One of the challenges with real estate funds is staying within the various requirements of a real estate fund at the beginning of its life and at the end of its life. At start-up, the fund may be sitting on substantial non-real estate while it is starting to invest. Similarly at the end of its life, a fund may be sitting on substantial non-real estate while its real estate investments have been sold off. Then the fund has to run through the muddy area of whether any of its non-real estate holdings are “securities”. That analysis is key when addressing the definitions and exemptions under the Investment Company Act.
Landwin Partners Fund I ran into this problem and got hit with an action from the Securities and Exchange Commission. The action was against the fund manager and the principal of the fund manager.
The fund manager, like all of us, noticed that the fund’s cash holdings were producing little to no interest. The fund’s bank/financial company offered some short-term bank notes to earn some interest. That spread to bonds, preferred stock and common stock that were unrelated to real estate.
According to the SEC order, $2.4 million of the fund’s $20 million of capital was in these non-controlling, non-real estate interests. The first problem was that the fund’s offering documents didn’t authorize investments in anything other than real estate. That put beyond its organizational powers.
The second problem was that the high ownership level of true securities implicated the Investment Company Act. Section 3(a)(1)(C) of the Investment Company Act defines an “Investment Company” as
“engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis”
The Securities and Exchange Commission lumped the fund’s holdings in real estate-related limited partnership interests and mortgage loans together with the publicly traded securities to take the position that the fund had exceeded that 40% threshold in the definition of an “Investment Company.”
I was surprised to see real estate partnership interests and mortgage loans being included in the definition of “security” for the purposes of the definition of an “Investment Company.” The fund had over 300 investors so it could not use the 3(c)1 exemption which imposes a 100 investor cap. I would assume that the investor base did not qualify the fund for exemption under 3(c)7 which requires the investor base to be “Qualified Purchasers.”
That would leave the fund looking to use the 3(c)5 exemption for investments in real estate. I assume the SEC took the position that the investments were securities and not the type of investments that qualify for the 3(c)5 exemption.
The SEC order didn’t go into details about the failure of the fund to meet those exemptions. It merely states that the fund failed to meet any exemption.
Similarly, the SEC order didn’t provide any information on why the real estate limited partnership interests or mortgage loans should be considered “securities.”
Mortgage loans as securities? Maybe. Sure, bonds and participating interests are more likely to be considered securities. If the fund was the lender, I didn’t think the loan would be considered a security. The order doesn’t tell us anything about the nature of the mortgage loans that made them securities. I would think that a mortgage loan would be considered an asset that qualified under the 3(c)5 exemption as “…(C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.”
Similarly, real estate limited partnership interests could be considered a security. It should depend how much control the limited partner has over the partnership. I believe that having major decision rights and some control over management moves the interest out of the definition of a security. As with mortgage loans, I would think that real estate-related limited partnership interests would be considered an asset that qualified under the 3(c)5 exemption as “…(C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.”
Real estate fund managers who are not registered as investment advisers should be concerned about this case. It sounds like the SEC is possibly taking an aggressive approach on what is a security and the availability of the 3(c)5 exemption for real estate fund managers.
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