DEMYSTIFYING SECURITIES LAW
The intersection of real estate and securities laws triggers fear in many seasoned real estate professionals including attorneys. Indeed, securities regulation is one of the most complex and confusing areas in American jurisprudence, and the penalties for securities law violations can be significant for everyone even peripherally involved in an illegal offering. On the other hand, it is virtually impossible to be involved in any aspect of investment real estate transactions without engaging in activities that are, at least arguably, regulated by securities laws. For this reason, a fundamental understanding of when securities regulations apply, and how they operate, is essential for every investment property principal and professional. Fortunately, this type of understanding, and the basic tools required to prudently navigate this complex area, is well within reach.
WHEN DOES A REAL ESTATE OFFERING BECOME A SECURITIES OFFERING?
Each time an investment opportunity is offered, the seller, broker, and any other professional involved in the offering, needs to ask herself whether the offering is regulated by securities law. Contrary to what many real estate professionals believe, the fact that a purchaser receives a deed does not mean that she is not buying a security. Any lingering doubt on this issue was removed in January 2009, when the U.S. Securities and Exchange Commission (the “SEC”) issued a letter ruling under which most sponsored tenant in common investment opportunities of the type commonly promoted in connection with 1031 tax-deferred exchanges are regulated securities offerings. A similarly common misconception is that a sale to fewer than 35 people is not a security. In fact there is no magic number of investors that ensures that an offering is beyond the reach of securities regulation. Even a single piece of investment property, deeded to two people, can be a regulated securities offering if the circumstances bring it within the relevant legal definitions under federal or state law.
The starting point for determining whether securities law governs an investment real estate transaction is applying the “economic realities” test first described by the U.S. Supreme Court in the 1936 case SEC v. W.J. Howey. To apply this test, ask whether someone will invest in a common enterprise with an expectation that profit will be earned substantially through the efforts of someone else. Since different parties in a joint real estate venture may have distinct powers and roles, this test must be applied separately for each purchaser. To illustrate, imagine that Bill, a real estate broker and property manager, finds a property to purchase, renovate and manage, but lacks the required capital. Bill seeks a single partner to provide cash, co-apply for financing, and share title, but stay out of day-to-day operation. Under the economic realities test, Bill is offering a security and needs to comply with securities laws. But if Bill’s roles were reversed, so that he had the money but needed a co-owner to operate the project, he would not be offering a security. The difference is that, in the first example, Bill sought a co-owner whose profits would derive from the efforts of someone else (Bill), while in the second example Bill sought a co-owner whose profits would derive, in substantial part, from that co-owner’s own efforts.
In short, whether a real estate investment is a regulated security depends on the extent to which the investor will be relying on someone else’s efforts to make a profit. The problem is determining when the level of reliance on another person tips the balance toward the securities side or, conversely, when there is enough investor self-reliance and control to tip the balance in the non-security direction. Occasionally, written regulations, court decisions or administrative rulings provide a definitive answer. But because regulations are based on generalized tests and guidelines, and rulings are based on specific transactions, the written law often fails to offer significant guidance. This leaves the seller, sponsor or real estate professional with two options: seeking a ruling from a regulatory agency, which is generally expensive and slow; or taking a calculated risk, either based solely on her own knowledge and experience or with the benefit of an attorney’s opinion.
HOW CAN A REAL ESTATE INVESTMENT COMPLY WITH SECURITIES REGULATIONS?
Securities regulations generally distinguish between offerings marketed to the general public and those marketed privately. Public offerings require a very long and expensive registration and approval process, while private offerings are generally exempt from these requirements. Federal laws recognizes numerous types of exempt private offerings, but many of these are either loosely defined (making compliance more difficult and risky) or too restrictive to be useful. One of the significant challenges involved in structuring a legally compliant real estate investment offering is determining which of the Federal private offering exemptions will work best.
An additional challenge is created by the fact that securities offerings are also regulated by most states. Consequently, depending on where and how an offering is made, and where the investors reside, an offering may need to comply with the securities regulations of one or more states as well as the Federal ones. So in addition to selecting the optimal Federal private offering type, the sponsor also needs to determine which state laws apply, and how the offering can be exempt from registration under all applicable state laws.
Fortunately, this compliance burden was greatly lightened by the National Securities Markets Improvement Act of 1996 (“NSMIA”), under which state securities registration requirements are overruled by Federal law under certain circumstances. NSMIA eliminates state power to regulate private offerings made under SEC Rule 506, the Federal exemption that is the most clearly defined and the easiest to obtain. Compliance with Rule 506 is surprisingly simple and much less costly than most real estate professionals assume. The offering must meet requirements described below relating to the manner of advertising and promotion, the information provided to investors, and the number and qualification of investors. Sales agents or brokers cannot be used unless they are properly licensed to sell securities. A relatively simple form must be filed with the SEC. And, as a result of NSMIA, the only possible state requirement is the filing of a copy of the SEC form with the state regulatory agency.
