The same is true for small businesses and other entrepreneurs. Some require more startup or growth capital than others; but the fact remains that just about every business or entrepreneur will need to raise capital, through one means or another, at some point in time.
What do the professional real estate investor and other small businesses and entrepreneurs have in common?
First, neither will likely be able to borrow the capital they need from conventional sources such as banks.
Second, both will likely need to work with private investors to raise capital.
The Securities and Exchange Commission (SEC) regulates that which are known as “securities.” The legal definition of a “security” for SEC regulatory purposes is a bit verbose, convoluted, and sometimes not terribly clear. Thus, many different and diverse arrangements can constitute a “security.”
The most prevalent misconception of what constitutes a “security” that we encounter is the idea that as long as there is no “pooling of funds,” that is, no combining of funds from different investors, the securities laws don’t apply.
Although ordinary stocks and bonds constitute securities, the definition of a security is much broader and all-encompassing. A lesser-known form of security is what is known as an “investment contract.” A leading United States Supreme Court case has defined an investment contract as “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party. . . .” SEC v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946). More recently, the Supreme Court stated that an investment contract is “an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” United Housing Foundation v. Forman, 421 U.S. 837 (1975). In United Housing, the word “solely” was conspicuously omitted from the definition of a security.
In an opinion that is recognized and cited nationwide, the United States Court of Appeals for the Fifth Circuit (which is composed of Louisiana, Mississippi and Texas) held that an interest in a Limited Liability Company (LLC) or an interest in a partnership is an investment contract (e.g., a security) if the investor was dependent on the promoter and could not exercise meaningful control. Examples include where the: (i) managing partner cannot be replaced or is very difficult to replace, (ii) investors are inexperienced in business affairs and cannot exercise their abilities to participate in management, or (iii) promoter has unique managerial abilities which cause de facto reliance on the promoter. Williamson v. Tucker, 645 F.2d 404 (5th Cir 1981).
The U.S. Supreme Court’s decision in Howey and United Housing, and the Fifth Circuit’s decision in Williamson, are and remain correct statements of the law. Thus, we see that even if the pooling of funds is relevant to a determination of whether a financing arrangement constitutes a security, it is not a necessary element of a security. In other words, it is clear that a security can exist even if there is no pooling of funds.
Thus, we learn from Howy and Williamson that the real estate investor, as well as the small business or other entrepreneur, who uses “other people’s money” is engaging in activity that implicates the securities laws. That’s the bad news.
The good news is that there are several exemptions to the securities law that often can be used to the benefit of a real estate investor, small business or other entrepreneur. At Lapin Law Offices, we can often assist a client in taking advantage of an appropriate exemption.
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Disclaimer: The information contained in this publication is provided by Lapin Law Offices, P.C., for informational purposes only and, shall not constitute legal advice or create an attorney-client relationship. The laws and interpretation of laws discussed herein may not accurately reflect the law in the reader’s jurisdiction and/or may not reflect current law. Do not rely on the information contained in this publication for any purpose. If you have a specific legal question, please consult with an attorney in your jurisdiction who is competent to assist you.