The 4-Pronged Test to Raise Money Legally and Avoid Fines, Lawsuits, and Jail Time
Have you ever thought about raising money from private investors and buying large multifamily buildings? If so, it’s important to know if you must adhere to the SEC guidelines. If you fail to do so, you will be susceptible to fines, lawsuits, and maybe even jail time.
In fact, the SEC’s main revenue stream comes from pursuing syndicators who break the “rules.”
In a recent conversation with Jillian Sidoti, an attorney who’s an expert on money raising techniques for real estate investors, said the SEC “runs on fines. That’s how they make money. That’s how they justify their existence, by generating revenue through fines. They’re looking for people who are not following the rules.”
Luckily, she told us all about the Howey Test and how investors may use it to avoid issues with the SEC.
Sticking to the Rules
Fines from the SEC can be problematic, but Jillian said the larger threat, in regards to breaking SEC guidelines, are your investors. “If you don’t do right by your investors, that not doing right by your investors [and] not following the law in the first place is going to be exhibit A against you in the trial against you when your investors come to see you [in court],” she said. “It could just be you having a falling out with an investor, or an investor needs their money back in the middle of the project. How are they going to get it back if you’re not very willing to give it to them [or you can’t give it to them]? They’re going to sue you and they’re going to use all of this evidence against you in order to get their money back.”
How can you avoid the wrath of both your investors and the SEC? It’s fairly simple: Don’t make the biggest legal mistake Jillian comes across – not understanding the difference between a security and a joint venture. And there is a lot of misinformation out there.
“I often hear people say to me, ‘Well, if I just use a joint venture agreement or call it a joint venture, then that’s not securities and I’m in the clear,’” Jillian said. “I’ve sat in a seminar where people say, ‘If you just use a joint venture agreement then you don’t have to worry about any of these securities laws and you can do whatever you want,’ and that is simply not true.”
Raising money for a deal and believing that securities laws do not apply to you (because you think it’s a joint venture) can land you in a lot of legal trouble down the road. It is not worth pursuing the short-term benefits of a joint venture.
Applying the 4 Prong Test
How to you know if securities laws apply to you? Jillian provided a simple 4 prong test, commonly known as the Howey Test. If these “prongs” apply to your situation, then you must adhere to SEC securities laws, which means it would highly benefit you to find a good securities attorney like Jillian.
Here is the 4-prong Howey test to differentiate between a security and a joint venture:
- Investment of Money: this will be a given since investors are giving you money to invest in a deal
- Expectation of Profit: of course, your investors expect to make money, which is why they are investing with you, so this will apply to your situation
- More than One Investor (i.e. common enterprise): This doesn’t mean “do you have one investor?” If you have only one investor period, you and that investor form the common enterprise. Again this will apply to your situation
- Through the Efforts of a Promoter: This is the “prong” that mainly differentiates a security from a joint venture. If you doing all the work and your investor or investors are passive, it qualifies as a security.
If your situation meets these four-prongs, it is an investment contract and you are required to follow SEC guidelines. According to the SEC, the definition of an investment contract is “an investment of money (#1) in a common enterprise (#3), with an expectation of profits (#2) based solely on the efforts of the promoter (#4).”
For more on the differences between a security and joint venture, read Joint Ventures or Securities – What’s the Difference? And of course, consult with a securities attorney.
When raising money for deals, in order to avoid fines from the SEC or losing potential lawsuits from your investors, you must understand whether or not your situation is regulated by the SEC. This is determined by the 4-pronged Howey Test:
- Is there an investment of money?
- Is there an expectation of profit?
- Is there more than one investor?
- Is everything done through the efforts of a promoter?
If the answer is “yes” to these four questions, you are regulated by the SEC and must adhere to their rules.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.