REAL-ESTATE TRANSACTIONS AND THE SECURITIES LAWS
When assembling a real-estate deal involving other investors (sometimes referred to as "syndication"), one must comply with state and possibly federal securities laws. When securities are issued, they must be registered or fit within an exemption. Otherwise the investors later may be able to sue the principals – and the State and/or SEC can impose fines and jail sentences. Frequently an offering is structured to fit within exemptions to the laws that otherwise require registration of the securities. One must weigh the advertising needed, whether financial requirements will eliminate too many investors, whether investors will come from more than one state, etc. to determine the best exemption.
- Table of Contents
- Definition of "Securities"
- General Rules
- California Exemptions
- Federal Exemptions
- Who May Sell the Securities
- How the Securities May Be Sold
The definition of "securities" is quite broad. Under federal law the term "security" means any " note, stock...evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement...", etc. The California definition basically tracks the federal one. Note that this definition includes promissory notes secured by real estate, although there are exemptions to the securities laws that can apply in that case.
There are some exceptions to the definition of "securities". General partnership interests are not considered securities, on the theory that general partners each have the authority to exercise meaningful control over the partnership. Limited partnership interests, though, are presumed to be securities.
If the investors are all tenants in common (meaning they are listed on the deed but there is no formal entity) AND are all involved in the management of the property, then there are no securities -- but the owners all have the same personal liability as if they were general partners. (Tenants-in-common arrangements with "centralized" management are generally considered securities.) Good insurance coverage is key in that case. NOTE: Case law strongly indicates that TIC interests offered by a sponsor as investments constitute securities.
Limited liability company interests generally constitute securities. This is certainly true for manager-managed LLC’s. Still, there is an exception under California law for member-managed LLC’ s where all of the members are actively engaged in management of the LLC. The California statute states that "security" does not mean :
a membership interest in a limited liability company in which the person claiming this exception can prove that all of the members are actively engaged in the management of the limited liability company; provided that evidence that members vote or have the right to vote, or the right to information concerning the business and affairs of the limited liability company, or the right to participate in management, shall not establish, without more, that all members are actively engaged in the management of the limited liability company....
As the definition shows, though, the members must be truly engaged in management, and not merely have the right to do so.
It is not yet clear whether there is a similar federal exemption (the cases seem to conflict), so the safer course at this time is to assume that offerings of LLC interests to residents of different states are securities under federal law.
There is also an exemption under California law for certain secured promissory notes. More specifically, there is an exemption for:
A promissory note secured by a lien on real property, which is neither one of a series of notes of equal priority secured by interests in the same real property nor a note in which beneficial interests are sold to more than one person or entity.
This works where there is just one investor per property. It does not work if there are different investors secured by the same property (unless each investor will have a lien with different priority). This is an unusual exemption in that it does not require any form to be filed with the State.
Also, if the promissory note has an equity (profit) "kicker" (versus just interest), then the note is a security.
Unfortunately, there is nothing comparable on the federal level.
Generally the location of the investors (and not the state where the entity was formed) determine what securities laws apply. For example, if you sell securities just in California, then you only need to deal with California securities laws. If you sell in other states as well, you generally must also comply with federal securities laws and the laws of each state where you sell.
Because registering an offering of securities with state and/or federal agencies can be expensive and time-consuming, generally the offering is structured specifically to comply with one or more exemptions from registrations. These types of offerings are frequently called "private placements".
One of the consequences of using securities exemptions, though, is that – with some exceptions -- public advertising is not allowed. Where it is allowed, restrictions on the advertising usually apply.
Another consequence of using the securities exemptions is that many of them impose financial requirements on the investors.
Finally, most securities exemptions require the filing of completed exemption forms with the relevant state/federal securities agencies. Still, this is vastly simpler than formally registering the offering.
If public advertising is required, then either a 25102(n) offering or a California SCOR offering offering must be used. See How the Securities May Be Sold below for a discussion of what does and does not constitute public advertising.
The California 25102(n) exemption allows up to $5 million to be raised, but only a "tombstone" (bare bones) ad can be used – though it can be placed on a web site too – and only "qualified" purchasers can invest. Complete information about the offering can only be given to those who respond to the tombstone ad and then sign a document verifying that they are a qualified purchaser.
