Buying a note with your own money is a loan purchase. Taking other people’s money to buy notes for them, through a fund, a pool or fractional shares of a note, usually means selling securities, and that brings in the Securities Act of 1933, an exemption such as Regulation D, the Investment Company Act and state blue sky laws. The manager carries those obligations, and investors should check them.
This page is general information about where the securities rules come in when money is pooled. It is not legal advice, the rules are detailed and enforced, and anyone planning to raise money from others should hire a securities attorney before talking to a single investor. What a note fund is, and how a share in one compares with owning a note, is covered on what is a note fund.
What turns a note deal into a security
A security is wider than stocks and bonds. Under the Securities Act, it includes an “investment contract”, which courts test using the Howey case: money put into a common enterprise, with an expectation of profit from the efforts of others. A fund interest fits that description almost by definition. You hand over money, it is pooled with other investors’ money, and the manager does the buying, servicing and collecting.
Notes themselves can be securities too. Under the Reves case, a note is presumed to be a security unless it closely resembles a type of note that is not, such as an ordinary mortgage loan on a home. That is why buying a whole real estate note for your own account is generally treated as buying a loan, while the same note cut into fractional interests and sold to a group of passive investors may be treated as a security. Where a given deal falls is a question for an attorney.
What changes when you pool money
| Buying a note yourself | Raising money to buy notes | |
|---|---|---|
| Main rules in play | Lending, licensing and servicing rules for the loan | Those, plus federal and state securities law |
| Who you deal with | A seller or broker | Investors who rely on you |
| Documents | Purchase agreement and assignment | Offering documents, subscription agreements, entity agreements |
| Filings | Recording the assignment | Federal and state securities filings |
| Liability for what you say | Mostly contract warranties | Securities anti-fraud rules on every statement to investors |
Registration and the Regulation D exemptions
Section 5 of the Securities Act says securities must be registered with the SEC before they are offered or sold, unless an exemption applies. Registration is costly and rare for a small fund, so most note funds rely on an exemption, most often Rule 506 of Regulation D.
Rule 506(b) allows an unlimited amount to be raised from accredited investors and a limited number of non-accredited investors who are financially sophisticated. The catch is that the fund may not use general solicitation, meaning public advertising, open seminars or a website pitching the fund to anyone. Investors generally come from people the manager already has a relationship with. If any non-accredited investors take part, they must receive detailed disclosure.
Rule 506(c) allows general solicitation, so the fund can advertise, but every investor must be accredited and the manager must take reasonable steps to verify it, which usually means reviewing tax returns, bank statements or a letter from a CPA or attorney. A form the investor ticks is not enough.
An accredited investor is someone who meets the SEC’s income or net worth tests, or holds certain professional licenses, or is an entity that meets its own tests. The figures are set by rule and have been revised, so check the SEC’s current definition rather than a number repeated online.
Either way, the fund files a notice on Form D with the SEC shortly after the first sale. Rule 506 is also closed to offerings where the manager or certain related people have a disqualifying record, under what are called the bad actor rules. And no exemption removes the anti-fraud rules: a misleading statement about the notes, the manager’s record or the risks can lead to liability even in a fully exempt offering.
The Investment Company Act
A separate law, the Investment Company Act of 1940, regulates funds that are primarily in the business of investing in securities. A note fund can be caught by it, which would bring a heavy layer of regulation. Funds usually rely on an exclusion instead. Some limit themselves to a set number of investors under section 3(c)(1), some admit only very wealthy qualified purchasers under section 3(c)(7), and some fit section 3(c)(5)(C), which covers entities primarily buying mortgages and other liens on real estate. Each has conditions about what the fund holds and who invests, and the choice affects how the fund must be run.
The manager, the people selling, and the states
- The manager may need to register as an investment adviser, with the SEC or the state, or qualify for an exemption, under the Investment Advisers Act and state law.
- Anyone paid a commission for bringing in investors may need to be a registered broker-dealer. Paying an unregistered person a success fee for raising money is a common problem in small funds.
- Each state has its own securities law, the blue sky laws. Rule 506 offerings are largely exempt from state registration, but most states still expect a notice filing and a fee, and other exemptions may need full state compliance.
- The fund’s notes still carry their own rules. Owning and servicing loans, especially owner-occupied ones, can raise state licensing questions; see do I need a license to buy notes?
If you are investing in a fund
As an investor, you are the person these rules exist to protect, so use them. Ask which exemption the offering relies on, and look up the fund’s Form D on the SEC’s public EDGAR database. Ask whether the manager is a registered adviser or relies on an exemption, and check the state securities regulator for complaints or orders. Read the private placement memorandum, the subscription agreement and the operating or partnership agreement in full, with an attorney if the amount matters to you.
A few signs deserve caution: a fund advertising openly but never asking you to prove you are accredited, a fixed return described as safe or guaranteed by the manager, pressure to invest before you have read the documents, or a salesperson paid per investor who cannot say whether they are registered. If your money would come from an IRA, ask also whether the fund borrows, because leverage inside the fund can create UBIT and UDFI for the IRA.
Owning notes directly instead
The other route is to own notes yourself, one at a time, and do your own checking. That avoids buying a security from someone else’s fund, though it brings its own work and the risk of one borrower. Smaller budgets can do it through buying part of a note. We work with individual notes in that way: investors who join the buyer list see notes we broker one at a time, with the figures behind each price, and each investor buys in their own name or their IRA’s.
Before money changes hands
If you are thinking of pooling money with friends, family or business contacts to buy notes, even informally, the rules above may already apply. An agreement over dinner to split a note four ways can be an offering of securities. Talk to a securities attorney first, settle the structure, the exemption and the documents, and only then speak to investors. Fixing a non-compliant offering after the money is in is far harder than setting it up correctly at the start.
Related questions
Is buying a single note for myself a securities purchase?
Generally no. Buying a whole real estate note for your own account is usually treated as buying a loan. Fractional interests sold to passive investors, or shares in a pool, are a different matter. Ask an attorney where a specific deal falls.
Can a note fund advertise to the public?
Only under an exemption that allows general solicitation, such as Rule 506(c), and then every investor must be accredited and verified. A Rule 506(b) offering may not be advertised publicly.
How can I check a note fund before investing?
Look up its Form D on the SEC's EDGAR database, check the manager with the state securities regulator, ask which exemption the offering uses, and have an attorney read the offering documents.
Do I need an attorney to start a small note fund?
Yes. Even an informal pool among friends can be an offering of securities. A securities attorney should settle the structure, the exemption and the documents before anyone is asked for money.