Previously, I went through the analysis that a fund manager is considered an investment adviser. But left
open the question of "what is a security?" That's a key question for fund
managers with alternative investments, like real estate.
The Investment Advisers Act gives a very broad definition
of a security:
any note, stock, treasury stock, security future, bond,
debenture, evidence of indebtedness, certificate of interest or participation
in any profit-sharing agreement, collateral-trust certificate, preorganization
certificate or subscription, transferable share, investment contract,
voting-trust certificate, certificate of deposit for a security, fractional
undivided interest in oil, gas, or other mineral rights, any put, call,
straddle, option, or privilege on any security (including a certificate of
deposit) or on any group or index of securities (including any interest therein
or based on the value thereof), or any put, call, straddle, option, or
privilege entered into on a national securities exchange relating to foreign
currency, or, in general, any interest or instrument commonly known as a
"security", or any certificate of interest or participation in, temporary or
interim certificate for, receipt for, guaranty of, or warrant or right to
subscribe to or purchase any of the foregoing. [202(a)(18)]
What's missing from that definition is hard assets
(collectibles, like baseball cards), futures contracts relating to commodities
(but not future contracts relating to securities), and real estate (but not
shares in real estate companies).
Pure bricks and mortar are not securities. So private
equity funds that invest directly in hard real estate assets are not giving
advice regarding securities. As you start adding additional levels of
ownership and holding companies, things get a bit grayer as you have more and
more organizational boxes between the fund and the real estate.
One of the early seminal Supreme Court cases on the
definition of a security involved a real estate deal. In 1946, SEC v
W.J. Howey Co. (328 U.S. 293) involved an offering of units of a citrus
grove development, coupled with a contract for cultivating, marketing, and
remitting the net proceeds to the investor. They held that it was an offering
of an "investment contract" within the meaning of that term as used in the
provision of § 2(1) of the Securities Act of 1933 defining "security" as
including any "investment contract," and was therefore subject to the
registration requirements of the Act.
For purposes of the Securities Act, an investment
contract (undefined by the Act) means 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, it being
immaterial whether the shares in the enterprise are evidenced by formal
certificates or by nominal interests in the physical assets employed in the
There are three components:
So passive investments, where investors do not have any
decision-making power are securities. Investments made by the principals who
are actively involved in the management of the enterprise are not securities.
Of course, that leaves a whole lot of business arrangement in between.
Shares of stock in a corporation do not have enough
involvement to get them out of the characterization of securities. Most real
estate is owned in partnership or partnership-like entities to take advantage
of some favorable tax treatment. There is an expectation of profits and
it's going to be a common enterprise. That leaves the "success on the efforts
of others" as the key test for investment entities.
Traditionally, limited partnership interests are
generally securities because limited partners rely on the general partners to
manage the partnership. Since Delaware and other states have given limited
partners to have more power in the management of the partnership and still
retain their liability shield, the analysis has gotten harder.
For a general partnership, those interests are generally
not securities because they fail to satisfy the "solely from the efforts of
others" part of the test. Usually all general partners have decision making
power with respect to the affairs of the partnership.
Limited liability company interests are tougher to make a
general statement. If the LLC is member-managed, then each member is involved
in management of the enterprise and therefore their interests would
generally not be securities. On the other hand, if the LLC is manager-managed,
then members are may be just passive investors, and their LLC interests are
more likely to be securities.
When it comes to real estate joint ventures, the managing
interest is not going to be a security. The non-managing interest is more
likely to be a security.
Notes, debt, and debt-to-own interests are likely to be
considered securities. You can see notes listed right in the definition of
securities. Given the continuing distress in the real estate debt markets, many
fund managers are looking at buying distressed debt instead of pure bricks and
mortar. That's going to push them into the role of giving "advice about
securities" and force them to look at registration as an investment adviser.
Deal structure may influence the analysis. It's common in
some jurisdictions to structure the transaction as a sale of interests in the
owner of the real estate instead of a sale of the asset itself. That
transaction structure could be viewed as a sale of securities, instead of a
sale of real estate.
additional commentary on developments in compliance and ethics, visit Compliance Building,
a blog hosted by Doug Cornelius.