As financial instruments and transactions increase in complexity, the federal and state securities laws and the court cases interpreting them have become equally sprawling and complicated. In the process, these laws have been interpreted to apply to a variety of real estate investment vehicles that industry professionals don’t commonly think of as securities. As a result, a real estate offering can easily evolve into a securities offering unbeknownst to the participants, subjecting them to SEC and state regulations and potential liability for any violations. This article is not a compliance guide, but rather an overview of some of the securities issues you should discuss with an attorney before soliciting investments for your next real estate project.
The Securities Act of 1933 (the “Securities Act”) was passed in the wake of the stock market crash of 1929 to protect the investing public by requiring issuers of securities to register with the SEC unless they qualify for an exemption from registration. The Securities Act defines a “security” to include, among other things, stocks, bonds, notes, and the catchall – investment contracts. An “investment contract” is an arrangement whereby investors pool their money in a common enterprise, with the expectation of earning a profit substantially from the efforts of others. Courts have interpreted the term broadly to include passive investments in privately held limited partnerships and limited liability companies, as well as tenancies in common, all of which are common real estate investment vehicles.
Take my buddy Bob for example. Bob is a real estate broker who likes to buy and flip apartment complexes on the side. Bob wants to raise money for his next real estate investment by selling equity in the property’s holding company to private investors. The investors will have the right to vote on certain major decisions, and Bob will be responsible for the day-to-day management and operation of the property. Because the investors will rely on Bob’s efforts to make a profit, the investment opportunity Bob is proposing most likely constitutes an investment contract and is thus a security. Accordingly, Bob must either register with the SEC or qualify for an exemption from registration.
SEC registration is an expensive and time-consuming process. Therefore, many real estate professionals seek to avoid it by relying on one of the commonly used federal exemptions from registration under Regulation D of the Securities Act, specifically Rule 506(b) and Rule 506(c), and their corresponding state exemptions. Under Rule 506(b) (formerly Rule 506), issuers may sell securities to an unlimited number of “accredited investors” (e.g., wealthy individuals and companies with $5 million in assets) and up to 35 non-accredited investors as long as they do not solicit investments publicly or advertise the offering. Rule 506(c) authorizes public solicitation and advertising; however, sales can only be made to accredited investors, and the real estate sponsor must take “reasonable steps” to verify accreditation. All securities sold pursuant to Rule 506(b) and Rule 506(c) are subject to resale restrictions, and notice filings must be made with the SEC and applicable state regulators within 15 days of the first sale pursuant to the offering. In addition, brokers and sales agents may not solicit potential investors for the venture or receive commissions on investments that are made (i.e., transaction-related compensation) unless they are registered as broker-dealers with the SEC and properly licensed to sell securities. Other exemptions from registration exist, but they are narrower and less established.
When an issuer is selling securities in an exempt offering, the issuer has to make full and complete disclosures to prospective investors of each and every fact such investors might consider material. These disclosures have to be presented in a way that is easy to understand and not misleading. The most common method of making these disclosures is in a private placement memorandum (“PPM”), which describes the terms of the offering and all material risks related to an investment in the company and the company’s investment in the property. The PPM also contains information about the issuer’s business, track record (if any), management, and ownership, as well as certain statements required by federal and state securities laws. Some of these risks (e.g., the risk of a natural disaster) are common to many exempt offerings across a wide variety of industries. But because each offering contains unique features and risks, the PPM should be tailored to the deal rather than treated as a boilerplate document.
There are severe penalties for engaging in an unlawful securities offering, including monetary penalties, rescission of investors’ capital (which can be particularly tricky if the issuer’s capital is tied up in an illiquid asset such as real estate), personal liability for the officers and directors of the sponsor, and, for willful violations, jail time. The SEC can also prohibit the principals from sponsoring or participating in securities offerings in the future. Although securities compliance complicates transactions and adds time and expense, the cost and inconvenience pale in comparison to those incurred in defending a lawsuit or investigation.
If you, like Bob, are considering raising capital for your next real estate venture or making a passive investment in a real estate offering, you should consult your attorney first. It’s well worth the investment.