Securities Issues in Real Estate Investments

J. Mitchell LittleScheef & Stone, LLP

DBA Real Property SectionFebruary 9, 2009

Text Message Transcript with Licensed RE Broker

Broker: Hey. U got some $$$ to invest?Mitch: In what?Broker: Apt. Complex in College Station.Mitch: U r breaking securities laws.Broker: Is not security.Mitch: Yes, it is.Mitch: This is my job, dude.Broker: No. U don’t know what ur talking about. Mitch: How much do you want?Broker: $25000.Mitch: What is the structure?Broker: LP.Mitch: Are u getting a commission on this?[Five-minute gap or so.]Broker: There’s only a few investors. Mitch: Doesn’t matter.Broker: Can’t u just say no?

The Statutes We Care About

The Securities Act of 1933 (15 USC §77a, et seq.)

The Securities Act of 1934 (15 USC §78a, et seq.)

The Texas Securities Act (Tex. Rev. Civ. Stat. Title 19, Art. 581)

Texas State Securities Board Rules (Tex. Admin. Code, Title 7, Part 7)

Section 4(A) of the TSA reads:The term "security" or "securities" shall include any

limited partner interest in a limited partnership, share, stock, treasury stock, stock certificate under a voting trust agreement, collateral trust certificate, equipment trust certificate, preorganization certificate or receipt, subscription or reorganization certificate, note, bond, debenture, mortgage certificate or other evidence of indebtedness, any form of commercial paper, certificate in or under a profit sharing or participation agreement, certificate or any instrument representing any interest in or under an oil, gas or mining lease, fee or title, or any certificate or instrument representing or secured by an interest in any or all of the capital, property, assets, profits or earnings of any company, investment contract, or any other instrument commonly known as a security, whether similar to those herein referred to or not. The term applies regardless of whether the "security" or "securities" are evidenced by a written instrument. Provided, however, that this definition shall not apply to any insurance policy, endowment policy, annuity contract, optional annuity contract, or any contract or agreement in relation to and in consequence of any such policy or contract, issued by an insurance company subject to the supervision or control of the Texas Department of Insurance when the form of such policy or contract has been duly filed with the Department as now or hereafter required by law.

Tex. Rev. Civ. Stat. Title 19, Art. 581-4.

What is a security?

An “investment contract” is:

1. An investment of money;2. In a common enterprise;3. With an expectation of profits;4. To be derived solely from the

efforts of others.

Caldwell v. State, 95 S.W.3d 563 (Tex.App.---Houston [1st. Dist.], 2002).

SEC v. W.J. Howey & Co., 328 U.S. 293 (1946).

This is the securities “catch-all” in an increasingly complex financial universe.

What is an “investment contract?”

1. Limited Partnerships

2. Limited Liability Companies

3. Tenant-in-Common (TIC) Transactions

4. True Joint Ventures

SUBSTANCE OVER FORM

Typical Structures/Syndication Methods

1. Limited Partnershipsa. Definitely a security under Section 4 of the TSA.b. Definitely an “investment contract.”

Typical Structures/Syndication Methods

2. Limited Liability Companiesa. Definitely a security under Section 4 of the TSA.b. Definitely an “investment contract.”

Typical Structures/Syndication Methods

3. Tenant-in-Common (TIC) Transactions a. Often used in 1031 Exchanges.b. High controversy.c. Unclear whether it’s a security under Section 4 of the TSA.d. Probably an investment contract.e. The SEC took the position on January 23, 2009 through a no-action letter that these are securities.

Typical Structures/Syndication Methods

4. True Joint Venturesa. Not securities. Russell v. French, 709 S.W.2d 312 (Tex.App.—Texarkana, 1986).b. Under Texas law, a joint venture is a general partnership. c. Is there common control?d. Can the joint venturers replace the person or sponsor who has managerial power?e. Is management delegated to someone else? f. Do the joint venturers even know who the others are?g. Detailed factual analysis is necessary to stay out of the “investment contract” rubric.

SUBSTANCE OVER FORM

Typical Structures/Syndication Methods

Section 12(A) of the TSA:Except as provided in Section 5 of this Act, no

person, firm, corporation or dealer shall, directly or through agents, offer for sale, sell or make a sale of any securities in this state without first being registered as in this Act provided. No agent shall, in behalf of any dealer, sell, offer for sale, or make sale of any securities within the state unless registered as an agent for that particular registered dealer under the provisions of this Act.

Tex. Rev. Civ. Stat. Title 19, Art. 581-12(A)

If you want to issue, offer or sell securities, you must register them and be registered yourself.

Federal and state registration is a lengthy and expensive process.

The expense and complexity associated with registered offerings have spawned a massive unregistered securities sub-industry.

The General Rule

Section 5(I) of the TSA:Except as hereinafter in this Act specifically provided, the

provisions of this Act shall not apply to the sale of any security when made in any of the following transactions and under any of the following conditions, and the company or person engaged therein shall not be deemed a dealer within the meaning of this Act; that is to say, the provisions of this Act shall not apply to any sale, offer for sale, solicitation, subscription, dealing in or delivery of any security under any of the following transactions or conditions: [ . . .]

I. Provided such sale is made without any public solicitation or advertisements:

(a) the sale of any security by the issuer thereof so long as the total number of security holders of the issuer thereof does not exceed thirty-five (35) persons after taking such sale into account;[ . . . . ]; or

(c) the sale by an issuer of its securities during the period of twelve (12) months ending with the date of the sale in question to not more than fifteen (15) persons (excluding, in determining such fifteen (15) persons, purchasers of securities in transactions exempt under other provisions of this Section 5, purchasers of securities exempt under Section 6 hereof and purchasers of securities which are part of an offering registered under Section 7 hereof), provided such persons purchased such securities for their own account and not for distribution.

