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The Howey Test: When is a Real Estate Interest a Security?

Post on: April 10, 2018 | Tim Boykin | 0

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The real estate industry adopted the provisions of the JOBS Act, particularly general solicitation using 506(c), earlier and more broadly than nearly any other industry. General solicitation complements the practices of many real estate developers looking for project financing, allowing developers with an online presence to rapidly expand their investor base regardless of personal connections or geographic proximity.

While the market is inundated with individuals and organizations that are extremely sophisticated in real estate development, there is a much broader range of understanding when it comes to raising capital compliantly. Many market participants don’t even realize that they are selling or helping to sell securities, as opposed to real estate interests—and the line is often blurred between the two.

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The distinction, though sometimes difficult to make, is a vitally important one, as securities are subject to regulatory requirements, such as registration with the Securities and Exchange Commission (SEC). So, even if a real estate company acknowledges it is dealing with securities, it may not fully recognize the additional responsibilities inherent to that activity. Real estate developers, especially those with “financing” or “investor relation” arms, are in danger of inadvertently committing fraudulent behavior. However, the outcome of a hallmark U.S. Supreme Court case provides a test for real estate developers to determine when their activities could be considered securities transactions. 

According to the Securities Act of 1933, a security is “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, or investment contract.”

The definition is broad, particularly the term “investment contract,” which can be interpreted in many different ways. In 1946, the Supreme Court heard the case SEC v. Howey, concerning the exact definition. The verdict resulted in the description of an investment contract as “a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” 

Out of that case, the four-part Howey Test emerged to determine whether a transaction was an investment contract and, therefore, a security. In order to be considered an investment contract, the following conditions must be met:

  • An investment of money
  • In a common enterprise
  • With an expectation of profits
  • Derived from the efforts of a third party

All four elements must be present for a transaction to involve a security interest. Still, the Court found that the test “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”

In practice, the first three qualifications are generally interpreted broadly. If one or more purchaser pools anything of value together with an eye towards a future return, the legal default is that the transaction constitutes a securities purchase. The final determination often hinges on the fourth and final qualification. When a venture’s success does not depend on the “entrepreneurial or managerial efforts” of the investor, then the interest sold is a security.

As a general rule, investments purely in real estate are not deemed a security. But what about when the real estate is purchased by the interest of a limited partnership (LP), general partnership (GP), or limited liability company (LLC)? Despite the Court’s guidance in Howey and its continued application today, significant gray areas remain. Each deal requires a “case-by-case analysis into the economic realities of the underlying transaction.” 


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About author

Tim Boykin

Tim focuses on strategic, firm-wide risk management, including cybersecurity and regulatory matters. His goal is to provide excellent customer service, while appropriately limiting liability, for WealthForge’s internal and external clients and stakeholders. Tim earned a bachelor’s degree from the College of William and Mary and received a JD and MBA from the University of Richmond. He holds the CIPP/US certification.
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