By William Kelly
Firms and individuals required to register as investment advisers and associated persons face a throng of regulatory requirements and restrictions. Under the Investment Advisers Act of 1940 (“Advisers Act”), investment advisers with assets under management (“AUM”) of $100 or more generally must register with the SEC. Registered investment advisers must maintain extensive records and are subject to ongoing SEC examination and reporting requirements. And while federal registration is not obligatory below the $100 million threshold, the majority of states mandate registration for advisers with between $25 million and $100 million in AUM.
An investment adviser, as defined under the Advisers Act, is any person or firm who meets three conditions: (1) engages in the business of advising others; (2) receives compensation in consideration for providing such advice; AND (3) the advice concerns the value of, or the advisability of purchasing or investing in, securities. The first two elements are easily triggered by private or real estate fund managers – their business model is rooted in the receipt of compensation in exchange for ongoing advice. The key question, therefore, is whether the advice pertains to “securities.”
Real estate is unmentioned in the Advisers Act’s definition of “security”. But the definition does include one particularly broad (and otherwise undefined) category: investment contracts. In a 1946 ruling, the Supreme Court held that an investment contract exists where: (1) a person invests money in a common enterprise; (2) the person expects profits from the investment; and (3) the outcome of the investment depends solely on the efforts of others. The case involved an offering of real estate interests; courts and SEC staff have since used this test to determine whether a real estate investment constitutes a “security.”
Each of a fund’s real estate investments must be analyzed in light of this three-pronged test. The outcome typically hinges upon the “solely on the efforts of others” factor, making the fund’s level of control or ownership over the investment critical. Where a fund invests directly in real property, this is clearly a real estate investment and therefore not a “security.” Conversely, highly structured investments such as those in securitized mortgages or other bungled real estate products are clearly “securities.”
Many real estate investment possibilities fall between these two extremes. This is where the “efforts of others” test becomes trickier. Passive investments in real estate are securities. Thus if the fund has no decision-making or managerial power over the real estate asset, this is a security investment. Indirect investments in real estate – where fund is invests in a separate entity, such as a partnership or LLC – typically are securities, though this involves more nuance. The key in this scenario is the level of control that the fund holds over the separate entity. If the fund buys shares of stock in a real estate investment corporation, the fund has little (or no) control – this is a security investment. Similarly, a limited partnership interest will likely be deemed a security – limited partners depend on the general partner to manage the asset. Conversely, if the fund obtains a general partnership interest, it will (probably) not be considered a security, given that general partners (or managing members, in the LLC context) have significant decision-making authority.
In each case, a fund manager seeking to remain unfettered by investment adviser registration must consult with counsel to evaluate each investment decision. Where too many of the fund’s real estate investments fall under the “securities” definition, the manager will be faced with the costly and otherwise burdensome prospect of investment adviser registration.
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