Securities regulators are coming down hard on real estate investments that cross the line into unregistered securities. What this looks like and when to be wary.
Securities scams move to where the money is, and today, that includes real estate. When these deals go bad, real estate development cases can turn into a securities fight pitting regulators against issuers and promoters.
We have seen similar efforts to raise capital through offerings of unregistered securities follow the money in payphones, oil and gas, viatical settlement investments, and even ice machines. While the particular instruments that were used vary – such as sale lease back transactions, joint ventures, and viaticals – the underlying business was tied to rising values in hot markets.
The securities investments we are seeing related to real estate today similarly follow perceived value in a rising real estate market. And, as has historically been the case when these investments result in litigation, the courts are ruling that the instruments used are securities and subject to enforcement by the SEC and state securities commissions.
Since it can be difficult for investors to know what they are buying into and for sellers to fully appreciate the status of these investments as securities, it is not uncommon for lenders (i.e., investors), who think they are invested in real estate, to get caught off guard when they learn that they have in fact purchased promissory notes, not real estate interests.
In a 2019 case, the SEC charged a Chicago-based property developer with securities fraud perpetrated through an unlawful securities offering. In raising more than $41 million through the issuance of promissory notes, defendants purported to generate returns for investors through the strategic acquisition of underperforming real estate, primarily large apartment complexes and other multi-family properties located in Illinois. SEC v. Northridge Holdings, Ltd., No. 19-CV-5957 (N.D. IL filed September 5, 2019).
Because of the structure of promissory notes, it can be difficult for lenders and investors to assess the value of the investment prior to the purchase. There are, however, warning signs to watch for in the details of the deal, which are highly important for investors and sellers to consider prior to promoting any instrument to main street investors as a “non-security.”
In an effort to avoid securities laws, real estate ventures often make use of instruments such as joint interest agreements, limited liability companies, limited liability partnerships, and promissory notes. Perhaps the most common instrument is the promissory note.
Many Americans are familiar with the concept of borrowing money from a bank to purchase their residence and that the bank’s loan is secured through a deed of trust or similar instrument in the underlying real estate. Promoters take advantage of would-be investors’ familiarity with this structure, and investors’ expectations that a promissory note secured by real estate in a rising market cannot miss.
Promoters of promissory note investment programs have relied on the notion that promissory notes historically have not been considered securities. Such notes used in the ordinary consumer purchase of a residence are not securities. In a typical real estate deal, a bank is the lender and the residential buyer is the borrower. When banks are the lenders, the background credit check is thorough, with title searches, credit risk assessments, and collateral checks to reduce lending risk. Generally, these notes are not securities for purposes of the securities laws.
The conclusion is different when the capital comes from main street investors, and not a bank. In a note investment program, the individual is the lender and the promoter is the borrower. This distinction is critical to a court’s determination of whether a particular note is considered a security, and as a result, subject to the securities laws. In SEC v. Rudnick, 20-CV-00532 (W.D. N.C. filed September 24, 2020), for example, the SEC charged a Florida real estate developer with securities fraud for offering promissory notes to investors to fund real estate ventures.
Courts from the U.S. Supreme Court on down have developed an analysis for distinguishing the nature of these transactions. A key issue is that main street investors, unlike bankers, are not in the business of vetting borrowers—who are often the company promoting the instruments. Similarly, investors have no ability to evaluate whether the real estate pledged as collateral to secure the promissory note was legally effected and would actually cover the value of the notes in the event of the borrower’s default.
Although the promoter may make representations as to the value of the property, and even provide appraisals by licensed appraisers, other critical information may not be available to assess whether the real estate could be foreclosed upon to repay investors in full. The warning signs are found in the details, which should include:
Because such details can turn what appears to be a “no risk” investment into a catastrophic investment loss, the lack of detailed disclosures and the inability of investors to properly understand their risk are critical to the success or failure of the promissory note investment.
A seller of securities may be strictly liable if not licensed or if the securities are not properly registered. This can be disastrous for the seller if the promoter defaults, leaving the seller liable for the investors’ losses.
Similarly, if the promoter and maker of the promissory notes sells the notes directly to investors and defaults, investors may have no recourse in the event of a default where the collateral cannot cover the default.
Investors or sellers urged by promoters to invest or sell promissory notes purportedly secured by real property should be wary in doing so and be sure to conduct comprehensive due diligence. It is not the alleged value of the real estate that investors should be concerned with, but all the fine details associated with the promissory notes and the related documents.
Paul Vorndran is a securities litigation and enforcement defense attorney with Jones & Keller in Denver. Reach out to Paul at pvorndran@joneskeller.com.
This information is not intended as legal advice. Readers should seek specific legal advice before acting with regard to the matters addressed above.