Tag: What’s a Security

Is it a Security?

In my ongoing quest to distinguish what’s a security and what’s not a security, a new case came down from Missouri on the topic. Disgruntled purchasers of condominiums at the Branson Landing Hilton Promenade Boutique Hotel felt they got a bad deal and sued the seller/issuer to get their money back: Obester v. Boutique Hotel (.pdf)

The owners claim the seller/issuer represented that the condominiums would be rented out and they would receive a portion of the profits, generating substantial revenue. I assume the investment did not turn out to be a financial windfall. According to the claim, the hotel rented its inventory of unsold units at a discounted rate.

Fee simple ownership of the “bricks and mortar” of real estate is not a securities transaction. “The offer of real estate as such, without any collateral arrangements with the seller or others, does not involve the offer of a security.” As you move further away from that model, you move closer and closer to the ownership a security than the ownership of real estate. The line between the two is not a bright line.

As with the Hard Rock San Diego case still working its way through the federal courts in California, combining the sale of real estate with a management agreement starts making the real estate look like a security.

In the Boutique Hotel case, the court goes back to the Howey case and uses a four part test to determine if there is an investment contract, where there is

  1. an investment of money,
  2. a common enterprise,
  3. a reasonable expectation of profits, and
  4. a reliance on the entrepreneurial or managerial efforts of others.

The court draws a distinction between a vertical commonality and a horizontal commonality to create a common enterprise. Vertical looks at the relationship between the seller and the purchaser. Horizontal focuses on the pooling of interests among investors. It’s an interesting way to look at the analysis, but it ends up not being decisive to the court.

What kills the securities claim is that the owners were not required to participate in the rental program. An owner could chose to not rent out its condominium or rent it out on its own. That means the business arrangement did not have a reliance on the entrepreneurial or managerial efforts of others.

That distinguishes the arrangement from the one being contested in the Salameh / Hard Rock San Diego case. San Diego restricted the rental program to the one run by the seller/issuer. Under San Diego zoning, the units had to be sold for non-residential use and be managed as part of the hotel.

These cases do little to help me decide when an interest in a manager-managed limited liability company is a security. But it’s clear that there is still a big gray space between what is a security and what is not a security.

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When is Real Estate a Security?

Fee simple ownership of the “bricks and mortar” of real estate is not a securities transaction. “The offer of real estate as such, without any collateral arrangements with the seller or others, does not involve the offer of a security.” As you move further away from that model, you move closer and closer to the ownership a security than the ownership of real estate. The line between the two is not a bright line. One of the latest cases to address the difference is Salameh v. Tarsadia Hotels 2011 U.S. Dist. LEXIS 30375, on appeal to the Ninth Circuit.

One of the seminal cases is SEC v. W.J. Howey Co., 328 U.S. 293 (1946). That case involved an offering of units of a citrus grove development, coupled with a contract for cultivating, marketing, and remitting the net proceeds to the investor. They held that it was an offering of an “investment contract” within the meaning of that term as used in the provision of § 2(1) of the Securities Act of 1933 defining “security” as including any “investment contract,” and was therefore subject to the registration requirements of the Securities Act.

Even though decades have passed, the line is bit a clearer, but still muddy as the Salameh case illustrates. The developer of the Hard Rock Hotel in San Diego used a condominium- hotel ownership structure to help provide capital.  The purchase/investment turned out to be a bad one, so they sued the developer.

Their claim was that a series of documents, including the Purchase Contract, the Unit Maintenance and Operations Agreement, and the Rental Management Agreement turned the ownership into a “security” and not the mere ownership of real estate. Since the securities were not registered, they could seek rescission. In this case, the ownership and control issues were not just split into separate documents, some of the documents were entered into at significantly different times.

The issues are not that new. The Securities and Exchange Commission noted the problem as far back as 1973 when it issued Release No. 33-5347 which had guidelines on the applicability of federal securities laws to the sales of condominiums and units of real estate development.

The investors/purchaser lost the court case.  The court The case is now under appeal and there are numerous other issues involved in the case so we may not any new insight on when an investment in real estate becomes an investment in a security.

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What is a Security? Is Real Estate a Security?


Previously, I went through the analysis that a fund manager is considered an investment adviser. But left open the question of “what is a security?” That’s a key question for fund managers with alternative investments, like real estate.

The Investment Advisers Act gives a very broad definition of a security:

any note, stock, treasury stock, security future, 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 (including a certificate of deposit) or on any 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, guaranty of, or warrant or right to subscribe to or purchase any of the foregoing. [202(a)(18)]

What’s missing from that definition is hard assets (collectibles, like baseball cards), futures contracts relating to commodities (but not future contracts relating to securities), and real estate (but not shares in real estate companies).

Pure bricks and mortar are not securities. So private equity funds that invest directly in hard real estate assets are not giving advice regarding securities.  As you start adding additional levels of ownership and holding companies, things get a bit grayer as you have more and more organizational boxes between the fund and the real estate.

One of the early seminal Supreme Court cases on the definition of a security involved a real estate deal. In 1946, SEC v W.J. Howey Co. (328 U.S. 293) involved an offering of units of a citrus grove development, coupled with a contract for cultivating, marketing, and remitting the net proceeds to the investor. They held that it was an offering of an “investment contract” within the meaning of that term as used in the provision of § 2(1) of the Securities Act of 1933 defining “security” as including any “investment contract,” and was therefore subject to the registration requirements of the Act.

For purposes of the Securities Act, an investment contract (undefined by the 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, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.

There are three components:

  1. expectation of profits
  2. a common enterprise
  3. depends “solely” for its success on the efforts of others.

So passive investments, where investors do not have any decision-making power are securities. Investments made by the principals who are actively involved in the management of the enterprise are not securities. Of course, that leaves a whole lot of business arrangement in between.

Shares of stock in a corporation do not have enough involvement to get them out of the characterization of securities. Most real estate is owned in partnership or partnership-like entities to take advantage of some favorable tax treatment.  There is an expectation of profits and it’s going to be a common enterprise. That leaves the “success on the efforts of others” as the key test for investment entities.

Traditionally, limited partnership interests are generally securities because limited partners rely on the general partners to manage the partnership. Since Delaware and other states have given limited partners to have more power in the management of the partnership and still retain their liability shield, the analysis has gotten harder.

For a general partnership, those interests are generally not securities because they fail to satisfy the “solely from the efforts of others” part of the test. Usually all general partners have decision making power with respect to the affairs of the partnership.

Limited liability company interests are tougher to make a general statement. If the LLC is member-managed, then each member is involved in management of the enterprise  and therefore their interests would generally not be securities. On the other hand, if the LLC is manager-managed, then members are may be just passive investors, and their LLC interests are more likely to be securities.

When it comes to real estate joint ventures, the managing interest is not going to be a security. The non-managing interest is more likely to be a security.

Notes, debt, and debt-to-own interests are likely to be considered securities. You can see notes listed right in the definition of securities. Given the continuing distress in the real estate debt markets, many fund managers are looking at buying distressed debt instead of pure bricks and mortar. That’s going to push them into the role of giving “advice about securities” and force them to look at registration as an investment adviser.

Deal structure may influence the analysis. It’s common in some jurisdictions to structure the transaction as a sale of interests in the owner of the real estate instead of a sale of the asset itself. That transaction structure could be viewed as a sale of securities, instead of a sale of real estate.

Image of Glass office building in downtown Los Angeles is by Ricardo Diaz