Hypothecations and Participations: Securities Exemptions in Private Lending

October 15, 2020 by Tae Kim, Esq.

Whether you are considering hypothecation, participation, a fund, or any other type of capital-raising activity, there are a variety of exemptions that the sponsor or broker may rely on.

This article discusses the securities exemptions related to these types of investments, and potential trade-offs, limitations, and legal implications among securities exemptions that managers and servicers should be aware of when facilitating these investments.

Are Hypothecations and Participations Securities?

Generally, yes, hypothecation and participation interests are securities. Under the Howey test, a transaction is considered a security if: (1) it is an investment of money; (2) with expectation of profits from that investment; (3) to a common enterprise; and (4) profits are derived from a promoter or a third party. The Howey test is reiterated in the multi-beneficiary loan settings in People v. Schock, which clearly indicates that fractional interest in a promissory note constitutes a security because the investor is “committing relatively modest sums” with the expectation of a profit based on the reliance of “skill, services, and solvency” of a promoter or a company.

If the promoter goes out to the market to seek investors to arrange the loans funded to borrowers, hypothecation and/or participation interests are generally constituted as purchase of securities. On the other hand, if the lender also actively controls these investments, it is arguable whether the interests are considered securities. The key element of determining if an investment is a security is whether the investor controls such investment.

Are There Any Exemptions within Securities Laws?


California Corporations Code Section 25102(f)

In California, a manager or a company may rely on a 25102(f) exemption. California Corporations Code section 25102(f) exempts an Issuer for up to 35 investors who have a pre-existing or business relationship with the Issuer, provided that the investor is making an investment for its own account and that the Issuer has not made any advertisement to offer the security. California requires the Issuer to file a 25102(f) notice with the DBO and pay a filing fee.

Many other states provide similar exemptions. For example, in Delaware, the Issuer may be exempted from registration if the Issuer complies with and ensures and ensures that the Issuer has sold its securities to no more than 25 persons in the state during any 12 consecutive month period, among other things. The Issuer must also reasonably believe all investors are purchasing for investment using their own account.

Limitations on State Exemptions

One-off transactions, or limited transactions, appear to be the target of these limited state securities exemptions. However, when multiple deals with numerous investors across the United States come into play, there is a higher risk of violating state securities laws. The Issuer must conduct due diligence in any state an investor resides to determine whether the Issuer is in compliance with the securities laws in that state. Along with the possible integration doctrine that may be applied, establishing a fund is likely the proper route to take.

Fund Investments

On a long-term basis, investments by way of establishing a fund would be more feasible for both the Issuer and investors. The most popular and cost-efficient rule that an Issuer generally relies on is Rule 506 of Regulation D. From a securities law perspective, the reason a fund should be created is two-fold – it creates an exemption from registration with the SEC, and it preempts state laws, in that the fund manager is not concerned about state regulations. In the event an investor resides in a different state than the Issuer, the manager need not be concerned about out-of-state securities laws compliance.

Fund investments also have practical implications. First, investor funds are more centralized. They are all in one account, and deployment of capital becomes much easier and more efficient to fund loans. The Fund becomes the lender of record, and the control of the loans and underlying property is all within the control of the Fund and its manager. The investors become “passive” because of limited control on the governance of the Fund, as reflected in the governance documents. On the other hand, investors have certain remedies under the securities laws, including allegations of a violation of Rule 10b-5. The SEC, as a matter of public policy, disallows Fund managers from circumventing Rule 10b-5 violations.


There are various securities law implications when making investments in hypothecations, participations, and fund investments. In certain instances, securities laws may not apply, as “control” appears to one of the main aspects in determining whether an investment is a security. When making these types of investments, issuers and investors alike should be cognizant of the securities implications and consult with securities counsel for assistance.

If you have any questions about the securities exemptions above, reach out to Geraci Law Firm here.

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