Compensation Cap, Escrow Release, and a 'Guaranteed' Distribution in a Farmland DPP
Your firm is managing underwriter for a $30,000,000 best-efforts offering of limited partnership units in Rolling Acres Farm LP, a DPP that will buy 2,400 acres of farmland and lease it to operating tenants. The sponsor's term sheet shows: selling compensation of 9.5% of gross proceeds; organization and offering (O&O) expenses of 8.0%, borne by the partnership; and a separate 1.0% 'due diligence reimbursement' payable to your firm. The minimum offering is $3,000,000, with subscription checks to be deposited in a non-interest-bearing escrow account at First Prairie Bank. The sponsor also wants authority, in its 'sole discretion,' to withdraw subscription funds from escrow before the minimum is reached, in order to post a $400,000 earnest-money deposit on the acreage. Sponsor-prepared sales material describes the 6.5% cash distribution as 'guaranteed by lease income.'
1. Can the firm accept the compensation structure as drafted? Show the arithmetic and state what must change before the offering documents are finalized.
Read the worked answer
No. Run the two DPP compensation tests separately.
- Selling compensation: 9.5% of gross proceeds is within the 10% ceiling.
- Combined test: O&O expenses plus selling compensation may not exceed 15% of gross proceeds. As drafted, 8.0% + 9.5% = 17.5%, an excess of 2.5% of $30,000,000, or $750,000.
The excess cannot be passed to the partnership; it must be absorbed by the sponsor (or the underwriter). Practically, the partnership's O&O burden must drop to no more than 5.5% of gross proceeds so that the total equals 15%.
The 1.0% 'due diligence reimbursement' is not a free pass. The firm must confirm it reimburses bona fide, itemized, out-of-pocket diligence services and is not a disguised conduit for additional selling compensation; if it is, it is counted against the 15% cap and pushes the deficiency to $1,050,000. Because the terms are being negotiated, the fix is documentary: restate the O&O line, disclose the sponsor subsidy, and keep the diligence file that supports the 1.0%.
2. How should the firm respond to the sponsor's request to pull subscription funds out of escrow before the minimum is reached? Address the escrow mechanics and what happens if the minimum is never hit.
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Refuse, and put the refusal in the escrow agreement rather than a side letter.
- Funds raised under a minimum/maximum structure are impounded: the escrow agent may release them to the partnership only when the stated minimum has been subscribed for and accepted, and the offering period has not expired.
- The sponsor's $400,000 earnest-money deposit (or the acquisition itself) must be funded with sponsor money or a sponsor loan to the partnership, disclosed as such. Using investor subscriptions to fund a deposit before the minimum is met converts an escrow into a general account and misleads investors about the contingency.
- Checks should be payable to the escrow agent, not the sponsor or the dealer, and the firm's WSPs should require the operations area to confirm the escrow balance with the agent before any closing is declared.
- If the minimum is not reached within the offering period (including any disclosed extension), the escrow agent returns each subscriber's funds promptly, with interest if the account earns any, and the offering terminates.
The judgment point: nothing in the escrow agreement should give the sponsor unilateral discretion. Discretionary release language defeats the purpose of the minimum and will not survive principal review.
3. The sponsor's sales material says the 6.5% distribution is 'guaranteed by lease income.' What is the firm's obligation, given that the sponsor, not the firm, drafted the piece?
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The firm owns the piece the moment it distributes or permits it to be used in connection with the offering.
- The statement is misleading. A farm lease produces rent that varies with tenant performance, crop conditions, and vacancies; a 6.5% distribution rate is a distribution rate, not a yield, and may be funded partly from offering proceeds or reserves. Nothing guarantees it.
- Communications must be fair and balanced and must not omit material facts; a rate presented as guaranteed without identifying the source of distributions and the risk of reduction violates that standard regardless of who wrote it.
- Principal approval is required before use, and the approver should reject it, not edit around it. Either delete 'guaranteed' or state plainly that distributions depend on lease revenue, are not guaranteed, and may include a return of capital.
- Written supervisory procedures should require that sponsor-supplied and third-party material pass through the same approval and file-retention process as firm-generated material.
The trap here is the assumption that sponsor authorship shifts responsibility. It does not; the underwriter that hands it to a customer is the one answering the question.