If the entity making the offering is a corporation (versus an LLC), then qualified purchasers for 25102(n) purposes are businesses with more than $5 million dollars in assets, and individuals with either a) a minimum net worth (in conjunction with their spouses) of $250,000 and gross income in excess of $100,000, or b) a minimum net worth of $500,000. The kicker is that the value of the residence must beexcluded in both cases. In addition, the amount of the investment by each individual cannot exceed 10 percent of the net worth of the individual.
The 25102(n) exemption can also be used with an LLC, but then the investors have to meet the federal " accredited investor" standards, which are discussed below.
Another alternative is the SCOR (Small Corporate Offering Registration) offering exemption. This is limited to offerings of up to $1 million. Unfortunately, California makes it much harder to conduct a SCOR offering than do other states. Audited financials are required for "open" offerings (as opposed to those limited to, for example, accredited investors) or for offerings exceeding $500,000. The money raised may only be used for operations, not to retire debt, and California requires a minimum price of $2 per share. In addition, the exemption is limited to corporations (not LLC’ s) with one class of stock. Finally, California requires that a SCOR offering be qualified by permit. This means that, unlike with most securities exemptions, the State has to approve the offering before it can be made. As a result, a SCOR offering involving California is usually not particularly attractive.
If public advertising is not required, the California 25102(f) and (h) exemptions are much easier to use.
These two exemptions have a number of similarities. Both have no limit on the dollar amount of the offering. Both are limited to 35 investors, although generally insiders and accredited investors are excluded from the count and spouses count as one investor.
One major difference is that the 25102(h) exemption is limited to corporations with one class of stock; the 25102(f) exemption can be used for all securities. This may be important because LLC’ s are often used with real-estate investments, given that a Subchapter S corporation cannot be used if its income from passive investments (such as rents) is more than 25% of its total income for more than three years in a row. Another difficulty of using the 25102(h) exemption is that it does not allowing selling expenses (commissions, discounts to brokers, promotional expenses); the 25102(f) exemption does.
On the other hand, the 25102(f) exemption requires the investors to have a substantive pre-existing relationship with one or more principals of the company or the capacity to protect their own interests (alone or in conjunction with an investment advisor); the 25102(h) exemption has no restrictions on the type of investor. Also, while "general solicitation" is allowed with neither one, the 25102(h) exemption allows individual personal communications to anyone. In contrast, the 25102(f) exemption allows advertising to be made only to persons reasonably believed in advance to meet the 25102(f) qualifications. What that means is that with the 25102(h) exemption (but not the 25102(f) exemption), letters or emails regarding the offer can be sent to a list of potential investors without knowing anything about them.
If the offering is being made to residents of more than one state, then the federal securities laws apply as well. That means that, with the exception of a federal Rule 506 offering (discussed below), the requirements for exemptions for both the state securities laws and the federal securities laws must be met.
The federal Rule 504 exemption may be attractive if the offering is for $1 million or less, since it allows public advertising and there are no investor qualifications.
If the offering is limited to accredited investors (defined below), there are approximately 40 states that have adopted the Model Accredited Investor Exemption (MAIE) – and no registration is required in those. The MAIE allows public advertising of a tombstone ad for the investment, much like the tombstone ad for the California 25102(n) exemption discussed above (although some states have variations).
The Rule 504 exemption may also be used in conjunction with a SCOR offering or (at least within California) the California 25102(n) exemption.
The federal Rule 505 exemption covers offerings up to $5 million. Although no general solicitation/advertising is allowed, there are no investor qualifications. It might possibly be combined with a California 25102(h) offering if one wanted to send individual offers to lists of individuals without knowing what their qualifications might be. Some other states also allow a Form D/Rule 505 filing rather than requiring their own exemption forms, although there are fewer of these states than those that have adopted the MAIE. As a result, the Rule 506 exemption is usually much more attractive.
