Corporate & Securities Law for the

Real Estate Investing Business

Presentation by Nancy Fallon-Houle

Nancy Fallon-Houle, P.C.

www.nfhlaw.com 630.598.0400 x 22

Real Estate Action Leaders

Rolling Meadows, ILApril 11, 2012

Do You Have a Legal Right to Operate the Business?

Are you bound by a Noncompete Agreement or Employee Manual? With current or former employer, partner,

vendor, or customer? Does it impede your right to operate

business, sell business, or raise capital from investors?

To what degree? Prohibit altogether? Limit as to geographic scope? Time limit? Duration?

Prohibits contact w/ specific customers, employees ?

Who Owns the Intellectual Property

Who Owns Intellectual Property that Runs the Business? In Real Estate, the IP is lists of customers,

employees, investors, vendors; business method; look & feel of website; tag lines: low IP business.

IP Developed Where? While you were employed elsewhere? If so, employer may own it.

Co-developed with another party? If so, they may partially own it. Are their legal rights assigned to you? If not, you don’t own it.

If Co-developed with current partner? Document Capital Contribution of both.

Protect your IP going forward with NDA, etc.

Name Selection & Search, Tag Lines, Product Names, Logos

Name check before business formed / operated; before use of d/b/a, product name, logo, tag line or domain name.

Common law rule: 1st to use name in industry is winner, even if they have not trademarked it or formed an entity.

Use of internet and websites, means you are doing business everywhere. Therefore, national, or global, name competition.

Can’t use same or similar name in the same industry. Even homonyms, same root words, or phrases prohibited if “likelihood of name confusion” may result.

Name search at many levels: Google, Federal trademark, state trademark, state corporate, common law unincorporated, state tax roster, county DBAs, biz directories, domains.

Like your name and don’t care if someone else is using it first? Beware of surveillance on the web by 1st Users looking for “infringers”! Electronic search systems used. [Handout]

Sole Proprietorship vs. Entity Personal Liability in sole proprietorship Separation of financial & tax matters, tax returns easier if

you are a corporation or LLC. Insurance easier to obtain for entity than for sole prop. Larger companies require entities around business owners. Perception of customers. Easier to obtain a Loan if you look like a "real business“. Due Diligence goes more professionally and easily if people

can conduct Due diligence on you on Sec of State site. If you will ever raise capital by issuing stock to investors or

reward employees with stock, it cannot be done with a sole prop.

Must file DBA with IL SOS, and County and a REG-1, therefore much of the time consuming cost of forming a corporation must also be done for a sole prop, therefore there isn't a huge difference in cost

Filings Required For All Businesses

If Either Sole Prop or Entity Federal Tax ID & State Tax ID d/b/a (doing business as, or Assumed Name) Trademark filings for Name and Logo Illinois Department of Professional Regulation Real Estate Broker License if buying/selling

property, or hire one. Business License in local jurisdiction Sales Tax Employer Payroll Tax Accounts Business Bank Account

Proper Entity Formation is Key Botched entity formation costs more to

clean up than expensive formation: Botched by online incorporation services,

accountant, divorce lawyer, or do-it-yourself. Common Mistakes in LLC or Corporate

Formation: Name not fully searched & not available under

common law or outside IL; Trademark Lawsuit Risk

Not Enough authorized shares, too low par value, wrong # of issued shares, thin capitalization;

Registered agent not biz owner, wrong county/state

Mistakes in board or managing members Wrong tax type, no accounting/tax advice

Common Formation Mistakes (Cont.)

Errors in, or Missing, “business purpose” (Resulting in loss of name protection, since industry is not stated.)

Missing addendum to Articles (Contains restrictions, removes effect of unfavorable IL statutory or case law provisions.)

No Stock or LLC Interests Issued, no ownership % decided, no share ledger, no capital contributions.

No Organizing Resolutions Adopted (Company does not legally operate until adopted, Agreements cannot be signed.) Or no other legal Agreement.

No corporate formalities. Using online service, accountant, or Do-it-yourself

does not save $: Botched entity formation clean-up costs 1.5 to 2x cost to correct. (Filing amendments, re-documenting, correcting tax ID errors, name change, share fix.)

Corporate Formalities After Start

Operate the company like a business , not hobby. Its business, not friendship! (Incl. customers &

employees) Implement processes and documentation. Buy QuickBooks; Keep diligent accounting records Separate finances business & personal Follow Corporate Formalities to Avoid “Piercing the

Corporate Veil” (Handout). Keep up with Corporate Maintenance, legal, tax. File Annual Corporate Report Sales & Use Tax Reporting, Payroll tax Reporting Maintain Insurance Sign documents & contracts in business name. Maintain separate actions, identity, contracts Two businesses? Use two business entities !

