Real Estate Investor Escapes Criminal Charges: Legal Factors When Raising Money from Others with Promissory Notes
Thousands of real estate deals/projects involve the use of promissory notes as a way to raise money to fund the project. If you are raising capital for a real estate project using promissory notes and you assume incorrectly that securities laws do not apply to your deal/project, you could be fined or possibly end up in an orange jump-suit.
In a recent California case called People v. Black, the California Court of Appeals was asked to whether a promissory note in the real estate deal (an investment in land in Idaho) was a security. Needless to say the project/deal did not go as planned. Once the lender felt that he was getting the “run-around” from the borrower, he hired a private investigator which eventually led to a criminal investigation of the borrower. Please note that this was a criminal case, which is important to mention because it highlights the fact that certain actions when raising capital can result in criminal charges, i.e., fraud, etc. Also, although this case is from California, it is instructive for many real estate venturers and investors even outside of California because the court used many securities law cases from the United States Supreme Court to reach its conclusion.
The court in Black concluded that the promissory note at issue was not a security. It used the “Howey Test”, to reach its conclusion, which derived from the famous securities case, SEC v. Howey Co., 328 U.S. 293 (1948). The Howey Test is this: If the funds were invested with the promoter/manager with the expectation of receiving a profit from a business enterprise, which profit wholly depends on the managerial efforts of the promoter/manager, then the promoter/manager has issued a security. The analysis of WHY the court reached this conclusion with respect to promissory notes and securities law is very instructive. Here are the “take-aways” from the case:
- Avoid Profits Sharing in Notes, Split of Profits v. Straight Interest / Promise to Pay. The promissory note in the Black case stated that the amount of interest paid to the lender would be either a percentage of profits from the sale of the underlying real estate, or two lots from the property if it is held for development. There was also a provision that whether the property is sold or developed, the principal amount plus 10% interest would be due one year from the date of the note. This last provision was a very important fact that the court seemed to place a lot of emphasis. However, it also conceded that “the promise of a fixed return does not in itself remove the transaction from securities laws” because as the United States Supreme Court stated in a case called Edwards, (SEC v. Edwards, 540 U.S. 389 (2004)), “unscrupulous marketers of investments could evade securities laws by picking a rate of return to promise.” In other words, the court in Black was careful to not “hang its hat” on just this one factor.
- Give Investor Control or Protections, Control of the Investment / Split of Profits. If the note is a profit-sharing note where the borrower has total control of the investment and there are not protections to the lender, the investment will look more like a security. The court relied on a United States Supreme Court case called Marine Bank, involving a profit-sharing arrangement involving loans between the parties. The U.S. Supreme Court held that the loan in that case was not a security because the lender in that case has a measure of control over borrower regarding the investment/project despite the fact that the borrower’s obligation to repay was based in part on the success of the venture/project.
- Avoid Bringing in Multiple Parties Without Proper Legal Documents, Negotiated One-on-one v. Offered as a Uniform Instrument to the Masses. The lender and borrower in this case knew each other for six years. They had appeared to individually negotiate this promissory note with each other as opposed to the lender simply taking the same promissory note and offering it to multiple investors especially in a public manner through public advertising. The court also used the Marine Bank case mentioned above in this context. As opposed to many deals/projects that involve promissory notes that are issued to many investors, another reason the U.S. Supreme Court held in the Marine Bank case that the profit-sharing loan arrangement was not a security was because of the one-on-one nature of the investment. The court in Black was careful to state that this is not the only factor but is simply one of a number of factors.
- Give Security for the Loan, Is the Promissory Note Adequately Secured. The lender in this case had secured the promissory note with his separate / personal property. This was a factor in the court’s conclusion but it is important to note that the security must be adequate. The court was careful to make this point and it did so by mentioning a case called Shock, (People v. Schock, 152 Cal.App.3d. 379 (1984)), in which the California court of appeals found that the public sale of fractional interests in secured promissory notes were securities, in part, because of the inadequacy of the collateral together with the investors’ dependency on the promoter’s success for a return on the investment subjected the superficial loan transaction to security regulation. Similarly, In a California case called Miller, (People v. Miller, 192 Cal.App.3d. 1505 (1987)), the promoter issued notes to multiple investors in connection with a luxury home purchase “scheme”. The court determined the notes and trust deeds were securities because the loans, i.e., the funds obtained by Miller were so far in excess of the value of the secured interest that no resale or foreclosure could recoup more than a few cents on the dollar to the individual lenders. Also, it should be noted that investors were solicited from the general public and had no control over the success of the venture. Likewise, in a 9th Circuit case called Wallenbrock, (SEC v. Wallenbrock, 313 F.3d 532, 9th 2002), the court found that promissory notes sold to the public which were secured by the accounts receivable of Malaysian latex glove manufacturers were securities. The court determined that if the receivables existed at all, the investors had no way of reaching the assets. If you are planning to invest and your investment is secured by the receivables of Malaysian latex glove manufacturers, it’s probably not a good investment. Nothing against the Malaysian latex glove industry, I’m just saying.
In summary, some promissory notes are securities and some are not. Each deal/project must be analyzed by looking at the substance rather than just its form. The details matter as does careful legal planning. In this case, the promissory note (a) was an actual promise to repay regardless of the success of the underlying venture/project, (b) was adequately secured, and (c) was negotiated one-on-one i.e., individualized versus a uniform document to be used by the mass investors. These facts were persuasive enough for the court to conclude the promissory note in this case was not a security. If you’re using promissory notes to raise money in real estate deals, please carefully consider the points in this article and call our office to discuss your situation.