An A Isn't the Same for Everyone — Why Regulation A+ Might be a B or C for Real Estate Funds
In music, a written C on the score doesn’t produce the same sound for every instrument. Unlike string instruments, many wind instruments aren’t in the key of C. In high school I also played B-flat (alto) and E-flat (soprano) clarinets.
String instruments and pianos are non-transposing instruments. The note that sounds when the musicians play those instruments is the same as the note written in the music. Many woodwind and brass instruments are transposing instruments.
When I play a C on my violin, the note that sounds is a C. But when I played a C on my B-flat clarinet, the sound that came out was a B-flat, a whole step lower than the C on the violin. When I played a C on my E-flat clarinet, the note was an E-flat, a minor third higher than the C on my violin. Most trumpets, French horns, English horns, and a number of other wind instruments also are not “C” instruments.
Despite the confusion, having transposing instruments makes it easier for musicians, many of who play several sized instruments. There was some adjustment in switching between my B-flat and E-flat clarinets due to the instruments’ size differences. However, the fingerings (which fingers used to play the notes) were the same on both clarinets. That made it easier to learn a new instrument and moving back and forth between instruments.
Regulation A+
In 2015, the US Securities and Exchange Commission (SEC) adopted what has become known as Regulation A+. Like transposing instruments, Regulation A+ was designed to make it easier for small businesses to raise new capital.
Regulation A+ was in the news again in 2018, because Congress passed a law expanding availability of Regulation A+. Specifically, Congress added reporting companies under the Securities Exchange Act of 1934 to the list of issuers who can use Regulation A+. On December 19, 2018, the SEC announced that it had adopted a rule allowing reporting companies to use Regulation A+.
From Regulation A+’s name, one might conclude that it’s the best regulation. Yet, just as an A played on alto clarinet sounds like a G, Regulation A+ doesn’t provide an A+ solution for all businesses or issuers. In particular, Regulation A+ often is not a good option for the typical real estate securities sponsor.
Real Estate Securities Offerings
Most real estate securities are sold under an exemption from registration under Rule 506(b) of Regulation D. Rule 506(b) requires that there be no general advertising relating to the offering and general solicitation of investors. Many real estate securities that are advertised publicly are sold under exemptions from registration under Rule 506(c) of Regulation D under the federal securities laws.
Real estate securities sponsors want to being able to take their securities to the market quickly. Both Rule 506(b) and Rule 506(c) allow securities to be sold without prior SEC or state securities regulator review or approval. Rule 506 requires only filing of minimal post-sale paperwork with the SEC and state securities commissions.
Although a responsible sponsor will provide regular, accurate reports to its investors, Rule 506 contains no ongoing SEC reporting requirement.
Unlike the Rule 506 securities, Regulation A+ is NOT an exemption from registration under federal and state securities laws. Rather, Regulation A+ is a quicker path to registration for small (up to $50 million) offerings.
Because Regulation A+ offerings are registered offerings, they have many of the qualities and requirements associated with registered offerings. Real estate fund sponsors may be unaware of or uncomfortable with these requirements. Some of the requirements do not work well with the typical needs of a real estate fund.
Regulation A+ vs. Rule 506(c)
Regulation A+ offerings look more like Rule 506(c) offerings than like 506(b) offerings. Like Rule 506(c) offerings, sponsors can publicly advertise Regulation A+ offerings. But unlike Rule 506(c) offerings, advertising for Regulation A+ offerings must be pre-approved by the SEC. This pre-approval can delay taking the offering to the market.
Also, unlike Rule 506(c) offerings, Regulation A+ offerings require SEC (and sometimes state) pre-qualification before selling securities. Qualification can take 11 or more weeks. The first Regulation A+ offering by a securities sponsor may take quite a bit longer. State approval requirements for some Regulation A+ offerings may further delay taking the offering to the market.
Regulation A+ requires significant offering documents, which are costly and take time to prepare. Although most Rule 506(c) offerings do use offering documents, there are no specific requirements regarding the format or content of those documents. Thus, Rule 506(c) offering documents can be tailored to the requirements of the specific investment and the sophistication of the targeted investors.
Despite the longer time and expense to take a Regulation A+ offering to the market, once the offering has started, Regulation A+ offerings can be sold to a broader group of investors. Rule 506(c) offerings may be sold only to accredited investors (generally investors who have a net worth over $1 million or an annual income over $200,000). Plus, Rule 506(c)issuers must take special steps to verify investor accredited status, which adds time and cost to the offering.