Two Businesses = Two Entities

Form an entity around the business to separate liability, income expense. Form separate business entities around each differing business.

Don’t try to smash together a real estate investment business with an IT consulting business or a retail store.

Single Purpose LLCs separate ownership & business, risk, liability, of each property.

A confused business description, on corporate docs and on website, will confuse customers.

Partner & Shares Do’s & Don’ts;

Don’t make spouse partner unless spouse works substantially in the business. For estate planning, use a will, not shares or interests in the biz.

Don’t confuse relationships, i.e. Business Partner vs. outside Alliance Partner.

Avoid temptation to give away equity as monopoly money because you don’t have real money to pay people for services.

Equity only to your closest partners inside the business. Once you issue equity, you can’t take it back, unless you buy it back at FMV.

Going into business with someone & no entity formed = Partnership by default. Partnership case law applies, not corporate or LLC case law.

LLC Agreement or Shareholder Agreement

Among Owners The Business Pre-Nup between you & partners: Who invested What, How much, what

%? What percentage of ownership Percentage Vote to pass an Issue? Title, Role, Responsibilities Profit & Loss Allocation, Ownership

Allocation Buy Sell Provisions – Death or Disability Departure of a Shareholder?

Noncompete? Dissolution Provisions – How to Shut

Down

Changes in Ownership Adding/Removing Partners Requires Legal

Docs. Corporate Split-Up requires a transaction

with $. Selling the Business: Plan years in

advance; keep ducks in order; Corporate Records, Legal, Accounting, Processes Documented, Good Management, not too much debt.

Realistic expectations as to selling price and timing. Obtain professional valuation.

Business brokers for Sale of Business – Use Reputable ones only.

Fiduciary Duty & Conflicts of Interest

Fiduciary Duty to your company & to the other owners.

Fiduciary Duty to all companies of which you are officer, director or control person. Must Balance.

Avoid Conflicts of Interest, disclose them to those who would be affected by them, would scrutinize them, or would later object to them when disclosed.

Avoid Conflicts of Interest in client relationships; Finders Fees, Referral Fees must be disclosed.

Due Diligence Others Conduct on You

Your Clean Background is Key: Principals: Shareholders/Owners, Directors,

Officers The entity itself, and Prior business (you can run, but you can’t hide,

by forming new entity) Due Diligence will be conducted by: Lenders,

Vendors, Industry Partners, Investors, Business Partners Background checks, criminal, regulatory,

licensures, tax liens, bankruptcy (business & personal), Facebook, LinkedIn, Google

Often a credit check as well Legal history (litigation, regulatory issues,

licenses) Business Reputation like virginity, once gone, can’t get

it back

Due Diligence You Conduct on

Others Conduct Due Diligence on Clients, Co-Owners,

Alliance Partners, Suppliers, Lenders, Investors: You are judged by the Company You keep. Bad people often prey on small businesses, new

businesses, or woman-owned or minority-owned. Beware of crooks, scammers, deadbeats, toxic

clients. If they found you, instead of YOU finding THEM, be especially careful. If seems too good to be true … it is.

Avoid the Toxic Client/Customer: High Maintenance, Doesn’t Pay, In a Rush, unprepared, energy-sucking.

Trust your gut, take off the money blinders.

Protection of Intellectual Property

Is protection of your IP Possible? Patented? Business Process Patent? Copyright? (Software, writings, art), Nondisclosure Agreement?

Is the Company Name, Tag Line or Product Name Trade-mark-able?

Don’t blow IP protection by putting your ideas in public domain before protecting! Tradeshow, conference, website.

You don’t own the business idea ‘til you own the IP! Impose NDA’s & Noncompetes on your

Employees: Reasonable in scope and duration

Securities Laws forReal Estate Investing

With Other People’s Money

What is a Security?Definition of Security in SEC vs. Howey 328 US 293 (1946) Investment of money, property or services, Into a common scheme or enterprise, With the expectation of profit, Through the efforts of others.

A Real Estate investment with more than one investor is a security (unless it’s a true loan).

An investment pool, including common pool of real estate investors, is a security.

Investors who actively work in the venture as MMs/GPs are not investors, and their interests are not securities.

Options, warrants, stock bonus, convertible securities, participating notes, are all securities.

