When Is an Interest in a California Real Estate Syndicate a “Security” Under State and Federal Laws?
Real estate syndicates in California offer investors a way to invest in real estate projects under the management of a syndicator, also known as a sponsor. The syndicate itself may use one of several different business forms under California law, such as a corporation or a limited partnership.
The individual investors own a portion of the syndicate. This raises an important question about state and federal securities laws: do investments in a real estate syndicate constitute “securities,” which might place them under the jurisdiction of state and federal securities regulators?
The rather complicated answer is that it depends on various factors, including how the syndicate was formed and the role of the investors in its ongoing operations. Determining the answer requires a careful and thorough review.
What is a “security?”
At the federal level, the Securities Act of 1933 regulates the offer, issuance, and sale of securities to the public. It defines “security” to include not only stocks, bonds, futures, and options, but also a wide range of “investment contracts” and other financial transactions.
California’s Corporate Securities Law of 1968 defines “security” in much the same way. It also adds provisions that exempt certain membership interests in limited liability companies (LLC) when the investors are “are actively engaged in the management of the limited liability company.”
What is a “syndicate?”
Neither California nor federal laws provide a distinct legal definition of a “syndicate” in the context of real estate investments. The California Legislature repealed the Real Estate Syndicate Act in the 1970s. At the same time, it amended the Corporations Code to allow licensed real estate brokers to sell interests in certain types of real estate investments without registering with state securities regulators. Since 1978, the Department of Corporations has had jurisdiction over the offering and sale of real estate syndicate interests.
When is a syndicate interest a security?
In 1946, the U.S. Supreme Court decided Securities and Exchange Commission v. Howey Co. The case involved a company that owned multiple citrus groves. In order to finance new developments, the company sold parcels of land to investors and then encouraged them to lease the land back to an affiliated service company to maintain and harvest the produce. Rather than marketing to individuals or businesses with knowledge of and experience in local agriculture, the company targeted investors from out of state, who lacked the skills to maintain the land on their own.
The Supreme Court held that this was an “investment contract” under the Securities Act, finding that this was a situation in which “individuals were led to invest money…with the expectation that they would earn a profit solely through the efforts of…someone other than themselves.” The investors who bought land from the company were not interested in joining the citrus farming business. Instead, the court said, “they are attracted solely by the prospects of a return on their investment.”
The situation described by the Supreme Court can also be found in some real estate syndicates. When investors who lack any particular expertise in real estate development or management entrust their money to a syndicator, with no intention of participating in the real estate project, this arguably constitutes an investment contract under federal and state laws. The investor’s interest would therefore be a “security.”
If you are interested in putting together a real-estate syndicate in California or elsewhere, it is important that you engage an attorney well versed in the relevant state and federal securities laws, who has experience with real-estate syndicates.
More Blog Posts:
FINRA Arbitration of Disputes Related to Real Estate Syndicates, Titles and Deeds, May 2, 2017
Organizing a Real Estate Syndicate and Securities in California, Titles and Deeds, April 25, 2017
Why Should I Invest in Real Estate? Titles and Deeds, March 10, 2017