COHOUSING AND SECURITIES REGULATION
excerpted from "Cohousing Development: Strategies And Structures"
by Don Lindemann
(Berkeley: University of California, Department of City and Regional
Planning, 1995)
This article should not be considered as definitive legal advice; it is intended only to acquaint you with the issues so that you can explore them more thoroughly with a local attorney if you feel a need to protect yourself.


When a cohousing group get to the point where it needs substantial investments from members to acquire and develop property, it may need to think about state and federal securities laws.

Some cohousing groups are unaware of these laws, while others are aware of them but seem to have concluded that they are not worth worrying about. "Let's just play fair and do the right thing," the thinking goes, "and not get into all this legal gobbledy-gook. If we tried to cover every legal base and eliminate the possibility of risk, we'd be so bogged down trying to protect ourselves that we would never be able to build cohousing at all."

Fair enough -- cohousing groups have achieved great things with, in some cases, the most informal of legal structures and agreements. However, it is probably worth pausing a moment at this point to consider what could happen if a project fell apart despite all the noblest and well-intentioned efforts of honest people. The consequences on group members could be particularly severe if they have not complied with state and federal securities laws.


Under federal law in the U.S., civil remedies are available to investors and violations may also be the subject of criminal prosecution. (I will not attempt to address securities issues under Canadian law.)

Federal law is constantly changing, and every state handles securities in a different way. Therefore, the information presented here should be considered only as a guide to the possible issues, and cohousing groups should of course consult a local attorney specializing in this area if they are concerned about compliance with securities laws. On the surface, at least, development of a cohousing group bears some similarities to that process known in real estate development as syndication. In a typical syndication, the promoter forms a limited partnership (just as some cohousing groups have done), bringing in investors who provide most of the capital required to purchase or develop a project (but who do not participate actively in its management). The sponsor, or syndicator, serves as the general partner and is responsible for all of the partnership's affairs. The capital may be raised in a public "registered offering" or in a "private placement" exempt from registration.

According to real estate authority Stephen P. Jarchow, most real estate syndications involve a security, particularly when they involve the silent participation of limited partner investors. "Consequently, syndicators must recognize that they are no longer dealing with mere real estate, but also with a security involving its own special regulatory constraints and considerations."

The point, in the current context, is that a small core group seeking co-investors in the development of a cohousing project might, it appears, be considered syndicators of a real estate security. According the Federal Securities Act of 1993, all securities must be registered. Registration is a complicated and expensive process, so the first thing a group should try to do is establish that membership is not a security in the eyes of the law. It is possible to get a so-called "no-action" letter from the SEC or state regulators that basically confirms this determination. If there is reason to believe that the SEC will construe a membership offering as a security, the group should identify an appropriate exemption from security registration requirements according to the rules comprising what is known as "Regulation D". Note that Regulation D, under some circumstances, requires that a specific type of disclosure statement must be provided to potential investors. Also, Regulation D prohibits the use of general solicitation or general advertising in connection with the offering or sale of securities.

It is important to keep in mind the real objective here: to minimize government red tape, attorney's fees and pointless paperwork. However, with or without regulations, one would expect that any cohousing group would want to provide full and accurate information about a project to newcomers.

IS MEMBERSHIP A SECURITY?
At one time the courts tended to limit the definition of a security to situations where investors relied solely on the efforts of a third party (promoter) to realize expected profits. In recent years, however, the requirement that investors rely solely on others has been generally replaced by a test of whether the investors rely on others for managerial efforts that are essential to the realization of profits. Usually, general partnership and joint venture interests are not considered securities because the participants take an active part in the management of the business. Limited partnerships (and perhaps LLC's) would be more suspect in the eyes of the SEC, although the presumption that a security is involved would be reduced to the extent that it can be shown that no profit motive is involved. In the cohousing context, where projects are often explicitly structured on a not-for-profit basis and members usually take an active role in managing the development process, it would seem that the presumption of a security is minimized. However, a countervailing factor is that most of the investors have little or no experience with real estate investment – and this tends to raise SEC eyebrows.

