The United States Supreme Court established the most commonly relied upon definition of a security, almost a century ago, in the landmark Howey case. The “test” is “whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.” Indeed, in Howey the question was whether the combined sale of land and a service contract constitute a security, which the court affirmed. Using this broad definition, courts in differing states and jurisdictions have found sales of condominiums, tenant-in-common interests, investments in real estate partnerships and investments in REITs to constitute the sale of a security.

Based upon various courts' interpretation of Howey, if you are involved in the real estate industry and you have investors, there is a decent chance you too are in the business of selling securities. So, intermixed with the tax considerations that drive your choice of investment vehicle, also consider your disclosure requirements. Further, if you find yourself in a position of not being as profitable as you once anticipated, do not be surprised if you find yourself a defendant in a securities fraud, shareholder derivative or related lawsuit.

Federal and State Law Claims

The purpose of this article is not to provide a substantive overview of either federal securities laws or the different Blue Sky laws, which exist in the various different states, seeing as there are entire treatises devoted to that subject. However, it is important to note the liability accrued from selling securities and its threat under both federal and state laws. State laws, in turn, may be substantively different not only from the federal laws, but also from the laws of other states.

In other words, a company selling investments in real estate must be prepared for the possibility of multiple claims brought in several jurisdictions and different courts. Certainly, every state in which a purchaser executes a transaction opens the selling company to possible claims under the laws of that state. Those claims, in turn, may raise arguments related not only to the substance of the state law, but local laws related to ancillary matters such as the enforcement of arbitration and choice of law provisions. Issues related to class actions, fiduciary duties and contracts, to name a few, could also impact not only liability, but whether a claim is one of state or federal law and whether it is brought in state or federal court.

The point is that it is important for a real estate company selling investments to be aware that the multiple states in which it has investors may give rise to multiple claims, both federal and local. Prudent sellers seek to minimize these exposures in the offering documents. However, if the investments go poorly, the company must be prepared for the possibility of defending itself in multiple jurisdictions under different laws.

Litigation vs. Arbitration

There are two truths that are less universal than they used to be. Arbitration, with a lower public profile and zero risk of runaway juries, is better for defendants. Secondly, and accordingly, many sophisticated contracts have an arbitration clause that the seller will seek to enforce. Those two truths are less universal in large part due to rising concerns about the costs and trade-offs of arbitration. However, there are other issues a seller of a real estate security should consider in the arbitration/jury trial equation.

Specifically, there is a rising concern (of uncertain measurability) about the risk of runaway arbitrators. It is common in a securities fraud civil matter for a number of defenses to be highly technical in nature. Is the plaintiff an appropriate plaintiff to bring these claims? Is there a statute of limitations bar? Are the disclaimers in offering documents “boilerplate” or “bespeaking caution?” Ultimately, is the arbitrator required to enforce the technical requirements of the law to bar a plaintiff's claims?

The answer to that last question is “not necessarily.” As an easy example, Georgia is cited as one of the few jurisdictions expressively stating that the statute of limitations applies to arbitrations. However, that same statute says if the statute of limitations is raised in the arbitration proceeding itself, the arbitrator in his or her “sole discretion” can decide whether to apply the bar. The statute further states that the exercise of that discretion is not subject to specific review from a court. In short, while the statute of limitations may apply in an arbitration hearing under Georgia law, the remedy for the failure of the arbitrator to enforce the time bar is less than clear.

One must add to this equation the legal hurdles to overturning any arbitration award. It is usually not enough to show that the arbitrator was wrong as a matter of law; instead, the burden in an appeal is to show that the arbitrator knew the law, knew the law applied and consciously chose not to apply the law. And that must be apparent from the arbitration record (another expense which parties to arbitration often overlook). As a practical matter, meeting that burden in an appeal from an arbitration hearing is extremely difficult, something that gives an arbitrator almost free rein to design an award however he or she sees fit.

There are many factors that go into the decision about whether to arbitrate or litigate. However, it is becoming less clear that the default answer to that question is arbitration. A real estate company selling securities should consult with the appropriate counsel and ask questions both at the time of contracting with investors and at the time a dispute arises from that sale.

Don't Forget the Government!

It is convenient to believe that a civil lawsuit for a failed real estate venture is the worst-case scenario, but this is simply not the case. Because of the frequency of investors seeking retribution after losing money, any issuer of securities, regardless of industry, also must be concerned about the government inserting itself into any potential dispute as a matter of regulatory or even criminal enforcement.

The SEC has been the subject of high-profile legal questions of late, ranging from statutes of limitations to administrative law issues. These issues serve to highlight, if nothing else, that the government remains active in the enforcement of federal securities laws. Indeed, according to a 2016 SEC press release, in fiscal year 2016 the SEC filed 868 enforcement actions, a new high for a single year. The same press release states that in 2016 the SEC obtained judgments and orders totaling more than $4 billion in disgorgement and penalties.

Nor should any real estate professional rest comfortably on the hope that federal enforcement will decline after the recent change in administrations. In late 2016, New York State Attorney General Eric Schneiderman said, “every day, state and local law enforcement effectively utilize Blue Sky Laws to root out the worst types of fraud, corruption and abuse on Wall Street and across major industries.” If the federal government becomes more “business friendly” and focuses less on regulation/enforcement, state enforcement agencies will likely fill the void.

Most of the exposure in an SEC or state attorney general investigation caps out at fines, disgorgement, debarment or loss of licensure. However, these agencies can (and often do) refer alleged violations of securities laws to prosecutors. Federal prosecutors and local district attorneys are authorized to investigate and prosecute real estate fraud schemes as securities fraud cases, which could lead to long prison sentences. Claims of breach of fiduciary duty, mail and wire fraud, tax fraud and conspiracy as well as violations of 17 CFR 240.10b-5, 15 USC 78j(b) and 78ff are punishable by significant prison terms with statutory maximums of 30 years in prison or more.

We believe there is definitely a trend towards the merger of securities and real estate, as industries and legal issues. A prepared real estate company will ensure that it is aware of these issues and will take all necessary precautions. That same company needs to consider whether it must also plan for litigation and enforcement if the cranes, metaphorically speaking, come crumbling down.

John C. Amabile is a trial attorney in Parker Poe's Atlanta office. He may be reached at (678) 690-5747 or [email protected]. Brian S. Cromwell is a partner in the White Collar Defense group in Parker Poe Charlotte office. He may be reached at (704) 335-9511 or [email protected]. The views expressed here are the authors' own.