MORE THAN YOU EVER WANTED TO KNOW ABOUT SECURITIES ISSUES IN REAL ESTATE LLCS
or why you should have a securities attorney as part of your team
Important note: This memo generally discusses the basic federal and state securities laws governing the issuance of securities, how they intersect with the ownership structure of limited liability companies, and the penalties for non-compliance with the Securities Laws. This memo, however, is a generic discussion and not specific legal advice or a legal opinion to you.
- 30,000 Foot summary
Ø Almost all LLC membership interests (“LLC Interests”) are “securities”. Even if the LLC has no other assets or business activities than holding and managing real estate.
Ø All issuances of LLC Interests to members who are not actively involved in the LLC’s business must either be registered or qualify under both federal and state registration exemptions.
Ø Luckily, many exemptions are available, and their conditions generally are not prohibitively difficult or costly. (Particularly in comparison to a securities lawsuit or administrative penalty!)
Ø However, except for offerings that are restricted to Accredited Investors (see below), every state has unique exemptions with differing amount, participant, disclosure, and filing requirements.
Ø Even Accredited Investor securities offerings require both federal and state Form D filings, and the payment of state filing fees, within 15 days after the sale.
Ø The penalties for violating the Securities Laws can be severe, including (a) return of the entire investment amount, (b) fines of up to three times of the investment amount, and (c) “cease and desist” orders against the promoters or developers.
Ø Thus, when offering or issuing any LLC Interests, (a) assume all LLC Interests are securities, and (b) consult with a securities attorney to assist on complying with the Securities Laws.
- OVERVIEW OF THE SECURITIES LAWS AND LLCs
Both the federal and state securities laws (“Securities Laws”) define “securities” extremely broadly. The express definition includes notes, stock, warrants, options, and any number of other investment contracts and agreements. In addition, the courts have found a “security” to exist where a person (a) is investing money or other property, (b) is not personally involved in the LLC’s business, and (c) is therefore relying on the efforts of others to provide a financial return. Every security sold in the United States either must be registered with the SEC or qualify for a federal exemption from registration. In addition, the securities either must be registered or exempt from registration in each state in which each potential investor lives.
Limited liability companies (“LLCs”) are a relatively new, hybrid form of entity that combines the pass-through tax treatment of partnerships with the owner liability protection provided by corporations. LLCs have relatively few statutory requirements, compared to the extensive laws governing corporations. For this reason, LLCs may be structured so that the economic and control relationships of the members mirror those found in (a) a general partnership, (b) a limited partnership or corporation, or (c) most commonly, somewhere on the continuum between them. For tax reasons, LLCs are generally the entity of choice for investing in and holding real property.
The flexibility and customizability of the relationships between LLC members are often cited as greatest advantages of using the LLC structure. In the securities context, however, that flexibility can cause the LLC to run inadvertently afoul of the Securities Laws. If there is only one member, who does not plan to accept other members or take investments from outsiders, the LLC Interests should not be considered a “security”. However, for multi-member LLCs, the LLC Interests generally meet one of the definitions of a security. The only exception is if all of the members are all actively involved in running the LLC or its business (mirroring a general partnership), in which case their LLC Interests generally would not be considered securities at that time. Unfortunately, once any original or subsequent member is not actively involved in the LLC’s business, or an LLC Interest are sold to someone not active in management, then the LLC Interests owned by that person would most likely turn into securities under the Securities Laws.
LLCs can be managed by either the members themselves or by a manager designated by the members. However, simply designating an LLC as “member-managed” will not absolve the LLC of compliance with the Securities Laws if, in fact, all of the members do not actively participate in the LLC’s management. In addition, as time passes, members who were initially active in the LLCs management may become passive investors. Subsequent investments by those members, or by other passive investors, will constitute the purchase of securities. Even the issuance of LLC Interests to employees as additional compensation may well constitute an offering of securities if that employee does not function in a managerial capacity.
Thus, given the availability and relative ease of qualifying for exemptions from registration as a security, it rarely makes any sense to make entity-structuring decisions solely for the purposes of avoiding compliance with the Securities Laws.
- WHY AM I READING THIS MEMO? I’M INVESTING IN REAL ESTATE, NOT SECURITIES, RIGHT?
