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Raising Capital With Private Lending

private lenders

SECURITIES CONSIDERATIONS WITH PRIVATE LENDING

Raising Capital With Private Lending 1

Private lending has been promoted since the 1990s as a way to raise capital.

private lenders

It’s the process of getting individuals to lend you money in exchange for fixed interest payments and a debt position in an asset like real estate acquired with the borrowed funds or in your business itself. From the lender’s perspective, the advantage of debt is that in a liquidation, debt holders have priority over equity holders.

Private debt instruments can be secured and unsecured. With real estate, common secured debt include promissory notes and mortgages or deeds of trust secured by real estate.

When taking money from a third-party to fund a business or real estate acquisition, the first question you have to ask yourself is if your transaction constitutes a security under state and federal securities regulations.

Do the borrowed funds in exchange for a secured promissory note constitute a securities transaction? Does the promissory note constitute security?

If the question is yes, you must either register your securities or qualify for an exemption from state and SEC registration.

The securities laws were instituted to protect investors – to ensure they receive accurate and complete information from the people taking their money about an investment opportunity.

On the federal level, the Securities Act of 1933 (adopted in the aftermath of the stock market crash that launched the Great Depression) requires companies seeking capital to either register through the expensive IPO process or qualify under an exemption for a private offering.

The most common exemptions relied on by companies are found in Regulation D of the Act. In either case, capital seeking companies are expected to deliver investors adequate documentation with all required disclosures before taking their money.

For public offerings, this documentation is the form of a prospectus and for exempt private offerings, this documentation is in the form of a Private Placement Memorandum (PPM).

Real Estate Private Lending and Securities

As a general rule, the situation where ONE private lender loans money to an investor to purchase a specific real estate asset secured by that asset using a promissory note and mortgage or deed of trust, this arrangement would be considered a transaction exempt from federal and state securities regulations.

Hard money is a common form of private real estate lending that is exempt from securities regulations. With hard money, it’s the lender that is typically soliciting the borrowers.

The real estate entrepreneur crosses over into securities territory when they no longer have a one-to-one transaction – one lender for one property. Once they start pooling investor funds when capital from multiple investors is used to acquire one or more real estate or business assets.

In contrast to hard money lenders who do the soliciting, in the pooled capital scenario, it’s typically the borrower doing the soliciting and this will be relevant to state and federal securities regulators.

As I mentioned, going public is a time-consuming and expensive process.

Naturally, many small companies can’t afford to hire Wall Street law firms and investment banks to go public so most want to avoid this. Many small companies look to qualify under one of the Regulation D exemptions; although less time burdensome than going public, can still take time and cost money in the form of legal and professional expenses involved.

For those who try to avoid the “security” designation altogether to avoid any securities compliance requirements to save time and money . . . Beware!

When Private Lending is Bad Advice

Those who seek to avoid having their offering be called security are usually the ones who get into the most trouble.

As a general rule, when it comes to securities, it’s better to be safe than sorry since being sorry can be in the form of civil and criminal liability.

Unfortunately, there is a lot of bad advice out there on how to skirt securities rules to save a buck or to tout a do-it-yourself ethos.

For example, there are a host of gurus and “glorified experts” out there who tell you you don’t have to worry about securities regulations when it comes to private lending because your borrowing arrangement is a “private transaction.” The word private says it all. No need to get regulators involved they tell you.

These hacks insist private lending is a transaction between two private parties, with the implication that it’s exempt from regulations.

I’ve seen this same excuse in a different type of business transaction on an episode of LIVE PD. The “john” told law enforcement it was just a private transaction between consenting adults and that there was no reason for the police to be involved. We all know how that turned out. He was arrested. That excuse didn’t work for the “john” and it won’t work for the guy pooling investors no matter what they call their transaction.

Exempt Transactions

When is private lending exempt?

Are you a lender in the business of lending money like a hard money lender or is the money coming from a pooled group of lenders financing your venture because you initiated the idea?

Some states such as California allow licensed real estate brokers and other licensed financial professionals to pool multi-lender capital to fund real estate acquisitions secured by mortgages or deeds of trust, but those exceptions are few and far between.

Trouble Finds You

If you’re skirting the securities regulations, here’s how it falls apart.

Let’s look at the two groups of regulators who would be interested in your activities:

  • The SEC (slow to act).
  • State Regulators (fast to act on complaints).

How do you get caught?

  • Inquiries from potential investors.
  • Complaints from your competition.
  • Your outreach hits the wrong house.

At one of my events, an attendee had sent out a direct mail campaign and one hit the house of a financial advisor. With one call by the financial advisor to state finance and securities regulators, the attendee was suddenly flooded with inquiries from state regulators wondering what they were up to and if they were violating any state regulations.

How do You Know You Have a Security? What’s the law?

SEC vs. Howey

Entrepreneurs have been trying to skirt securities laws and regulations for decades. The SEC finally had enough and in 1946 it put its foot down.

Before 1946, a security was what the SEC said it was in the Securities Act of 1933, which defined a security as “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, or investment contract.”

