The Covering Legal and Regulatory Issues of Management

VOL. 24, NO. 9 • SEPTEMBER 2017

When Real Investing Involves Securities: An Overview of Advisers Act Registration Obligations for Fund Managers By John D. Reiss

hile many US real estate fund manag- eliminated the so-called “fourteen-or-fewer clients” ers may not view themselves as being in exemption in 2011, previously unregistered private Wthe business of investing in securities (or fund managers of a certain size were confronted with advising on such ), a signifi cant portion a potential registration obligation under the Advisers of the industry has reluctantly found itself subject to a Act.1 For many managers that sponsor hedge, pri- registration requirement or other compliance obliga- vate equity, and funds, the analysis was and tions as an investment adviser under the Investment remains straightforward: their funds clearly invest in Advisers Act of 1940, as amended (the Advisers Act). “securities” and, as such, they are required to regis- As discussed further below, proceeding without reg- ter as an investment adviser with the US Securities istration is entirely appropriate in the right circum- and Exchange Commission (SEC).2 For private real stances and should be strongly considered, but taking estate fund managers, however, the analysis is often this approach may reduce a manager’s fl exibility in more nuanced. marketing its business and managing its portfolios. Th e Advisers Act defi nes “investment adviser” to As such, each manager’s examination of its status and include (with certain exceptions): options is a bespoke exercise that requires careful con- sideration of its current and anticipated investments, any person who, for compensation, engages in its marketing strategy, its size, and the expectations the business of advising others, either directly and demands of its base. Th is analysis is par- or through publications or writings, as to the ticularly important for new and emerging managers, value of securities or as to the advisability of but can also be relevant for more established manag- investing in, purchasing, or selling securities, ers that have thus far remained unregistered (or that or who, for compensation and as part of a may wish to consider de-registration). regular business, issues or promulgates analy- ses or reports concerning securities.3 Impact of Dodd-Frank; Key Advisers Act Defi nitions Th e defi nition naturally focuses on securities When the Dodd-Frank Wall Street Reform because the SEC is dedicated to overseeing the secu- and Consumer Protection Act (Dodd-Frank Act) rities industry. It does not regulate real estate agents,

Copyright © 2017 by CCH Incorporated. All Rights Reserved. 2 THE INVESTMENT LAWYER private home sales, or direct purchases of commer- 1934 (the Exchange Act). For the most part, the SEC cial buildings. By way of example, Form ADV, the and courts have interpreted the defi nition under registration statement for investment advisers, lists these various Acts consistently, although in some cir- real estate together with collectibles and commodi- cumstances the defi nition of “security” has been held ties as being “non-securities” that are excluded from to be more expansive in the Investment Company calculating an investment adviser’s under man- Act context. Nevertheless, interpretations of the def- agement.4 can frequently over- inition under each of these Acts can be informative lap with securities investing, however, so care should as the SEC has cited to them when engaging in the be taken before a real estate fund manager tries to analysis under the Advisers Act.7 simply opt out of the defi nition. Th e Advisers Act Whether certain real estate-related assets consti- makes it unlawful for an investment adviser to con- tute securities depends on the facts and circumstances duct its business in the United States absent registra- in each case. Th ere is no dispute that certain interests tion or a relevant exemption.5 are not securities. For example, a fee simple interest Th e Advisers Act defi nes “security” as in real estate is not a security.8 Such interests stand at one end of the spectrum. Publicly traded mortgage- any note, , treasury stock, security backed securities, passive interests in widely off ered future, , debenture, evidence of indebt- REITs or passive interests in any investment vehicle edness, certifi cate of interest or participation such as another real estate investment fund, how- in any profi t-sharing agreement, - ever, are each securities under most circumstances. trust certifi cate, preorganization certifi cate Between these two extremes are various other or subscription, transferable share, invest- real-estate-related assets that must be analyzed based ment contract, voting-trust certifi cate, cer- on the particular facts and circumstances. tifi cate of deposit for a security, fractional undivided interest in oil, gas, or other min- Holding Companies and Joint eral rights, any put, call, straddle, option, or Ventures privilege on any security (including a cer- Many real estate funds hold real estate assets tifi cate of deposit) or on any group or index through holding vehicles or other structures formed of securities (including any interest therein by the fund or by the investment manager on behalf or based on the value thereof), or any put, of the fund. Such a holding company may be a lim- call, straddle, option, or privilege entered ited partnership or limited liability company, for into on a national securities exchange relat- example. Th e SEC has taken the position that lim- ing to foreign currency, or, in general, any ited partner interests in a limited partnership that interest or instrument commonly known as holds and manages real estate assets generally are a “security”, or any certifi cate of interest or securities for purposes of the Securities Act and the participation in, temporary or interim cer- Investment Company Act.9 A general partner inter- tifi cate for, receipt for, guaranty of, or war- est, however, is generally not considered a security rant or right to subscribe to or purchase any unless, for example, the general partner does not of the foregoing.6 participate in management or has any ability to do so (such that while labeled a “general partner” it Virtually identical defi nitions are provided under may be viewed as “relying on the eff orts of others” the Securities Act of 1933 (the Securities Act), the rather than its own).10 If such a general partner also Investment Company Act of 1940 (the Investment formed the underlying limited partnership as part of Company Act), and the Securities Exchange Act of a fund formation process (as opposed to acquiring

