Are you a private lender? Nonconventional lender? Mortgage broker?

It’s essential for you, as a private lender, to remember that if you are raising capital
from investors, you are selling securities, and you need to consider local and/or
federal securities regulations.

There are many misconceptions and myths in the private lending industry when it comes to securities laws. Read further to make sure you are complying with local and federal securities regulations as necessary.

Myth1: Brokering and selling loans to investors does not constitute a security.

FALSE.

The Securities and Exchange Commission and every state securities regulator has made it a point that promissory notes, when sold to investors, are almost always a security. This includes unsecured notes, secured notes, mortgages, and fractional or participations notes. The facts surrounding the transaction, the expectation of the parties involved, along with the parties themselves all inform the question as to whether these investments are securities.

Legally speaking, the “Reves Test” is the dispositive test to evaluate whether a promissory note is a security. This test comes from a famous case called Reves v. Ernst & Young. The court explicitly carves out most notes as securities, except when the nature of the transaction and the expectation of the parties indicate it should be treated as a security. Unfortunately, most regulators, including the SEC, view most of the note investments in our space as securities. For these reasons, this myth is busted.

Myth 2: Friends and family capital raises are not subject to securities regulations.

FALSE.

First, cousin Bob can become plaintiff Bob in a split second. Second, the SEC and state regulators are interested in protecting investors, regardless of the existence of any personal relationship between the investor and the sponsor.

The law is very clear. If you are offering securities, you must either register or find an exemption. Below are the three most relied upon securities exemptions in private lending.

• REGULATION D RULE 506b/506c // Regulation D is a federal securities “safe harbor” that establishes that if an “Issuer” (i.e., someone who offers and sells securities to investors) relies on its requirements, it is exempt from registration with the SEC.

  For clients who operate national fractionalized loan offerings, debt offerings, and debt funds, 99% will utilize Regulation D’s Rule 506B or 506C.

  Figure 1 shows some key features of both regulations.

• REGULATION A // Regulation A was amended and significantly expanded in 2014 as part of the JOBS Act. This amendment essentially opened the door to true “crowdfunding” in the sense that is permits issuers to raise capital from the public (in a certain limited fashion). In many ways, Regulation A can be viewed as a “semi-public” offering.

  Regulation A is comprised of two tiers, each with unique restrictions. Notably, Tier 2 is significantly more popular because it does not require state-by-state qualification. Figure 2 shows some key features of both tiers of Reg A.

• LOCAL SECURITIES REGULATIONS // For lenders who raise capital from one state, state securities regulations can be immensely useful. Many states have variations of the federal securities exemptions set forth above. For example, California has California Corporations Code 25102(f), which is essentially identical to Rule 506(B) of Regulation D but limited to California only.

  These regulations are highly effective for raising capital in a single state, but to truly scale and raise money nationally, the federal options listed are recommended.

Today, nonconventional lenders, debt funds, and mortgage brokers nationwide have a broader means to raise investor capital at the private level thanks to the JOBS Act. However, selecting the right option can often be a challenge.

It is recommended to rely on Regulation D’s Rule 506(B) or 506(C) to establish your initial capital raise, whether it be friends and family or high net worth investors. From there, a determination can be made to either remain within the same investor class or expand to the general public. Thanks to Regulation A, the path to a public offering is much less burdensome.

Myth 3: Selling securities to friends and family does not require a private placement memorandum.

FALSE.

First, it is considered best practice to always use some form of disclosure to investors when offering or selling securities. This is usually done via a private placement memorandum. Legally speaking, the SEC requires a properly written private placement memorandum whenever offering or selling securities to even one nonaccredited investor. It also requires the accredited investors to receive the same disclosures.

Second, it wildly deviates from industry standards.

Finally, it is incredibly risky to offer or sell securities to investors without providing adequately written offering documents. Why? Because properly written offering documents disclose every material fact as it pertains to the securities being offered. This includes the terms of the investment, the limitations on liquidity, the fees, the risks, and past malfeasance by the issuer. As an issuer, these documents provide added protection from disputes stemming from a lack of information, which is the fundamental precept to securities fraud allegations.

If you are a private lender, mortgage broker or nonconventional lender, it’s imperative that you consider local and/or federal securities laws whenever investors are involved. This includes institutional investors. Cutting these corners can easily result in fines, penalties, and even disqualification from the sale of securities. ∞

If you are interested in learning more, please sign up for AAPL’s Certified Fund Manager online course or contact Kevin Kim at k.kim@geracillp.com or (949)379-2600.