Question: What laws apply if you are raising funds from private lenders to: a) fund your real estate investing or private lending business, or b) if you are loaning their funds to others?
When Securities Laws Apply
If you are borrowing or pooling funds from private investors who are not in the business of lending money (such as hard money lenders), you are either issuing promissory notes (“Notes”) or “investment contracts.” In either case, you are probably selling securities, which means you will need to comply with federal and/or state securities laws.
Securities laws are designed to protect investors from fraudulent claims made by promoters and require that investors be given all of the material information they need to make informed consent, prior to making their investment decision. Thus, government regulations require that the offer or sale of securities (also known as a “securities offering”) must be registered with a regulatory agency (as in a public offering) and sold by licensed securities broker/dealers, unless the “Issuer “of the securities qualifies for an exemption from registration. There are many exemptions (both state and federal), but the most commonly used are some form of “private offering” or “private placement” exemption that allows an issuer to borrow or pool money from multiple investors. To use a state exemption, all participants (issuer and investors) and the assets must be in one state, or you must qualify for a separate exemption in each state where you will issue securities to investors.
Regulation D, Rule 506 is the most commonly used federal securities exemption because it pre-empts state securities laws (also known as “blue sky laws”), allowing issuers to raise money from investors in any state without regard for determining additional state securities requirements. Nevertheless, it generally still is required that you file a notice with the SEC and in the states where your investors claim their primary residence. As of Sept. 23, 2013, as a result of the Jumpstart Our Business Startups (JOBS) Act, Rule 506 now has two subpart exemptions, one that allows advertising and the original rule that does not, and one new provision:
- Rule 506(b) allows an issuer to raise an unlimited amount of money from an unlimited number of accredited investors, and up to 35 sophisticated investors. Investors may self-certify their qualifications. However, if you include sophisticated investors, you must provide a disclosure document (private placement memorandum) and you are prohibited from engaging in any form of advertising or general solicitation.
- Rule 506(c) allows an issuer to raise an unlimited amount of money from an unlimited number of accredited investors and you can advertise the offering, but you must take reasonable steps to assure that all of your investors are accredited (and no sophisticated investors are allowed). There are additional rules pending that might require additional filings, disclosures and submission of ads to the SEC prior to use.
- Rule 506(d), also enacted on Sept. 23, 2013, under the JOBS Act, prohibits certain “bad actors” who have been the subject of certain regulatory or financial disciplinary actions (“disqualifying events”) from participating in any Rule 506 offering as a manager, director, officer or employee, or as an owner of ≥20% of the voting interests (“covered persons”).
When Other Laws Apply
On the flip side of the private lending business, if you are loaning money to others, your lending activities likely will be regulated under a myriad of state and federal laws including such things as:
- Licensing laws
- Real estate or mortgage laws
- Usury/loan-sharking laws
- Foreclosure laws
Determining what state’s laws apply to your private lending business may be a challenge: Is it the state where your borrower maintains his or her primary residence or legal entity? Is it the state in which the property is located? Or is it both? You will need to consult a real estate lawyer in your state to navigate this minefield. This article focuses on the securities laws related to borrowing or pooling private funds and leaves the discussion of the legal aspects of lending the money to others.
How Will You Raise Money From Private Investors?
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Borrowing Money and Issuing Promissory Notes
Notes are included in the definition of “securities” under federal securities laws and most state securities laws. Certain notes with maturity dates of less than nine months are exempt from regulation under federal securities laws, but the states are allowed to impose their own regulations on the issuance of notes to private investors. In Reves v. Ernst & Young, 110 S. Ct. 945 (1990), the U.S. Supreme Court determined that notes sold to raise capital, where purchasers buy them to earn a profit (in the form of interest or shared profits), will be conceived as investments in a business enterprise, and thus, will be deemed securities.
Many states already have existing regulations and a strict enforcement policy for those who offer, sell or advertise promissory notes to private investors. There is no consistency among state “blue sky laws,” so the only way to know if you are on solid ground is to examine the “blue sky laws” in each state where you will make offers to private investors, before you offer notes to them. Alternatively, you could follow the rules for a Regulation D, Rule 506 securities exemption and pre-empt the state law requirements.
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Pooling Money from Private Investors
Another method of raising money from private investors for a private lending business is to pool passive investor funds in a single entity, such as a manager-managed limited liability company (LLC). The manager issues LLC interests to passive, private investors, who “capitalize” the company. The LLC will either invest the company funds directly into real property or notes secured by real property, or it may act as a private lender or hard money lender to originate its own loans to other real estate investors/entrepreneurs, according to the company objectives described in the LLC’s business plan, and under control of the manager.
Profits earned by the LLC from all of its investments are usually split between the manager and its investors in some pre-defined way. So instead of borrowing money and issuing individual or fractionalized promissory notes, the LLC will have an operating agreement describing the rights and duties of the members and the manager, including:
- What fees, if any, the manager will earn
- How profits and losses will be allocated
- How/when the investors will get their initial “capital contribution” back
- How and when the fund will liquidate
- Whether investors can seek a return of their funds before dissolution of the LLC
- How disputes will be handled; etc.
Regardless of the entity used (limited partnership, corporation, trust, etc.), the above description is a classic example of a securities offering and will require that the issuer of the securities (i.e., the manager) comply with federal and/or state securities laws. If all investors, the manager and the assets to be acquired by the LLC are within a single state, a state securities exemption can be used. Thus, the only way to truly protect yourself if you are crossing state lines is to conduct your offering in compliance with Rule 506 of the federal securities laws so you don’t get stuck on trying to figure out each state’s compliance requirements.
However, even that may not be enough if you start raising money in a big way, engaging in successive funds or if your company has more than 100 investors. In those events, you will need qualified securities counsel to help you determine: a) whether you may need to obtain a securities license to sell the securities, or b) if your company will be classified as an investment company under the Investment Company Act of 1940.
Taking Your Business to The Next Level
Regardless of whether you are borrowing money from one investor at a time, issuing single investor notes, issuing a series of notes of equal or successive priority, or fractionalizing notes, if you are repeatedly borrowing money from private investors from multiple states, you are in the borrowing business and under federal law your notes will be considered securities. So you must comply with federal securities laws, unless there is a specific state exemption that will allow you to do this where all of your activities are contained in one state. If you are pooling passive investors’ funds in an entity such as an LLC, you are also selling securities, and you must comply with securities laws or risk prosecution.
You will need to select an appropriate state or federal securities exemption for your private offering (with the assistance of qualified securities counsel) and strictly adhere to its rules. If your investors or the assets in which you plan to invest are from multiple states, then you should consider doing a Rule 506 securities offering.
NOTE: This information is of a general, educational nature and may not be construed as legal advice pertaining to your specific offering, exemption or situation. Such advice must be sought from your own attorney, pursuant to an attorney-client relationship, after consideration of your specific facts or questions.