Tex. Rev. Civ. Stat. Title 19, Art. 581-5I.

Exemptions from Registration

Section 5(T) of the TSA:T. Such other transactions or conditions as the Board by rule, regulation, or order may define or prescribe, conditionally or unconditionally.

Tex. Rev. Civ. Stat. Title 19, Art. 581-5T.

(k) Uniform limited offering exemption.

In addition to sales made under the Texas Securities Act, §5.I, the State Securities Board, pursuant to the Act, §5.T, exempts from the registration requirements of the Act, §7, any offer or sale of securities offered or sold in compliance with the Securities Act of 1933, Regulation D, Rules 230.505 and/or 230.506 [ . . .]

Vastly simplified:(1)Accredited investors;(2)No commissions to unlicensed brokers;(3)No public solicitation;(4)File SEC Form D correctly.

Exemptions from Registration

Two Competing Notions:1. Any cold call is a public solicitation.

(SEC, Texas SSB)Tumbleweed Bowling Corp. v. P.T. Matise, 388 S.W.2d 479 (Tex.Civ.App. Beaumont 1965, reh. denied).In Tumbleweed Bowling, the controlling facts in leading the Court to hold that the defendant engaged in public solicitation in selling stock were:

(1) he did not know the purchasers before he contacted them; and

(2) that he would have continued talking to people until he sold all $150,000 of the stock in question.

What is public solicitation?

Two Competing Notions:2. There needs to be a closer review of

the solicitation. (Issuers)Sibley v. Horn Adveritising, Inc., 505 S.W.2d 417 (Tex. Civ. App. 1974, reh. denied). In Sibley, the Court found that the offering was exempt from registration because:

(1) “An offering to those shown to be able to fend for themselves is a transaction ‘not involving any public offering.’”

(2) The investor was able to fend for himself because he was an experienced investor and had personal experience with the issuer in previous offerings.

What is public solicitation?

Is it a security under Section 4?

Is it registered under Section 12?

Is it exempt under Section 5?

A Simple Flow Chart

Yes.

No.

No.

Your investors get a rescission.

Section 33A(1) of the TSA: A person who offers or sells a security in violation of Section 7, 9 (or a requirement of the Commissioner thereunder), 12, 23C, or an order under 23A or 23-2 of this Act is liable to the person buying the security from him, who may sue either at law or in equity for rescission or for damages if the buyer no longer owns the security.

Rescission

Section 33A(2) of the TSA: A person who offers or sells a security (whether or not the security or transaction is exempt under Section 5 or 6 of this Act) by means of an untrue statement of a material fact or an omission to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading, is liable to the person buying the security from him, who may sue either at law or in equity for rescission, or for damages if the buyer no longer owns the security. However, a person is not liable if he sustains the burden of proof that either (a) the buyer knew of the untruth or omission or (b) he (the offeror or seller) did not know, and in the exercise of reasonable care could not have known, of the untruth or omission. The issuer of the security (other than a government issuer identified in Section 5M) is not entitled to the defense in clause (b) with respect to an untruth or omission (i) in a prospectus required in connection with a registration statement under Section 7A, 7B, or 7C, or (ii) in a writing prepared and delivered by the issuer in the sale of a security.

Rescission

Section 33(D)(1),(6), and (7) of the TSA: (1) On rescission, a buyer shall recover

(a) the consideration he paid for the security plus interest thereon at the legal rate from the date of payment by him, less (b) the amount of any income he received on the security, upon tender of the security (or a security of the same class and series).[ . . . ](6) On rescission or as a part of damages, a buyer or a seller shall also recover costs.(7) On rescission or as a part of damages, a buyer or a seller may also recover reasonable attorney's fees if the court finds that the recovery would be equitable in the circumstances.

Calculating a Rescission

Section 33(F)(1) of the Texas Securities Act:A person who directly or indirectly controls a seller, buyer, or issuer of a security is liable under Section 33A, 33B, or 33C jointly and severally with the seller, buyer, or issuer, and to the same extent as if he were the seller, buyer, or issuer, unless the controlling person sustains the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of the existence of the facts by reason of which the liability is alleged to exist.

Now It Gets Ugly...

Section 33(F)(2) of the Texas Securities Act:(2) A person who directly or indirectly with intent to deceive or defraud or with reckless disregard for the truth or the law materially aids a seller, buyer, or issuer of a security is liable under Section 33A, 33B, or 33C jointly and severally with the seller, buyer, or issuer, and to the same extent as if he were the seller, buyer, or issuer.

Now It Gets Much Uglier...

But . . . Sterling Trust Co.v. Adderly, 168 S.W.3d 835 (Tex. 2005).

An aider is subject to liability "only if it rendered assistance to the seller in the face of a perceived risk that its assistance would facilitate untruthful or illegal activity by the primary violator." The aider "must be subjectively aware of the primary violator's improper activity."

Are your clients raising money to buy real estate?What is the deal structure?Do your clients have a disclosure document (PPM, CIM)?Are your clients cold-calling?Are they paying commissions to brokers in conjunction with raising money?Are they filing Form D with the SEC?

How do I Navigate This?

Harder to raise money the right way.A well-done disclosure document can cost up to $25,000.00.Form D filing fees in each state from which your client raises money.Ongoing legal fees.Threading the needle . . . One wrong move can detonate your exemption from registration.

The Costs of Compliance

Selling unregistered and non-exempt is a felony (Minimum 2 years, up to $5,000.00 fine).Personal liability for every penny you raised, with interest and attorney’s fees.SEC Receivership

The Costs of Non-Compliance