THEY’RE BA-A-A-CK! Although it may still be a little early for real estate investment promoters to start dancing in the streets, the most recent depression in the industry is showing clear signs of abating. With this improved outlook comes a resurgence in the creation of real estate investment vehicles like limited partnerships and other types of real estate syndications. This makes it worthwhile to reexamine the rules that govern the legal ways in which money can be solicited for such investments.
Historically, when promoters have wanted to raise money from investors for a real estate opportunity, the vehicle of choice has been a limited partnership. They have more tax advantages than corporations; they limit the liability of the investor partners to the amount of their investments; and they reserve control of the development entity to the general partners who, presumably, are more knowledgeable in conducting the business of the partnership than the limited partners are.
What is sometimes overlooked in the solicitation of money for such enterprises, however, is the fact that these investments usually constitute securities, the sale of which is regulated by various Federal and state laws. Violation of these laws can have serious consequences. Investors may be entitled to get back all of their money plus damages from both the promoters and anyone else involved in the solicitations. Violators may also be subjected to criminal penalties like fines and imprisonment. Consequently, it is a good idea for anyone involved in soliciting such investments (and for investors, themselves) to have some idea of what the rules are.
Sales of stock in a corporation are almost always going to be sales of securities. Sales of interests in a partnership may or may not be sales of securities. Generally, where the interest in a partnership being sold gives the investor a true general partnership interest (the investor has unlimited liability and an equal say with all of the other general partners in the business decisions of the partnership), the transaction will not constitute the sale of a security. In contrast, the sale of a limited partner interest in a limited partnership will almost always be the sale of a security. The investor limited partner will almost always be relying upon the skill and expertise of the general partners for the success of their investment and they, the limited partners, will have only very limited rights in the management of the partnership. As suggested by these examples, the essence of a “security” is that it involves a situation in which someone invests, and risks the loss of, their money in a common enterprise with the hope of receiving profits solely from the efforts of others.
As a general rule, securities may not be sold unless they are registered with the appropriate Federal and state regulatory authorities. The Federal agency that regulates the interstate sale of securities is the Securities and Exchange Commission (the “SEC”). State securities laws (“Blue Sky Laws”) are regulated by different agencies in the various states.
Where securities are offered for sale by any type of advertising or solicitation to the general public, such offerings are considered “public” offerings. The bad news is that registration requirements for public offerings are extensive, complex and very expensive to satisfy. The good news is that the Federal and state legislatures have developed a variety of exemptions from these requirements for purely private offerings. The basic idea behind these exemptions is to reduce the complexity and expense of regulatory compliance where the securities are not offered for sale by any general solicitation or public offering, and any one of the following three criteria exist:
- The money is being raised within one state only and totals less than $1,000,000; or
- The investment is purchased solely by investors who are relatively sophisticated and who therefore do not need the extensive protections otherwise afforded investors by the Federal and state securities laws; or
- The investment is purchased by a relatively small number of “non-accredited” investors.
These exemptions are set out in a Regulation issued by the SEC called “Regulation D.” The criteria for qualifying under each exemption are slightly different. However, in all cases resales of the securities by the original investors are restricted and certain information must be filed with the SEC before the first sale and periodically thereafter. There is no prohibition in any of the Rules against the payment of sales commissions on the sales of the securities.
One of the most important concepts incorporated into Regulation D is the “accredited investor” concept. This term is defined to include individuals and entities who come within any one of several defined categories. Probably the most important categories are people whose net worth, or joint net worth with their spouses, exceeds $1,000,000 and people who have had individual income of more than $200,000 (or $300,000 with their spouses) in each of the last two years and who reasonably expect their income to equal or exceed that amount in the current year. The accredited investor concept is important because accredited investors are excluded in counting the maximum number of investors permissible under certain exemptions and because accredited investors do not have to be given certain types of information which must be given to non-accredited investors. Thus, where securities are sold only to accredited investors, the types and amount of information that must be included in disclosure documents are minimal.
Obtaining an exemption from registration under Regulation D does not relieve the promoter from complying with the anti-fraud provisions of the Federal and state securities laws (the anti-fraud laws would still punish severely any misstatement or omission of a material fact which is made in connection with the offer), but it does substantially simplify compliance.
Qualifying for an exemption from registration with the SEC under Regulation D may or may not satisfy a promoter’s obligation to comply with applicable state securities laws. This is an important question to resolve because compliance with state securities laws may be even more complex and costly then complying with Federal law. This is especially important in an area like ours where the sale of a security might be regulated by Federal securities laws as well as the laws of the District of Columbia, Maryland and/or Virginia.
In a future article, we will examine in a little more detail the specific requirements for exemptions under Regulation D and the interplay of Regulation D with the securities laws of the District of Columbia, Maryland and Virginia.