Copyright © 2017 by CCH Incorporated. All Rights Reserved. VOL. 24, NO. 9 • SEPTEMBER 2017 3 such interest on a secondary basis), this would also contract arises from the Howey case.13 Under Howey, lend further support to the position that such a gen- an investment contract constitutes a security when eral partner interest is not a security. With respect there is: (1) an investment of money; (2) in a com- to a limited liability company, the role of a man- mon enterprise; (3) where a person is led to expect aging member or manager could also be viewed as profi ts; (4) solely from the eff orts of the promoter or substantially analogous to that of a general partner third party. Additionally, analysis of whether a debt for purposes of the foregoing analysis. Additionally, instrument is a note that may be deemed to be a wholly-owned limited liability companies (or other security for purposes of the Advisers Act might be wholly owned vehicles such as subsidiary REITs) are informed by factors set forth in the Reves case under often formed for the purpose of holding one or more the Securities Act (for example, plan of distribution, real estate assets. Generally speaking, if a fund forms an expected secondary , etc.).14 an entity through which to hold an asset that is not a security, such formation should not constitute advis- “In the Business” ing on an investment in securities. Separately, to fall within the defi nition of an A “joint venture” is also a common construct investment adviser, a person must be “in the busi- in the context of real estate investment. Th e term ness” of providing advice with respect to investing does not necessarily refer to any specifi c type of legal in securities. Th e SEC Staff has said that it “con- entity (a so-called joint venture could be formed as siders a person to be ‘in the business’ of providing a limited partnership, a limited liability company, such investment advice if, among other things, the or even a corporation, for example), but rather is person provides specifi c investment advice on any- a descriptive term implying joint economic partici- thing other than rare, isolated and non-periodic pation along with some notion of joint managerial instances.”15 As such, a real estate fund manager that responsibility. Th e SEC Staff and various courts advises on investments in securities only occasion- have agreed that a joint venture need not be treated ally, and does not hold itself out as providing advice as a security, and the Staff also has accepted that on investing in securities, could potentially make the position even in the case of a joint venturer hav- argument that they do not meet the defi nition of ing just a 25 percent stake, as well as in the case an investment adviser simply because they are not of a joint venture formed as a corporation (which in the business of providing investment advice with issues shares of common stock that are more com- respect to securities. monly known as securities).11 As such, while the rel- evant facts and circumstances are critical, it is clear RAUM Thresholds; Interplay that real estate joint ventures can potentially be with Investment Company Act considered non-securities for purposes of the Assuming for argument’s sake that a real estate Advisers Act.12 fund manager does fall within the investment adviser defi nition, that manager generally speaking would Real Estate Debt also have to have $100 million or more of “regulatory For real estate fund managers that focus in assets under management” (RAUM) to be required whole or in part on real estate-related debt, the ques- to register under the Advisers Act.16 In making this tion becomes whether the relevant debt instruments determination, a manager must calculate the value of could be characterized as “investment contracts” its securities portfolios. With one important excep- or “notes” such that they could be viewed as being tion, a fund or account is a “securities portfolio” only securities under the Advisers Act. Th e key analysis in if at least 50 percent of its value is attributable to considering whether an instrument is an investment securities. Th e critical exception to that general rule

