This article is Part 2 in a series explaining the protections provided by state and federal securities laws for investors who risk their capital in value-adding investment schemes generally offered by unlicensed promoters.
For information on fixed-asset real estate syndication which does not create a securities risk, see Part 1.
California vs. federal risk capital tests
Syndicators need to understand when their real estate investment offerings fall under securities laws, which face additional regulations, including the need for a securities permit to be obtained to publicly solicit investors.
When does a securities risk exist?
To determine whether a securities risk exists in an investment program, state and federal courts apply slightly different risk capital tests. [See RPI ebook: Forming Real Estate Syndicates Chapter 13]
The California risk capital test requires the investors’ capital to simply be placed at risk of loss due to a value-adding activity promised to be completed after the group acquisition of a property, whether or not a profit is expected or intended. Compared to federal securities law, California securities law is further reaching, covering more investment conduct than federal securities law. Thus, a California real estate syndicator is primarily concerned about the California securities law as it is the set of rules most protective of investors.
The federal risk capital test, on the other hand, revolves around the element of the expectation of a profit on a property investment which includes a value-adding activity. For a securities risk to exist under the federal risk capital test, the investors needs to be induced to join the program by, among other activities, a promise they will profit from their capital investment.
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Value-adding activities to enhance an acquisition
Conversely, a syndicator’s offering of a group investment program to fund the development or renovation of property improvements, or an ongoing resale-marketing program, farming operation or business opportunity operation, contains securities risks.
A securities risk arises at the moment an investors’ capital is placed at a risk of loss through the need of others to complete significant value-adding activities before or after acquiring a property.
One activity before acquisition which presents securities risks is the syndicator’s selection and identification of a property for acquisition after the investors release control of their cash to the syndicator, called a blind pool investment.
Exemptions exist to remove specific group investment programs which contain securities risks from further compliance with securities laws (more on that below).
Unless exempt, the syndicator offering an investment program with a risk of loss controlled by the securities law reports to the appropriate government agency:
- the California Department of Financial Protection and Innovation (DFPI) to comply with state securities rules (and qualify for a permit); or
- the Securities Exchange Commission (SEC) to comply with federal law (a registration).
Failure to qualify or register the offering of a real estate syndicated investment program containing a securities risk the syndicator does not manage under an exemption exposes the syndicator who offers a program with a securities risk to civil and criminal liability.
Activities controlled by securities law which create a securities risk include:
- pre-closing blind pool asset selection;
- after-closing development of the property;
- a business opportunity aspect for use of the property acquired, or
- collective post-acquisition coordination by management with owners of other properties (pooling arrangements).
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Investor use coupled with development
A syndicator’s promise to investors of future profits does not alone present a securities risk under the California risk capital rule. However, the promise of profits accompanied by a further promise to perform an activity that will add value to the property, such as property development, rezoning, and like property enhancement achievement, present a securities risk.
For example, consider a developer who sells membership interests to investors in a yet-to-be-built property development designed as a country club. The developer fails to complete construction of the promised improvements. The investors demand the developer returns their investment.
The investors claim the developer violated California securities law, that the club memberships sold were unqualified and non-exempt securities risks in a construction project.
The developer claims the country club memberships are not controlled by California securities law, since the memberships merely provided for personal recreation with no expectation of a profit.
However, unlike federal securities law with its profit-driven test, an expectation of profit is not an element required to bring a group investment program under the protection of the California securities law.
Here, the sale of memberships included a type of risk-of-loss exposure which is a securities risk. The investors risked their capital on a “yet-to-be-built” project, relying on the developer to complete the promised construction of improvements after the members released their investment funds to acquire membership in the group’s ownership of the property. [Silver Hills Country Club v. Sobieski (1961) 55 C2d 811]
Expertise to create a return of investment
Now consider a syndicator who sells several small parcels of adjacent agricultural land planted with citrus trees, each individual investor taking title to one parcel. The sale of each parcel is coupled to a long-term service agreement agreed to by the investor acquiring the parcel. Under the service agreement, the syndicator will care for the trees and harvest and market the fruit produced by all the parcels managed under the service agreement.