Borrowing Debt vs. Raising Investor Equity

When Loans Are /Are Not Securities

Security: Shared equity ownership in the property or investment Investor owns a percentage or $ value of the LLC or LP or

corp. Note or Loan Convertible into stock or equity ownership. Participating Note, or Loan, where borrower’s payments

only due, or lender makes more $, if investment makes profits. No fixed P&I.

Not a Security: Debt, Loans, Notes (generally), Borrowing a loan from

lenders Fixed payments, payment dates & obligation amount Payment Not Based on Profits or Loss: Borrower’s

payments due even if business becomes financially unsuccessful

Lender has priority rights over investors in liquidation

Borrowing Debt vs. Raising Investor Equity – Pros & Cons

Lenders easier to find Debt faster to negotiate and close. Debt less costly than equity in a few ways.

Equity (Investor money) more expensive than debt due to securities compliance costs. Deal must be larger to make it worth cost

Equity: Issuer gives up a piece of the company Investors share fully in profits & losses and only get

paid if there are profits; while lenders get paid regardless of profits & losses.

Lenders often prefer debt because of lender priority in liquidation or dissolution.

Securities Laws Apply if Investors in the Deal

Sale or Issue of Security:Issuing any equity interest in an investment LLC in exchange for cash, property, services, or vendor contract, is a security. Selling LLC interests, or stock, LLC or LP interest in a

real estate investment, any fund interest, is a security.

Selling investment or issuing shares to your parents, your employees, board members, advisors, is a security sale.

Giving a security for services or property is a security sale!

Find exemptions under 4(2) or Reg D where security issued. Registration exemptions typically require a notice

filing, even in very small deal. There are no disclosure exemptions (Need PPM or

Offering Memo, or abbreviated version of them.)

Disclosure Doc - Why ? § 10b-5 (anti-fraud) laws require “full and

fair disclosure” of all info material to investment decision: Offering, terms, principals, risks, industry, repayment, exit strategy, more.

Why PPM? Oral disclosure is inconsistent, time-consuming and not memorialized.

Legal Protection (to Issuer), from investors if unsuccessful investment, and exaggerating brokers. Investors may sue.

Don’t say anything outside of the book, and don’t say anything untrue or misleading.

Investor Perception: Improved with professional book; Increases investor confidence that compliance done correctly.

Forces Issuer to crystalize thoughts in writing.

Anticipates & answers investor questions.

Can and should be a marketing document: Touting the virtues of investment strategy, your background, your team.

Time Saver for your sales pitches. Balances Sales Pitch with Full Disclosure Puts your money where your mouth is:

You have invested personal assets in start-up costs (legal, accounting, printing.)

Disclosure Doc (PPM) - What ?

Material information for investment decision, “full and fair disclosure” about deal and principals.

Biography and 20-year historical background of principals and 5% owners.

“Bad boy” history on all principals: Criminal, Fraud, Regulatory/licensing history, court actions, bankruptcy, tax liens.

Disclosure Doc (PPM) - What Else? Investment Strategy / Property

Types, Geographic Scope Prior Performance / Track record Financial condition including debt. Any brokers or Finders ?

Compensation to whom and how much ?

Fees charged to investors; fees & expenses to fund, clear & concise.

Material Agreements, including debt.

Risk Factors: Strategy Risks, Market Risks, Your Competition, Your experience level.

Any other affiliated funds ? Who owns what of this fund ?

No Disclosure Exemptions

· Disclosure required even if a “no filing” registration exemption applies.

· Family & a few very close friends can acquire disclosure through relationship with you; but give them missing info.

· Only use this method for people who would forgive you if you lost all of their money

· Institutional Investors, highly sophisticated, in securities business , mega net worth, small in #, Disclosure by due diligence.

Registration Exemptions Do not rely on 4(2), generally: Parameters too ambiguous in terms of

numbers and relationship. State exemptions non-uniform, some require

pre-offer filings and state- reviewed filings. Use 4(2) in very limited circumstances only:

10 sales to family and very close friends, but lack of state exemptions may preclude cost-effective use.

Very sophisticated institutions, small #, but lack of state exemptions may preclude cost-effective use.

Regulation D ExemptionsDo not use Reg D Rule 504 or 505: 504 is limited to $1 million in sales, Must be registered in at least one state,

many states require full-blown registration

CPA reviewed Financials required. 505 is limited to $ 5 million in sales, State 505 exemptions are a landmine.Do Rely on Reg D 506 as the only practical

and cost-effective exemption.

Regulation D Rule 506 - Conditions

Unlimited dollar amount on offers & sales.

Unlimited time for offering. Unlimited Accredited Investors

Permitted. Subject to ‘40 Act 100 / 500 investor

limit Subject to ‘34 Act Reporting

Requirements for over 500 investors. Maximum of 35 Nonaccredited

Investors. No General Solicitation.

