Syndicators’ favorite fundraising tool — Regulation D — could open them up to fraud suits

When federal regulators charged John Kralik with securities fraud last month, the allegations boiled down to one blunder: The sponsor pitched investors on one thing and did another.

The head of JKV Capital sold investors on plans to fix and flip foreclosed homes, pulling in $17 million through a mix of online advertising and social networking.

He then spent the money on a Mercedes-Benz, a vacation in Cabo San Lucas and swimming lessons for his kid, a lawsuit filed by the Securities and Exchange Commission claims.

Fraud happens every day. But Kralik’s alleged wrongdoing is unique to this cycle.

Kralik raised money by tapping Regulation D — a securities rule that lets investors fundraise out from under the prying eyes of regulators.

It has a few versions. Kralik used the latest addition: legislation passed in 2012 that allowed crowdfunders to advertise investment opportunities online. It became a hit with the multifamily syndicator crowd — groups that pool funds to buy properties.

The rule change spawned a new generation of those crowdfunders, investors who pounced on rising rents and low interest rates to do billions of dollars in deals throughout the pandemic.

But those boom times have passed. Syndicators who failed to complete their renovation projects and raise rents are scrambling for capital as loans come due and rate caps — protection against rising rates on floating-rate loans — expire.

As more sponsors default and properties head to auction, the limited partners eating those losses are now considering whether they may have reason to sue for fraud. If those investors become whistleblowers, federal investigations could follow.

“When everything was going up, people really didn’t think about the downsides,” said Ian Ippolito, a crowdfunding investor and commentator. “When they see losses, emergency capital calls — it makes one think twice.”

The problem for litigious limited partners — or perhaps federal regulators — is that proving fraud under Regulation D is tricky precisely because the rule grants freedom from regulatory scrutiny. 

“It’s certainly easier to get away with fraud when you don’t have to tell people very much about what it is you’re doing,” said Zachary Fallon, a securities attorney at financial technology-focused law firm Ketsal who formerly worked at the SEC.

Regulation what?

For most of the 20th century, raising money was a lengthy and expensive process that demanded a tedious amount of disclosure. 

The Reagan administration cut through the red tape, rolling out a key exemption to encourage investment, called Regulation D, Rule 506(b).

The rule lets investors raise money privately and doesn’t require lengthy disclosures or audited memos. In short: It simplifies and speeds the investment process.

Sponsors tapping 506(b) can market to an unlimited number of accredited investors,  those with a net worth over $1 million  or incomes over $200,000 a year,  and 35 nonaccredited investors — your average Joes. 

The rule was a favorite of the real estate crowd for decades. 

In 2012, the Obama administration upped the ante, introducing an even easier route to raise money. It would eventually set the multifamily market on fire.

The JOBS Act of 2012 introduced 506(c), an exemption rule under Reg D that allowed funds to “broadly solicit and generally advertise” an offering to accredited investors. 

“For the first time, ordinary Americans will be able to go online and invest in entrepreneurs that they believe in,” President Barack Obama said when he signed the legislation. 

“[Regulators are] gonna care if unaccredited investors start losing money — they’re gonna care.”
Jillian Sidoti, securities attorney turned consultant to syndicators

506(c), which went live in 2016, ushered in a new generation of fundraisers and allowed them to access accredited investors outside of their social circles. As social media bloomed, finding new investors became as easy as a Facebook algorithm.

“The JOBS Act basically unlocked the gates,” said Adam Gower, whose firm GowerCrowd teaches crowdfunding to real estate syndicators.

The two rules have been a boon for the industry. About 70 percent of all capital raised for real estate-related offerings last year was under Regulation D, according to data from the SEC’s Office of the Advocate for Small Business Capital Formation.

The party really got started when the pandemic upended real estate, the Federal Reserve slashed rates to near zero and rents soared. As rookies got in the game, Regulation D offerings hit a historic high in 2022, according to a report by SLCG Economic Consulting presented to the SEC last fall.

“My firm represented a lot of syndicators from 2020 to early 2022,” said Sean Tate, a Dallas-based securities attorney who runs Tate Law Group.

Swapnil Agarwal of syndicator Nitya Capital tapped both Reg D rules to raise capital through 48 separate funds between 2020 and 2022, according to SEC filings. GVA Real Estate, a multifamily syndicator in Austin, amassed at least $277 million from limited partners — some of them unaccredited —  in 2022 alone.

Meanwhile, a universe of multifamily mentors — self-proclaimed gurus such as Brad Sumrok — was rapidly expanding, teaching newbies how to invest in syndications and start their own. 

“The market was really jumping,” Tate said.

What counts as fraud? 

In November 2021, Jay Gajavelli, the brains behind syndicator Applesway Investment Group, notified the SEC that he had raised about $8.4 million for Redford Houston TX LLC. It was a 506(b) offering. 

Gajavelli had handed out a private placement memorandum, a document outlining the deal, to investors. 

“Private investors would participate in profits from the operation and ‘flip’ of the Redford Apartments,” an 844-unit Class B apartment complex in Houston, according to court records that showed Gajavelli’s terms. 

Less than two years later, Arbor Realty Trust foreclosed on the Redford Apartments, plus another 2,400 units across Houston, leading the investors to lose their equity. Five filed suit, alleging that the memo failed to disclose a number of “material facts” regarding the asset. 

Those facts were: The property was not cash-flowing, it housed a “significant” number of low-income renters and it was not Class B. The biggest alleged omission was that the property would be financed with a floating-rate loan from Arbor, according to the investors’ suit, which has since been settled. 