The syndicator coordinates the operations of all the parcels as a single, large-scale farming operation. Essentially, it is one group of investors who provide the capital for a venture offered and controlled by the syndicator. However, the syndicator has the experience, knowledge and equipment required to conduct a successful farming operation and produce and sell the crop.
However, the management agreement calls for each investor as owner of a separate parcel to receive a share of the net operating income from the production and marketing of the crops. Their share is based on the investor’s pro rata ownership among all parcels farmed under the service agreement, called a pooling arrangement or horizontal commonality investment.
Now in contrast to another common enterprise, consider the purchase by several investors as co-owners of a multi-unit apartment building. The syndicator forming the group will manage the apartments by locating tenants and renting existing units.
While the syndication of a group to own an apartment building as a fixed, fully existing asset managed by the syndicator (or others) does not pose a securities risk, the management arrangements of the parcels of citrus groves does contain a securities risk.
Common economic risk versus the securities risk
To distinguish the type of group investments, look at the types of the risks involved:
- one involves producing a crop and marketing it by others — the syndicator, etc. — for a return of the investment;
- the other involves the marketing of existing vacant units without further improvement.
Here, the distinguishing feature is the classification of these two different risks.
- The management of the citrus groves calling for the development of the crop, as well as a pooling arrangement, is a securities risk.
- The apartment management situation is limited to locating tenants to fill vacant units as permitting by local market conditions, not further improvements, and presents only an economic risk.
Without the securities risk of loss classification, economic risks alone are not the concern of the securities law. Every deal has economic risks contributing to income, profits or loss. Few also present a securities risk.
Here, the success of the farming operation was inextricably interwoven with the efforts of others to produce a crop and market it to generate an income and, ultimately, a return of the investment. Further, the pooling of income and expenses between different investors was an additional type of securities risk. [Securities and Exchange Commission W. J. Howey Co. (1946) 328 US 293]
As for the investment by several co-owners in an existing apartment complex, the only risk of loss remaining after acquisition is in the demographics of the local economy for future income and profits (or loss). No promise existed to enhance the value of the property after closing through value-adding activities, like improvements, promised to be delivered by anyone. Thus, no conduct presenting a securities risk existed.
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Post-closing value-adding activities
Activities promised to occur after closing which create a securities risk include:
- obtaining government approval or permits for zoning or a higher and better use of the property;
- making further improvements or significant capital alterations in a renovation or repurposing of the property;
- pooling arrangements to share income and costs with owners of other property; or
- operating a business or farming operation that requires expenditures for inventory, production or sales.
Thus, for a securities risk to exist, the syndicator or others must undertake an ongoing investment enhancing activity to be completed after taking ownership of the property. This value-adding activity continuously places the return of the investor’s capital at risk of loss until the promised activity is completed.
The funds put at risk of loss might be contributed by the investors or as borrowed capital, like originating a mortgage on the property.
Syndication efforts controlled by securities law
The securities issue for the syndicate manager is to determine which investment activities include risk situations that trigger the application of securities law.
The existence of a securities risk is a matter of the substance of the transaction activities involving the property, not the form of ownership used to take title to the property and for management of the group of investors. It is the economic function of the real estate investment program which determines whether a securities risk exists. The vesting for holding title as co-owners of the property is unrelated to the function of the property.
Editor’s note — An exception to the substance-over-form rule is the issuance of stock. Any transaction that involves the issuance or transfer of investment certificates which are formally called stock is a controlled security. The economic substance of an investment labeled stock as the form of ownership is of no concern. [Landreth Timber Company v. Landreth (1985) 471 US 681]
For example, the citrus grove investment program reviewed above was structured as a sale of a parcel of improved agricultural property. Each investor became the sole owner of an individual parcel of land — a real estate sales situation that, without further contracts for crop production after the acquisition, does not contain a securities risk.
