Insight

Navigating the US regulatory maze: What real estate managers need to know

US Flag

Following the passage of the 2011 Dodd-Frank Act, many real estate (RE) managers need to balance the legal and investor relations risks of non-compliance against the burden of unnecessarily complying with onerous disclosure and reporting requirements.

At IQ-EQ, we are trying to help RE managers navigate the complex maze of SEC regulations. To this end, we have published a detailed white paper on the registration and regulatory considerations applicable to RE funds. You will find below the key highlights excerpted from this paper:


What are the key RE fund structures in the US? 

  • For US taxable investors: Funds are structured as pass-through entities and, more specifically, as limited partnerships
  • For tax exempt organisations: Such investors can use a corporate entity or ‘blocker’ through which the business of the underlying flow-through fund is not attributable to the investor. However, with such blockers still subject to entity-level taxation, the use of a real estate investment trust (REIT) – subject to a completely separate tax regime – is gaining popularity. The most tax efficient structuring option is the use of private placement group annuity contacts (GAC) and insurance dedicated funds (IDF) that can be applied when an investment fund is ‘insurance dedicated’ and not publicly available.


What are the main legal and regulatory frameworks that apply to RE funds and their managers from a securities law perspective?

Securities law

Basic requirement and applicability to a fund

Investment Advisers Act, 1940

Regulates those who advise others, for compensation, on investing, purchasing or selling securities. Could potentially apply to GP or management company

Investment Company Act, 1940

Regulates the organisation of companies, including mutual funds, that engage primarily in investing, reinvesting and trading in securities, and whose own securities are offered to the public. Could potentially apply to the fund

Securities Act, 1933

Regulates businesses that issue securities. It generally requires the registration of securities and dissemination of financial information of the companies issuing securities, and prohibits certain potentially misrepresentative practices. Applies to the sale of interests in the fund-of-funds investors’ structures

Securities Exchange Act, 1934

Regulates securities transactions on the secondary market (after issue) as well as individuals or businesses who act as agents in the sale or trading of securities (broker-dealers). Applies to anyone compensated for sourcing investors, whether an employee of the fund manager or an unaffiliated third party

 

When are RE interests classified as securities under the Advisers Act?

The four-part ‘Howey Test’ emerged in the 1946 ruling by the US Supreme Court in the SEC v. Howey case to determine when a transaction is considered a security. To satisfy the test, four elements must be met: (i) an investment of money, (ii) in a common enterprise, (iii) with an expectation of profits, (iv) and derived from the efforts of a third party.

Type of interest

Status as security or otherwise

Direct real estate

Never classified as a security

Holding company: Limited partnership, LLC or JV

When a RE fund invests through a special purpose vehicle (SPV), if the interest is non-controlling or a minority share, it would be considered a security, while a controlling interest or majority share would be classified otherwise.

Real estate loans or notes

Securities laws generally imply that any ‘note’ is presumed to be a security. However, the 1990 ruling by the US Supreme Court in the Reves v. Ernst & Young case resulted in an additional test based on factors such as whether the parties’ intent is investment or short-term financing, if there is a broad distribution plan for the note, if the investing public would expect the note to be treated as security, or if an alternative regulatory regime governs the note. 

Stock in Real Estate companies

Almost always considered a security

 

Mixed portfolio

Mixed portfolios containing a variety of assets are subject to the same analysis as applicable to each individual asset above.

 

What are the compliance obligations when registration as an investment adviser is required because the applicable RE fund is investing in securities?

  • Making public disclosure filings
  • Submitting to periodic SEC inspections
  • Placing certain assets in custody
  • Obtaining fund financial statement audits
  • Restricting certain political giving if advisory services are provided to state/municipal investor
  • Complying with detailed record-keeping obligations
  • Implementing a comprehensive compliance programme;
  • Designating a chief compliance officer
  • Establishing a code of ethics to address standard conduct and fiduciary obligations.


What exemptions do the Securities Act and the Investment Company Act provide?

While a limited partnership or membership interest in the fund entity would generally be a security, and the sale of such interest subject to the Securities Act, 1933, a number of exemptions may apply.

Exemption clause

Particulars of exemption clause

4(a)(2) Private Placement

Under this exemption, issuers can sell securities to an unlimited number of ‘sophisticated investors’ without public advertising and general solicitation.  

Regulation D Safe Harbour

Most commonly used method to ensure compliance with 4(a)(2) and avoid offering securities to the public, relying on Rule 506(b) or 506(c)

Rule 506(b)

Allows a fund to sell to an unlimited number of accredited investors and up to 35 non-accredited investors

Rule 506(c)

Same as Rule 506(b) except that it offers smaller start-ups the flexibility to undertake general solicitation of investors

 

Whether or not a pooled investment vehicle qualifies as an ‘investment company’ under the Investment Company Act, 1940, is determined by answering the following question based on the four-part Howey Test: Does the pooled investment vehicle or fund invest in securities? Nevertheless, the ’40 Act contains a number of exemptions that allow an investment company to circumvent registration as an unregistered investment company or ‘private fund’.
 

Exemption clause

Particulars of exemption clause

3 (c) (1)

 

Exempts companies whose outstanding securities are not owned by more than 100 investors and which do not intend to do a public offering of such securities

3 (c) (5)

 

Exempts companies that primarily engage in purchasing or acquiring mortgages and other liens on and interests in real estate

3 (c) (7)

Exempts privately offered vehicles that restrict sales and ownership of outstanding securities to ‘qualified purchasers’

 

Ready to get grounded?

It is clear that the interpretation of SEC registration requirements poses a plethora of challenges in view of the multiple regulatory frameworks governing the treatment of RE interests and their classification as securities.