Copyright © 2017 by CCH Incorporated. All Rights Reserved. 4 THE INVESTMENT LAWYER is that for any “private fund” (that is, any fund that While Advisers Act registration does not imply any is not registered under the Investment Company particular level of skill or training, it does involve Act in reliance on Section 3(c)(1) or Section 3(c)(7) an inherent degree of regulatory oversight that thereof), the entire value of the fund is included for tends to be viewed in a positive light by prospec- purposes of calculating RAUM, regardless of the mix tive . Other managers may just desire the of securities and non-securities held by the fund. fl exibility to be able to invest in any type of real While in-depth Investment Company Act analysis estate assets, including real estate-related securi- of real estate funds is outside the scope of this arti- ties, without having to continually monitor and cle, the intersection between the Advisers Act and analyze their registration obligations. Conversely, a the Investment Company Act can be very relevant large unregistered real estate fund manager should to the Advisers Act analysis. For example, it would be prepared to receive questions on the topic given seem unlikely (although perhaps not impossible) the prevalence of Advisers Act registration among that a real estate fund manager whose funds and/or its peers (and the same would be true for a reg- co-investment vehicles all rely on Section 3(c)(5)(C) istered manager considering a de-registration). As (the real estate exemption from registration under noted previously, however, a no registration posi- the Investment Company Act17) would have suffi - tion for such a manager may be entirely legitimate cient RAUM to be able to or be required to register and appropriate, and such an approach could be under the Advisers Act. Conversely, a real estate fund explained in detail to any interested parties. manager whose funds and/or co-investment vehicles And what about smaller or emerging real estate all rely on Section 3(c)(1) or Section 3(c)(7) and have fund managers for whom a no-registration position an aggregate value of more than $100 million would is viable, including on a going forward basis, and to seem more likely than not to have a registration obli- whom the legal and compliance costs and ongoing gation.18 As such, the compliance approaches taken obligations for Advisers Act registration seem daunt- by a real estate fund manager with respect to its own ing? For these managers it may also make critical registration status under the Advisers Act and that business sense to remain unregistered.21 Advisers of its funds and/or co-investment vehicles under the Act registration entails the preparation and fi ling of Investment Company Act are intimately connected, Form ADV, which calls for information regarding and one should not be addressed without consider- an adviser’s ownership structure, business activi- ation of the other. ties, investment strategies, fees, disciplinary history and confl icts of interest, among other items. Form Market Practice and SEC Focus ADV is publicly available and must be updated at on Real Estate Fund Managers least annually. Advisers Act registration also requires It is interesting to note that Advisers Act reg- appointment of a chief compliance offi cer and devel- istration is fairly commonplace among the largest opment of various compliance policies and proce- real estate fund managers in the current market.19 dures.22 Th e Advisers Act places certain restrictions At least some of these managers likely registered on advertising and political contribution activity, even though they could take the position that as well as on arrangements for the custody of cli- they are not required to do so (or, by extension, ent assets, and requires that an adviser maintain even though the SEC could theoretically chal- certain books and records regarding its business. lenge their basis for registering20). Some of these Signifi cantly, an adviser registered under the Advisers managers may view Advisers Act registration as Act is also subject to both routine and special exami- helpful in their marketing eff orts and in the due nation by SEC Staff , which can be an operationally diligence process conducted by potential investors. burdensome and intimidating exercise. A recent

