Prefer to read than listen? Read the transcript of the podcast below. 

Host Nick Robinson: Welcome back to the CNM legal podcast, a podcast where Principal of CNM Legal Chris Mee joins us to talk about news affecting the Australian Financial Services industry. On this podcast, we break down the developments in the industry ASIC decisions and other interesting things that come across the sector as they arise. Today we’re expanding the podcast by inviting Mark Wist to join Chris and I. Welcome Chris, welcome Mark.

Chris Mee: Thank you.

Host: On this episode we’re talking about property development raising equity and the compliance that can come with undertaking such projects Mark, I understand you have some experience in this space. Briefly can you give us your background?

Mark Wist: Sure Nick. 35 years in real estate funds management, compliance and governance, and a number of advisory roles, portfolio analytics, all that sort of stuff, valuation originally.

Host: 35 years will do it.

Mark:  Usually

Host: And Chris, thanks for joining us again. Why do we need a financial services lawyer’s expertise in this conversation?

Chris Mee: So there’s a part in this process of property development where developers will move away from being able to fund projects from their own balance sheet. And that normally means raising equity from other people. Once that happens you start getting the consumer protection laws stepping in to ensure that when you do that you’re doing that in a compliant way.

Host: So I think it’s fair to say that most of our listeners would understand that a developer and a builder and probably a lender would be involved in a project like these. Can you tell us about the other entities that may become involved?

Mark Wist: Surely. And so typically the builder is an entity on its own and isn’t so much involved. It’s a subcontracted second or third party and isn’t really involved in the capital raising as such. The developer, however, is kind of like the producer of a movie as opposed to the director. And the developer brings together all of the dozens of different elements necessary, all of the subcontractors, the capital and that’s both equity and debt and everything else necessary to take a project from a bare piece of grass to a completed built environment type building.

And so, in a licensed environment, if a developer needs equity above the exemptions that I think Chris will talk about a little bit later, there will be other entities involved and that’ll be a licensee, a trustee and perhaps a custodian, depends on on the nature of the license. There’ll be a funds administrator and perhaps a registry. All of those things perform different functions in the licensed environment. And and most of them are quite necessary in order to run a compliant organization.

Host: Can you help me understand what you mean by a licensed environment?

Mark Wist: Yeah. So in order to raise equity from mums and dads or from other investors—and there are generally two categories of investors— there typically needs to be an Australian Financial Services Licence involved and that sets out a deep pool of rules and regulations inside which anybody raising money from those investors needs to operate and that goes from having certain compliant activities and and mechanisms in place, right through to the way that an offer is disclosed and described. And the way that money is raised and the filters that money goes through, the way that it’s held, and the way that it’s distributed inside the project and also how it’s distributed at the conclusion of the project. Each of those steps has an important role and each of those steps has an overlay of a set of rules around them.

Host: I suppose it becomes a different sort of process when you start using the word investors versus a developer doing it on their own. Is that the right way to think about it?

Chris Mee: Oh yeah, absolutely. So once you start managing other people’s money, that’s when the laws get concerned about you. Happily you can manage your own money and spend it as you wish, but if you need to go and raise that from other people, that’s when you start looking at why we have consumer protection laws in the first place. It’s to protect investors and their monies from being used inappropriately.

Host: Okay, so it’s great to get a better understanding of who’s involved. But what is life look like for a developer who’s been doing this for a while, but now needs to start raising equity.

Mark Wist: Yeah. So as a developer, there is a real focus on aggregating or securing land and completing development project and all of those different bits and pieces and a lot of it revolves around debt and and often their own money. And so as soon as we’ve discussed money comes from parties outside that developer’s own little ecosystem, that’s when the financial services laws kick in. And so it becomes a very different mentality if you like. So a developer can operate

with relative freedom, there aren’t really that many rules apart from you know, standard commercial corporate type rules that govern how a developer operates.

