This article examines the history of federal and California securities laws and how each applies to real estate syndicates.
What is a security?
As broadly defined, a security is a stock, bond or a right to ownership which is sold to an investor with the promise of future financial return on the original investment.
For example, the sale of stocks and bonds issued by corporations qualify as securities and are currently regulated under federal and state securities law. These laws came about after the initial unregulated sale of securities produced mass instances of fraud and misrepresentation throughout the U.S., which devastated investors lured in by the promises of huge financial returns.
However, not all group investments in a co-ownership are inherently securities. Real estate syndicates investing in existing income property, for example, are not securities.
To enhance real estate brokers’ and syndicators’ understanding of when securities law applies to real estate investment programs, an overview of securities law in California and federal legislation is necessary.
Blue skies lead to federal securities law
In the beginning, there were blue skies — or, blue sky laws. California and many other states passed blue sky laws (so named because without them, hucksters would attempt to sell “everything but the blue sky”) in the early 1900s. These laws mandate securities registration in an attempt to curb rampant fraud in the securities business.
California’s first blue sky law, the Investment Companies Act, created the State Corporation Department in 1913. Under the leadership of the Commissioner of Corporations, the State Corporation Department attempted to moderate securities and group investments in California.
However, referring to blue sky laws as “legislation” is generous. Blue sky laws are ineffectual due to lax enforcement by state attorneys and intentional allowance of violations in the name of interstate commerce.
California tried to improve the situation again in 1917 with a blue sky law called the Corporate Securities Act, which regulated securities for much of the next few decades. However, the Corporate Securities Act’s reach was limited like many other states’ blue sky laws, setting a trend but failing to alleviate the need for federal securities regulations.
Federal attempts at creating uniform blue sky laws applicable to all states were made around 1922, to no avail. It wasn’t until Franklin D. Roosevelt took the helm in 1933 that federal securities law became a real possibility. Roosevelt pressed the Federal Trade Commission (FTC) to create a federal securities law bill which, after rigorous revisions, ultimately became the federal Securities Act of 1933. The Securities Act of 1933 increased enforcement of antifraud regulations in securities trading, as well as required securities investors to be informed of the inherent risks in their investments.
Originally, the FTC was in charge of enforcing the Securities Act of 1933. However, the FTC’s vast portfolio left it little time or means to wholly supervise securities regulation — leading to the passage of the Securities Exchange Act of 1934.
The Securities Exchange Act of 1934 established the Securities and Exchange Commission (SEC) to regulate federal securities law. Thus, the SEC was dedicated solely to the oversight of securities trading across the U.S., including individual securities traders, associations, investors and self-regulatory organizations (SROs) like the New York Stock Exchange. [See Elizabeth Keller’s Introductory Note: A Historical Introduction to the Securities Act of 1933 and the Securities Exchange Act of 1934]
Thus, the federal bar was set. The Securities Act of 1933 and the Securities Exchange Act of 1934 (collectively called the Acts) finally initiated enforcement of securities trading regulations and introduced legal protections for investors, direly needed after decades of unethical and fraudulent behavior by Wall Street insiders.
Soon, California followed suit and established its own securities laws — state laws more stringent even than their federal counterparts. The Corporate Securities Law of 1968, molded from the 1917 Corporate Securities Act, governs securities in California today. The Corporate Securities Law of 1968 extended California’s regulatory control to non-issuer transactions, in which the seller of securities does not receive a direct benefit from the sale.
Securities vs. syndicates: Where’s the divide?
In real estate, syndication of the ownership of a specifically identified property is often mistakenly thought to be a security. Real estate syndicates, however, are not automatically classified as securities; whether they are or not depends on the timing for delivery of the title or improvements to the real estate acquired by investors funds.
For example, a real estate syndicate which invests in existing income property acquired at the time the investor releases their funds (and places them at risk of loss) is not a security. The risk of loss in an investor’s shift of funds directly into a parcel of real estate is an economic, not a securities risk, the earnings being dependent on the market conditions arising in the future and not a promise to locate or improve a property. Because the property already exists, disclosed to the investors as the property directly acquired by their funds and not subject to further development, the investors are placing no financial risk in the syndicator to seek out and acquire a suitable property or to add promised value to the real estate through further improvement. [Fargo Partners v. Dain Corp. (8th Cir. 1976) 540 F2d 912]
On the other hand, investment in a property which will be improved by some type of construction or development by the syndicator — the promise of added value — is a security, As a security, the investors puts up money before receiving the completed property, a value to be realized only on its successful completion.
For example, when an investment is made by a group in a farm or orchard operation which requires cultivation, development and marketing of the resulting product at the hands of the syndicator (or others, called pooling arrangements), the investment qualifies as a security. [Securities and Exchange Commission v. W. J. Howey Co. (1946) 328 US 293]
Additionally, the sale of memberships in a country club or similar membership enterprise are also securities when the construction of the club-house improvements are yet to be completed. [Silver Hills Country Club v. Sobieski (1961) 55 C2d 811]
In both above examples, the investors infused the syndicate program with their funds before the improvements promised for the investment were fully completed and, if completed, able to generate further earnings for the investors. Thus, state and federal securities laws apply.
Real estate syndicates and accredited investors
The eventual result of all this state and federal legislation was the establishment of the accredited investor designation, a pseudo-rank for experienced financiers who can by their investment expertise account for their own risks taken when making an investment. The so-called accreditation is set forth by the SEC. It was meant to protect investors from taking on too much risk and to help syndicators identify experienced, low-risk investors for the securities they were offering. Without a securities risk, there is no security; without a security, there is no accredited investor requirement.
However, the accredited investor designation has become intentionally muddled, ignoring the divide between securities and non-securities in real estate syndication. Unlicensed real estate syndicators turn to attorneys for advice on forming real estate syndicates. They are told they need to locate accredited investors to form a group investment because group real estate investments (no matter how vested) are inherently securities — an incorrect assumption made by attorneys who can’t be bothered with more than boilerplate securities information, as in the general definition given at the outset of this article.
To be a security, a real estate investor’s money needs to be placed at a risk of loss beyond their control:
- before selection, identification and acquisition of title to the real estate; or
- when the real estate is identified up front but the source of investment returns are improvements not yet constructed.
When the real estate is identified and title delivered to the investor concurrent with their money being released for investment in the property — the existing asset — the investment program offered by the syndicator is not a security since no securities risk of property selection or further improvement is then involved.
Licensed real estate brokers operating as syndicators are aware of the difference between securities and non-securities in real estate investment. These brokers are able to form real estate syndicates to freely invest in existing income properties without concern for inapplicable securities laws. The licensed broker operating as a syndicator just needs to do their due diligence, make the proper disclosures on the property and vet potential investors to ensure they are financially and temperamentally capable of managing the particular investment opportunity at hand.
Want more information about securities law in real estate syndication? See Chapter 13: Securities aspects of syndication in Forming Real Estate Syndicates, available through the first tuesday Realtipedia.