiesto challenge crowdfunding practices that they may perceive asunwise from a policy perspective.

Earlier this year, for example, the Washington State AttorneyGeneral brought an action against Altius Management (Altius).According to the complaint, Altius used a crowdfunding plat-form (Kickstarter) to obtain investment in a venture that wouldcreate and sell Asylum Playing Cards featuring artwork by aSerbian artist. Altius promised that investors would receive vari-ous rewards, such as a deck of the Asylum Playing Cards. Afterreceiving more than $25,000 in funding, Washington alleged,Altius never produced the rewards and refused to refund theamounts received from investors. Washington sued Altius undera generally applicable state statute prohibiting false, fraudulent,or misleading statements in business transactions. Washingtondid not invoke state or federal securities laws in its complaint.

An interesting note from the Altius litigation is that Washing-ton sued the company obtaining the investments but not Kick-starter, the crowdfunding platform that Altius used. Whether,and to what extent, there is any theory under which the crowd-funding platform itself could also be held liable for false, fraudu-lent, or misleading statements made by the business remainslargely unexplored. Nonetheless, it is a risk that must be consid-ered by crowdfunding platforms, as future litigation exploringthe possibility of such liability seems inevitable.

Steven Ellis , a partner in Goodwin Procters Consumer Financial ServicesLitigation and Crowdfunding Groups, has extensive experience in thedefense of consumer class action lawsuits in both federal and statecourts across the country. Contact Steve at 213.426.2614 [email protected].

Nicole Tate-Naghi , an associate in Goodwin Procters Consumer Finan-cial Services Litigation and Crowdfunding Groups, focuses her practiceon general commercial, securities and consumer class action litigationand counsels clients on a variety of litigation issues in the nancial, realestate, and commercial industries. Contact Nicole at 213.426.2609 [email protected].

Some crowdfunding platforms have already taken steps to at-tempt to minimize potential liability for fraudulent representa-tions by companies using their platforms. Kickstarter, for exam-ple, includes provisions in its terms of service that disclaim anyduciary duty to investors, any duty to monitor the truthfulnessof the statements made by companies that use its platform, andany representation as to the accuracy of any data or information

provided by those companies. By directly disclaiming responsi-bility for monitoring the accuracy of the companies using theplatform, Kickstarter and other platforms seek to escape liabilityfor statements by those companies that are later alleged to befalse, fraudulent, or misleading. Whether disclaimers providean effective shield when there are allegations of misconduct bycompanies being funded is likely to be tested in future cases.

Indiegogo, an international crowdfunding site, formerly statedto investors that it would catch any and all cases of fraud. But,after one of the companies on its platform, Healbe GoBe, wasinvestigated for fraudulent representations (including misrepre-

sentations regarding the quality of its product and its location),Indiegogo removed the statement and substantially modiedits overall messaging. Even the most compliance-focused andrigorous crowdfunding platform may not be able to police allcompanies that seek funding through it. Whether the law willevolve in the direction of allowing solid defenses for platformsthat work diligently and in good faith to spot and remove offend-ers remains to be determined.

Continued litigation, including potential class action litiga-tion, regarding allegations of fraud by companies obtaininginvestments through crowdfunding is likely. The ip side of theexibility of crowdfunding, and its ability to provide individualsthe ability to invest directly in small companies and start-ups,is that some crowdfunding investors may be less sophisticated,and less careful, than large institutional or accredited investors. The issue of whether crowdfunding platforms may be subjectto liability for the false statements of the companies using theirplatforms remains open, and is a risk factor that crowdfundingplatforms should consider, and protect themselves against, asthe industry continues to develop and expand.


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the U.S. when it makes the offer and the investor must be out-side the U.S. when it acquires the interest) and (ii) no directedselling efforts are made in the U.S. by the sponsor or any of itsagents or representatives.

Much to the frustration of those raising capital outside of theU.S. under Reg S, directed selling efforts is a fact-specic andpotentially complex analysis. Even if not restricted by the localnon-U.S. jurisdictions from which the capital was being raised,articles, notices, interviews, and other communications whichcould reasonably be expected to nd their way into or be acces-

sible from the U.S. would give U.S. securities lawyers great pause.