The traditional sale and purchase of real estate by more than one person, with each of the purchasers holding a direct ownership interest in the real estate, is not subject to the Securities Laws. However, where an LLC owns the real estate, the persons who own LLC Interests do not have any legal right to the real estate owned by the LLC. On the other hand, as discussed above, LLC Interests may not be considered securities if the LLC is member-managed and all members have (a) a say in the management of the LLC and the property in proportion to their LLC Interests, (b) proportionate allocations of profits and losses, and (c) the right to proportionate distributions from the LLC. This arrangement is typical of many LLCs formed by a small number of members, who already know each other, to purchase residential real estate.
In contrast, in a typical commercial real estate investment LLC, the non-management investors have almost no right to vote except on whether to dissolve the LLC, and sometimes, but not always, on management’s proposal to sell the property. Economically, the investors generally have the right to receive specific “preferred” distributions from the LLC. Preferred distributions generally equal the return of their original investment, plus a specified percentage, before the manager starts receiving distributions. In exchange, the investors don’t share in any additional profits over the preferred return amount, which are retained by the managers. This arrangement is functionally the equivalent of a loan from the investors to the LLC without a promissory note, which qualifies them as securities. For this reason, the Washington Securities Division is specifically watching for non-compliant offerings by commercial real estate LLCs.
Recently, “Tenant-In-Common” (TIC) arrangements have become a popular commercial real estate financing vehicle designed in order avoid application of the Securities Laws. In a TIC arrangement, the investors each purchase a percentage of direct ownership in the real estate as joint owners, but then designate a property management company, which is usually a company related to the developer, to manage all of the property’s affairs and make distributions of profits according to a TIC Agreement. TIC Agreements are similar to investment LLC Agreements in that the purchasers have almost no rights beyond voting on the sale of the property, and are therefore actually passive investors. For this reason, many states, including Washington, have passed regulations making TIC arrangements subject to the Securities Laws.
The penalties for violating the Securities Laws can be severe. They potentially include (a) being required to return all of the non-active members’ investments (i.e. rescission), (b) penalties to the government of up to three times of the investment amount, and (c) “cease and desist” orders against the active members which will have to be disclosed in any future fund raising efforts.
Luckily, there are many exemptions from the registration requirements of the Securities Laws available and qualifying for them is generally not prohibitively difficult or costly. On the other hand, there are no exemptions from compliance with the “anti-fraud” provisions of the Securities Laws. Those laws require the Company to provide potential investors with sufficient material information about the Company and the investment opportunity that the potential investor is reasonably able to make an informed investment decision. Therefore, in most circumstances, all potential investors should be provided with a written package of all information pertinent to the offered investment in the LLC, before they invest.
Generally, investors only file a lawsuit for rescission or make an administrative complaint when they receive less return than they expected, or lose their entire investment. However, real estate promoters or developers are generally very optimistic, and always believe that their deal will succeed; otherwise they would not pursue the project. For this reason, at the beginning of the investment, the penalties for violating the Securities Laws do not feel very threatening to the promoter or developer. Unfortunately, when things go wrong, it is frequently for reasons the promoters or developers did not predict or could not control. Regardless, the regulators or disappointed investors may seek remedies and penalties against the LLC, and sometimes against the promoters or developers personally, for technical filing failures that may have little to do with the reasons for the economic situation. Unfortunately, if rescission or penalties are sought, it usually will be when you and your LLC (“Company”) can least afford to fulfill the demands.
- HOW DO I SELL SECURITIES WITHOUT REGISTERING THEM WITH THE SEC?
Registering securities with the SEC is prohibitively expensive and time consuming unless your company is ready to become a public reporting company. For this reason, most LLC investments are made in reliance on federal and state exemptions from registration. You should hire a securities attorney, well before accepting an investor’s money, to identify the available exemptions and to prepare any necessary disclosure documents and exemption filings. The following is a very brief discussion of the most commonly used federal exemptions.
Regulation D – Generally. Many private offerings of securities (i.e. “private placements”) in the United States are done in reliance on Regulation D of the federal Securities Laws. This is because Regulation D (a) provides fairly bright line rules for compliance, and (b) if an investor sues or files an administrative complaint, the investor has the burden of proving that the Company did not comply with its rules.
