Previously, I went through the analysis that a fund manager is considered an investment adviser. But left open the question of “what is a security?” That’s a key question for fund managers with alternative investments, like real estate.
The Investment Advisers Act gives a very broad definition of a security:
any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security (including a certificate of deposit) or on any group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guaranty of, or warrant or right to subscribe to or purchase any of the foregoing. [202(a)(18)]
What’s missing from that definition is hard assets (collectibles, like baseball cards), futures contracts relating to commodities (but not future contracts relating to securities), and real estate (but not shares in real estate companies).
Pure bricks and mortar are not securities. So private equity funds that invest directly in hard real estate assets are not giving advice regarding securities. As you start adding additional levels of ownership and holding companies, things get a bit grayer as you have more and more organizational boxes between the fund and the real estate.
One of the early seminal Supreme Court cases on the definition of a security involved a real estate deal. In 1946, SEC v W.J. Howey Co. (328 U.S. 293) involved an offering of units of a citrus grove development, coupled with a contract for cultivating, marketing, and remitting the net proceeds to the investor. They held that it was an offering of an “investment contract” within the meaning of that term as used in the provision of § 2(1) of the Securities Act of 1933 defining “security” as including any “investment contract,” and was therefore subject to the registration requirements of the Act.
For purposes of the Securities Act, an investment contract (undefined by the Act) means 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, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.
There are three components:
- expectation of profits
- a common enterprise
- depends “solely” for its success on the efforts of others.
So passive investments, where investors do not have any decision-making power are securities. Investments made by the principals who are actively involved in the management of the enterprise are not securities. Of course, that leaves a whole lot of business arrangement in between.
Shares of stock in a corporation do not have enough involvement to get them out of the characterization of securities. Most real estate is owned in partnership or partnership-like entities to take advantage of some favorable tax treatment. There is an expectation of profits and it’s going to be a common enterprise. That leaves the “success on the efforts of others” as the key test for investment entities.
Traditionally, limited partnership interests are generally securities because limited partners rely on the general partners to manage the partnership. Since Delaware and other states have given limited partners to have more power in the management of the partnership and still retain their liability shield, the analysis has gotten harder.
For a general partnership, those interests are generally not securities because they fail to satisfy the “solely from the efforts of others” part of the test. Usually all general partners have decision making power with respect to the affairs of the partnership.
Limited liability company interests are tougher to make a general statement. If the LLC is member-managed, then each member is involved in management of the enterprise and therefore their interests would generally not be securities. On the other hand, if the LLC is manager-managed, then members are may be just passive investors, and their LLC interests are more likely to be securities.
When it comes to real estate joint ventures, the managing interest is not going to be a security. The non-managing interest is more likely to be a security.
Notes, debt, and debt-to-own interests are likely to be considered securities. You can see notes listed right in the definition of securities. Given the continuing distress in the real estate debt markets, many fund managers are looking at buying distressed debt instead of pure bricks and mortar. That’s going to push them into the role of giving “advice about securities” and force them to look at registration as an investment adviser.
Deal structure may influence the analysis. It’s common in some jurisdictions to structure the transaction as a sale of interests in the owner of the real estate instead of a sale of the asset itself. That transaction structure could be viewed as a sale of securities, instead of a sale of real estate.