Being a securities and real estate attorney, I often get asked about joint ventures for the purpose of investing in real estate, primarily fix and flip ventures or the buying of distressed notes secured by real estate. Most frequently, the conversation involves one party with capital and one party with the know-how and a property to flip or the ability to buy distressed or discounted notes. The parties want to form a joint venture (usually in the form of a Joint Venture Agreement) for the purpose of one party providing the capital and the other party providing the property or distressed note and doing the work. This type of structure is often pitched to real estate investors by virtually all of the real estate education seminars being conducted on a weekly basis across the United States. Just because that structure is being pitched doesn’t mean that structure has been vetted properly or doesn’t violate securities laws.
If you are a real estate investor, whether it be for fix and flip properties or for distressed notes secured by real estate, and you have heard this pitch from one of the many seminars, before going out and there and raising capital from investors to fund your fix and flip project or your buying of distressed notes, you should either contact an experienced securities attorney or you should have a solid understanding of what an investment contract looks like. Running afoul of federal or state securities laws, could severely impact your ability to raise capital in the future. Better to spend the money on the front end and get competent advise as opposed to on the back end .
Under Section 2(a)(1) of the Securities Act of 1933 (“Securities Act”), “unless the context otherwise requires,” the term “security” includes any note, stock, treasury stock, security future, security-based swap, 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, certificate of deposit, or 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, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.
Section 3(a)(10) of Securities Exchange Act of 1934 (“Exchange Act”), “unless the context otherwise requires,” the term “security” includes means any note, stock, treasury stock, security future, security-based swap, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, any put, call, straddle, option, or privilege on any security, certificate of deposit, or 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 instrument commonly known as a “security”; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.
The definitions are substantially similar and are not intended to be treated differently in application. It is intended that the definition of security be very broad so that it encompasses all forms of investment instruments and contracts that may be used in the commercial world.
It should be noted that both statutory definitions include the qualifying language ““unless the context otherwise requires.” The inclusion of such qualifying language requires a facts and circumstances analysis of all relevant facts and circumstances in order to determine whether a security is involved in a specific transaction.
The landmark U.S. Supreme Court case interpreting the definition of an “investment contract” as a security is SEC v. W. J. Howey Co., 328 U.S. 293 (1946).
Under the Howey Test, the Supreme Court created a test, commonly known as the “Howey Test,” that looks at an investment’s substance, rather than its form, as the determining factor for whether it is a security. Even if an investment is not labeled a “stock” or “bond,” it may very well be a security under the law. An investment contract can take many different forms and its underlying character may not be as easily recognizable.
The Howey Test defines an investment contract as follows: “… an investment contract for purposes of the Securities 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…. Such a definition…permits the fulfillment of the statutory purpose of compelling full and fair disclosure relative to the issuance of the many types of instruments that in our commercial world fall within the ordinary concept of a security…. It embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”
The Howey Test is a four-part test. Under the Howey Test, an investment contract exists where there is: (1) an investment of money; (2) there is an expectation of profit from the investment; (3) the investment of money is in a common enterprise; and (4) Any profit comes from the efforts of a promoter or third party.
Let’s take a look at each part of the test in a little more detail.
An investment of money. In spite of the fact that the term used in Howey is “money” , subsequent case law has expanded this concept to include any form of consideration with value.
There is an expectation of profits from the investment. Profits can take the form of capital appreciation, cash return on investment or other earnings, such as dividends or interest. For purposes of the Howey Test, profits refer particularly to a return to the investor and not necessarily the success of the enterprise as a whole. The expectation of profits analysis turns on a finding that the investor is motivated by a return on his investment. For example, the court in a later case found that sale of shares in a housing cooperative that were bundled with the cost of the apartment itself and used for common operating expenses and upkeep of the building, did not give rise to a securities transaction where the investors were attracted by the prospect of acquiring a place to live, and not by financial returns on their investments. Alternatively, courts have found that the sale of a condominium unit itself can be a security where (i) the offer of the unit is accompanied with an opportunity to participate in a rental pool; (ii) the offer of the unit requires use of an exclusive rental agent; (iii) the offer of a unit that limits time of use of the owner or involves shared ownership (time share arrangements); or (iv) advertising the sale of a unit with an emphasis on economic benefit, such as rental income or tax benefits.
The investment of money in a common enterprise. The term common enterprise is not precisely defined and courts have used different interpretations. The majority of federal courts define a common enterprise as involving “horizontal commonality,” which involves the pooling of money or assets from multiple investors whereby the investors share in the profits and risk in some proportion. Another group of federal courts define a common enterprise as involving “vertical commonality,” which focuses on the relationship being the investor and the promoter. The vertical test defines a common enterprise as one in which the investor is dependent on the promoter’s efforts or expertise for the investor’s returns. Broad and narrow versions of the vertical commonality test exist. The broad version requires that the investor’s fortunes be tied to the efficacy of the promoter’s efforts. The narrow vertical commonality requires that the investor’s profits be tied to the promoter’s profits, meaning they must rise and fall together. The bottom line is that if a commonality of enterprise is found, regardless of the form it has taken, this factor in the test will be satisfied.
Any profit comes from the efforts of a promoter or third party. The efforts of the promoter or third party must be undeniably significant in the success or failure of the enterprise. The analysis hinges on whether any profit that comes from the investment is largely or wholly outside of the investor’s control. If so, then the investment might be a security. If, however, the investor’s own actions dictate whether an investment will be profitable, then that investment is probably not a security.
I hope after reading this you have a better understanding of a what an investment contract is and looks like. I also hope that you can understand how the typical joint venture structure being pitched by the real estate education seminar companies might be an investment contract and thus a security. If your questions or confusion persists, feel free to contact us and we would be happy to discuss with you as well as assist in structuring your venture so that you do not run afoul of federal or state securities laws.