A short notice, called a Form D, must be filed with the SEC (and with each state in a Rule 506 offering), within fifteen days after the first “sale” of securities under Regulation D. However, failure to file on time may not affect the availability of the exemption if a good faith effort to comply is made. Your acceptance of subscription funds triggers the filing requirements, even though you have not yet “closed” the offering. To avoid timing problems, we advise have the Form D filed on the date that the offering package is finalized.
Rule 506 Offerings. Rule 506 of Regulation D is the most popular exemption because you can raise an unlimited amount of funds from an unlimited number of “Accredited Investors” (discussed below) so long as:
(a) no non-accredited investors are accepted (unless audited financial statements and a public-company style disclosure document are provided, in which case there can be no more than 35 non-accredited investors);
(b) no “general solicitation” is used to attract potential investors to the offering.
Rule 504 Offerings. If you must include non-accredited investors in your offering (and you can’t comply with the information and audit requirements of Rule 506), then federal Rule 504 permits you to conduct an exempt offering under the following conditions:
(a) The offering amount is no more than $1 million in any 12-month period.
(b) No more than 35 non-accredited investors are permitted.
(c) No “general solicitation” may be used to attract potential investors to the offering, except under very limited specified circumstances.
Section 4(2) Offerings. If Regulation D exemptions are unavailable for some reason, the “non-public” offering exemption found in Section 4(2) of the federal Securities Act of 1933 (“Securities Act”), may be available. Section 4(2) permits the raising of unlimited funds without registering the securities with the SEC. Unfortunately, Section 4(2) says only that a “transaction not involving any public offering” is exempt from the registration requirements of the Securities Act, leaving the requirements for the Section 4(2) exemption uncomfortably vague and uncertain. In addition, if an investor sues or complains, the Company, not the investor, has the burden of proving that it complied with Section 4(2).
The case law and SEC guidance are, not surprisingly, inconsistent. Viewed most restrictively, Section 4(2) requires that each person to whom the securities are offered (and not just the actual purchasers), be “sophisticated investors”, i.e. they have substantial financial means, have access to adequate information regarding the proposed investment, and are capable of evaluating the merits of the investment. There is also an ill-defined limit (perhaps thirty-five or fewer) on the maximum number of offerees. The greater the number of offerees over just a handful, the more likely it is that the offering may not comply with Section 4(2). Also, like Regulation D, no “general solicitation” may be used to attract potential investors to the offering.
Despite its lack of clarity, the Section 4(2) exemption is a very useful fallback exemption where there are a limited number of founders and/or investors who are sophisticated, or if an intended Regulation D offering fails to qualify for some reason.
- ARE THERE STATE REGISTRATION REQUIREMENTS?
The requirements for Rule 506 offerings, at the state level, are all the same, due to having been pre-empted by federal law, although each state may charge a fee for filing the Form D. However, offerings made under federal Rule 504 or Section 4(2) are not pre-empted by federal law, and must therefore qualify under various state “limited offering” exemptions.
State limited offering exemptions often contain significantly different requirements as to the maximum offering amount, number and type of purchasers, limitations on commissions, and filing requirements. Certain states also have unique requirements regarding net worth, income, or sophistication standards for investors. In addition, state exemptions may require filing of an exemption notification either before or after the date of first sale of the securities in the state. For example, Washington has a Rule 504 equivalent exemption, however, no more than 20 non-accredited investors are permitted, and the Form D must be filed at least 10 days before the first offer or sale to a Washington resident, along with a small filing fee.
For those reasons, before you first make an offer (not sale) in any state, you should advise us where your potential investor lives as soon as possible. This will permit us to research the applicable state exemptions, make any required regulatory filings, and add to the offering package any legends required by those state’s Securities Laws. Failure to do so may violate the state’s Securities Laws and give the investor a right to rescission or money damages.
As part of the offering documentation, we will prepare a state‑by‑state analysis summarizing the requirements of each available state exemption. You will need to confirm that you intend to make offers in no other states, unless you let us know before doing so. However, while the securities exemption memorandum summarizes the most important requirements of the listed states, each state may have unique definitions or interpretations regarding such things as what constitutes an offer, or who is deemed to be a broker or dealer, that are not discussed. If you have any questions regarding the requirements of any state, please contact us.
