Organizing a Real Estate Syndicate and Securities in California

Red Rock CanyonAuthor: Staff

Real estate syndication allows you to put your private savings into real estate investments when other financing isn’t available for them. The syndicator’s responsibilities and obligations to an investment group and the investors’ responsibilities to each other are determined by how the syndication is organized.

Choosing the form of organization requires the syndicator to look at the advantages and disadvantages of each. Many people prefer a limited partnership. When there is a corporate form, you can have central management, but most syndicates do not use this form because of negative tax consequences. General partnerships allow you to avoid double taxation but incur unlimited liability, and in addition, there is no central management. A limited partnership allows you to have centralized management but also keep certain tax advantages.

Some syndicates are organized as limited liability companies. This form allows members to actively participate in managing the syndicate and provides for limited liability with specific exceptions. It can incur taxes like a partnership, while avoiding certain double taxation problems that happen when the form of the syndicate is a corporation. But an LLC cannot hold a real estate license in California.

As of 1978, the regulation of real estate syndicate interests is conducted by the California Department of Corporations. Certain forms of business used to pool the investment money for a syndicate may be considered securities offerings. If it’s a securities offering, the syndicator will then need a permit or exemption from permitting from the Department.

Sometimes an interest in a syndicate is a security, and it’s important to be aware of the securities laws in connection with organizing the syndicate or investing. The SEC has enforcement authority over securities, so numerous problems can arise in connection with the offer and sale of these interests.

In 2012, the SEC announced an asset freeze against a firm and owner that it accused of real estate investment fraud. They claimed that the firm and its owner were selling units in partnerships that had been organized to buy empty land and then sold them at a profit at a later date. But they didn’t tell investors that they were in some cases paying more than five times the fair market value of the land. They also didn’t tell investors that this land was encumbered by mortgages that were used to help finance the purchases.

In arguing against the SEC’s request for a preliminary injunction, the firm and its owner argued that these interests in the general partnership were not securities because the general partnership was not an investment contract. They also argued that when an investor in a real estate syndicate anticipates that profits will arise from the appreciation of real property values, the investment can’t be considered a security subject to SEC enforcement.

The appellate court in that case explained that securities laws define “security” to include investment contracts, which are any contracts whereby someone invests money in a common enterprise and is led to anticipate profits only from a third party’s efforts. In other words, schemes can’t avoid securities laws just by calling themselves joint ventures or general partnerships.

Generally, the test is that an investor can designate that a joint venture or general partnership interest is a security when:  (1) the agreement leaves so little power with the partner or venturer that the arrangement distributes power in the same way that a limited partnership would, (2) the venturer or partner is so inexperienced in business that he can’t intelligently use the power he has, and (3) the venturer or partner depends so much on the unique managerial or entrepreneurial ability of the manager or promoter that he can’t replace that manager or otherwise use meaningful partnership powers.

The key question is an investor’s expectations when he or she initially invests, rather than what happens if an investor later delegates powers to a promoter or partner. A court will look beyond the general partnership agreement to other materials, including oral representations made by a promoter at the time of investment.

If you are thinking about forming a real-estate investing syndicate, it is important that you have counsel prepare not only the corporate documents, but also properly navigate the securities laws.

If you are considering putting together a real estate syndicate, you should also read our article that digs into the question of when is an interest in a California real estate syndicate a “security” under state and federal laws.

You might also enjoy our article on FINRA Arbitration of Disputes related to Real Estate Syndicates.

More Blog Posts:

Why Should I Invest in Real Estate?

The Golden Rule of Real Estate Investing: Like-Kind Section 1031 Exchanges