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SEC Staff Takes 3 Years to Confirm: Tenant-in-Common Interests in 2 Common Real Estate Investment Models Are Securities


									DLA Piper | Publications | SEC Staff Takes Three Years to Confirm: Tenant-in-Common ... Page 1 of 4


5 FEB 2009

SEC Staff Takes Three Years to Confirm: Tenant-in-Common Interests in Two Common Real Estate Investment Models are Securities

Richard Marks Jeremy Lustman

The SEC has issued a No-Action Letter1 asserting that it considers undivided tenant-in-common interests in real estate (TIC Interests) under two common investment models to be “securities” under the Securities Act of 1933 (the Act). This action—a January 14, 2009 response to a February 2006 request—is an apparent effort to preserve jurisdictional authority, bringing the SEC position in line with the Financial Industry Regulatory Authority (FINRA) position first expressed in 2005 by the National Association of Securities Dealers, Inc. (NASD). This development will likely require significant changes in the way sponsors of TIC Interests and certain investment counselors (who have previously relied on the SEC silence), design, market, syndicate and counsel investors regarding investments in TIC Interests. TIC Structure A TIC Interest is an arrangement in which two or more persons or entities own undivided fractional interests in a single income-producing real property asset, such as a shopping center, hotel, apartment complex or office building. Each owner is free to sell, encumber or otherwise deal with his, her or its own interest in the property. Typically, the owners share equally in the management and other decisionmaking requirements of property ownership. The key benefit of a TIC Interest investment is that, if properly structured, it allows investors to take advantage of a tax-free exchange pursuant to Section 1031 of the Internal Revenue Code (the IRC), by exchanging the proceeds from an investment real property just sold (or to be sold in the near future) for replacement investment real property, thereby deferring income tax liabilities and reinvesting dollars pre- 2/5/2009

DLA Piper | Publications | SEC Staff Takes Three Years to Confirm: Tenant-in-Common ... Page 2 of 4

tax, rather than after-tax. In addition, TIC Interest investors receive an opportunity to participate in institutional-quality real property (in which they otherwise would not be able to invest), together with the benefits of professional management and pre-arranged favorable financing. TIC Investments for Tax Law Purposes In 2002, the IRS issued a Revenue Procedure (2002-22) (the Revenue Procedure), in which it specified 15 factors the IRS would consider in determining if a TIC Interest constituted an interest in real property and not an interest in a business entity (i.e., a tax partnership) for income tax purposes. These factors must be analyzed in the context of any prospective TIC Interest investment; among them, unrestricted alienation, a limited number of co-owners, and guidelines for the distribution of sale proceeds, as well as restrictions on revenue and expense allocation, call options, and business activities. However, the Revenue Procedure only addressed the issue of whether a TIC Interest would qualify as “real estate” for tax law purposes and not whether a TIC Interest would also qualify as a “real estate” investment (as opposed to an “investment contract” form of security). TIC Investments for Securities Law Purposes Over the years, TIC Interest investments have changed. The standard form used to be one of common ownership and management of income-producing real property held by a few investors who were often brought together by a real estate broker and who typically played an active role in hiring and overseeing management. Now, many of these structures have evolved into complex investment vehicles involving pre-arranged financing, master leases to transfer risks and assure returns, and limited or encumbered controls over management that are made available to a large number of unrelated investors through registered broker-dealers. This reality was validated in 2005 when FINRA (then NASD), pre-empting what has now been identified as the SEC staff position, alerted member firms that (i) TIC Interests were “non-conventional investments” and (ii) securities brokers were required to follow FINRA (NASD) rules in marketing TIC Interest products. Nevertheless, a significant divergence of views on the issue continued to develop once the SEC staff remained silent with respect to its own position (until the publication of the No-Action Letter), following the release of the FINRA alert. Many TIC Interest sponsors adopted a more conservative approach by abiding by the FINRA position; they marketed, offered, and sold complex TIC Interest investments as securities to prospective investors who (i) received a private placement memorandum that identified risks associated with the investment and provided sponsor and financial information, (ii) played a more passive role in management issues, and (iii) were more focused on the cash-on-cash returns than the character, quality or location of the property and potential growth in value. Other TIC Interest sponsors, however, adopted a more aggressive approach in response to the SEC silence and structured their investment opportunities to fall into grey areas -- fitting within established SEC principles and judicial decisions concerning real estate investments that avoided characterization as “investment contract” securities, while still marketing the TIC Interests in a manner akin to private placement securities. A number of these TIC Interest sponsors continued to offer and market TIC Interests through licensed real estate brokers, believing strongly that the TIC Interests were real property and not securities. SEC Staff Position Ends Years of Silence and Uncertainty 2/5/2009

DLA Piper | Publications | SEC Staff Takes Three Years to Confirm: Tenant-in-Common ... Page 3 of 4

The No-Action Letter issued last month ends years of silence and uncertainty regarding the SEC staff position concerning TIC Interests as “securities” under the Act. By simply disagreeing with the opinion of the sponsor’s counsel respecting two fairly typical TIC Interest investment structures, the SEC staff expressed a strong warning to all TIC Interest sponsors that it was reserving the right to impose the registration and anti-fraud requirements of the Act upon them. The immediate impact of the SEC staff position will be to provide the TIC Interest investor community with more robust disclosure and more careful monitoring of compliance with SEC Regulation D offering requirements. It will also likely result in a myriad of consequences for TIC Interest sponsors who previously marketed TIC Interests solely as real property and who may have either failed to achieve projected results or defaulted on commitments to TIC Interest investors. The No Action Letter has already opened the enforcement door – just one day after the No-Action Letter was issued, the State of Idaho Department of Finance filed a $9.75 million civil lawsuit against a TIC Interest sponsor, contending the defendants engaged in a scheme to defraud investors through the sale of unregistered securities. How to Proceed The SEC staff position in the No-Action Letter was limited to two specific investment models: A long-term master lease; and A property management or asset management agreement that is terminable on an annual basis and under which a TIC Interest holder electing termination could be required to sell its TIC Interest (and accelerate its tax deferral). The SEC staff did not comment on specific aspects of either mode, but rather gave a blanket disagreement with counsel’s opinion that the TIC Interests in the models were not securities. In this regard, a number of TIC Interest sponsors and other investment counselors will likely contend that the SEC staff’s position would not apply to their unique structure or set of circumstances. However, given the potential costs, risk and exposure in defending any enforcement action, affected parties should consider the following courses of action: Becoming immediately compliant with all relevant securities laws and regulations; Conducting a review of past TIC Interest offerings to evaluate potential exposure for past activities; and Requiring all marketing agents of their TIC Interests to be aware of the SEC staff position. In publishing the No-Action Letter, the SEC staff sent a clear message to TIC Interest sponsors, professional advisors, and the investment community that it would no longer accept the self-policing regime that had previously been in place. Given these developments and their likely impact, affected TIC Interest sponsors and investment counselors should consult with securities counsel as soon as possible to evaluate alternatives and consider next steps.

1 See No-Action Letter, dated January 14, 2009, addressed to each of OMNI Brokerage, Inc., Argus Realty Investors, L.P., PASSCO Companies, LLC. 2/5/2009

DLA Piper | Publications | SEC Staff Takes Three Years to Confirm: Tenant-in-Common ... Page 4 of 4 2/5/2009

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