- CAN I ADVERTISE THE OFFERING IN THE PAPER OR ON THE INTERNET?
Both Regulation D and Section 4(2) prohibit the Company, or any person acting on its behalf, from offering or selling securities by any form of “general solicitation or general advertising.” For example, the Company cannot advertise in the paper, engage in a mass mailing, conduct informational meetings with potential investors, or issue a press release that discusses the existence of the offering, until after the offering has been concluded and all sales to investors have been finalized. A conservative interpretation of the SEC’s view is that all potential investors should be people with whom the Company, its directors, officers, or full-time employees have a pre-existing personal or business relationship.
Unfortunately, that interpretation does not come close to the reality of information flow in today’s world. Several years ago, the SEC begun permitting offerings conducted through the Internet, but only to accredited investors that are qualified through a web portal, and a waiting period expires, before receiving any information about the offering. In addition, the recently adopted federal JOBS Act requires the SEC to adopt regulations permitting general solicitation in offerings that are limited to accredited investors. However, these regulations are still in proposed form and the final version is yet to be seen.
- WHO CAN BUY THE SECURITIES?
Under federal Regulation D, securities can be sold to an unlimited number of accredited investors but no more than 35 non-accredited investors (subject to the information requirements of Rule 506). However, in some states, the number of non-accredited and/or total investors may be far less, depending on the requirements of the specific exemption. The Company should require a detailed Investor Qualification Questionnaire from each potential investor in order to reasonably rely on proposed investors’ assertions that they are accredited.
Accredited Investors. Whether an investor is considered “accredited” depends on the investor’s classification and whether the investor meets the requirements for that classification. Individuals (rather than entities) qualify as accredited investors if they satisfy any one of the following standards: (1) have a net worth (with their spouse) in excess of $1 million not including their personal residence, or (2) individual income for the past two years and a reasonable expectation of income for the current year of at least $200,000 (excluding spouse), or (3) joint income with their spouse of at least $300,000, for the past two years and a reasonable expectation of such income for the current year. Directors and executive officers of the Company also are classified as accredited investors.
There are different requirements for corporations, partnerships, trusts, and non-profit organizations to qualify as accredited investors. Generally these entities will be accredited investors only if: (1) all of the equity owners are accredited investors (not available for trusts) , or (2) the entity has assets (as distinguished from net worth) in excess of $5 million, and was not formed for the purpose of making the investment. Employee benefit plans are accredited investors only if: (1) the investment decision is made by a plan fiduciary, a savings and loan association, bank, insurance company, or registered investment advisor, (2) the plan has total assets in excess of $5 million, or (3) a self-directed employee benefit plan where its investment decisions are made solely by one or more individuals who are accredited investors. Finally, an IRA benefiting an accredited investor also is an accredited investor.
Non-Accredited but Sophisticated Investors. Investors who do not qualify as accredited investors are referred to as a “non-accredited investors”. Under Regulation D, you may sell to non-accredited investors only if each non-accredited investor, either alone or with a purchaser representative, has sufficient knowledge and experience in financial and business matters that the potential investor is capable of evaluating the merits and risks of the proposed investment. This is generally analogous to the “sophisticated” investor requirements under the court rulings in connection with Section 4(2).
- WHO CAN SELL THE SECURITIES?
Under Securities Laws, both the Company and any individuals involved in the selling process must either register, or be exempt from registration, as a broker-dealer, if they receive a commission. Broker-dealer exemptions vary from state to state and often do not parallel federal exemptions. Therefore, even if a federal broker‑dealer exemption is available, there may be a different or no comparable state exemption.
In order to avoid registration as a broker-dealer, many financial consultants will locate investors in exchange a flat “consulting” fee, which is due whether or not the offering closes. This is not as common in real estate investments as it is in operating companies.
Many (but not all) states exempt issuers and their employees who sell their own securities in an exempt transaction, provided that (a) they are not engaged in the business of effecting transactions in securities, (b) they receive no sales compensation or commission for their sales activities, and (c) they have substantial duties for the Company other than the sale of its securities.
- HOW DO I SATISFY THE DISCLOSURE REQUIREMENTS?
