In this article you will learn two reasons why your real estate fund might not be an Investment Company and can therefore raise capital from an unlimited number of retail (even non-accredited) investors using Regulation Crowdfunding (Reg CF).
One of our clients is a real estate private equity fund that invests in real estate. Our client’s attorneys said their fund uses the 3(c)(1) exemption of the Investment Company Act of 1940, which provides an exemption from having to register as an investment company for a fund whose securities are not publicly offered and are owned by less than 100 investors.
Real Estate Fund Raising Capital Using Regulation Crowdfunding (Reg CF)
Our client wanted to fundraise from the public using the Regulation Crowdfunding (Reg CF) exemption, which allows companies to sell shares to the public without registering with the SEC.
Reg CF allows an unlimited number of investors. Our client and their attorney wanted to understand how they could maintain the 3(c)(1) status while doing a Reg CF where they may have more than 100 investors.
Can A 3(c)(1) Real Estate Fund Raise Using Regulation Crowdfunding (Reg CF)
The following is an annotated response our attorney, Mark Roderick, gave to answer this question.
First, Mark lays out his (correct) understanding of how the client’s private equity fund is structured.
As I understand, your fund buys fee-simple interests in real estate, such as multifamily projects. You put each project into a separate, wholly-owned limited liability company agreement for liability purposes. The fund controls each of those project entities.
Real Estate Fund Raise May Not Be and Investment Company
Mark explains why this type of company or fund is not considered an Investment Company defined in law as a company where 40% or more of its value comes from investing in securities.
Your fund is not a prima facie “investment company” and hence doesn’t need the exception under section 3(c)(1) of the Act, which provides an exemption for issuers with no more than 100 owners.
There are two reasons why your fund isn’t an investment company.
Reason #1: The Fund Doesn’t Own Securities
Under section 3(a) of the Act, an “investment company” means a company in the business of holding “securities.”
Section 2(a)(36) of the Act includes a definition of “security” similar to the definitions in the Securities Act of 1933 and the Securities Exchange Act of 1934. This definition would typically include an interest in a limited liability company.
However, the definition in section 2(a)(36) is qualified by the decision of the Supreme Court in Securities and Exchange Commission v. W. J. Howey Co. et al., 328 U.S. 293 (1946). There, the Court held that an arrangement is a “security” if and only if the following three criteria are present:
It involves an investment of money.
It involves a common enterprise.
The investor has a reasonable expectation of profits to be derived from the efforts of others.
Here the third criterion is not present. The fund isn’t expecting profit from the project entities from the effort of others but rather from its efforts as the controlling party. It’s the same reason general partnership interests aren’t securities.
Thus, the interests the fund holds in its subsidiaries aren’t securities, and because the fund doesn’t own securities, it’s not an investment company within the meaning of section 3(a).
Reason #2: 17 CFR §270.3a-1
A regulation issued by the SEC, 17 CFR §270.3a-1, provides that an issuer that would otherwise be treated as an investment company will not be treated as an investment company if no more than 45% of the value of its assets or its income is attributable to securities other than securities in companies:
That is controlled by the issuer;
Through which the issuer is engaged in a business other than investing in securities; and
Which are not investment companies themselves.
Each project entity owned by the fund satisfies all three of these conditions. Hence, the fund fits within 17 CFR §270.3a-1 and is not an investment company.
You can see that 17 CFR §270.3a-1 codifies Reason #1.
General Partner Stake is NOT a Security
In layperson’s terms, one of the critical aspects of what makes something a security is that one is purchasing a silent partner (or limited partner) interest in a company. No one expects a silent partner to show up for work. Buying a stake in a business that one will work at and control is, however, by definition, not purchasing a security.
Given this, if you, or the company you control, is a general partner (GP) in a real estate deal, your ownership in that deal is not a security. Therefore your company that owns the GP interests in real estate deals is not an Investment Company.
Most Real Estate Funds are Not Investment Companies and Can Use Reg CF
This distinction is important for another reason. Whenever one sells securities, the law states that they must be registered with the SEC unless one uses an exception. Reg CF is one such exception. Investment Companies, however, cannot raise money using the Regulation Crowdfunding (Reg CF) exemption from registering securities.
Since most real estate private equity funds invest in real estate as a GP, which are not securities, they are not Investment Companies and, therefore, can raise money using Reg CF.
Disclaimer: Invown does not offer investment of legal advice. This article is neither investment or legal advice and is for informational purposes only and for legal advice please seek out a qualified attorney.