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When it comes to investing in notes, buying bigger often results in better prices as well as better allocation of risk. Of course, spreading risk over fifteen assets is better than having all of your eggs in one basket. However, using your entire IRA or your life savings is something most people do, or should, shy away from. Raising money, then, becomes a fairly significant issue in this industry. This article, and several that follow, will delve into the idea of raising capital – naturally, the information here is provided generally, and with a keen eye toward the purchase of mortgage notes, so, while you may find information that is relevant to all types of fundraising, the details may differ. And, please, before you enter into the realm of private fundraising, please consult with your own attorney.
As I see it, the primary difference between raising capital and the sale of a tangible good is based on the idea of a “security.” Specifically, securities are regulated by the Securities and Exchange Commission, under rules and regulations set forth in the Securities Act of 1933 (“Securities Act”) and Securities and Exchange Act of 1934 (“Exchange Act”). Therefore, the foundation of a successful fundraise is a clear understanding of the definition of a security because in order to sell a security, it must be registered or fit within an exemption to registration.
Section 2(a)(1) of the Securities Act defines a security as follows:
The term “security” means any note, stock, treasury stock, security future, security based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. (emphasis added)
This intentionally broad and inclusive definition causes headaches for business people, but with wise counsel, it can be explained. In future articles, we’ll discuss the mechanics of selling securities (and compliance with the regulations), but for now, let’s just talk about the one bolded word above: any note.
If, in fact, a mortgage were deemed to be subject to SEC regulation as a security, the entire secondary market would be burdened with significant federal compliance (e.g., registration of each individual mortgage with the SEC, or finding an exemption to registration prior to each individual transaction). Thankfully, the Supreme Court in Reves v. Ernst & Young (1990) 494 U.S. 56, limited the definition of security when it held that various instruments commonly denominated as “notes” are not securities, specifically, a note secured by a mortgage on a home. The rationale (i.e., that this type of note and other similar instruments did not fit within the ordinary purpose of a security) remains true. Therefore, though other state statutes may regulate who can own a mortgage, the actual transfer of the mortgage is not regulated by the SEC.
As a result of the Supreme Court’s holding, a company that was financed through the issuance of securities (by way of debt or equity) can participate as a buyer, seller, and owner of mortgages and deeds of trust and can do so efficiently.
Please be aware, however, that this limitation of the definition is very narrow. In other words, compliance with the Securities Act and the Exchange Act will be necessary when raising the funds themselves, but the use thereof in the purchase of mortgages and deeds of trusts will fall outside of the regulations. As with most things “legal,” however, there is often an “it depends.” In this case, mortgages and deeds of trust are often collateralized and the resulting instrument (for example a CDO) will fit within the definition of a security. As a result, an entity looking to purchase these securities will have to follow an entirely different set of guidelines as a result.