Disclosure Requirements. The Securities Laws require the Company to provide all potential investors with full, fair, and complete disclosure of all “material” facts about the offering and the Company, its management, business, operations, and finances. However, materiality is a difficult concept to define precisely. Generally, information is material if a reasonable investor would consider the information important in making an investment decision. At a minimum a fact is “material’’ if you are reluctant to disclose the information out of fear that if the investors know about it they would not buy the securities.
Facts which are disclosed must be developed fully. For example, you cannot state that the Company owns a manufacturing facility and not disclose that the building is uninsured, has been hit by lightning, or has been condemned by the health department. At a more subtle level, you cannot state that the Company owns a building and not disclose that the property is subject to a mortgage, a fact that does not conflict with ownership but does affect the economic value and other attributes of real estate ownership.
For offerings that accept non-accredited investors under Regulation D, the Company must provide substantially the same information as required in a public offering prospectus, including audited financial statements. However, audited financial statements are not required if (a) the investors are required to be accredited, or (b) the offering is being conducted under Rule 504 and certain other conditions are met. For this reason, most private placements under Rule 506 are limited to accredited investors.
In all cases, the Company must comply with the “antifraud” provisions of the Securities Laws. For securities law purposes, fraud is a much broader concept than you might think, including omissions in disclosure (sometimes even unintentional ones) rather than just deliberate misrepresentations. Regardless of whether you intend to defraud an investor, you will be liable if you fail to disclose a material fact. For example, information related to sensitive areas such as risk factors, conflicts of interest, source and use of funds, compensation and other ownership and benefits to management and promoters, and other business information must be disclosed. Failure to comply with these provisions can result in the imposition of money damages against the Company and potentially against its managers and any others associated with the offering, personally.
Disclosure Documents. We provide assistance to the Company in drafting the offering package so that it complies with the disclosure requirements and antifraud provisions of the Securities Laws. While we assist with the drafting the offering package, and will review and comment on the parts prepared by the Company, the accuracy of the offering documents generally are the Company’s responsibility. You must be satisfied that the disclosures are balanced, set forth all the material pros and cons, and take all material facts and circumstances into consideration.
The offering package functionally serves two purposes that are inherently in conflict with each other. First, it may serve as a marketing tool to sell the securities. Because selling the securities is your primary goal, your tendency will be to create an offering package that describes the Company in an overly positive way. The offering package, however, also is a document that protects you from being sued by disappointed investors and regulators if the investment is not successful. Because protecting you is our primary goal, our tendency will be to recommend as much disclosure to investors as possible, even if it causes the offering package to be a less effective marketing tool.
I always encourage clients to look at the offering package and filings under the Securities Laws as a type of insurance policy. The role of the offering package is to protect the Company from disgruntled investors’ claim that they did not receive adequate information to make an investment decision. However, the protective value of the offering package may be damaged severely or completely destroyed if any person involved in the selling effort makes oral or written representations different from those in the offering package. All sales presentations, both oral and written, should be governed by the content and general thrust of the offering package. This includes any transmittal letters to investors and any deal summaries provided to them. I strongly recommend that summaries in any form, be passed by us before distribution to investors.
During the offering period, the offering package must be amended and updated to correct any inaccurate information, or to add any new material information that occurs with respect to the Company’s business, management, financial condition, or other matters. When in doubt, assume the changes are material and check with us. If the information is material, then you must circulate a supplement to the offering package which discloses the new or changed information.
- WHAT INFORMATION AND COMMITMENTS DO I NEED FROM THE INVESTORS?
The Company must have a reasonable basis for believing that each proposed investor satisfies the suitability standards stated in the offering package, and that the proposed investor understands the risks of the offering. Unfortunately, the Company generally has no way to make this determination, as that information can be provided only by the prospective investor.
The subscription documents for the offering generally contain an investor questionnaire designed to elicit this information and other appropriate representations from investors. Several important elements of qualifying for exemption from the Securities Laws (such as investor sophistication, investment intent, and ability to bear the economic risk of an investment) depend on facts that only the individual investor will know. The Company must ascertain and confirm these elements. That is why there are so many seemingly intrusive and personal questions in the subscription documents.
The Company or its attorney must carefully review the signed subscription documents to confirm (a) that they are completely filled out and internally consistent, and (b) that based on the investor’s representations in the subscription documents, and the Company’s personal knowledge of the investor, the Company has a reasonable basis for believing that the investor is suitable either as an accredited or sophisticated investor.
