Is a TIC a security?

TIC refers to Tenancy in Common, not the blood-sucking insect. A TIC is a completely legal way of owning real estate that has been around for hundreds of years. When one of the parties owning real estate dies, that ownership interest passes to that owner’s heirs. The alternative is joint tenancy, in which case when the part owner dies, the remaining owners get that ownership interest. If you’re married, you probably own your home in a joint tenancy. (There is also a tenancy by entirety for married couples that operates like a joint tenancy, but also limits the sale of an interest without your spouse’s consent.)

There is a market for TICs in commercial real estate because of Section 1031 of the tax code that allows for tax-deferred exchanges. If you sell commercial real estate and don’t want to pay taxes immediately on the gain, you can buy a replacement piece of real estate and defer the gain. The problem is finding a replacement and finding one at an equivalent price. Fractional TICs were developed allowing an owner to more easily achieve tax-deference.

The problem with TICs has always been avoiding the treatment of the interest as a security. This goes back to the Howey definition of a “investment contract” as “investment in a common enterprise with the expectation of profit to be derived through the essential managerial efforts of someone other than the investor.”

For a fractional TIC, there is a common enterprise. The investor’s ownership interest is combined with the other fractional owners. There is an expectation of profit. Given that the real estate needs to be managed, there is generally some sponsor exerting some level of control over the real estate on behalf of the TIC owners. A lessee does not want to have to negotiate of dozens of TIC owners when entering into a lease.

The key is giving the TIC owners enough control so that they are not solely relying on the “managerial efforts of others” for the real estate investment to be successful.

Many TIC investments involve real estate with a long lease to a credit tenant. So even though the TIC owners have a say in management, there is little management that needs to be done.

One of the dangers to the sponsor is that the TIC owners will claim that the TICs are securities, giving the TIC owners additional right, if the investment goes south.

That is what happened in the Highwoods case in Durham, North Carolina. NNN Realty bought a property, largely leased to a credit tenant and set up a TIC syndication.

To avoid the treatment of the TICs as securities, the affiliated agreements granted some control to the TIC owners. The Management Agreement for the Durham Property gave the TICs the ability to hire and fire the property manager, the leasing agent, and the asset manager. It also allowed the TICs to control the Durham Property’s expenditures by approving budgets. However, firing the asset manager, an affiliate of the sponsor, involved paying expenses and would trigger a default under the mortgage loan.

The TIC owners claim that they were induced to purchase interests in the Durham Property by materially false statements or omissions in a private-placement memorandum concerning the probability that the Durham Property’s primary credit tenant would renew its leases. The primary credit tenant’s leases were critical to the Durham Property’s value, as demonstrated when that tenant later terminated its leases and the Property went into foreclosure.

The lawsuit was filed in North Carolina so the challenge to the TICs as securities was based on North Carolina law.

North Carolina’s Rule 06A.1104(8)(a) requires both a “common enterprise” and “the expectation of profit to be derived from the essential managerial efforts of someone
other than the investor.” “Essential” management does not necessarily connote “exclusive” management. 18 N.C. Admin. Code 06A.1104(8)(a) (emphasis added). Rule 06A.1104(8)(b) does not expressly require a “common enterprise,” but it contemplates a scenario where at least a portion of the value provided by the investor is subjected to the risk of an enterprise in which the investor “does not receive the right to exercise practical and actual control over the managerial decisions of the enterprise.”

The PPM stated as a risk-factor on reliance on management:

[a]ll decisions regarding management of the Company’s affairs . . . and the management of the Property, will be made exclusively by the Manager, the Property Manager and their Affiliates, and not by any of the Members or the Purchasers. Accordingly, no person should purchase LLC Units unless that person is willing to entrust all aspects of management of the Company to the Manager and management of the Property to the Property Manager.

The court realized that the documents around the ownership of the TIC gave the TIC more control than that risk factor warns.

The court looked to SEC v. Merchant Capital, LLC  (483 F.3d 747) involving the treatment of general partnership interests as investment contracts under the federal securities laws. That court came up with six factors that would make a general partnership interest more like a limited partnership interest or investment contract:

(1) the partners’ ability to elect the managing general partner was not meaningful, because the vote had to be made at the time of investment, and the promoter was the only nominee;

(2) the limitation on removing the managing general partner for cause by unanimous vote effectively meant that the managing general partner could not be removed;

(3) the various investors were geographically diverse and had no meaningful opportunity to develop relationships;

(4) the investors’ potential liability was limited to the amount that each investor invested, with no vicarious liability for the acts of other investors;

(5) the right to approve expenditures, while facially significant, was diluted by the managing general partner’s ability to control information;

(6) the investors had no particular expertise in the business in which they invested.

The NNN court found these factors instructive and ruled the TIC interests could qualify as securities. The court denied the summary judgment on this issue request by the sponsor.

On appeal, the North Carolina Secretary of State and the North American Securities Administrators Association want the appellate court to rule that the TICs are securities in this case.

So clearly, TICs can be securities.