Anyone can invest in a Regulation A+ offering, although there might be a limit on how much non-accredited investors can invest. Regulation A+ also does not contain accredited investor verification requirements like those in Rule 506(c).
Still, Regulation A+ may not be appropriate for issuers who sell a lot of securities, since at most, an issuer can sell only $50 million in securities during any 12-month period. Rule 506(c) contains no such limitation.
Regulation A+ Tiers
There are two tiers of Regulation A+ offerings, Tier 1 and Tier 2. Some of the differences between Tier 1 and Tier 2 include:
Limit on Aggregate Offering Amounts in a 12-Month Period–The Tier 1 limit is $20 million, but Tier 2 offerings can aggregate to $50 million in a 12-month period.
Financial Statements–At the time of the offering, Tier 1 offerings must have CPA-reviewed financial statements, but Tier 2 offerings must have two years of audited financial statements.
State Filings–Tier 1 offerings must comply with state registration (or exemption) requirements in every state in which they are offered for sale. Tier 2 offerings are not subject to state registration.
Federal Qualification–Although both Tier 1 and Tier 2 offerings must undergo an initial qualification filing with the SEC, only Tier 1 must file an exit report upon completion of the offering.
Ongoing Financial Reporting–Tier 2 offerings must submit ongoing SEC financial reporting similar to Forms 8-K, 10-Q, and 10-K for registered offerings. Tier 1 offerings need not submit ongoing filings to the SEC, but they must comply with any applicable state laws.
Investor Types–Any investor may invest in both Tier 1 or Tier 2 offerings, but non-accredited investors should expect to be limited in the amount they can invest in Tier 2 offerings. Plus, states may impose additional requirements on sales to non-accredited investors.
Using Regulation A+ for Real Estate Securities Offerings
The ability to advertise the offerings and sell to unaccredited investors may be attractive to some real estate securities sponsors. Yet, generally, Regulation A+ is not well-suited for real estate securities due to the timing and financial reporting requirements.
Many real estate securities offerings are used to provide equity funding for a specific property the real estate securities sponsor has under contract. Most real estate purchase contracts must be closed within 75 to 90 days after they are signed, with the first 30-60 days being a “due diligence period,” when the purchaser determines whether to proceed with the purchase.
Until the sponsor has conducted its due diligence, it will not have much of the information required to prepare the documentation required for a Regulation A+ offering. Therefore, the sponsor must wait until well into the due diligence period before it can commence the SEC approval process.
Real estate securities sponsors spend significant time and money on due diligence and will not want to invest additional money or energy on the SEC pre-qualification process for a Regulation A+ offering until the due diligence period is completed and the sponsor is sure it wants to purchase the real estate. By that time, there may be only 30 or 60 days remaining until the closing date, so the SEC qualification isn’t likely to be completed before the equity is needed at closing.
Financial reporting requirements provide an additional challenge for most real estate sponsors. Regulation A+ disclosures generally must include either CPA reviewed or audited financial statements. Yet, many real estate sellers do not have reviewed or audited financial statements, making it impossible for sponsors to provide them to investors.
Even where the real estate sponsors can provide reviewed or audited financial statements or can find an exception to the requirement, the ongoing reporting requirements in Regulation A+ add to the ongoing cost of the offering. The additional compliance costs for Regulation A+ offerings will both increase up-front costs and reduce investor returns as compared to Rule 506(c) offerings.
Regulation A+ Should be Plan B or C for Real Estate Sponsors
To be successful, real estate fund sponsors need to be nimble and adaptable. Since it is a registered offering, rather than an exemption from registration, Regulation A+ is the opposite. Regulation A+ is time consuming and imposes strict requirements on sponsors.
Further, although all securities offerings include up-front costs and ongoing accounting costs, both sets of costs are higher with Regulation A+ offerings. These costs inevitably impact the investors’ bottom line, making it difficult for Regulation A+ offerings to compete with Rule 506(c) offerings in the market.
Therefore, although Regulation A+ can be a valuable tool for some issuers, usually it is not the first option real estate securities sponsors should pursue for their equity needs. Either Rule 506(b) or Rule 506(c) usually will come closer to providing the nimbleness and flexibility necessary for a successful real estate fund.
© 2019 by Elizabeth A. Whitman
Any references clients and their legal situations have been modified to protect client confidentiality.
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