This article applies the use of the syndication process to fund the equity purchase (EP) of property from a seller-in-foreclosure.

Funding to buy a foreclosure

The purchase of property in foreclosure is typically negotiated in the space of hours and closed in the course of a few days. Such fast-moving deals require assurance that purchase funds are available at the outset of negotiations.

For example, a broker, acting as a syndicator, forms small investment groups as LLCs to gather funds to buy property. He locates an owner-occupied one-to-four unit residential property in foreclosure. He contracts to buy the property in his own name as a principal by entering into an equity purchase (EP) agreement with the owner, called a seller-in- foreclosure. [See first tuesday Form 156]

Escrow is opened on expiration of the seller’s five-business- day cancellation period since the syndicator has not received a cancellation notice from the seller-in-foreclosure.

Prior to closing, the syndicator will assign his rights under the purchase agreement to an investment group he will form as a limited liability company (LLC). [See Buying Homes in Foreclosure, 5th edition, “Assigning your purchase rights,” 141-148; and first tuesday Form 370]

However, the escrow period is short in anticipation of closing before the foreclosure sale. Thus, the syndicator will not have sufficient time to conduct his due diligence investigation and prepare an investment circular on his findings, much less prepare the LLC documents and locate investors to fund acquisition of the property. [See first tuesday Form 373-1]

As a result, the syndicator buying foreclosures often solicits commitments from prospective investors to fund the purchase of foreclosure properties before locating the real estate, called a blind pool investment program. The syndicator forming a blind pool is said to be given a “blank check” by the investors to later locate, analyze and acquire suitable property for the placement of their funds.

Creating a securities risk

After the group members fund the LLC for the purpose of buying foreclosure properties, the syndicator locates a suitable property, negotiates the purchase terms, arranges financing, closes escrow, and rehabilitates and manages the property either as a rental or for immediate resale.

However, this blind pool arrangement includes conduct or activity with risks which constitutes a corporate security. When the investors hand over their capital to the syndicator before a suitable property is selected, a risk of loss exists which is controlled by the securities law, not the economics of the real estate market. The investors funding the program rely entirely on the investment expertise of the syndicator to later locate and investigate a property of sufficient value and quality for an investment and then use their funds to acquire it. Only after acquisition does the function of the marketplace come into play. [Underhill v. Royal (1985) 769 F2d 1426]

When forming a blind pool investment program, the syndicator wants to:

  • avoid the creation of a public offering under the securities statutes by qualifying for an exemption; and
  • minimize the moral risk perceived by prospective investors he solicits to fund a blind-pool investment by obligating himself in the LLC operating agreement to make a full disclosure of the financial aspects of the investment as soon as he acquires the property he selects for investment. [See first tuesday Form 365]

A closely knit group

The blind pool syndicator avoids regulatory activity governing corporate securities by soliciting personal and business acquaintances without publishing the availability of the investment program to members of the public. His conduct will be classified as under a nonpublic or private offering exemption to the securities law.

To comply with the nonpublic exemption rules when forming an investment program (blind pool) controlled by the securities law, the program must:

  • include no more than 35 members, a husband and wife being one member;
  • all members must have a deep-rooted, pre-existing personal or business relationship with the syndicator, or be sophisticated investors with prior experience in similar investments;
  • each member agrees his purchase of a franctional interest in the LLC is for his own account and not for resale; and
  • no member is solicited by advertisement. [Calif. Corporations Code §25102(f)]

The blind pool syndicator who fails to comply with all elements of the private offering exemption must qualify and obtain a securities permit from the Department of Corporation before accepting funds from members — no matter how the members are solicited. [People v. Humphreys (1970) 4 CA3d 693]

Assessable LLC interests

In an EP investment program, the property is generally intended to be flipped in an for immediate resale. As an alternative, the property may be held as a rental for investment.

Investors in an EP investment program based on an intent to flip the property as soon as possible do not expect to receive spendable income from rental operations during the period of ownership. Specifically, the members expect a negative cash flow situation until the property acquired is resold.

Also, an EP investment program for flipping the property acquired may incur unforeseen renovation expenses or carrying costs beyond those anticipated by the syndicator. Thus, the reserve fund initially established to cover operating and ownership expenses prior to resale is prematurely exhausted.

To maintain the solvency of the program, an additional contributions provision is included in the LLC operating agreement. The additional contributions provision enables the syndicator to periodically obtain additional capital contributions from the members on his request should the EP investment program face a deficit cash flow while owning the property.

Provisions for
EP syndication

The EP syndicator will include provisions in the LLC operating agreement and disclosures in his investment circular (marketing package) regarding the existence and risks of the blind pool funding. [See first tuesday Form 372]

The contents of the LLC operating agreement for an equity purchase are designed for use in California. However, no two sets of syndication circumstances are identical. The formulas and arrangements members contract for in an operating agreement must, by necessity, vary from transaction to transaction.

Therefore, legal counsel is recommended to assist with the necessary adjustments to provisions in the operating agreement and investment circular to conform to the specific facts of each EP syndicator’s program. Also, counsel lends experience developed advising others on syndication programs. The operating agreement accompanying this chapter is intended for use as a basis for seeking further advice from the reader’s legal counsel.