The following is a guest post written by Kim Lisa Taylor. Kim and the other members of the Syndication Attorneys team focus on helping small business owners/developers structure and convey their investment opportunities in a way that will attract private investors, both domestic and foreign. They teach their clients how to use securities laws effectively and provide them the tools and resources they need to achieve their business goals legally.
QUESTION: What securities laws apply to raising money from private investors?
The Securities Act of 1933 was enacted in the wake of the stock market crash in the 1930s after many investors lost money to investment “Promoters” (aka “Sponsors” or “Syndicators”) who promised returns that were never realized. The government subsequently passed laws to protect investors from unscrupulous sponsors. The new laws defined what constituted a “Security” and required that anyone selling a security be required to disclose all of the risks of the investment necessary for the investor to make an informed decision, among other requirements.
What is a Security?
Both federal and state securities laws contain a comprehensive list of items that are considered securities by definition, one of which is an “investment contract.” In 1946, the U.S. Supreme Court determined that “an offering of units of a citrus grove development, coupled with a contract for cultivating, marketing and remitting the net proceeds to the investor, was an offering of an ‘investment contract’,” (U.S. v. Howey, 328 U.S. 293 ). The Supreme Court held that: “The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.”
Based on Howey and subsequent case law, the current standard for determining whether an investment constitutes an investment contract—and thus a Security—has been reduced to a four-prong test including:
- an investment of money,
- in a common enterprise,
- with the expectation of profit,
- based solely on the efforts of the promoter.
A good rule of thumb is that whenever someone raises money from private investors and then makes decisions on their behalf, a security has been created.
Under federal and state securities laws, the sale of securities must be registered with the government as a public offering unless the sponsor or the transaction otherwise qualifies for an exemption from registration.
What if I Want to Pool Money?
A typical investment contract (sometimes called a Syndication, Private Placement or group investment) involves a sponsor that proposes to pool money from private investors for a specific purpose, such as to buy commercial real estate; buy and “flip” foreclosure real estate properties, or to provide funds for the startup of a new company, etc. The sponsor will identify the opportunity for which funds are needed, formulate a business plan or property information package containing financial projections and assemble a group of investors interested in investing in the opportunity.
The sponsor will acquire the property or start the business using the investor’s funds, manage it and pay the investors a return on their investment from cash flow during operations and/or on resale of the property/business. Investors may earn interest on their investment and/or a percentage of the cash flow or equity. The sponsor will be reimbursed for his or her startup expenses and will typically be paid a percentage of the cash flow and equity for finding, organizing and managing the investment. The sponsor may alternatively (or additionally) earn “fees” on acquisition, refinance or resale.
Can I Avoid Creation of a Security if I am Raising Private Money?
Because registering an offering can be a prolonged and expensive process, many sponsors seek measures to avoid creation of a security altogether. For example, a security may not created if all investors participate unanimously in decisions involving the investment, such as in a “member-managed LLC,” or in a Tenant in Common (TIC) ownership.
Another example of an exempt transaction is where a private lender loans money to an investor to purchase real estate using a promissory note and mortgage or deed of trust secured by the real estate. As long as investor funds have not been “pooled” or the note has not been “fractionalized” by combining investor funds to make up the total loan amount, this may qualify as an exempt transaction.
What if the Sponsor is Only Raising Money from Family and Friends?
It doesn’t matter who the investors are, if the sponsor is making decisions on their behalf, it’s still a security. However, there is an exemption from registration known as a “Private Placement” exemption that allows a sponsor to raise money from people he or she knows without registering the offering. One such exemption is offered by the federal Securities and Exchange Commission (SEC) under Regulation D (17 CFR § 230.501 et seq.), Rule 506(b). Under this exemption an unlimited number of “accredited” investors can be used, an unlimited amount of money can be raised, investors can come from any state, and state Securities rules are generally superseded as long as required notices are filed.
In addition to the Regulation D, Rule 506(b), most state securities agencies also offer exemptions from registration and there are other federal exemptions available, e.g., Regulation D, Rules 504 and 505; each of which has its own specific set of rules. As an example, the rules for a Regulation D, Rule 506(b) Private Placement exemption include the following:
- The sponsor must not engage in general solicitation or advertising of the opportunity. The sponsor must have a substantive, pre-existing relationship with any investor to whom he or she offers the securities. This is what distinguishes a Private Placement exemption from a public offering, in which general solicitation is allowed.
- The sponsor must qualify prospective investors as “accredited” or “sophisticated” based on their income, net worth, financial or investment experience, or assistance of their professional financial advisers, before their funds (i.e., “Subscription”) can be accepted.
- The sponsor must disclose all foreseeable risks of the investment and may not guarantee returns. This is typically done in a Private Placement Memorandum using a format prescribed by the SEC.
- The sponsor must promptly return all money to investors if the minimum investment amount has not been raised in the time frame specified in the offering documents or if the objectives of the investment are not realized (i.e., the property is not purchased or the company is not opened, etc.).
- A notice of the sale of securities must be filed with the SEC (Form D) and any states in which securities have been sold. The notices (and applicable fees) must generally be filed within 15 days of the first sale of securities.
To Whom Does a Private Placement Exemption Apply?
The sponsor may be called a syndicator, promoter, manager, general partner, etc. However, regardless of title, the exemption generally applies to the issuer, i.e., the person, group or company that is actually selling (promoting) the securities.
What is the Usual Source of Investment Funds for a Private Placement Offering?
Investors can invest their savings or retirement funds in Private Placement offerings. Many retirement accounts allow the account owner to use a third-party administrator or custodian to set up a self-directed individual retirement account (IRA) or self-directed 401(k) account. The account owner can direct the custodian to release his or her retirement funds to purchase private placement interests, interests in a limited liability company or limited partnership, etc.
What If The Sponsor Doesn’t Comply With Securities Laws?
Failure of the sponsor to comply with the Private Placement exemption rules may subject the investment to unnecessary legal exposure, which could impact the viability of the investment. The sponsor could be subject to substantial civil and criminal penalties for the sale of unlicensed securities. Regulatory agencies or other creditors could force liquidation at a disadvantageous time, or the sponsor could spend investor funds defending charges or paying fines.
Furthermore, a sponsor who neglects to comply with the law may be less likely to comply with the provisions contained in the offering documents or may not understand his or her fiduciary obligations to the investors.
A syndicator who fails to follow securities laws puts the entire investment at risk.
If you are an investor contemplating investing your private funds or self-directed IRA funds in an investment opportunity that you believe is a security, conduct your own due diligence and ask questions of the sponsor to determine whether the sponsor is following the rules of any applicable exemption, and whether the sponsor has hired a securities attorney to assist with preparation of the offering documents and compliance with the myriad securities laws.
If you are a sponsor thinking of pooling investor funds, you should seek the advice of a competent securities attorney or registered broker-dealer to help you structure your transaction to either: a) avoid creation of a Security, b) qualify for an exemption, or c) register it as a public offering.
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Disclaimer: WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied upon as legal advice.