The federal Rule 506 exemption allows offerings in unlimited amounts – but only to sophisticated or accredited investors. The big advantage this type of offering has is that it is exempt from all state regulation (although notices have to be filed in some states). In other words, no state is allowed to make any kind of review of the terms of the offering and possibly forbid the offering. For this reason, this exemption is frequently used.
The offering can only be made to individual accredited investors (although sophisticated investors may invest as well as long as there is a substantive pre-existing relationship).
Basically, accredited investors are:
Any organization not formed for the specific purpose of acquiring the securities offered and having total assets in excess of $5,000,000;
Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
Any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of the purchase exceeds $1,000,000;
Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income in the current year.
While the federal Regulation A exemption initially looks attractive because of its " test the water" provision, the problem in California is that an application for qualification – which is relatively complicated – must be filed with the State first. Moreover, other states’ securities laws apply to Reg. A offerings. (Reg. A offerings are also limited to a maximum of $5 million.) In addition, Reg. A "test the waters" offering can only be done by a licensed broker-dealer. If the entire offering is being done solely in California, the broker-dealer only has to be registered with California; if the securities are being offered to those in other states, the broker-dealer must also be registered with the SEC. Because of these restrictions, the Reg. A exemption is not very attractive.
The general rule is that anyone who attempts to sell securities must be licensed as a broker.
Fortunately, California law states that this does not include an officer or director of the company making the offering or an individual occupying a similar status or performing similar functions (such as the manager of an LLC), assuming that he/she does not receive compensation specifically related to purchases or sales of securities. In other words, they can do it as part of a salary, but not, for example, on a commission basis.
Federal law is virtually the same.
Everyone else must hold a broker’ s license. If the offering is being sold only in one state, then the broker needs to be licensed in that state only. If the offering is being sold in more than one state, then the broker must be licensed with the SEC as well.
As discussed above, the rule with many private placements is that public advertising is not allowed.
What you can do in those offerings is individually contact potential investors you reasonably believe meet the requirements of the securities exemption. (This often includes potential investors who have a substantive pre-existing business or social relationship with one or more of the principals.) You can contact them by letter, phone, email, etc. as long as the communication is targeted to them individually. What you cannot do is run a newspaper ad, set up a web site, pass out flyers, etc. offering to sell the securities. You also cannot send offers to sell to people on a list if you have no idea whether they meet the qualifications to be an investor. On the other hand, if, for example, you are making a Rule 506 offering, you can purchase a list of investors from a reputable company if the company warrants that it has pre-screened the investors and had a licensed broker determine that they are accredited investors; in that case, you can contact the potential investors on the list individually.
In addition, companies can provide information about themselves to the public as long as the information does not constitute an offer. In other words, as long as there is not an attempt to sell – or attempt to solicit an offer to buy – securities, you can provide information about what the entity is doing or plans to do.
For example, a company can have a web site that generally describes what the company is doing and says something like "For more information, click here." (The web site itself, of course, cannot offer to sell any securities or elicit offers to buy the securities.) That link must then lead to an investor questionnaire/certification and a statement that it should be completed and returned to the company. That questionnaire/certification must then be reviewed a determination made as to whether the person is qualified. If and only if the person reasonably appears to be qualified, then offering materials may be sent and/or a password given to a special section of the web site that contains offering materials.
Another option is to hold "educational" seminars where you present what the company is doing. The seminars, of course, cannot make or solicit any offer to invest. You can, though, pass out investor questionnaires and tell people that if they want more information about the company they need to complete the questionnaire and return it. Alternatively, you can mail or email the questionnaires to the attendees. The forms that are returned can then be reviewed to determine which investors qualify for the offering. You can then make an offering aimed solely at those who reasonably appear to be qualified.
Although the SEC is reconsidering the issue, if a federal securities exemption is being used (because not all the investors are from one state), then only a licensed broker can make the determination that a potential investor is qualified (unless the potential investor has a substantive pre-existing business or social relationship with one or more of the principals so that the principal reasonably believes the potential investor is qualified). This is not the case if the offering is being made only to potential investors in California.
Note that you cannot just ask potential investors if they are qualified to invest. Instead, you must use an investor questionnaire and have the answers reviewed to determine if the investor is qualified or not.