The New World OrderUnder new Rule 506(c), sponsors are expressly permitted to

engage in general solicitations, so long as certain other require-ments are satised, including that all the purchasers be accreditedinvestors and that the issuer takes reasonable steps to verify suchaccredited investor status. The new freedom under Rule 506(c) al-lows issuers to broadly market their offerings, including utilizingonline capital raising tools, advertising in publications, and freelyspeaking at conferences and to the press.

While this represents a signicant growth opportunity forraising U.S. capital, a sponsor nonetheless still has special con-siderations to take into account if raising non-U.S. capital bothfrom the U.S. and non-U.S. perspectives. If relying on Rule 506(c) even with respect to non-U.S. sourced capital the height-ened verication of accredited investor status still applies. Inthe absence of being able to rely upon self-certication, thiscan prove challenging.

The natural reaction would be to continue to rely upon twoconcurrent offerings, one under Reg D under new Rule 506(c)and one under Reg S. The SEC conrmed in its release adoptingRule 506(c) that an issuer may concurrently rely upon Rule 506(including new Rule 506(c)) and Reg S and that, so long as therequirements under each are satised, the onshore offering (i.e.,Rule 506) and offshore offering (i.e., Reg S) will not be integrated.

For the non-U.S. offering, as always the laws of the local juris-dictions apply; this now includes AIFMD in the EEA. AIFMD repre-sents a signicant tightening of the regulations for the manage-ment and marketing of alternative investment funds (AIFs) in theEEA. The ultimate goal of the AIFMD is to develop and adopt a

John Ferguson , a partner in Goodwin Procters Real Estate CapitalMarkets Group and co-chair of its Real Estate Private Investment FundsPractice and chair of its Infrastructure Practice, represents a wide rangeof clients in forming private investment funds, partnerships, jointventures, and other transaction structures, and in acquisition,nancing, restructuring, and disposition transactions. Contact Johnat 212.813.8827 or [email protected].

Lauren Lebioda is a contract attorney in Goodwin Procters Real EstateCapital Markets Group with a focus on real estate private investmentfunds. Contact Lauren at 212.813.8826 or [email protected].

uniform set of rules by 2018 that will govern the marketing andmanagement of AIFs within the EEA, including requirements thatnon-EEA sponsors establish a place of business and obtain autho-rization in the EEA prior to marketing any AIFs in the EEA. Howev-er, the AIFMD became effective on July 22, 2013 and the industryis currently operating in an interim period (i.e., until 2018) duringwhich compliance with each member states local private place-ment requirements and the minimum requirements specied inthe AIFMD is required. In other words, a jurisdiction-by-jurisdic-tion patchwork approach is required.

Whats New is Old and Whats Old is NewIn the new world of crowdfunding and AIFMD, roles have

reversed. With a goal of protecting investors, marketing fundsand raising capital, the EEA has become more restrictive andregulated. At the same time, with the goal of facilitating capital-raising and economic development, pursuant to the JumpstartOur Business Startups Act (the JOBS Act), the U.S. has openedup a channel to raise capital in a dramatically less restrictivemanner. In an ironic twist, the free-speaking U.S. sponsor now,however, essentially needs to effectively be concerned abouttwo sets of directed-selling efforts restrictions. One needs toavoid a U.S. general solicitation under Rule 506(c) from ndingits way into Europe such that it could constitute marketingunder AIFMD. And at the same time, if a U.S. sponsor is concur-rently marketing in Europe in compliance with the AIFMD anddoes not wish to comply with the heightened accredited inves-tor requirements of 506(c), then such efforts still need to notconstitute directed selling efforts into the U.S. (notwithstand-ing a concurrent general solicitation in the U.S.) to preserve RegS availability for the offshore offering.

For more information on the AIFMD, please visit:www.goodwinprocter.com/AIFMD

In an ironic twist, the free-speaking U.S. sponsor now, however,essentially needs to effectively be concerned about two sets ofdirected-selling efforts restrictions.


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A Guide to Real Estate Crowdfunding Today