Accredited Investor

$ 1 million net worth (excluding home), or

$ 200,000 annual gross income, or $ 300,000 joint annual gross income

with spouse.

Higher QEP Investor test for funds with <100 investors.

Nonaccredited Investors Change the Nature / Cost

of Compliance Audited Financial Statements Required. More Lengthy Offering Book Required

under Reg D 506 and 502. If nonaccrediteds permitted as

investors, compliance often becomes prohibitively expensive (legal & accounting costs).

Nonaccrediteds do not qualify as ‘40 Act QEP investors for > 100 investor fund.

Federal Exemption Filing:

SEC Form D SEC Form D 10 page disclosure

notice filed online on EDGAR. Disclosure of principals and deal

terms Disclosure of brokers & finders,

names & fees, offering amount, $ sold, # investors.

File with SEC 15 days after 1st sale in any state. Plus in states file 15 days after 1st sale in each state.

Integration of Offerings

Multiple Offerings must have 6 month window between each offering, or

Start a separate fund with completely different trading strategy (gray area).

Consequence of failure to comply = all funds lumped together as 1, by the SEC.

Not a problem if total of all nonaccredited investors in all funds < 35.

Blue Sky (State Securities Law) 50 states each have own securities

laws. State of residence of investor is key. State review and comment on Reg D

506 pre-empted by federal law (National Securities Market Improvement Act 1996)

Filings still required in each state: Form D, Notice Letter & Fee

15 days after sale in each state (except PA & NY).

New York attempt to require pre-offer filing.

Private vs. Public Offering Distinction

Private Offering = No Public Solicitation, no cold-calls, no mass email or mail to unknown recipients, no newspaper or magazine ads, no planted articles, no websites selling, No Internet Solicitation, no LinkedIn Hunt for Investors, No Facebook PR

Pre-existing Relationship with your Investors Required = Must know your investor, even if not long,

Or selling broker-dealer must have pre-existing relationship with his /her investors.

New Law 4/9/2012 – Public Solicitation permitted in Private Offering, if only selling to accredited investors.

What Contact is Allowed? Jobs Act 4/5/2012 (Eff. 7/5/12):

Nonaccrediteds: Must know Nonaccredited Investors in advance of offering. “Pre-existing Relationship of sufficient length and duration to determine suitability of investment”.

Accrediteds: May solicit unknown investors, but may sell only to confirmed Accredited investors. Must verify Accredited status.

SEC No Action Letters: Issuer may solicit Accredited Investors from pre-qualified list of prior accredited subscribers to password-protected list. Lamp, IPO.Net

Reg D Rule 504 & Crowd Funding

Blue Sky for Reg D 504 (Small Public Offering of $1 million) requires full registration in at least one state.

504 allows public solicitation. Crowdfunding – New Law effective 7/2012

– allows public or social media offering up to $500,000, but limit of $500 per investor.

Crowdfunding does not work for investment fund.

1934 Act: Broker-Dealer Issues (Person Selling)

Person selling your investment must be registered as a broker-dealer in US and in states. No commissions.

Issuer-Dealer Exemptions for you, the fund operator, and your partners: Rule 3a4-1 and comparable state exemptions: Officer or Director status required, No commissions, and No other concurrent deals.

· Hire a broker to help you sell ?

Money Finders· Beware: Unregulated industry, no

licensing of finders. · Some are expelled brokers; or

people with criminal records.· Quality & ethics run the gamut. · Disclosure on Form D brings finder

before SEC & states, may cause regulatory trouble for unregistered finder.

· Will increase your legal fees to use one.

Bonus Slides (if Time)

Websites & LinksWebsite Developers Don’t Always Know: If your website links to a site outside of

yours, don’t imply or state a connection or relationship between the 2 sites, unless there is one.

You may be responsible to your readers for accuracy of info on the other site.

Don’t post someone else’s trademark on your site, nor as a link on your site, without permission. Don’t use a trademark that is “confusingly similar” to another trademark.

Credit the writer

Websites & Social Media You must own the intellectual property on your

site, or instead must have permission to use it. (Jury still out about using content of others, or links to their content).

Statements on your site about your company must be true! If not = fraud. Ditto for social media - Facebook, LinkedIn, YouTube, Twitter. Can’t put water back in the dam once it has spilled out via social media.

Privacy Policy may be required on your website. Consider privacy of clients before using FB,

LinkedIn, Twitter posts about your work. Know rules for allowing kids under 13: COPPA

http://www.ftc.gov/privacy/coppafaqs.shtm.

