Private Lending Funds: When is a note a security?

With significant growth in the hard money lending industry in recent years, many sponsors of private lending funds have requested guidance regarding whether the underlying loans and other debt instruments in such funds are considered “securities” under the Securities Act of 1933 (“Securities Act”), the Investment Company Act of 1940 (“ICA”) and the Investment Advisers Act of 1940 (“Advisers Act”) (collectively, “Acts”).  Below is a general overview of what types of notes fall under the purview of the Acts.

Each of the Acts contains an identical definition of what constitutes a security, including “any note” and “evidence of indebtedness.” A common misconception is that all investment instruments are similarly categorized for the purposes of the Securities Act, the ICA and the Advisers Act. However, the SEC and the Supreme Court have taken the position that the scope of the term “security” varies under each Act. Because the Acts are generally targeted toward separate entities and intended to achieve different objectives, instruments deemed not to be securities for purposes of one Act may be regarded by the SEC as securities for the purposes of another Act. Ultimately, whether the underlying loans purchased or originated by a private lending fund are deemed securities can have far-reaching impacts on the fund and its sponsor, including investment adviser registration requirements for the sponsor and the number of investors that can be admitted to the fund.

Securities Act of 1933

For the purposes of the Securities Act, the Supreme Court held in Reves v. Ernst & Young that every note is presumed to be a security, but that presumption can be rebutted by showing that the note bears a strong resemblance to a judicially crafted list of notes that are presumed not to be securities. Included in this list of non-securities are:

1. note delivered in consumer financing
2. note secured by a mortgage on a home
3. short-term note secured by a lien on a small business or some of its assets
4. note evidencing a character loan to a bank customer
5. short-term note secured by an assignment of accounts receivable
6. note which formalizes an open-account debt incurred in the ordinary course of business

While the Supreme Court did not elaborate on the scope of each of these categories, it did adopt a “family resemblance” test which is a purpose-based approach to determining whether an investment instrument closely resembles one of the judicially-crafted family of instruments that are not considered securities. The family resemblance test asks the following questions to assist in making the determination if the context and purpose of an instrument closely resembles a category of notes from the list:

1. Is the purpose of the debt transaction to raise money for the general use of a business enterprise or to finance substantial investments and is the purchaser motivated primarily by the profit the notes are expected to generate for the business?
2. Does the issuer’s plan of distribution seek to establish some form of common trading in the notes, either for speculative or investment purposes?
3. Is there a reasonable public expectation that the instruments should be treated as “securities”?
4. Is there some mitigating factor such as the existence of another regulatory scheme that sufficiently protects investors, thereby rendering strict application of securities laws unnecessary?

Based on the judicially crafted family of notes, particularly the first two examples, and the family resemblance test, it is likely that the Supreme Court would hold that hard money loans backed by mortgages, for example, would not be considered securities.

The Securities Act diverges from the ICA and the Advisers Act by including exceptions to the definition of securities.  For example, the Securities Act states that any note with a maturity date of less than nine months is presumed not to be a security. However, the ICA and the Advisers Act do not contain such a presumption. Therefore, under the Securities Act, notes with a term of less than nine months are presumed not to be securities, whereas under the ICA and the Advisers Act, such notes must overcome a presumption that they are securities in order to be exempt from the regulations of those Acts. The various notes that are presumed not to be securities under the Securities Act demonstrates the narrower scope of the definition of securities under the Securities Act than that of the ICA and Advisers Act.

Investment Company Act of 1940

Hard money loans are lending instruments in which a lender offers funds to a borrower in exchange for a promissory note secured by the borrower’s assets, typically real estate. It has been established that all promissory notes are securities under the ICA. Because the Supreme Court issued the list of non-security notes based on its interpretation of the Securities Act, we cannot be certain whether the Supreme Court or the SEC would hold this list of notes to be securities under the ICA or the Advisers Act.

Additionally, promissory notes with a maturity date of less than nine months do not contain the presumption that they are not securities under the ICA. Therefore, promissory notes of any term can be deemed securities and the fund issuing promissory notes may be subject to the ICA.

Assuming hard money loans are deemed securities under the ICA, a private lending fund can be structured in a way that exempts it from being considered an investment company under Sections 3(c)(1), 3(c)(7) or 3(c)(5) of the ICA.

Section 3(c)(1) of the ICA provides an exemption from the definition of an investment company for private offerings “whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons.” Essentially, to avoid being considered an investment company, the lending fund can be offered to no more than 100 persons, accredited or non-accredited, and comply with advertising restrictions, such as not advertising details of the fund to the public. Section 3(c)(7) also provides an exemption for private funds and requires that the outstanding securities are owned exclusively by “qualified purchasers.”

Section 3(c)(5) of the ICA offers an exemption to registration for issuers primarily engaged in acquiring mortgages and similar real estate interests. Specifically, Section 3(c)(5)(C) provides that “any person who is primarily engaged in purchasing or otherwise acquiring mortgages and other liens on and interests in real estate” is not an investment company. Therefore, a lender of hard money loans backed by mortgages would likely not be subject to the ICA. This exemption is often the most utilized by lending funds because it does not impose other restrictions, such as investor type or count limits and advertising rules.

However, for a lender to qualify for the 3(c)(5)(C) exemption, they cannot issue redeemable securities, face-amount certificates of the installment type, or periodic payment plan certificates. Because a lender cannot issue redeemable securities under this exemption, the lender must be structured as a closed-end fund to qualify for the exemption. The lender must also satisfy the “Asset Composition Test.” The Asset Composition Test requires:

1. at least 55% of its assets consist of “mortgages and other liens on and interests in real estate” (called “qualifying interests”) and the remaining 45% of its assets consist primarily of “real estate-type interests”;
2. at least 80% of its total assets consist of qualifying interests and real estate-type interests; and
3. no more than 20% of its total assets consist of assets that have no relationship to real estate.

Investment Advisers Act of 1940

While the SEC has not issued formal guidance as to whether it would take a similar position as it does with the ICA with respect to the Advisers Act and default to all promissory notes being deemed securities, the Bureau of National Affairs has stated that because of the investment characteristics that exist when loans are pooled together or when advice about loan investments is given, loans either are or may be treated as securities under the ICA and the Advisers Act.

If hard money loans and similar investment instruments were to be deemed securities under the Advisers Act, the sponsor may need to register as an investment adviser with the SEC or the appropriate state securities bureau, depending on a variety of factors. Registering as an investment adviser can impose significant regulatory burdens on a lender, including disclosure of all material facts and conflicts of interest, prohibitions against the lender acting as principal for its own account, limitations on advertising, safeguarding the client’s collateral, record examinations, etc.

Ultimately, whether private investment lenders are subject to the Acts depends on the structure and the purpose of the instruments, the availability of exemptions from being deemed an investment company and / or an investment adviser and the purpose for which the SEC is evaluating the loans. Because the definition of a security under each of the Acts varies, fund sponsors must be mindful of how the underlying loans will be structured on the front end of launching a private lending fund and should consult qualified legal counsel to confirm compliance with applicable securities laws.