“The danger with Regulation D is that it’s largely up to the issuer what they disclose,” Gary Ross, a securities attorney at Ross Law Group in New York, said. “They could not disclose anything.” 

Under securities law, if a sponsor doesn’t disclose a “material fact,” that omission could be fraud.

But there’s no definition of a material fact, according to attorneys. It could be failing to disclose a sponsor’s background and previous securities law violations.

Firms may also land in trouble when they guarantee returns or don’t lay out a backup plan to investors about what happens if a deal falls through.

“They should say what would happen to the money, whether it gets redeployed into another investment or returned,” Joan MacLeod Heminway, a professor at the University of Tennessee College of Law, said.

Disclose, disclose, disclose

Material facts could also include losses or trouble spots, knowledge of which could help investors weigh risk. 

“It’s really hard for an investor to have a problem with an offering if they’ve been told multiple times: These are the risks, these are the potential problems,” Tilden Moschetti, a securities lawyer who works with syndicators, said.

Disclosures don’t need to be “in your face,” according to Moschetti. In a pitch deck, they could be folded into the fine print of the risk section. But it’s better to err on the side of caution.

“If it’s my client asking me, I would say let’s disclose,” Moschetti said.

The alternative could give investors who experienced losses reason to sue.

Say a syndicator with a portfolio of bleeding properties and upcoming loan maturities is marketing a new deal.

That move has become a common one, industry observers say. 

Syndicators make money on fees — usually acquisition, sometimes asset management. That revenue can keep a struggling firm chugging along.

But the syndicator should give investors some sort of a heads-up — either in the pitch deck or private placement memorandum — that its properties are distressed. If limited partners know the nitty-gritty, they may think twice about giving money to a firm that hasn’t been a great steward of others’ capital, attorneys say.

If the limited partners who do invest in the new deal ultimately see their equity wiped out, they could have cause to sue on allegations that disclosures around the firm’s performance omitted material facts. 

“I see real estate firms continuing to buy properties and continuing to take in acquisition fees, but then you have this other deal over here failing,” said Jillian Sidoti, a securities attorney who is now a consultant to syndicators.

“I don’t know if those deals are fraudulent or not without really digging into the paperwork,” Sidoti added. “But I wouldn’t invest with them.”

It’s when times get tough and firms recommit to making things right for investors that they often run afoul of securities law, observers say.

When operating expenses ballooned at Kralik’s JKV Capital, Kralik allegedly started funneling money from the private offerings into the business to keep it afloat, according to the SEC’s complaint. 

“The intentions at the beginning are good, and then there’s some form of panic,” said Sidoti.

Industry observers watching distressed syndicators continue to do deals have speculated as much is happening. And those multifamily investors would be hard-pressed to prove that activity was unintentional.

But, again, syndicators largely operate outside of regulators’ purview. The SEC would need to audit a firm to find evidence of commingling funds and assess whether it amounts to fraud.

Placing blame

Regulation D has been around for more than 40 years, but the post-syndication frenzy has led some attorneys to question whether the SEC should tighten the rule so that fraud is less likely to slip through the cracks.

Most attorneys The Real Deal spoke with take little issue with the online advertising that 506(c) allowed, subsequently spurring the syndication boom. The provision cut through the exclusivity that previously was integral to investing. It democratized access to capital, as intended.

Lawyers, however, have criticized the SEC’s standard for accreditation. 

“The definition uses net worth and income for individuals as a proxy for sophistication,” Fallon said. 

The idea behind these thresholds was that “these folks can essentially fend for themselves” and wouldn’t need the protection of disclosures, Fallon said. They knew what to ask for and were able to absorb losses in worst-case scenarios, he said. 

Heminway, the University of Tennessee law professor, criticized the proxy, saying one does not always mean the other. 

“It may result in sophistication, but it may just be that these people are habitual investors or have a high net worth, which doesn’t necessarily mean they are smart or sophisticated,” she said.

“There are a lot of rich dummies, and there are a lot of poor smart people,” Fallon said. “The definition doesn’t account for that.” 

The income threshold for accreditation has not changed with inflation. 

The SEC is considering updating the definition of accredited investor “to improve protections for investors,” according to commission documents, though it’s unclear what the update would look like. 

Once losses come to the surface, experts say, the SEC is more inclined to tighten, review and warn the public. The commission, which did not respond to a request for comment, takes tips on fraud — most of them come from disgruntled investors, former business partners or employees. Investors can also notify state securities regulators.

If investors pipe up, regulators could probe syndicators’ operations, asking if funds arrived at the right places and whether firms accurately and completely conveyed their deals. 

But investors are reluctant to speak about losses. Losing money, especially money that was set aside as savings or retirement, can be humiliating. 

“They feel like they have been abused, and that sense of being abused can lead to shame,” Gower said of investors he’s spoken to. “There is this resistance to talk.”

TRD has spoken to a number of multifamily investors — dentists, doctors and engineers — who have lost upwards of $100,000, some of whom are looking to sue. Almost all have declined to speak on the record. 

In the case of Kralik, the SEC started investigating after an investor flagged losses to the agency, according to a source familiar with the matter. 

The SEC is aware that fraud exists within the Regulation D space. In August 2022, it sent out an “investor alert,” aimed at helping educate investors in private placement offerings. 

“Fraudsters may use unregistered offerings to conduct investment scams,” the SEC said, adding that the agency does not “approve” any private placements. 

Yet the regulator is often focused on bigger fish, such as large-scale affinity frauds in which investors appeal to groups they have something in common with: a shared religion, ethnicity or job.

“With that being said, they’re gonna care,” Sidoti said of regulators.

“Especially if there are older people who’ve lost money, if unaccredited investors start losing money — they’re gonna care.”