Commonly Overlooked Securities Issues in Private Lending

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Private lenders are typically utilizing some form of capital sourced from a variety of investors to fund their loans such as institutional investors, high net-worth investors, and retail investors. Geraci LLP specializes in securities within the context of private lending and has leveraged its decades of collective experience to provide the following overview of some of the most overlooked issues and how to resolve them.

Before we get started, let’s establish the most important ground rule of securities law: if you offer or sell a security you MUST register it (either with a state regulator or the SEC) OR find an exemption such as Regulation D, which sets out the guidelines for exemptions from registration requirements, permitting some corporate entities—mainly smaller ones—to offer and sell securities without registering first. Below are some of the most common securities issues we see in private lending.

“It’s a Loan not a Security”

There are many potential scenarios in which a private lender is technically not offering a security because the investment is simply a debt structure. Examples include:

  • Co-Lender/Multi-Beneficiary Lending/Fractional Interests in Loans
  • Notes in Which the Investor Lends Money to the Company
  • Participation Interests
  • LLC or LP Interests

Debt investments are typically considered securities. There is a widely held misconception that simply because a given amount of capital is being loaned, it does not qualify a security. The analysis is considerably nuanced but can be simplified as follows: if the end investor is intended to be passive in their investment, and reliant on the private lender’s efforts for success (i.e., earn returns), it is always going to be considered a security. Additionally, if the above fact patterns are facing investors as opposed to other professional lenders, SEC regulatory officials will generally consider it a de-facto security.

To complicate matters, we have seen many private lenders offer these investments to non-accredited investors in MULTIPLE states. In these scenarios, federal anti-fraud regulations will apply and require the equivalent of a prospectus—meaning a private placement memorandum. This is a disclosure document intended to provide information to potential investors regarding the structure of the underlying business, the details of the investment opportunity, and the risks associated with both.

Investment Company Act & Investment Adviser Act Regulations

We see this mostly in the following forms:

  • Debt funds that buy/sell securities as part of its investment thesis
  • Lenders that also offer annuities
  • Private lenders that market their investment strategies as “Separately Managed Accounts”

If a debt fund is solely designed to be originating, funding, and/or making loans secured by real estate for its own account, there is a strong argument that the debt fund and its fund manager should not need to address compliance with the Investment Advisers Act and the Investment Company Act—meaning the fund manager would not have to file as a private fund adviser or register as a registered investment adviser. However, if the fund were to buy or sell securities—such as purchasing marketable securities, trading loans in such a manner that the trade constitutes a sale of securities or buy/sell exempt securities—all these requirements would then kick in and the fund or fund manager would have to take the necessary steps to remain compliant from a regulatory standpoint.

Private lenders who hold themselves out to the public as offering “real estate annuities” or “separately managed accounts” may find themselves in the same regulatory framework because these are strategies typically offered by Registered Investment Advisers (RIAs) and thus the private lender would be “holding oneself out” as an RIA. An RIA is an individual financial advisor or corporate entity that offers clients advice on financial matters and owes them a fiduciary duty (i.e., they have an obligation to act in their clients’ best financial interest and offer them the most cost-effective products) that is enforced via registrations with either the SEC or state securities regulators.

Commissions, Referral Fees, and Finders Fees

This is the most common issue we see in all securities related issues. The SEC has given clear guidance that “transaction-based compensation” is tantamount to broker-dealer activity. This means that paying an individual or entity to assist you in raising capital when the payment is premised on a transaction is not permissible unless the party being paid is a licensed broker-dealer. In other words, lenders should not pay referral fees, commissions, or even finders fees without first consulting with a qualified securities attorney. The SEC takes this very seriously and has historically penalized both parties with disgorgement, penalties, and potentially disqualification from offering or selling securities. Until the SEC rethinks its position on these rules, it is not advisable for issuers of securities to pay anything that remotely looks like a commission.

Still have questions about Securities law? Let us help. Contact Geraci LLP for more information today.

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