But as soon as it becomes a licensed operation, then there are there’s a huge overlay of compliance that needs to happen. So with a license and they either have their own or more likely hire one from somebody else to start with, they are suddenly thrust into doing everything in a very particular way and the way that they raise their money has to be in a compliant way. So it has to be through a certain type of disclosure document that addresses certain things like fees, like what’s going to happen to the money once it’s raised, how it’s distributed. What rights the trustee, all that sort of stuff.

There are also people that the operator needs to report to, like the licensee, periodically that they’ll need to say what’s going on, kind of like the headmaster in a school analogy. And there are also some documents that they need to live by, some compliance documents that they’ll need to have in place that set some fairly firm guidelines, tram tracks around their operations. And so they need to hold money in trust, and then the distributions going out need to be authorized properly, and accounts need to be siloed so you can’t sort of cross -pollinate other operations with monies that have been raised for a specific purpose.

And then a trust needs to be wound up once it’s established if it’s a single purpose, which is conventional for a property development. So that there’s there’s a lot of extra things to think about when you’re dealing with other people’s money.

Host: Okay, so if you’ve identified that this is an option for your business or for your project that you’re looking to fund what are some of the big mistakes that you see developers making when they go to raise equity.

Chris Mee: There are sort of three fundamental mistakes that we see a lot of when developers first take the step into raising capital. The first one of those relates to a thing called the 2012 2 rule which is an exemption from the requirement to have a regulated off document.

And just to explain it, it means that you can raise up to two million dollars in any 12-month period from up to 20 investors without having the requirement to issue a prospectus if you’re a company or a PDS for a managed investment scheme. Now the common mistakes around that exemption is that it was really just intended for people who were private trusts. So, if you and Mark and I wanted to go and buy an office, a strata title office, we could tip in some money each and we wouldn’t fall under the sort of regulations for having to issue an offer document or anything like that.

It wasn’t really ever intended to be an exemption to go and use as a basis for undertaking commercial capital raising. And one of the reasons for that is that the offers that you make must be personal. So you can’t go out and broadly advertise these kinds of offers. You can’t put something on Facebook to collect investors. You have to actually know them before you approach them. So that’s one of the biggest mistakes we see because people don’t take that into consideration and developers who use the exemption are often advertising to get investors using the exemption.

Host: So is your mistake that you’re describing to us using this loophole when you shouldn’t be?

Chris Mee: Yeah it is and it’s not using it the right way for the right reasons. But it’s often quoted by people that we hear in the industry that this is a viable way of raising money

for a development project and really it’s not. The second part of the problem with the exemption is that it’s just an exemption from registration in the case of managed investment schemes and disclosure and disclosure in the case of companies, but there’s no exemption from the requirement to hold an AFS License.

Host: So the exemption is the exemption of what

Chris Mee: Yeah for providing disclosure and registration in the case of managed investment schemes, but it doesn’t mean that the person raising the capital doesn’t need an AFSL. Unfortunately. There’s no relevant exemption that ties into it even though people think that if you raise under it you’re exempt from everything.

Mark Wist: And the parallel thing to that is being in the business of…

Chris Mee: That’s right, because you if you are in the business of raising capital, then you need an AFSL. 

Host: Yeah. Yeah, and when you say exemption for needing an AFL, that’s either having your own or going underneath someone else’s.

Chris Mee: That’s correct. Yeah

Host: Any other mistakes we should know about Chris.

Yes. So the second major issue that we see with developers raising money is that they do it by way of loans.

Okay.

Chris Mee: Now it’s true that credit products are not financial products under the Act that is true. So a loan that a commercial lender might make to a borrower is not a financial product and you don’t need that. The lender doesn’t need an AFSL to do that. There is only one kind of loan that is a financial product under the Act and that’s margin lending. So margin loans are a financial product. But loans themselves are not. 

The issue with developers is that they get lots of little loans from investors that they pool and they pool that money together and those people are not in day-to-day control of the project. That means it’s a managed investment scheme. So it’s in fact an interest in a scheme, even though they all might be signing up a loan agreement. So it’s a common fallacy amongst developer capital raisers that if you do it by way of a loan, then it’s exempt.