However, each owner bought into a farming arrangement to own a parcel of real estate with no reasonable ability to independently control or operate to produce, much less market, a crop. Success was entirely in the hands of the syndicator to create value for a return of their invested funds through the husbandry, production, marketing and sale of the crop.
Again, the agri-business program included a further type of securities risk: the pooling of expenses and income with owners of other property.
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Pooling intended to avoid management
Consider an investor who purchases a condominium unit through a real estate broker. The purchase of a residential unit without other post-acquisition strings attached does not constitute a securities risk (other than fractional co-ownerships of a unit for time share purposes as controlled by the subdivision law).
However, the broker also arranges for the buyer to enter into a rental pooling agreement (RPA) with a vacation rental management company for the ongoing operation of the unit. The broker has no connection to the management company employed in the RPA and receives no kickback or fee for the referral. Without the management company’s pooling agreement, the investor will not buy the property.
Under the RPA, the management company oversees a rental operation within the condo project in which the investor’s unit is located. The property manager distributes spendable rental income to the investors of the individual units under management. The allocation of income and expenses to each investor is based on their pro rata share of all units participating in the RPA. The sharing is not based on the actual performance of each investor’s separate unit, an activity called a pooling agreement.
The RPA is a primary inducement for the investor to purchase the condominium unit. The pooling arrangement enables the locating of tenants, maintenance of the unit and collecting rental income without becoming involved in any way beyond reviewing the manager’s monthly statement, a type of portfolio investment plan.
More strategically, the investor plans to cover their monthly mortgage payments and condo assessments out of the rental income.
Future return generated by the efforts of others
Continuing our previous example, the unit fails to produce the level of rental income the investor expected. The short fall in income is due solely to market forces in the local economy, not management. The investor makes a demand on the broker who sold them the unit for a return of their investment.
The investor claims the purchase of the condominium coupled with the RPA created a securities risk. The investor relied on the management efforts of others in the joint operation of several individually owned units to produce a return of their investment.
The broker claims they did not create the securities risk, that the investor was not required to enter into the RPA as part of the agreement to purchase the condominium. Further, the broker was not in control of the management of the property.
Did the broker create a securities risk by arranging an RPA for the investor as part of the purchase of the property?
Yes! The purchase of the condominium unit coupled with the RPA was presented to the investor as a single investment scheme with two separate components.
Here, the investor was induced by the broker to invest their funds in a property since the investor’s expectation of profits produced by the efforts of others operating the common enterprise of an ongoing pool-and-split program allowed the investment to be management free.
Since the broker arranged for the investor to place their funds at risk on the close of escrow by acquiring the unit in anticipation of a future return generated by the efforts of others — the pooling and management of several separately owned properties under the RPA — a securities risk was created. [Hocking v. Dubois (9th Cir. 1989) 885 F2d 1449]
Exemptions when a securities risk exists
For syndicators, a nonpublic offering exemption exists in California law. This exemption is the most useful exemption available when soliciting and forming an investment group in a promotional program which includes an activity containing a securities risk. However, for an erstwhile syndicator with no deep-rooted, pre-existing, long-term relationship with monied people, this friendship exemption is not for them.
The nonpublic offering exemption is called the 35-or-less interrelationship rule, and applies when:
- the solicitation of investors is limited to 35 (spouses counting as one);
- all investors solicited each enjoy a meaningful, pre-existing business or personal relationship with the syndicator;
- the investors agree not to resell or distribute the interests they acquire;
- the solicitation of investors does not involve public advertising; and
- the syndicator files a notice of the transaction subject to the exemption with the California Department of Financial Protection and Innovation (DFPI). [Calif. Corporations Code §25102(f); see DFPI Form: Limited Offerings Exemption Notice]
Thus, when an investment program does contain a securities risk, such as exists in a construction or development project, the syndicator whose solicitation of investors meets the requirements of the 35-or-less interrelationship rule for the nonpublic offering of a securities risk is exempt.
