This article originally appeared on Law360, and is republished here with permission.
Human ingenuity is a remarkable thing — particularly in the investment context. Dating back to the advent of the mutual fund, to the more recent emergence of peer-to-peer lending and the indexed exchange-traded funds, creative investment products flood the market.
Securities laws have long existed to ensure investors receive full and fair disclosure and to punish investment promoters for making inaccurate or misleading statements. In recognition of the ever-evolving nature of investments, courts interpret securities laws broadly and emphasize the substance of an offering over its form. In the current low interest environment, real estate has seen growth.
Unlike traditional direct investments in real property, many of these real estate investments can implicate securities issues. This article offers a short primer on federal security basics and highlights some red flags that may signal securities risk in real estate transactions. Many of these red flags can be seen in DiTucci v. Ashby, and Fucci v. Bowser, two cases pending in the U.S. District Court for the District of Utah.
We start with the statutory definition of “security.” Both the Securities Act and the Securities Exchange Act have similar definitions. Each includes predictable items like “note,” “bond,” “debenture,” and “stock.” “Fractionalized undivided interests [of] oil, gas, and other mineral rights” are also included, but real estate interests are not.
Yet, both acts define “security” to include the less concrete term “investment contract.” Whether a direct investment in real estate constitutes a security turns on whether the transaction falls within the catch-all category of “investment contract.”
“Investment contract,” though itself undefined, was commonly used in state securities laws prior to the enactment of the Securities Act. By employing the term “investment contract,” which “had been broadly construed by state courts so as to afford the investing public a full measure of protection,” Congress crystallized in the Securities Act (and later the Exchange Act) the term’s prior judicial interpretation.
This broad interpretation is borne out of necessity. As explained in Reeves v. Ernst & Young: “Congress’ purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called.”
In other words, human ingenuity around investment mandates some flexibility. Constraining the meaning of “security” to obvious forms would undermine the statutory purpose. For this reason, whether an investment constitute an investment contract (and therefore a security) flows from the substance and economic realities of a transaction, rather than its name.
In Howey, the SEC alleged security violations against three defendants that owned large tracts of citrus acreage for cultivation. The defendants kept half the groves to themselves and offered the other half to the public for investment. Each investor was offered a land sales contract for a fraction of the available acreage and also a service contract, on the premise that a successful investment was only feasible when coupled with an agreement to cultivate the grove.
The targeted investors were predominately nonresidents lacking industry knowledge, skill and equipment to care for and cultivate citrus trees. Indeed, the investors were attracted to the investment by the expectation of substantial profits. In practice, all of the produce was pooled by the defendants and the investors were entitled to pro rata share of the net profits.
Against this backdrop, the defendants argued the transactions involved “no more than an ordinary real estate sale and an agreement by the seller to manage the property for the buyer.” The Howey court disagreed, holding the transaction clearly constituted an investment contract. Looking at the transaction as a whole, the court reasoned:
The respondent companies are offering something more than fee simple interest in land, something different from a farm or orchard coupled with management services. They are offering an opportunity to contribute money and to share in the profits of a large citrus fruit enterprise managed and partly owned by respondents. They are offering this opportunity to persons who reside in distant localities and who lack the equipment and experience requisite to cultivation, harvesting and marketing of the citrus products. Such persons have no desire to occupy the land or to develop it themselves; they are attracted solely by the prospects of a return on their investment.
The Howey test was born. An investment contract is “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."
Whether a given offering constitutes a security is a factually intensive question decided on a case-by-case basis. Nevertheless, Howey and subsequent authorities provide a helpful rubric. The following are some red flags that might signal securities concerns in a real estate transaction.
The transaction involves the sale of fractionalized interest in real property.
The sale of fractionalized interests in real estate to investors — also known as tenant-in-common, or TIC, interests. Generally, a TIC interest is an undivided interest in real property owned by two or more people. TIC interests are a common form or real property ownership used for ages without significant controversy.
By way of example, four siblings inherit a single tract of land and a residential property from a parent in equal shares as tenants in common. In that case, each sibling owns an undivided 25% interest in the land and the house as opposed to a section or certain rooms. Each is entitled to sell his or her share of the property and may likewise be entitled to proportional shares in rents or profits.
TIC interests in real property make sense when the property owners have a natural connection as in the forgoing example. TIC interests raise security concerns when the TIC is used to carve up ownership in real property among multiple investors whose primary connection is the shared desire to earn profit from the property.
This is especially true where the resulting interest in the property is too small to be independently useful. The citrus grove interests sold in Howey are a prime example. There, the majority of the investors bought such small parcels of property (as little as 0.65, 0.7 and 0.73 acres) that owning the property made little economic sense absent a broader economic scheme.
The real estate investment comes packaged with other contracts.
When real estate interests are packaged with leases, operating or service agreements, especially if coupled with promises of cash flow, they may be securities. Issuers and investors should not assume that the offering of real estate is not a security when the sale is coupled with other agreements.
The seller/promoter retains interest.
Another warning sign is the promoter’s retention of an interest alongside investors. In SEC. v. TLC Investments, the promoter offered TIC investments in real estate. The defendant argued that the investment was not a common enterprise under the Howey test.
The court disagreed, explaining that the promoter’s advertisements offered individual investors the opportunity to “take title to property as tenants-in-common” with the promoter. Because the promoter’s fortunes were “inextricably linked to the fortunes of the individual investors,” a “common enterprise” existed and the real estate interests were deemed securities.
The transaction involves the pooling of funds.
The pooling of funds among tenants, promoters and property management companies is also a red flag. This factor can exist on the front end — as with the Howey investors knowingly pooling small sections of land into a larger common enterprise — or on the back end, when promoters/operators secretly merge funds earmarked for specific investments into a larger pool.
An example of the latter arose in SEC v. Sunwest Management Inc. In Sunwest, a promoter of TIC interests acquired senior housing facilities to be managed by a sole property manager. While investors were told they were investing in specific units and would receive rents from those units, rents were actually paid from cash generated by the facilities as a whole. For example, if one facility lacked funds to pay rent, the management company advanced cash from another facility to pay the unprofitable facilities’ rent.
In holding the TIC interests were securities, the court cited the foregoing as “creat[ing] a relationship wherein the TIC investor in each facility invests in a common enterprise with all other TIC investors in the same facility.”
The transaction involves the expectation of passive profit.
A transaction that offers an investor profits solely from the efforts of the promoter or a third party will raise security concerns. In Blackwell v. Bentsen, the U.S. Court of Appeals for the Fifth Circuit explained that a land investment scheme constituted the sale of securities because it was essentially one transaction that resulted in “an investment for the purpose of producing an income through the activities of others than the owner.”
Many of the red flags are at play in pending litigation against Rockwell Debt Free Properties Inc. According to allegations contained in two lawsuits, Rockwell sold fractionalized, undivided interests in commercial buildings across the country to TIC investors. Coupled with the sale agreements, were lease agreements promising investors reliable passive rent income. Rockwell allegedly retained ownership in some subject properties. Additionally, funds invested in specific properties were allegedly pooled and used to pay obligations related to other properties.
When the tenant defaulted on its lease obligations, investor-plaintiffs brought claims for violations of numerous federal and state securities laws. If successful, Rockwell may be strictly liable to the plaintiffs for rescission of the investment.
These Rockwell lawsuits are a cautionary reminder of the security risks that may arise even in real estate investments. Disclaimers and innocent violations offer no safe harbor. Even an unsuccessful sale can cause problems as an improper offering is enough to give rise to liability. Before participating in a transaction involving the sale real estate interests with red flags, seek advice from counsel with expertise in securities law.