Host: Yes, and the reason that you’re against this is because all the people that have loaned that money are not protected because there’s no AFSL involved. Is that right?

Chris Mee: That’s right. So typically if they’re raising money that way there’s no AFSL involved, the money that they put into the investment is not put into trust.

Host: Yeah. So the the money is all loaned by many different people but they’re not protected by anything. There’s no compliance that an AFSL holder would have to follow?

Chris Mee. No, that’s right. So when the developer believes that they’re exempt from the requirements, then there is no compliance obligation in relation to the product. There’s nothing protecting the moneys that are given to the developer. There’s no obligation to provide their services honestly fairly and efficiently like there is in AFSL space.

Chris Mee:  And so there is effectively no compliance obligations at all.

Host: Yeah, which is totally fine when a developer is playing with their own money, but when they’ve gone out and they’ve lended or raised it’s a very different conversation because of even just the amount of people that could be involved, right?

Chris Mee: Yeah. That’s right. So in their view, it can be any number of people can make these small loans and they’re generally targeting, you know, people who don’t understand the risk that they’re taking. Construction risk, it’s high risk, high return. It’s what it is. And people who sometimes get involved in these projects look at the returns, but don’t necessarily at the risks, or only hear the returns and don’t hear what the risks are. If the risk is spelled out to them.

And so they’re probably people who can least likely afford to lose money, whereas in a development project you’ve got to be prepared to take a significant amount of risk and for that you get rewarded with a high return compared to other investments. So that’s why they need the protection of the consumer laws because those selling techniques, which is the third problem in relation to developers, is going to cause them to potentially lose money.

Host: And Mark, do you see much of this in your space?

Mark Wist: Yeah, unfortunately I do and it’s important to clarify as well, it’s not a clarification, it’s 

an extrapolation of that, the compliant behavior is specific to the way that the money is treated. It doesn’t regulate how the developer operates the development business. The development business is simply operated as it normally would be in terms of, you know, subcontracting and dealing with the day-to-day operations of a conventional development. The financial services overlay just makes sure that things happen with regard to the actual money in a compliant way, not not what the developer does and in the day-to-day business.

Host: I do want to follow up on that in a minute. But Chris, can you help me out with the third thing you are going to mention regards advertising of these products?

Chris Mee: Yes. So the third biggest issue we see are selling mistakes when developers are going out to raise capital and not selling the product but actually selling the investment. The first one is selling equity as debt and the second one is selling an illiquid product, something that’s inherently liquid like a property development— you can’t just sell it when it’s, you know, sticks in the ground—as a liquid investment. So saying you can either redeem or withdraw. The first one is more prevalent, which is is when you make an investment in a property project, it’s effectively an equity investment because you’re giving them money to go and produce this thing which they then sell to give you a return. That’s the fact of it. But unfortunately we see more often than not probably people trying to to sell that as some sort of fixed interest investment. 

Host: Yeah, because that’s what you see right you see the return right like that’s that that’s the the big sell.

Chris Mee: Yeah, that’s right.

Host: But really what they’re selling is we’re going to build something and you’re going to get something back.

Mark Wist: Maybe

Host: Maybe

Chris Mee. Yeah, that’s right. Yeah, absolutely right,

Host: So they’re selling it as a percentage return, but they should be selling it as a this is the project.

[00:17:00.300]

Chris mee: This is the project we hope or are targeting to get a certain return, whatever that is, rather than saying ‘you will get this return’. So you see developers trying to do backflips around this, so this week I undertook a little experiment. I thought I’d Google fixed interest investment just to see what came up, and to see if I got a property developer in there wanting to give me a fixed interest investment. And sure enough I Googled ‘fixed interest investment’, and the first sponsored link that comes up is a property developer. 