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Accredited investor SEC exemption
Consider a syndicator who solicits investors for a California property the syndicator intends to develop on behalf of the group. Paperwork registering the program with the SEC authorizes the syndicator to offer an unlimited amount of memberships to investors as a limited private placement offering.
To comply with the federal securities law private placement offering exemption, the program may only be offered to individuals the syndicator can qualify as accredited investors. [17 Code of Federal Regulations §230.501]
The syndicator solicits a small business owner to invest in the program. The business owner does not qualify as an accredited investor under the SEC restrictions for a limited private placement offering exemption. Further and of no concern to the SEC exemption, the syndicator has no prior relationship with the small business owner.
The California DFPI serves the syndicator with a desist and refrain order to cease offering membership. DFPI claims the syndicator is violating state securities law by publicly offering a membership in a value-adding promotional venture without the investment program being qualified or a notice of exemption filed with the DFPI.
The syndicator claims the DFPI’s authority was preempted by the filing with the SEC as an exempt securities offering.
Is the syndicator exempt from the DFPI’s desist and refrain order due to the syndicator’s filing with the SEC as an exempt offering?
No! California securities law controls the program since the SEC exemption was not adhered to by the promoter. The syndicator did not limit solicitation of investors to only accredited investors as the SEC exemption requires. Thus, the offering fell outside the scope of the SEC limited private placement exemption and, without preemption, became subject to state securities law.
Nor did the offering comply with California’s nonpublic offering exemption, called the 35-or-less interrelationship rule. The investor had no prior informative relationship with the syndicator to be aware of the efficacy of the syndicator to perform. [Consolidated Management Group, LLC v. Department of Corporations (2008) 162 CA4th 598]
Disclosure of securities and limitations on recovery
Consider a syndicator whose investment program contains a securities risk activity, such as a condo conversion subdivision or parceling of an unimproved parcel of real estate. To solicit investors, the syndicator posts a notice of the investment opportunity in the recreational rooms of condominium projects and mobilehome parks they have an interest in. They do not obtain a permit or file a notice of the offering of the investment program as exempt with the DFPI.
Here, the syndicator publicly offered an investment opportunity with a securities risk activity — property bought to be subdivided for resale — to anyone visiting the recreational rooms. Thus, their investment program was a non-exempt offering of a securities risk. As a result, any investor in the program may recover the full amount of their investment from the syndicator, plus 10% interest from the date of investment, less any distributions received by the investor.
Statute of limitations on recovery
As a shield against delayed civil actions by an investor to recover their investment, their claim under California securities law is subject to time constraints, called the statute of limitations. The limitations place time deadlines beyond which an investor is barred from filing a claim for the recovery of money.
An action to recover the investor’s funds needs to be filed prior to the earlier of:
- two years after the date the investor funds the investment; or
- one year after the investor discovers the securities law violation. [Corp C §25507(a)]
Thus, when a syndicator prepares their investment circular (IC) they disclose they did not obtain securities permits — whether or not a securities risk might exist. This proviso places the investor on notice of the potential violation from the outset of their investment. With the inclusion of this proviso in the IC, the investor’s recovery under California securities law is subject to a one-year statute of limitations for filing their complaint to recover their contribution to the investment.
Until the one-year limitation period expires, the investor in an investment program that contains a securities risk which does not qualify for an exemption or was not qualified by the DFPI may unilaterally withdraw their investment funds at any time (plus interest less any distribution of earnings).
However, on expiration of the one-year period following disclosure, the syndicator is no longer liable for any civil claims to money for securities violations. Crimes are a different issue.
Realistically, when an investor contributes funds to a real estate syndication, they are unlikely within one year to be aware they need to withdraw or file an action. Real estate investments are not often observed as having gone awry within one year.
Thus, even when the syndicator is certain their investment program contains no activities that are securities risks, a disclosure that no permit exists limits the syndicator’s exposure to civil monetary liability under California’s securities law by commencing the one-year statute of limitations. [See RPI Form 372 §1.7]
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