What you need to know about the legal implications of direct investments vs. indirect investments

There are two common categories of private lending investments an investor can make:

1. Direct investments
2. Indirect investments, which are made by investing in a Fund

Let’s look at the securities exemptions related to these types of investments as well as the potential trade-offs, limitations and legal implications that managers and servicers should be aware of when facilitating these types of investments.

Direct Investments

Investors can make direct investments through what are sometimes called “trust deed” investments. These investments take the form of investing in fractionalized interests of a loan (i.e., multibeneficiary loans) or whole notes.

The investor generally becomes the lender of record under the promissory note and related loan documents. As a lender of record, the investor has enforceable remedies and rights from the loan documents, including, among others, the right of payment of principal and interest and the right of foreclosure on the loan. The lender (i.e., investor) can control the outcome of the loan and can enforce the terms.

Are Direct Investments Still Securities?

Generally, yes. Under the Howey test, a transaction is considered a security if it meets the following:

• It is an investment of money.
• There is an expectation of profits from that investment.
• The profits go to a common enterprise.
• Profits are derived from a promoter or a third party.

The Howey test is reiterated in the multibeneficiary loan settings in People v. Schock, which clearly indicates that fractional interest in a promissory note constitutes a security because the investor is “committing relatively modest sums” with the expectation of a profit based on the reliance of “skill, services and solvency” of a promoter or a company. The promoter goes out to the market to seek investors to arrange the loans funded to borrowers.

In these instances, direct investments are generally constituted as purchase of securities. On the other hand, if the lender also actively controls the direct investments, it is arguable whether the interests are considered securities. The key element of determining if an investment is a security is whether the investor controls such investment.

Are There Any Exemptions in Direct Investments?

Before delving into any available exemptions in this type of investment, we must first ask, “Exemption from what?”

The securities laws generally require an issuer of securities to register with the government body regulating the securities laws—either with the Securities and Exchange Commission (SEC) or a state counterpart (e.g., in California, the Department of Business Oversight, or DBO. However, the registration process is extremely burdensome and cost prohibitive.

Think of the stock market. S&P 500 companies must register with the SEC before going to the public to raise money. In order to avoid this registration process, agencies provide several exemptions from registration. Here are a few examples:

California Corporations Code Section 25102(f) // In California, a manager or a company may rely on a 25102(f) exemption. California Corporations Code section 25102(f) exempts an issuer for up to 35 investors who have preexisting or business relationships with the issuer, provided the investor is making an investment for its own account and the issuer has not made any advertisement to offer the security. California requires the issuer to file a 25102(f) notice with the DBO and pay a filing fee.

Many other states provide similar exemptions. For example, in Delaware, the issuer may be exempted from registration if the issuer complies with, among other things, that the issuer has sold its securities to no more than 25 persons in the state during any 12 consecutive month period. The issuer must also reasonably believe all investors are purchasing for investment in its own account.

California Business & Professions Code Section 10237 and California Corp Code Section 25102.5 // California has a unique real estate investment exemption for real estate brokers issuing securities—California Business & Professions Code Section 10237. The broker-issuer must have a California real estate brokers license from the California Department of Real Estate and must generally comply with the following:

• File a notice provided in Business & Professions Code Section 10238(a) within 30 days from the date of closing
• Ensure advertising complies with California law
• Real property securing the interests is located in California
• Notes or interests must be sold by or through a real estate broker
• There are no more than 10 investors securing the fractionalized interests
• The rights of these investors are identical in terms, including foreclosure rights, interest rate, etc.
• Loan-to-value ratios comply with Section 10238(h)

In addition, because California law governs this transaction, the real estate broker cannot rely on this exemption if an investor resides outside of California. All transactions—investment funding, loan closing, real property location—must be conducted in California.

Limitations on State Exemptions

As an issuer gains additional experience and a positive reputation among investors, word travels and the issuer gains traction and obtains more investor funds for fractionalized interests and whole note investments. Now comes the issue: How far can the issuer rely on state exemptions?

One-off transactions (or limited transactions) appear to be the target of these limited state securities exemptions. However, when multiple deals with numerous investors across the U.S. come into play, there is a higher risk of violating state securities laws. The issuer must conduct due diligence in any state in which an investor resides to determine whether the issuer is compliant with the securities laws of that state. Along with the possible integration doctrine that may be applied, establishing a fund is likely the proper route to take.

Fund Investments

On a long-term basis, investments by way of establishing a Fund would be more feasible for both the issuer and the investors.

The most popular and cost-efficient rule on which an issuer generally relies is Rule 506 of Regulation D. From a securities laws perspective, the reason a fund should be created is twofold: (1) It creates an exemption from registration with the SEC and (2) it preempts state laws, in that the fund manager is not concerned about state regulations. In the event an investor resides in a different state than the issuer, the manager need not be concerned about out-of-state securities laws compliance.

Fund investments also have practical implications.

Investor funds are more centralized. They are all in one account, and deployment of capital becomes much easier and more efficient to fund loans. The Fund becomes the lender of record, and the control of the loans and the underlying property is all within the control of the Fund and its manager.

The investors become “passive” because of limited control on the governance of the Fund, as reflected in the governance documents. On the other  hand, investors have certain remedies under the securities laws, including allegations  of violation of Rule 10b-5. The SEC, as a matter of public policy, disallows Fund managers from circumventing Rule 10b-5 violations.

What happens when the issuer violates securities laws?

Penalties for violation of securities laws are generally draconian. Penalties are harsh for the issuers and managers. Fraud (whether intentional  or negligent, or whether malicious or not) are at the crux of these penalties. As a historical context, the penalties, in one form or another, originated from the 1929 stock market crash, which led to severe economic consequences for the U.S. During this time, fraudulent practices were rampant, and the SEC (and state regulators) took on the role of safeguarding investor money.

An exemption rule violation may require the issuer to  register with the SEC or a state government agency. Rescission of investor money and/or fines may also be required. Issuers should be  cognizant of the consequences and consult with a lawyer, especially if the issuer is unsure of securities law implications when managing a fund.

As discussed, there are various securities laws implications when making direct and/or indirect investments, and  securities laws pertaining to exemptions vary widely. In certain instances, securities laws may not apply, as “control” appears to be one of the main aspects in determining whether an investment is a security. When making these types of investments, issuers and investors alike should be cognizant of the securities implications and consult with securities counsel for assistance.