Your trust deed deal could be a potential sale of securities.

New business agreements are drawn up every day for a variety of reasons. Frequently, businesses owners and attorneys craft contracts that may not appear to be a securities transaction but may actually fall under a category of regulated securities and be subject to state and/or federal securities laws.

We see this often in the private lending industry. A broker has a loan that needs to be funded and solicits private investors to fund either the entire loan or a portion of the loan (fractionalized trust deed investment). The investors, in return, obtain a note and trust deed reflecting the fractional ownership of the note and trust deed held by the multiple investors. The percentage is determined by the amount invested by the investor as compared to the amount invested by all investors.

The broker often retains servicing of the note and is authorized to engage in various activities on behalf of the trust deed investors, such as acting on behalf of the investors during the foreclosure process, etc. The question then becomes, has the broker (whether an individual or company) engaged in a securities transaction that is regulated by the Securities and Exchange Commission (SEC) or by an applicable state securities regulator? The answer is often yes.

Offering trust deed investments to investors may require registration with the SEC or one or more states. If it is not done correctly, it may open up the broker to scrutiny from regulators, or worse, expose the broker to SEC and/or state antifraud and securities regulations, which may include penalties.

The Securities Act of 1933 defines a security as “any note, stock, treasury stock, bond, security-based swap, security future, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, note or fractional interest,” and
20 other categories that won’t be listed here. Among other factors, a whole loan or fractionalized interest in loan is considered a security because it is an investment contract
that involves risk. Further, generally any evidence of indebtedness such as a note is defined as a security.

Brokers seeking capital from investors to fund loans by arranging trust-deed investments must be aware that such a transaction is considered an offering of securities that must be registered with the SEC and/or a state’s securities regulators unless an exemption applies.

Complying With Securities Regulations

The SEC and every state require the registration of the offering and/or sale of any security, unless an exemption from registration can be found. The most viable option for a broker is to find an exemption from registration, because the registration process is often lengthy and cost prohibitive. However, complying with state securities regulations or exemptions becomes too burdensome when there are investors located in multiple states.

The analysis of where the offering must be registered is often focused on where the investors are located. This means that if you are a broker offering fractionalized interests in loans to investors in multiple states, you must comply with each state’s securities regulations. As you may have realized, having investors from multiple states creates an extremely painful process, at least from a securities compliance perspective.

Although some states have identical statutory laws as the SEC, there is very little uniformity among state securities statutes. It is vital to consult with an attorney who is familiar with federal and state securities regulations not only covering securities transactions but also covering securities transactions involving trust deed investments.

Fortunately, many states often exempt from registration any loan transactions where there is only one investor on the note and trust deed (e.g., whole loan investment). However, the same may not apply to fractionalized interests or multilender loans. In California, for example, a licensed real estate broker who offers and sells fractionalized interests in notes is considered an issuer of securities but is generally exempt from registration because the broker is licensed. This holds true provided that the fractionalized interests are sold to
10 or fewer investors.

Other states, such as Texas, do not have a clear exemption for transactions involving the fractionalization of trust deeds, but they may offer a clear exemption applicable to the offer and sale of whole loans, where the entire note secured by real estate is sold in a single transaction.

Still other states have indirect exemptions that may indirectly exempt fractionalized notes based on the characteristic of the investor, number of investors, location of all investors, size of the transaction, etc. These limitations often require all investors to reside in that one state, or that no advertisements are used, or that there is a limitation on the dollar amount that may be offered and sold within any 12-month period.

Further, if selling to non-accredited investors, states and the SEC will often require that each non-accredited investor receives a material disclosure package outlining the loan transaction, the risks involved, material terms, fees to the broker and a summary of the proposed investment. These disclosers are necessary so that the investor makes an informed decision when deciding to purchase the trust deed investment.

In conclusion, if you are a broker arranging trust deed investments with investors located in multiple states, you must comply with registration requirements in each state where your investors reside. Or, find a federal exemption that preempts the application of state law.

It is important to note that many states prohibit the offer and sale of securities to non-accredited investors, unless an exemption applies. Often, exemptions that do allow the sale to non-accredited investors will require the broker to provide disclosure documents to such investors and do not allow the use of general solicitation or advertisements when offering trust deed investment opportunities. Every state is different. It is therefore imperative to speak with a securities attorney who not only understands securities regulations, but also understands the nature of trust deed investments.

Relying on a Federal Exemption

One of the most frequently used exemptions from securities registration is Rule 506 of Regulation D. Rule 506 allows an issuer to offer and sell securities to investors across the U.S. The main advantage of relying on Rule 506 is that the issuer would be able to offer securities such as trust deed investments in multiple states without having to register the offering in every state where investors reside (Rule 506 preempts the applicability of state securities regulations). However, when using Rule 506, the issuer is required to use disclosure documents, follow certain general solicitation restrictions depending on whether the offering is a Rule 506(b) or 506(c) offering, and file a Form D notice with the SEC, among other things.

The best advice is to consult with an experienced attorney who is familiar with securities laws before offering and selling trust deed investments. It is essential to make sure you are complying with securities regulations so that you do not become the subject of an enforcement or investigatory action by the SEC or state regulators. At the end of the day, a few minutes with an attorney could save hundreds of dollars when responding to the SEC or state regulators. ∞

(This article is not to be taken or treated as a substitute for specific advice, whether legal advice or otherwise. It does not seek to provide legal advice on any of the issues herein.)