Many a hack and conman thought that if they just called their security by some other name that this should escape scrutiny by state and SEC regulators. They were in for a rude awakening.

In 1946, the SEC decided to hit entrepreneurs trying to get cute with the meaning of a security by broadening the term “investment contract” to serve as a catch-all. It did it through the landmark 1946 Supreme Court case, SEC vs. Howey where it came up with a four-part test for determining whether a scheme was an investment contract and therefore a security.

The test – known as the Howey Test – is still used today. The test uses four factors for determining whether a transaction is a security. According to the test, to be considered an investment contract, the following conditions must be met:

  • An investment of money.
  • In a common enterprise (pooled money with other investors).
  • With an expectation of profits.
  • Derived from the efforts of a third party.

Consequences | What can happen to you?

All securities transactions – even exempt transactions and even whether you think you’re offering a security or not – are subject to the antifraud provisions of the federal securities laws.

This means that you and your company will be responsible for false or misleading statements that you or others on your behalf make regarding your company, the securities offered, or the offering.

Violations of the antifraud provisions can result in criminal, civil, and administrative proceedingsPrivate parties also can bring actions under certain securities laws. Also, if all conditions of the exemptions are not met, purchasers may be able to return their securities and obtain a refund of their purchase price.

What are common examples of someone violating the antifraud provisions?

  • Not disclosing material facts. For example, telling your investors you’re not offering a security. Other examples include misstatements about management’s experience, the company’s business, etc.
  • Not following the use of proceeds represented to the investors. For example, using proceeds for personal compensation without disclosing this to the investors.

On the SEC’s Radar

The surge of private lending vehicles for raising capital – much of it due to bad advice from online hacks – has drawn the attention of the SEC.

Security regulators have taken aim at real estate investors that are pooling money through the sale of promissory notes, trust deeds, and the like but are not qualifying their offerings under an exemption.

Regulators have focused on real estate investors that are advertising real estate securities to stop companies from selling unregistered or unqualified securities.

For Your Protection When Raising Capital

Securities regulation has its advantages. While some real estate companies are following through on their commitments – paying the returns they offered their investors – others are not. Being registered or qualifying under an exemption and providing the required disclosure documents (i.e., prospectus, PPM) not only protects those investing money in your company, but it also protects you.

If your company loses money, but you gave your investors a fair warning about all the risks involved, having those disclosures documented protects you from your investors.

With everything documented in your offering document, you’ll be able to avoid the “he said she said” rabbit hole as long as you disclosed all the material facts regarding your offering and all your investors were qualified for the offering.

Don’t look at securities regulation as a negative. Securities regulation not only weeds out the competition but also lends legitimacy to what you’re doing. Having an offering document makes you look “official” and gives you credibility.

Final Warning

The state regulators are the SWAT team of securities regulation. They’re the first responders. States are not sitting around waiting for the passive investors to cry for help. They are proactive – looking for trouble before people seriously get hurt. They are actively searching for violators anywhere they can – on Facebook, LinkedIn, in search results, Craigslist, traditional media, etc. Anyone advertising an offer of a return in exchange for their money is going to draw attention.

After the state regulators swoop in, next will be the SEC. They are specifically looking for solicitations for private lenders – and it’s not just online. Several have been found advertising in magazines, newspapers, and direct mail.

Don’t fall for the B.S. offered by talking heads and so-called “experts” who have no clue what they’re talking about. They just want your views and your clicks. Don’t listen to these clowns. Calling the transaction a private transaction isn’t going to save you. If it walks and talks like a security, the regulators are going to call it a security no matter what you call it. It doesn’t work for the sex worker on Hollywood Boulevard and it sure won’t work for you when the enforcement division of your local state securities division comes knocking.

You don’t want to mess with securities laws. Screwing up can result in civil penalties, jail, or both.

One of the private lending situations that would be exempt from regulation would be the hard money-type situation involving a one-for-one transaction – one lender for one property. The only other way to keep out of being considered a security is if you and your investors are involved in a true partnership where all of you have a vote and say in the business and are ACTIVELY involved. Of course, most entrepreneurs want the freedom to run the company as they see fit, so giving up power is not something they would consider.

Saying your investors have a say but putting in provisions in your contracts that would essentially neuter them isn’t going to cut it. It will be your burden to prove to the SEC that your other partners are actively involved.

Ignorance is not a defense. There is no workaround to the SEC laws. They have locked that down six ways from Sunday, as many people before us have learned the hard way to try to game the system.

The SEC has what I call the “mom and dad” rule. Whatever they say is what it is on any given day. Don’t matter how many ways you slice it up, or how many beers you kick back with someone, the law still applies. They can and will step through whatever scheme you set up and bust you just by looking at your intent.

Now that I’ve scared you, I don’t want you to be discouraged.

Just because the regulators are cracking down on private lending doesn’t mean you can’t use it to your advantage and raise the money you need for your real estate ventures.

You just have to do it the right way. Doing it the right way can mean your company being flush with capital to operate your legitimate real estate investing business without looking over your back.

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