He says in headline terms, I’m going to get a fixed return of up to 10% per annum. This is the first line so up to 10% pretty good, could be less than 10%. Up to. And the second line of their sponsored link, it says ‘invest in fixed income property projects with returns of 10%’. So now it’s definitely 10% sent. ‘Up to’, ‘definitely now’. So I go to their website and then in big font, really really big font, it says ‘10% fixed net return per annum paid monthly’ with a couple of asterisks on the website, which I am now reading off actually, I’ve printed it.

Host: Fortunately they had asterisks.

Chris Mee: Yeah, fortunately. Then there’s a series of bullet points and it says ‘returns of 10% per annum paid monthly’. So it’s telling me told me three times that I’m getting now getting 10% not up to 10% but actually 10% paid monthly. I’m going to get a 15% bonus paid on successful completion. There’s no additional costs or fees and I’m getting a registered mortgage security.

So now it’s starting to talk about, well, this is actually a mortgage fund, but how do I get a 15 % bonus paid on successful completion of what, the loan that I’m making? I don’t know. 

Host: Reasonable question.

Chris Mee: Okay. So it’s all good. Really good. Sounds great. 10 % fixed net return. The couple of asterisks you go down the page that are connected with that statement on their website, they say this, the fixed 10 % advertised interest rate is net of fees and expenses, which I’ve already said, so there are no hidden fees that cut into the stated interest rate. You receive 10 % interest per annum paid monthly. So that’s excellent. You’re definitely going to get 10 % paid monthly.

Host: That’s how I read it.

Chris Mee: That’s how I’m reading it. Yeah. But just below that, it’s got another asterisk and it says, returns are targeted. Which is a real downer. Because I thought they were fixed and they said that they were fixed and I would get it monthly. Then they say just below the statement that returns are targeted, is that none of the asset managers or any other person guarantee the repayment of capital, the performance of the funds, or any particular return from the fund. So there it’s a bit of a downer again. 

Do I get my 10%, do I not get my 10%? I’ve got no idea. I don’t know that they know, but I’m pretty sure it’s not fixed. You’re not definitely going to get it, and you only get something if the project is successful but none of it says any of this in the ad and that’s because they’re trying to sell an equity investment as a debt product and when you start doing that you get into all of these kinds of problems about

What am I actually selling? Am I selling an interest rate to you that you are definitely going to get, or am I selling you the hope that you might get something back from a property project? And it’s normally the latter. And so we see these kinds of problems all the time.

Mark Wist: And a prudent trustee and a responsible trustee simply wouldn’t permit that sort of advertising because it crosses all sorts of boundaries and it’s not good.

Host: Well, I can see the problems that Chris has pointed out. Thank you Chris, but where does that fit if this was someone who was operating under someone’s AFSL? Would it one, whose problem would it be? And then secondly, whose job is to make sure that it doesn’t do the things that this one obviously does.

Chris Mee: Well. This one in fact does have an AFSL.So it’s actually ASIC’s issue to go and start talking to them about why they’re getting conflicting information to investors about what this product is actually going to return. A headline return of 10 % fixed net return, but with a whole bunch of caveats about, well, actually, maybe it’s not fixed. Particularly with it getting smaller and smaller and smaller.

Mark Wist: Yeah, and the caveats are hidden. And ASIC might and should also have a bit of a problem with anything being described as fixed when it’s got anything to do with a property development, because they just are not congruent. And paid monthly, there are certain things that would need to be in place in order for anything to do with property development, because it’s not an income-producing asset during its development phase to enable a monthly distribution

Host: So that just doesn’t make sense.

Correct.

Host: I understand that 15% on completion. That could be nice. I don’t understand a monthly on a project.

Chris Mee: That’s a great point that Mark’s made about there is no income coming from the project, so how do you fund a return? And this is what happened pre 2005 before the collapse of the debenture industry for the first time in Australia, was that financial planners would say, ‘well we like your product but you know, we want to make sure firstly that our investors can redeem, they can get out of the fund if they need to. And we also want some sort of income payment, you know, because they need the money to pay for living expenses or whatever it might be. And so we need those two features.’ 

