Hidden Dangers for Developers: Risks Involved in Recruiting Passive Investors

Developers who cut corners to take advantage of the current real estate climate may be in violation of their perceived exemption status.

As of late, commercial developers are facing major financial loss and run the risk of losing their Regulation D exemption status if the SEC or state regulators find them in violation of certain securities rules and regulations when bringing on equity partners.

“Developers need to heed this warning because these agencies are being more vigilant than ever in protecting investors,” cautioned Suzanne A. Mulvihill, real estate partner at Haight Brown & Bonesteel. “Developers without a broker-dealer license are often not operating within the confines of the law.”

Mulvihill who handles complex real estate transactions, sat down with Inside Counsel to discuss the legal risks involved in recruiting passive investors. As commercial development increases, she warns that developers who cut corners to take advantage of the current real estate climate may be in violation of their perceived exemption status. If the SEC or state agency discovers this, fines and sanctions can be levied and the securities exemption status can be removed, which would mean every project would have to be registered with the SEC and developers could face fraud lawsuits.

“The right of rescission is the right to essentially unwind the deal and for the investor to get back their entire investment, plus interest. Rescission is rescinding the deal, or unwinding, as though it never happened,” she explained. “Deals made illegally are viewed as unenforceable by state regulators, so investors can receive their entire investment back. This is particularly onerous when the investment is in real estate which has lost value since the initial investment.”

So, how can worst-case scenarios for developers be prevented? 

If in doubt, they should sell through a broker dealer to ensure compliance, according to Mulvihill. There are issuers exemptions available under both state and fed law but there are limitations and restrictions. For example, if the person selling the security is employed or in any way associated with the sponsor, they cannot receive any kind of transaction-based compensation and sale activities must be passive in nature.

Lately, the SEC and especially the state of California have been called heavy-handed when it comes to commercial developers who fail to follow the letter of the law regarding their exemption status. But according to Mulvihill, they aren’t necessarily heavy handed, but they do have the law in their favor.

Real estate investments were never traditionally thought of as a security per se until recently (within the last 10-15 years), so it is still novel, according to Mulvihill. She said, “The SEC views the sale of undivided TIC interests as securities, and sales of interests in joint ventures have always been considered securities. Thus, sponsor-developers would be forced to defend the action if they do attempt to use an Issuer’s Exemption which could be costly in and of itself.”

Further reading:

Avoiding a Crisis: Corporate Succession Planning

LawGeex Raises $7M, Riding Surge of Corporate Interest in AI Contracting

Equity Crowdfunding GC Talks Regulations, Job Challenges

Disclosure Policies: What Every Public Agency Should Know

Contributing Author

author image

Amanda Ciccatelli

Amanda G. Ciccatelli is a Freelance Journalist for InsideCounsel, where she covers intellectual property, legal technology, patent litigation, cybersecurity, innovation, and more. She earned a B.A....

Bio and more articles

Join the Conversation

Advertisement. Closing in 15 seconds.