Website Legal Notices & Disclaimers

Importance depends on nature of the business and info on the website.

States terms & conditions of Use of the site, including disclaimers for: Warranties for website information, Responsibility for information on other linked websites, Endorsement of the products/info offered on other

websites, Liability for damages resulting from use of website or info

contained on the site, or any other site to which it links.

Prohibited activities (posting offensive or illegal content)

Monitoring rights of the website owner, Intellectual property notices, and Allowing kids to use site.

Email & Internet Advertising RulesThe CAN-SPAM Act establishes requirements for e-mailed commercial messages. Penalties for violations.  Summary of the rules: Don't use false or misleading header information.

Your "From," "To," "Reply-To," and routing information - including the originating domain name and email address - must be accurate. Must identify the message sender or initiator.

Don't use deceptive subject lines. The subject line must accurately reflect the content of the message.

Tell recipients where you're located. Your message must include your current street address or a post office.

It’s illegal to spam people who don’t want advertising emails, even your newsletters! Ask permission of recipient first.

Tell recipients how to opt out of receiving future email from you. Your message must include a clear explanation of opt out procedure, or provide working “unsubscribe” link.

Honor opt-out requests promptly.

Business Contracts Must be In writing to be enforceable. (An email can be

a writing! Email can be a contract if contract elements present.)

Elements of Contract: Capacity, Offer, Acceptance, Consideration Exchanged, Legal Purpose, Meeting of Minds, mutual assent.

Expensive to retroactively paper oral agreements, so paper them when they are agreed to.

Documenting an oral discussion can bring up deal-killing discussion points. Know before you start performing or acting under the contract.

Read, and understand, every word. The section or word you skip will come back to bite you. No such things as “boiler plate”, unless you want someone else’s deal not contemplating your terms.

“Reps & Warranties”: Make sure your “reps” are true & can be done (for example insurance requirement)

Breach & Indemnification Get Insurance to cover Indemnification Clause Many Items are Business Points, not Legal Think Through What could go wrong from a

business standpoint Business person makes business bullet points for

lawyer to draft into agreement Plain English Writing Realistic Expectations as to Cost & Timing When to involve counsel Services Contract: Assignable if biz sold (if stated

in agreement)

Business Contracts (Continued)

Classification of Employee vs. Independent Contractor

Very Hot issue with IRS, IL Dept. Rev, and IDES. IRS presumption of being Employee (even part-

time), several factor-test (Handout) “IRS Audit Focus on Worker Classification -

Employee or Contractor” & “Employee or Independent Contractor CCH” (Handout)

Legal conclusion revolves mainly around who has control over the person: Sole employer, Location of work, whose equipment, hours or dress dictated, other clients of the consultant.

Categorize most all contractors as employees, budget for payroll taxes.

Difficult expense for all early stage and small businesses

Worker Classification (cont.)

IRS going back and retroactively reclassifying “independent contractors” as employees; Retroactively imposing payroll tax, interest and penalties on all prior wages paid. No time limit!

Illinois employer laws possibly stricter than federal in the classifying contractors as employees, for unemployment tax, and UE claims, purposes. 10 hours/week = employee

Illinois Short Deadlines

Legal issues arise from hiring employees, such as Unemployment Liability (Be sure to terminate someone within 30 working days if they don’t work out, to avoid UE claim.) Even Part-Timers. That is 30 actual days of work, don’t count days not worked.

Illinois Directory of New Hires: Employers required to report all new employees, and their personal information within 20 days of their first day of work. Even Part-Timers

Federal & State Employment Laws

Harassment illegal – Applies to all businesses regardless of # of employees

Discrimination illegal. Some laws apply only to businesses with

over 10 employees or over 20 employees Dangerous Work – requires attention to

other regulations Document Problem Employees

Business Points Business Ducks in a Row:

Due Diligence, Conflicts, Fiduciary Duty, Know Competition, Assess Risks, Be Prepared Entity Formation, Ownership, Document Arrangements Document Business Processes Internally, to systemize the

business.

Use Technology to Operate & Promote Your Business Continue to use the efficiency of technology to better your

business, your own management of it and documenting processes.

Never say “I don’t use email” or “I’m not good with technology”.

Don’t use AOL, Hotmail or Yahoo email address for business – smacks of “cheap” or lack of experience. Gmail is fine.

Never have a live website stating “under construction”. At least have 1 page “Name, Address, Location, Phone, Email, & “what we do””

Use Email-able brochures, so colleagues can easily refer you to others. Paper is dead. Biz cards OK.