The Wealth Elevator Syndication eCourse

What is a Security?

Both federal and state securities law contain a comprehensive list of items that are considered securities by definition, one of which is an “investment contract.” 

Based on U.S. v. Howey, 328 U.S. 293 [1946], 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 for diligence review 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 law, the sale of securities offerings must be registered with the government as a public offering unless the sponsor or the transaction otherwise qualifies for an exemption from registration.

It doesn’t matter who the investors are (even if they are family/friends, financial advisors, or institutional investors), if the sponsor is making decisions on their behalf, it’s still a security, unless they are doing a Private Placement. 

Exemptions to Creating a Security

Because registering an offering can be a prolonged and expensive process, many sponsors seek measures to avoid the creation of a securities offering altogether.

Member-Managed LLC or Tenant in Common (TIC) Ownership

A security may not be created if all investors participate unanimously in investment management decisions involving the deal, such as in a “member-managed LLC,” or in a Tenant in Common (TIC) ownership.

Private Lender Loan

If a private equity 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.

Private Placements

There is an exemption from registration known as a “Private Placement” exemption that allows a sponsor to raise money from people they know 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 and disclosure are filed.

The Private Placement exemption applies to the sponsor. 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.

In addition to the Private Placement 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, advertising, or disclosure 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 conduct reasonable diligence to 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 (Guide 5).
• 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.

Investing with Retirement Funds – Private Placements

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 potential risk and 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.

Do Your Due Diligence Before You Invest!

When deciding whether to invest a portion of the assets of a qualified profit-sharing, pension or other retirement trust in the Company, a fiduciary should consider whether: (i) the investment is in accordance with the documents governing the particular plan; (ii) the investment satisfies the diversification requirements of Section 404(a)(1)(c) of Employee Retirement Income Security Act of 1974, as amended (“ERISA”); and (iii) the investment is prudent and in the exclusive interest of participants and beneficiaries of the plan. 

PLAN ASSETS – ERISA  

Under ERISA, whether the assets of the Company are considered “plan assets” is also critical. ERISA generally requires that “plan assets” be held in trust and that the trustee or a duly authorized Manager have exclusive authority and discretion to manage and control the assets. 

ERISA also imposes certain duties on persons who are “fiduciaries” of employee benefit plans and prohibits certain transactions between such plans and parties in interest (including fiduciaries) with respect to the assets of such plans. Under ERISA and the Code, “fiduciaries” with respect to a plan include persons who: 

• Have any power of control, management, or disposition over the funds or other property of the plan;
• Actually provide investment advice for a fee; or
• Have discretion with regard to plan administration.

If the underlying assets of the Company are considered to be “plan assets,” then the Manager(s) of the Company could be considered a fiduciary with respect to an investing employee benefit plan, and various transactions between Management or any affiliate and the Company, such as the payment of fees to Managers, might result in prohibited transactions. 

A regulation adopted by the Department of Labor generally defines plan assets as not including the underlying assets of the issuer of the securities held by a plan. However, where a plan acquires an equity interest in an entity that is neither a publicly offered security nor a security issued by certain registered investment companies, the plan’s assets include both the equity interest and an undivided interest in each of the underlying assets of the entity unless:

• The entity is an operating company or;
• Equity participation in the entity by benefit plan investors (as defined in the regulations) is not significant (i.e., less than twenty-five percent (25%) of any class of equity interests in the entity is held by benefit plan investors). Benefit plan investors are not expected to acquire twenty-five percent (25%) or more of the Units offered by the Company. Management of the Company intends to preclude significant investment in the Company by such plans. Employee benefit plans (including IRAs), however, are urged to consult with their legal advisors before subscribing for the purchase of Units to ensure the investment is acceptable under ERISA regulations.