Relating to Real Estate
Avoiding Securities Law Pitfalls in Real Estate Transactions
Real estate professionals and investors need to be aware of the federal and state securities laws when bringing investors into a real estate project.
A typical real estate deal involves a developer/sponsor signing a purchase agreement for real property. The deal is financed mostly with a loan from a bank but often requires some equity brought to the table. The sponsor sells interests in the property owner, often either a limited liability company (“LLC”), a limited partnership, or an LLC that owns 100% of the owner of the property (usually itself an LLC). Usually investors in the property owner receive a preference, and the sponsor receives a split of distributions without contributing capital. This common real estate scenario in fact involves a sale of a security that is subject to federal and state securities laws.
What is a Security?
The Securities Act of 1933, as amended (the “Securities Act”) was passed in the wake of the 1929 stock market crash to protect the investing public. Section 2(a)(1) of the Securities Act defines “security” very broadly:
[A]ny note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, . . . transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, . . . any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities . . ., or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.
What isn’t included in the above definition is an interest in an LLC or a limited partnership. Most case law in this area involves an examination of whether such an interest is an “investment contract.” An investment contract exists if there is: (a) an investment of money, (b) in a common enterprise, (c) with the expectation of profits derived solely from the efforts of others. Courts examine the facts and circumstances of each situation in making this determination.
Almost all interests in LLCs and limited partnerships are securities if control is vested in a managing member or a general partner, even if the entity only holds and manages real estate and has no other business operations. The more control an investor has, the less likely the investment would be deemed a security (such as an LLC that is member-managed and all decisions are decided by a vote of the members).
Sales of participation interests in loans are also generally deemed to be securities, as are sponsored tenant-in-common (TIC) investment opportunities.
Debt Can Be a Security
Debt can be a security if the debt is convertible into equity (e.g., a convertible promissory note), there is no fixed obligation of principal or interest like in a typical mortgage loan, or if payment to the lender is only due if the business makes money. Promissory notes are presumed to be securities, but that presumption can be rebutted. Typical bank notes or short term notes secured by assets would not be deemed securities.
So What If It’s a Security?
The Securities Act provides that in the event of any sale, purchase, offer to sell, or offer to purchase a security, the security must be registered with the Securities Exchange Commission (the “SEC”) (i.e., through an initial public offering, a very expensive endeavor) unless an exemption is available. Additionally, securities either must be registered or exempt from registration in each state where an investor resides. A public offering of securities in a real estate acquisition deal is usually not practical, and therefore the sponsor must rely on an exemption.
Some commonly held misconceptions regarding securities and registration include the following:
- Sales to friends and family are exempt;
- Sales to fewer than 35 people do not require any compliance—there is no magic number;
- Sales to “accredited investors” do not require disclosures;
- If investors have voting rights then it’s not a security; and
- Interests in real estate funds are not securities.
Types of Exemptions
Many exemptions from registration are available to issuers of securities, but some are more expensive to comply with than others. Some exemptions include:
- The intrastate exemption: Securities Act applies to offerings only to residents of a single state.
- Securities Act Regulation Crowdfunding: This exemption allows a public offering of securities if the transactions take place online through an SEC-registered intermediary, either a broker-dealer or a funding portal. Regulation Crowdfunding permits an issuer to raise a maximum aggregate amount of $1,070,000 through crowdfunding offerings in a 12-month period.
- Regulation A+ Offerings: The revised Regulation A under the Securities Act (now called Regulation A+) to create two tiers of exempt offerings Regulation A+ offerings are more like “mini-IPOs.”
- Securities Act Section 4(a)(2): provides a general exemption for transactions “not involving any public offering or distribution.”
- Regulation D: Promulgated under Section 4(a)(2), Regulation D provides a safe harbor from the registration requirements if an issuer complies with the rules under Regulation D.
Regulation D, Rule 506 Exemption
Regulation D, Rule 506(b) is the most common exemption used by issuers (whether involving a real estate deal or not). There is no maximum offering amount, and the offering may be to an unlimited number of “accredited investors” and up to 35 non-accredited investors. There are significantly more disclosure requirements for offerings to non-accredited investors, including audited financial statements, and although there are no specific disclosure requirements for accredited investors, issuers must still comply with the anti-fraud rules discussed below.
To qualify for a Rule 506(b) exemption, the issuer must have a reasonable belief that an investor is accredited, and the issuer, investment advisor, or the broker-dealer must have a pre-existing, substantive relationship with all accredited investors. A 506(b) offering cannot use any general solicitation or advertising, and no commissions or other remuneration may be paid in connection with the offering unless to a registered broker. A Form D must be filed electronically with the SEC within 15 days of the first sale.
