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The Audit Process: What You Must Know When Regulators Come Knocking

February 17, 2023
The Audit Process: What You Must Know When Regulators Come Knocking

While it’s hoped that you’ll never experience an audit, there’s always a chance. So, it’s important to know what to expect when regulators come knocking (or emailing, calling, etc.). Unfortunately, many people don’t and suffer the consequences.

There’s a right way and a wrong way to go about this process and taking an incorrect path can lead to some serious fallout, up to and including time in prison if you’re not playing aboveboard. In this post, we will explore what you need to know about going through an audit and answer several commonly asked questions.


The Process and Your Stance

If you’re about to experience an audit, you’ll have at least some warning. It might be a phone call, email, or letter. Whatever it is, someone will contact you. In most cases, that first contact will also include a request for all your documentation, including customer records, PPMs, emails, and everything else.

Your first instinct might be to say “no”. That’s the wrong decision. Give the regulators everything they ask for. You don’t have to volunteer any information, but if they ask for something, provide it. This is where ensuring that anything and everything that goes on within the business is documented will pay dividends.

Next, the regulators will tell you to give them some time. These things can drag on for weeks or even months depending on the scope of the audit and the size/complexity of your deal. Be patient and don’t get angry.


How to Comport Yourself

Too often, dealmakers and decision-makers get angry with regulators. That does not work. It usually backfires.

Regulators are only doing their jobs. The more you can help them do those jobs, the faster they can conclude their investigation and you can get back to business as usual (assuming they don’t find evidence of wrongdoing, of course).

Think of regulators like police officers during a traffic stop. All they know is that there’s something suspicious going on. Maybe they’ve had a complaint from an investor. That automatically makes them suspicious.

When a police officer makes a traffic stop, they are automatically on high alert. They don’t know if you have a gun on you. They don’t know if you pose a threat in some other way. Regulators must approach your audit in the same way – cautious and predisposed to suspicion.

You should be sincere and upfront. You should be genuine. Work with them to provide the information they need. If you are not doing anything intentionally wrong, then it could be something that you missed within your processes, or it could be something as simple as a stolen credit card or personal financial information that links back to your company in some way. By working with regulators, you can get to the bottom of things, set the record straight, and then get back to doing business.


Arm’s Length Transactions: What Is Documented When a Property Is Contributed for Shares?

Property contributed for shares is common in deals, but it can complicate the audit process. It usually looks something like this:

Someone buys a property, and then they want to syndicate and bring in investors. They contribute the property to an entity and then begin selling shares of that entity, either taking cash or a position back. No matter what, there’s a value to that property being contributed.

What kind of documentation is necessary if you’re going through a regulatory audit? In most cases, you’ll need supporting documentation that answers key questions regulators will have, including:

  • Is it a related party transaction?
  • Do you have the original purchase documents?
  • What was initially paid for the property?
  • Were any appraisals conducted?
  • Are there any additional fees associated with the property, like management fees?
  • Is there a major unexplained markup on the property?


Can You Use a Rental Portfolio?

Rental properties are popular assets that can also be contributed to an entity, like how other properties are. In this scenario, you can take multiple properties you’ve been renting and add them to an entity. Then you sell them into syndication and investors begin paying you back for those.

You’re allowed to keep a percentage as a sponsor or as a manager, and you can also charge other fees, including property management fees. However, an appraisal of at least one property in the deal is essential. This helps to establish real market value. Otherwise, it’s just your word to establish value.

For shorter-term transactions, you’ll need a broker price opinion (BPO) from a real estate transactions broker. A third-party unaffiliated real estate broker will give a written opinion on the value of the property.


What Constitutes Long-Term vs. Short-Term?

Choosing to use an appraisal or a broker price opinion is important, and it should hinge on how long you plan to hold the property. If you intend to hold it for six months, then a broker price opinion should be fine. However, if you want to hold it for a longer period, say five years, you’ll need to have an actual appraisal.


The Question of Additional Fees

While it’s acceptable to charge additional fees, such as property management fees, auditors will check to see if the services those fees pay for are being provided. Is the property being maintained? Who is providing the service? Regulators will also delve into the cost balance here. For instance, if you’re charging $300,000 for a service and outsourcing it to someone who only charges you $15,000, that’s a red flag in most cases. Make sure that your documentation breaks everything down to a granular level.

It’s not so much about the amount being charged as it is whether the amount is “fair and reasonable within the market”. For instance, consider the Airbnb market. Once, property management fees were around 30%. Today, that’s decreased to around 15%. However, if 30% was the going market rate at the time the deal was structured, it should not raise eyebrows with regulators. If it was structured today, though, it might be a warning sign that causes regulators to dig deeper into things.

A lot of this is in how you look at the deal. If you’re trying to get rich quickly and marking up your fees exorbitantly, it will come back to bite you when the regulators notice what you’re doing. A better option is to look at this as a career opportunity that allows you to stairstep your way upward over time. It’s a game of patience where greed will land you in hot legal water.


Clarifying on Fees

Fees are part and parcel of this process. While exorbitant fees might raise red flags with regulators, do not think that means you cannot be compensated for cash outlays and investments you make. That is legal and necessary in this industry.

For instance, suppose you were putting together a deal for 500 single-family rental units. A lending group is providing a 30-year loan at 6.5% and you’re providing $2 million as startup funding.

Putting this type of deal into a fund is a way to leverage it into additional properties. It allows you to legally take some cash out from selling properties in maintaining your carried interest, still getting management fees and no acquisition fees on your sales, which could be more questionable. As you move forward to acquire more rental properties, accepting acquisition and disposition fees is generally accepted and regulators should have no problem with it.

Of course, this applies to “normal” acquisition and disposition fees. That might be 1 to 2% of the purchase price. It can also include financing fees, asset management fees, property management fees, and more. And if you’re working with a third-party property manager that does things like collect rent, repair roof damage, and maintain air conditioners, it will cost more. This is usually seen as the cost of doing business. As the person putting the deal together, your responsibility is to the company and to make sure the company’s assets are well maintained and well managed.


In Conclusion

Audits happen regularly. All it takes is a single investor complaint and you could receive an email, phone call, or letter letting you know that you’re about to have a visit from the regulators. It is your responsibility to work with those regulators and provide them with the information they need to set the record straight.

Remember – there’s always a reason for an audit. It could be something you’re doing intentionally; in which case you could be facing legal fallout. It could also be a genuine mistake; in which case you want to correct it as soon as possible so you can deliver on your promise to your investors and build a thriving business.

Be prepared for auditors by documenting everything. You should also make sure that any fees within the deal also make sense from a market perspective. Are they reasonable? Were they reasonable when the deal was initially put together?

Finally, make sure you have experienced legal help. A securities law specialist can give you the advice, guidance, and assistance necessary when it comes to documentation and assessing the fee structure and can even represent you during an audit.

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