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SEC “sweep” examination targeting real estate advisers serves to highlight both the prevalence of John D. Reiss is counsel at Shearman and Advisers Act registration among such managers, as Sterling LLP. Th e author would like to thank well as perhaps the intention of the SEC to extend the partners in his fi rm’s Investment Funds and its regulatory reach further into the real estate sec- Real Estate practice groups (and, in particular, tor.23 Areas of particular interest for this SEC ini- Nathan J. Greene) for their assistance and sup- tiative have included expense allocations, the use of port in the preparation of this article. affi liates for services such as management (and the related fees paid in connection therewith), NOTES and co-investment procedures. 1 Th e “fourteen-or-fewer clients” exemption was widely Regardless of size, should a real estate fund man- available to fund managers in large part because ager decide not to register, it also should be mindful each fund was generally deemed to be only one cli- of the applicable Advisers Act analysis when crafting ent, with no look-through to underlying investors. its disclosure in private placement memoranda and Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). the provisions of its fund operating agreements (for Th ough outside the scope of this article, it should example, clear investment limitations or deal struc- be noted that, post-Dodd-Frank, private real estate turing parameters that are helpful for its Advisers fund managers, particularly those that engage in any Act analysis could be considered, and extra caution interest-rate or currency hedging activities, need should be taken with respect to any discussion of to also be mindful of their potential registration or investing in securities). notice fi ling obligations as a “commodity pool opera- While Advisers Act registration has become tor” and/or “commodity trading advisor” under the increasingly common for real estate fund managers Commodity Exchange Act. of all sizes in recent years, those managers whose 2 Much has been made recently of a potential overhaul investment portfolios and strategies allow them of the Dodd-Frank Act, and a total repeal (or tar- to do so still have every right to take the position geted resurrection of the “fourteen-or-fewer clients” that, since they advise on investments in real estate exemption) would dramatically alter the registration and not securities, they are not required to register landscape for many fund managers. Additionally, on under the Advisers Act. With the Trump adminis- June 8, 2017, the US of Representatives passed tration and new SEC leadership now at the helm, it the Financial CHOICE Act of 2017 (the CHOICE also remains to be seen whether the SEC may take Act), which proposes to scale back or eliminate many a more hands-off approach to real estate fund man- of the post-crisis fi nancial reforms promulgated by agers generally, including with respect to enforce- Dodd-Frank. Section 858 of the CHOICE Act calls ment actions and the interpretation of registration for Section 203 of the Advisers Act to be amended by obligations.24 (a) providing that no investment adviser shall be sub- Both emerging and larger fund managers ject to the registration requirements of the Advisers who are uncertain about their Advisers Act sta- Act with respect to providing investment advice tus (or who believe they could tailor their busi- relating to a private equity fund, and (b) requir- ness and product off erings so as to not be subject ing that the SEC issue fi nal rules to: (i) defi ne the to a registration requirement) should consult with term “private equity fund” for these purposes, and legal counsel regarding their particular situation. (ii) require investment advisers to private equity funds Th oughtful analysis to determine available options to maintain such records and provide such reports and an appropriate course of action is well worth as the SEC deems necessary. Th is proposed Advisers the time and eff ort. Act amendment has the potential to release a wide