In 2013, JOBS Act amended Regulation D to add Rule 506(c), which permits general solicitation in Rule 506 offerings, such as email blasts and other forms of advertising. Such an offering must meet all of the same requirements of 506(b) except that the offering may be to ONLY accredited investors, and issuers must take reasonable steps to verify the accredited status of the investor.
Federal regulations governing an offering made in accordance with Rule 506(b) or Rule 506(c) preempt state blue sky laws; therefore, all that a state can require an issuer to provide is a copy of the Form D filed with the SEC, a filing fee, and a consent to service of process.
What Is An Accredited Investor?
Rule 501(a) of Regulation D provides several definitions of an accredited investor. Below are just some of the main categories of accredited investors that are typical of investors in real estate deals:
- An individual with over $1 million in net worth (excluding equity in the individual’s principal residence and debt on the principal residence);
- An individual who made over $200,000 in salary for each of the last two years, or $300,000 with the individual’s spouse, and expects to make at least that for the current year;
- A director, managing member, general partner, or executive officer of the issuer;
- An entity (including a trust) with over $5 million in assets not formed for the purpose of investing; and
- An entity owned entirely by accredited investors.
No matter what exemption an issuer relies on, the anti-fraud provisions of Rule 10b-5 of the Securities Exchange Act of 1934, as amended, always apply to offerings of securities. Issuers must disclose any material facts necessary to make any disclosed or omitted information not misleading. Accordingly, even though there are no specific disclosure requirements for Rule 506 offerings to accredited investors, anti-fraud concerns nevertheless warrant a disclosure document.
Private Placement Offering Documents
When raising capital under a Rule 506 offering to accredited investors, issuers should provide: (a) a Private Placement Memorandum (“PPM”), (b) a Subscription Agreement/Investors Questionnaire, and (c) a copy of the Operating Agreement/Limited Partnership Agreement of the issuer.
A PPM is the disclosure document provided to potential investors that includes material information to make informed investment decisions. The PPM provides a full and fair disclosure about the deal, its principals, the market, the risk factors, fees and payments, summary of the organizational documents of the landowning entity, litigation and proceedings, and tax issues. If past performance disclosures are made in the PPM, disclaimers should be included that past performance is not a guaranty of future performance.
A subscription agreement is completed by prospective investors and indicates their intent to purchase the equity being offered in the offering. It will include representations and warranties that each investor (a) is buying for its own account, (b) understands the risks involved, (c) is experienced in making such investments, (d) can afford the financial risk of the investment, and (e) has reviewed all disclosures and had the opportunity to ask questions. The subscription agreement also requires the investor to confirm its accredited investor status. An investor questionnaire supports the investor’s representations as to accredited status and sophistication by providing additional information about finances and investment experience.
What Could Go Wrong?
Occasionally, a deal goes south and an investor loses its investment or receives a lesser return than expected. If the issuer did not provide any offering documents or obtain representations and warranties from the investor, the issuer has no proof that it warned investors of the risks involved. The aggrieved investor can then make a claim for rescission and/or file a complaint with SEC and applicable state agencies, and the issuer must then spend significant time and expense to respond to any complaints.
Penalties of Failure to Comply with the Securities Laws
Violations of the federal securities laws can result in an order of rescission (i.e., having to return the money that has already been invested in the property). The SEC can also impose monetary penalties up to three times the investment amount, and issue “cease and desist” orders against active members prohibiting the member from continuing the current offering and/or precluding such member from offering securities in the future. Any such cease and desist order would need also to be disclosed in subsequent offerings.
Any person who willfully violates any provision of, rule, or order under the Maryland Securities Act is subject upon conviction to a fine not exceeding $50,000, imprisonment not exceeding three years, or both.
In addition, the Maryland Securities Commissioner may take administrative action in court to obtain similar remedies or a civil penalty up to a maximum amount of $5,000 for any single violation.
An issuer or unregistered broker-dealer or investment adviser is also at risk from a private action by an investor. The investor may be able to recover the amount of the investment plus interest and reasonable attorney’s fees in the action, less the amount of any income or gain actually received.
In a real estate deal, what disclosures you give to prospective investors is a matter of risk assessment and how close you are to the investors. Often many sponsors/developers do not want to go through the expense and time it takes to do a compliant offering, and if they are only dealing with a handful of close friends, they may be willing to take the risk that nothing will go wrong.
However, it is in the deal sponsor’s best interest to always comply with the federal and state securities laws. Disclosure documents are meant to protect the sponsor/developer from investors claiming “I didn’t know” or “you never told me that” – at the very least, the operating or limited partnership agreement of the issuer should contain the investment representations and warranties typically included in a subscription agreement. Developers often find that “friends and family” are not so friendly when they lose money, so it is best not to be penny-wise and pound foolish when it comes to the securities laws.
For questions, contact Michele Walsh, (410) 576-4216.