11.WHEN CAN THE INVESTOR SELL THE SECURITIES THAT THEY PURCHASED?
All securities sold in a Regulation D offering or under Section 4(2) are “restricted” securities, meaning that investors may not sell them without registration or another applicable exemption. In the securities purchase documents, the investors must represent that they (a) are purchasing the securities for investment purposes only, and (b) understand that the securities have no resale market and very limited transferability.
Restricted securities may not be resold for an indefinite period of time. For persons not closely associated with the Company that period is generally two years or more, and for insiders it may be far longer. Generally the Company should require a selling investor to provide an opinion from their attorney detailing the exemption upon which they are relying, and that opinion should be reviewed by the Company’s securities attorney.
- WHAT OFFERING PAPER TRAIL SHOULD I CREATE?
Before the offering begins, you should establish internal procedures and checklists that will make it easier for you to comply with the rules concerning the conduct of the offering and the information sent to, and received from, prospective investors. Only specifically designated persons should distribute the offering package, each copy of which should be numbered. Copies for internal use also should be numbered. A list of each person to whom the offering package is sent should be maintained and should indicate whether it is for internal use, bankers, purchaser representatives, lawyers, accountants, or specified investors. A file should be maintained for each potential investor containing accurate records of correspondence, meetings, phone calls, etc., to record what questions were asked, what additional material was provided, and what due diligence was performed to determine each investor’s accreditation.
After the offering closes, the Company should maintain a complete set of the offering materials, including all signed subscription documents, as that information will be essential if the securities exemption ever is challenged. The absence of appropriate written records may make it impossible for the Company to defend itself successfully against a future exemption challenge. Furthermore, the more information provided by the investor in writing, the better able the Company will be to later defend its exemption.
We know that the securities laws can be complex and often seem overly burdensome and complex when applied to investing in real estate. However, the importance of doing so is clearer if you think of securities law compliance as a form of insurance. You would not dream of start construction without having your contractor’s bond and liability insurance in place to protect you from unexpected events. In the same way, the time and money you spend on obtaining good offering documents and the necessary exemption filings will go a long ways towards protecting you from the potentially severe consequences of a securities lawsuit or administrative action.
This is an exciting process, and we would be pleased to assist you with it!
Eugenie Rivers – Securities / Real Estate Attorney
Eugenie Rivers at Cairncross
Advocates Law Group
 While a number of states have now added LLC ownership interests to their express definitions of “securities”, the federal securities laws, and many state securities laws, do not. However, under several court-developed interpretations of the Securities Laws, there is currently no doubt that many, if not most LLC Interests are securities, and are therefore subject to the Securities Laws.
 If for some reason it is important that the LLC Interests in a multi-member LLC not be considered securities, the LLC Agreement should expressly require all members to actively participate in management, forbid the admission of passive investors in the future, and require any member who becomes inactive to sell their LLC Interests to the Company or the active members.
 Commercial real estate includes multi-family complexes of five units or more, and construction of residential developments.
 This informational package can be referred to as private placement memorandum (PPM), an offering memorandum or package, or the disclosure documents. The required level of detail will depend on a number of variables, including which exemptions from registration is being relied on, and the sophistication of the potential investors.
 Theoretically, if an offer is made to even one “unsuitable” investor, i.e., an investor who is unsophisticated or without “access” to information, the Section 4(2) exemption may be unavailable for the entire offering. Rule 506, on the other hand, primarily deals with actual purchasers of the offered securities, so may still be available if a prohibited offeree does not actually purchase the security.
 New York is the only state that does not comply with the federal pre-emption of Rule 506 offerings, on the basis that it regulates the issuing companies as broker-dealers, and not the securities being offered in the Rule 506 offering. New York considers the sale of interests in a real estate investment LLC to be “real estate syndications” requiring the approval of substantial documentation and filing fees of over $3,000 before closing the investment from even one New York investor.
 The federal antifraud provisions arise primarily from Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as well as Section 12(2) of the Securities Act. These provisions collectively prohibit any person, in connection with the purchase or sale of any security, from misrepresenting or omitting a material fact or engaging in any act or practice that constitutes a “fraud” or deceit upon any other person.
REAL ESTATE ATTORNEY