The Rule 506 restriction on advertising and promotion prevents general solicitation of investors, such as print advertising, mailing to strangers, internet postings, or seminars open to the public. Project sponsors must rely on existing networks of family, friends, past investors, and other professional contacts. This limitation often seems prohibitively burdensome to novice sponsors, but in fact small real estate offerings made to the general public by unknown individuals are rarely successful. Most people base their investment decisions primarily on trust, and a novice sponsor’s first offerings are overwhelmingly likely to be funded by those that know her. Once the sponsor develops a track record, early investors will reinvest and recommend the sponsor to their associates. Viewed in this context, the inability to advertise to the general public is unlikely to be a significant handicap.
Rule 506 requires the sponsor to provide each prospective investor with information sufficient to evaluate the merit of the offering, an opportunity to ask questions and obtain additional information necessary to verify the accuracy of the information, and a disclosure on resale limitations. Most sponsors create a Private Placement Memorandum (“PPM”) to satisfy these requirements. A PPM is a detailed business plan with a series of important disclosures, disclaimers and warnings. A thorough and accurate PPM is the sponsor’s best insurance against liability to a disgruntled investor or securities regulator, and it is not the place to rush or cut corners. Moreover, a readable and understandable PPM can illustrate the diligence and professionalism of the sponsor, and convince wary investors to commit.
A Rule 506 offering may include an unlimited number of “Accredited Investors” plus up to 35 “Non-Accredited Investors”. An Accredited Investor is someone who has net worth or annual income above the statutory threshold. A Non-Accredited Investor is someone who does not meet the net worth or income requirements, but who has sufficient knowledge and experience in financial and business matters to capably evaluate the merits and risks of the investment. Satisfaction of the income/net worth requirements for the Accredited Investors, and satisfaction of the knowledge and experience requirements for Non-Accredited Investors, is generally achieved by having each investor fill out and sign an “Investor Questionnaire” form. The sponsor of a Rule 506 offering must also exercise reasonable care to ensure that no investor is an “Underwriter” as defined by Federal law. This requirement is satisfied by asking each investor to certify that she is not acquiring the investment for resale, and disclosing that the offering is unregistered and therefore cannot be resold unless a registration exemption applies.
CHOOSING BETWEEN COMPLIANCE, AVOIDANCE AND HOPE
Although complying with securities private offering requirements has become significantly easier in recent years, it still entails significant costs, extra effort, and burdens on the offering, documentation and closing process. For this reason, some sponsors and brokers attempt to escape securities regulation by giving each investor significant independence and control. But while it is theoretically possible to avoid securities compliance in this way, the vagueness of securities law, coupled with the aggressiveness of enforcement agencies, makes this approach risky. When an offering structure is within the large gray area between security and non-security, a regulatory agency will always take the position that securities compliance was required. Moreover, offerings designed to avoid securities requirements by shifting independence and control to investors may undermine the success of the project by depriving the sponsor of the autonomy needed for success.
Given the choice between a fairly expensive and burdensome compliance process, or an offering structure that undermines the management of the project, many sponsors and brokers choose to ignore the issue altogether and hope that they do not get caught. They deal only with investors who they know and trust, and if a transaction does not work out, they absorb most or all of the loss so that no investor becomes unhappy enough to complain to a regulator. This approach is very common, and can be successful over many transactions and many years. But the risk of this approach is often not fully appreciated by the sponsors and brokers that use it. One common mishap is that an investor dies, goes bankrupt or becomes incapacitated, and the family member or trustee that assumes control of the investor’s affairs, and does not have the longstanding relationship with the sponsor, complains to regulators or a court. And once enforcement begins, the defense costs and liabilities for those involved in the transaction can be astronomical.
ABOUT THE AUTHOR
D. Andrew Sirkin is a recognized expert in fractional ownership and other co-ownership arrangements including shared vacation homes, TICs, equity sharing, co-housing, and legal subdivisions such as condominiums. His practice areas include transaction planning, offering materials, co-ownership agreements and CC&Rs, entity formations, regulatory approvals, fractional lending and mediation. From offices in San Francisco California, Evergreen Colorado, and Paris France, he has worked on projects all over the World, including most U.S. States, as well as Italy, France, Spain, Portugal, Ireland, Argentina, Nicaragua, Costa Rica, Panama, Dominican Republic, Nicaragua, Belize and Mexico. Since 1985, he has prepared fractional ownership documentation for over 6,000 clients. He is an accredited instructor with the California Department of Real Estate, and frequently conducts co-ownership workshops for attorneys, real estate agents, corporations, and prospective home buyers. Andy is the co-author of The Condominium Bluebook, published annually by Piedmont Press, and The Equity Sharing Manual, first published by John Wiley and Sons in November 1994 (order the book). He has written numerous articles on related topics, including "Fractional Ownership" and "Questions and Answers on Tenancy In Common", all of which are available at www.andysirkin.com. Mr. Sirkin can be contacted via email at DASirkin@earthlink.net. Mr. Sirkin can be reached by telephone at 415-738-8545.