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The concepts of securities and joint ventures are among the basics of real estate investments.
Securities are investment contracts in which individuals invest their money with the expectation of making a profit, mainly from someone else’s efforts. This typically means very little control on the investors’ side, who hope for potential financial gains based on the expertise of others.
On the other hand, a joint venture (JV) involves a collaborative partnership between two or more parties. In this type of investment, all partners actively participate, share responsibilities, and split the profits or losses according to their contributions.
In short, securities are passive investments, while JVs are active or participative investments and thus are not subject to securities regulations or the SEC.
Understanding these distinctions is vital for anyone interested in real estate investment, whether on the selling side or as an investor. It facilitates informed decisions and helps compliance with appropriate laws to prevent potential legal pitfalls.
Securities Laws in Real Estate: Grasping the Fundamentals
Both federal and state definitions of “securities” encompass the term “investment contract.” To discern if the real estate investment you’re selling falls under securities, it must satisfy two criteria:
- Your investors are putting money into a shared venture with you.
- These investors expect to earn profits primarily from your efforts, expertise, and/or experience.
A standard investment contract could be any of the four-prong Howey Test:
- Operating agreement for a manager-managed limited liability company (LLC)
- Limited partnership agreement
- Corporate shareholder’s agreement
- A trust agreement with multiple beneficiaries
All these entities comprise a management group and passive investors.
In real estate, securities are financial instruments that come with specific legal obligations. Stringent securities regulations like the Securities Act are designed to protect investors, requiring full disclosure and registration before selling to ensure transparency.
The sale of securities must be registered with pre-approved securities regulators in offerings such as Regulation A+ or a public offering unless an exemption applies, such as Regulation D or Regulation CF.
Typical rules for securities exemptions include:
- Restrictions on advertising
- Limitations on investor qualifications (based on financial status or geographic location)
- Caps on the number of investors
- Disclosure of investment risks
To comply with a securities exemption, the issuer of the securities (promoter, manager, or syndicator) must first determine which exemption applies, draft the appropriate documents, and comply with the rules for that exemption. Exempt Securities Offering documents include a Private Placement Memorandum (PPM), a Subscription Agreement, Securities Notice Filings, and the Investment Contract.
Under securities laws, the issuer is mandated to provide all material facts to allow investors to give informed consent. These are anything that could influence an investor’s decision, such as the issuer’s criminal history, recent bankruptcy, or failed investments. Failure in disclosure or any misrepresentation can lead to fraud charges.
Many investors are reluctant to acknowledge they are selling securities due to the complexities or the cost of drafting the offering documents. However, the consequences of non-compliance with securities laws are severe and not worth the risk. Litigation expenses and fines from regulators are substantial, and imprisonment is probable in some cases.
The truth is that laws like Rule 506 and Regulation A+ can facilitate business growth. They allow for an unlimited number of investors and the ability to raise unlimited funds while maintaining control over the investment. With new crowdfunding regulations, you might even be able to advertise your offering with fewer restrictions.
Joint Ventures in Real Estate: Differentiating from Securities
A joint venture, a.k.a. general partnership, in real estate is a business arrangement where two or more parties come together to undertake a specific project, such as developing a property. Each participant maintains control over their contributions to the venture, and all parties share decision-making, profits, losses, and risks.
In lieu of an investment contract, JVs require a formal Joint Venture Agreement. This covers a clear, written outline of each partner’s duties and how they will be compensated.
One major advantage of JVs is the pooling of resources, which can result in increased capital and a blend of diverse skills and expertise. This collaborative effort enhances the overall success of the project.
As mentioned above, joint ventures are not considered securities contracts by the SEC and are not subject to securities regulations nor require any filings under securities law or an exemption.
There are two types of JVs:
Simple Joint Venture
This involves two or more individuals or companies pooling resources (money, labor, or skills) to achieve a common goal, such as purchasing and renovating a property. They could also form a syndicate to manage a company raising funds through a securities offering.
Complex Joint Venture
Here, a private equity firm or family office partners with a syndicate to acquire a large commercial property. Each party contributes to the down payment and closing costs, signs the purchase loan, and shares management responsibilities.
However, joint ventures aren’t without challenges. Consider these:
The main drawback is the possibility of investor earnings being taxed at ordinary income rates. Also, the requirement for active involvement by all participants could disqualify self-directed IRA investors due to prohibited transaction rules.
Compared to a securities investment contract, a JV doesn’t include the fourth prong of the Howey Test. Rather, a project’s success is based on the investors being actively involved in managing it. Unfortunately, those with full-time jobs might lack the time, desire, or capability to engage in the management of a real estate venture.
Another downside is that everyone is a manager, so no single person can make decisions for the group as they can in a company raising money through a securities offering. When decisions are made by majority or unanimous consent, misaligned expectations or contributions can lead to conflicts.
JV partners generally share the risks, revenues, expenses, and assets related to the project proportionately, but also liability for each other’s actions. This may be a burden some investors are not willing to assume.
On the bright side, JVs require a simpler Joint Venture Agreement instead of the more complex securities offering documents. Keep in mind, though, that it might be cheaper to draft but could result in higher legal fees and emotional stress if the deal goes south.
Joint Ventures Vs. Securities: Wrapping Up
It’s easy to misclassify securities as joint ventures, especially when you’re deeply involved in the intricacies of real estate projects. This can result in failing to comply with securities laws, which can bring about significant legal repercussions that can derail your investment goals.
To prevent these costly errors, it’s crucial to familiarize yourself with the distinct characteristics that separate securities from joint ventures.
How can you be absolutely certain? Seek the counsel of a legal expert who specializes in real estate investments. They can provide valuable insights into the nuances of your investment structure, whether it’s securities or JV, ensuring that you comply with all relevant regulations.
This proactive step can save you from future legal headaches and ensure your investment is structured correctly from the get-go. Remember, understanding these legal distinctions not only safeguards your investment but also builds trust with your partners and investors.
Taking the time to get it right from the beginning can save you from costly mistakes down the road, allowing you to focus on growing your real estate portfolio with confidence. Are you into real estate investments but debating between selling securities and forming joint ventures? Shams Merchant is the leading real estate private equity and syndication lawyer in the country, representing clients in real estate projects across the nation. Shams specializes in real estate syndications, fund formations, securities law, and private placements for commercial property investments and development in all 50 states. Shams has been featured in publications like Law360, the Austin Business Journal, BisNow, and The Real Deal.