And so property developers said ‘Yeah. Okay. Well we can do that. We will get enough people putting money into our pooled fund that will be able to pay out any redemptions when they come in from new investors paying their money, so it’s not coming from the project but it’s just coming from old investors wanting to get out and new investors coming in, so we’ll do it that way. And then how do we pay an income return? Well, we’re going to have excess cash potentially from new investors coming in so we can pay income out of the excess cash that we have that we can’t invest or we might borrow money and then we can pay distributions from that. And then at the end of the project when it’s successful, then we can pay back that debt. We can pay back all of the equity capital that we’ve received and we’ve paid a return and we’ve made our fund liquid.’

Now, that is all problematic when people have an expectation that they’re going to get a return and that they can pull out of the fund at any stage. And so that was the huge problem when WestPoint collapsed, for example, in 2005 and a whole bunch of other ones. City Pacific, for example, had issues around liquidity when they had made certain promises to people that they were going to do this. 

So it was an illiquid product that was sold as liquid, mainly by financial planners. And people were angry when they got caught in frozen funds. So developments went south. There were a lot of additional problems with ride and party transactions amongst it, but the problem was their money was trapped when they thought they could get it out at any time. And that they would get a return. But the real reality of it the property development is that of course, it is an illiquid investment and it doesn’t produce income until you actually build a thing and sell it.

Mark, I did want to go back to when developers decide to go through this process. What do they like to deal with for the first time? I imagine there’s a few more checks and balances in place, but does it become too hard for them? Is it painful or is it you have a process for walking people through this?

Mark Wist: I do and I’ve done this a fair number of times and I’ve had developer clients who have pulled the pin halfway through because it’s too hard, and they choose to either operate in a non-compliant way and take the risk that they are never discovered, or that they just stay small, but as Chris said that is problematic in and of itself because if you are in the business of, then that 1012e reference to the Corporations Act or that 21220 exemption doesn’t apply to you anyway, so you don’t have the protection of that. 

So either way once aware that they want to raise more than 2 million dollars or want to go to more than 20 people who are not personal contacts, then there seems to be a draining of color from their face to start with because there suddenly is somebody else to report to and that it’s a significant mind shift from a property developer who is conventionally accustomed to operating in a certain way to get things done. They’re solution -driven operators typically, and sorry to categorise developers as that, but they are typically a certain type.

Host: Problem solvers a lot of the time, right?

Mark Wist: Absolutely, they have to be problem solvers because in a property development there was seldom a day goes by that there isn’t a problem that needs to be solved on site, even as small as the plasterer doesn’t show up one day, which means that the plumber can’t come back to cap off blah blah blah. And so to overlay this significant set of rules that have even more significant consequences if they’re broken is something that some developers that I’ve dealt with shy away from and are not enthusiastic about.

And to be fair, there are others who are right. So I have clients who are enthusiastic about tightening up the ship making things compliant making things better and acting in the best interests of clients or the investors, which at the end of the day is the ultimate goal.

Host: It should be too, right?

Mark Wist: Absolutely.

Host: Yeah, I suppose that’s interesting to think about those two types of people, One, that is ‘I want everything to be compliant so I can protect the money of the people who have entrusted me’. Yeah, versus ‘Let me do whatever I want. I’m really good at it. I’m going to go make these people a bunch of money.’ Yeah, there’s there’s a problem there.

Mark Wist: Yeah, there is a dichotomy of philosophy between those two types and you know the the ones who are choosing to operate in a compliant way, I think also have the advantage of being able to demonstrate clearly that they are embracing a protection mechanism for their investors, that they can point to a license and a licensee in saying ‘I embrace all of these additional rules that protect you the investor. So if you have a choice between me the licensed capital raiser who will do the same thing as the next person who isn’t licensed but doing otherwise the same thing, you should be encouraged to choose me because your money is protected by the financial services laws.’

Host: Look, I think you both very much for your time. I think there’s some really valuable stuff in there. Thanks for thanks for spending some time in the room..

Chris Mee: Thanks, Nick. 

Mark Wist: Thanks, Nick appreciate your time.