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universe of private fund managers from Advisers (in which the Th ird Circuit held that a limited part- Act registration requirements, but the SEC’s defi ni- nership interest was not a security for purposes of the tion of “private equity fund” and the reporting and Securities Act where the limited partner held a 98 recordkeeping that will be required of such unreg- percent interest as well as various approval and con- istered advisers will be critical to determining the trol rights). true practical impact. Further, the prospects for the 10 See, e.g., Williamson v. Tucker, 645 F.2d 404 (5th Cir. CHOICE Act to be passed by the US Senate and 1981), cert. denied, 454 U.S. 897 (1981) (Williamson) become law in its current form are uncertain at best. (under the Securities Act and the Exchange Act). See As such, while any progression of the CHOICE Act also Coldwell Banker Commercial Group, Inc., SEC should be closely monitored, it would be premature Staff No-Action Letter (Jan. 21, 1982) (Coldwell at the time of this writing (July 2017) to rely on its Banker) (under the Advisers Act). Th e analysis is implementation as part of any analysis of a private based on the facts and circumstances and driven real estate fund manager’s registration obligations by the premise that a controlling interest, involving under the Advisers Act. active and extensive participation and management, 3 Section 202(a)(11). negates the existence of a security in the context of 4 Form ADV: Instructions for Part 1A, Instruction to real estate investment. Item 5.F, p.9. 11 See, e.g., Williamson; Gordon v. Terry, 684 F.2d 736 5 See Section 203(a) of the Advisers Act. (11th Cir. 1982), cert. denied, 459 U.S. 1203 (1983) 6 Section 202(a)(18) of the Advisers Act. (concerning joint venture interests in undivided inter- 7 See, e.g., Exemptions for Advisers to Venture Capital ests in real estate, under the Securities Act) and New Funds, Private Fund Advisers With Less Th an $150 World Associates, SEC Staff No-Action Letter (Aug. 9, Million in Assets Under Management, and Foreign 1985) (taking a no-action position if an entity held Private Advisers, Investment Advisers Act Release No. over 40 percent of its assets in joint ventures without 3222 (June 22, 2011), at notes 458 and 749 (cit- registering under the Investment Company Act). ing Reves, infra at n.14, which related to whether an 12 Similarly, investments in “club deals” would need to arrangement resulted in a security for purposes of the be considered based on the facts and circumstances Securities Act, as the basis for investment advisers to (including managerial responsibilities of each party), determine whether a commercial lender has issued a but also have the potential to be considered non- security for purposes of the Advisers Act). securities investments with respect to one or more of 8 See, e.g., SEC v. W.J. Howey Co., 328 U.S. 293 the parties. (1946) (Howey) (under the Securities Act: noting 13 See, e.g., Arizona Property (“investment contracts that certain exceptions to that rule); Arizona Property refer to fee interests in real estate, such as orange Investors, Ltd., SEC Staff No-Action Letter (Aug. 9, groves, are securities”), citing Howey. 1979) (Arizona Property) (under the Investment 14 See Reves v. Ernst & Young, 494 U.S. 56 (1990). Company Act: “Generally, we would not consider fee 15 Independent Drug Wholesalers Group, Inc., SEC interests in real estate to be securities.”); Kenneth H. Staff No-Action Letter (Apr. 16, 1992) (declining Flood, SEC Staff No-Action Letter (Mar. 2, 1984) to take no-action position with respect to scheduled, (under the Advisers Act: “A complete fee interest in periodic provision of investment advice). real estate in itself would not be a security.”). 16 Note however that, for New York-based investment 9 See Securities Act Release No. 4877 (Aug. 8, 1967). advisers, the generally applicable RAUM threshold is Th e general rule that limited partnership interests $25 million. are securities is not absolute, however. See Steinhardt 17 Section 3(c)(5)(C) excludes from the defi nition Group Inc. v. Citicorp, 126 F.3d 144 (3d Cir. 1997) of “investment company” under the Investment

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Company Act any person that is primarily engaged securities). Th e fact that a fund is open-end or closed in “purchasing or otherwise acquiring mortgages and end, however, should not in and of itself have an other liens on and interests in real estate.” impact on the Advisers Act analysis. 18 Note however that a manager solely of private funds 20 Any such action by the SEC would obviously signal with less than $150 million of RAUM is exempt a signifi cant pullback of the SEC’s regulatory reach. from full registration but is required to fi le an abbre- Further, it should be noted that even if Advisers Act viated Form ADV as an exempt reporting adviser. registration is determined to not be required for a 19 See “Private Equity Real Estate Top 50—2016 Edition particular manager, state investment adviser registra- of Who is Registered”, available at: http://www. tion obligations could still apply. compliancebuilding.com/2016/05/04/private- 21 Note that unregistered investment advisers are equity-real-estate-top-50-2015-edition-of-who-is- still subject to the anti-fraud provisions of the registered-2/. Note that the PERE list referenced Advisers Act. here focuses only on commingled closed-end real 22 Some such policies, such as the requirement for a estate funds, and excludes core and core-plus funds. code of ethics and procedures designed to prevent Managers of funds within the “core” spectrum insider trading, can seem wholly inapposite to the (which are often structured as open-end products), business of a traditional real estate fund manager may be better positioned to take a no-registration (as compared to a investing in publicly approach under the Advisers Act as such funds tend traded equities, for example). to have a narrower mandate to buy and hold hard real 23 See Marc Wyatt, acting director, OCIE, “Private Equity: estate assets (as compared to opportunistic funds, for A Look Back and a Glimpse Ahead” (May 13, 2015), example, which generally speaking have broader dis- available at www.sec.gov/news/speech/privateequity- cretion to invest in a wide range of real estate-related look-back-and-glimpse-ahead.html. assets, some portion of which could be considered 24 See also discussion of the CHOICE Act in n.2, supra.

Copyright © 2017 CCH Incorporated. All Rights Reserved. Reprinted from Th e Investment Lawyer, September 2017, Volume 24, Number 9, pages 14–20, with permission from Wolters Kluwer, New York, NY, 1-800-638-8437, www.WoltersKluwerLR.com

Copyright © 2017 by CCH Incorporated. All Rights Reserved.