How, then, to proceed? I suggest that you talk to your attorney to try to determine if your membership offerings could possibly be construed as securities. If there is any doubt, the conservative approach would be to assume that a security is involved. Jarchow notes that a lawyer can influence the outcome of the security determination issue by the way the agreement is structured. Among the factors that courts have examined are the number of partners, the size of the offering, type of management, sophistication of the partners and how the offering is made (public vs. private). "It may be desirable to avoid or minimize dependence on some unique entrepreneurial or managerial ability of a promoter or manager that cannot be replaced or that others must rely on to exercise their powers meaningfully." For groups who believe they are not selling a security but want to be on the safe side, Jarchow offers this advice: "One may wish to give a "general partnership or joint venture" letter . . . spelling out rights and liabilities of a general partner or venturer under state law, the risks of the general partnership or joint venture, and the rights and powers of the partners. This can be either with or without a disclaimer that the interest is not a security. Another alternative is to disclaim security status but comply with Regulation D or other private offering requirements as a failsafe. The amount of disclosure will vary with the personal circumstances and sophistication of the different partners."

According to Ray Gasser, a member of Ecovillage Ithaca, the group applied to the attorney general of New York for a "no action" letter, "which basically said that all of us who have put up our hard-earned green have been intimately involved in all phases of the design and development of the project, that we are the developers and are building for our own use, not for speculative re-sale." Gasser confirms the point that complete and accurate information should be provided to newcomers, even though the group believes a security is not involved. "Make sure that in anything that people sign there are lots of CAPITAL LETTER PHRASES stating very clearly that any money put into anything you're doing is AT RISK and that by accepting money you aren't IN ANY WAY guaranteeing anyone a house or a lot, or anything at all. Not even an OPTION on any of the above."

REGULATION D AND THE PRIVATE PLACEMENT MEMORANDUM
If we assume the worst case -- that membership in a cohousing group involves sale of a security, this does not mean the security has to be registered as a public offering with the SEC. Instead the group in this case would identify a basis for exemption for the registration requirement (under Regulation D) and proceed with the form of disclosure statement -- if any -- required under that regulation. Regulation D provides exemptions from security registration requirements under rules 504, 505 and 506.

Rule 504. This rule provides an exemption from registration for sales of up to an aggregate of $500,000 of securities to an unlimited number of investors within a 12-month period. Syndicators relying for their exemption on this rule are not required to deliver any specific disclosure documents.

Rule 505. This rule provides an exemption for offers and sales of a maximum of $5 million of securities within a 12-month period to not more than 35 investors.

Rule 506. This rule generally provides an exemption from registration requirements for offers and sales of an unlimited dollar amount of securities to a group of not more than 35 investors who meet certain suitability requirements. (There is no limit on the number of investors if they are "accredited", but it can be safely assumed that most people involved in a cohousing group do not fall in this category.) Regulation D sets forth specific requirements for a disclosure statement or "private placement memorandum" for securities that qualify for an exemption from registration requirements. As indicated above (Rule 504), no specific form of disclosure is required if the total amount of securities is less than $500,000.

The Pioneer Valley group apparently relied on Rule 504 in determining that they did not need to adhere to any particular format for disclosures to potential members. To stay under the $500,000 limit, they set membership shares at a nominal amount and construed all other contributions to the development entity as deposits on future homes -- but this strategy may not work in every state. Another approach might be to define contributions as loans to the development entity, but this could be problematic, as reported by Jim Snyder-Grant of the New View group in West Acton, Massachusetts: The assessments -- which ran near an average of $1500/month during the heavy months before our construction loan & land closing -- are in effect loans, since we will be giving house discounts to match assessments plus interest, but are apparently not quite treatable as loans for tax purposes.

I'm not sure why our accountant pursued this more conservative route. It could be because the interest is contingent: if people leave the group, they eventually get their money back, but no interest. There is no formal promissory note for assessments: instead, the interest arrangement,including the contingencies, is laid out in the corporate papers.

(Cohousing-L, 12 Dec 94 12:47:22 ES)

Finally, regardless of the basis for exemption, Regulation D prohibits the use of general solicitation or general advertising in connection with investment offerings, including the following:

Obviously many cohousing groups have recruited members through advertisements, if only a free listing in some type of "community billboard" section of the local paper. It is hard to imagine a way to develop a group without the use of some kind of advertising, and it is also hard to imagine getting in trouble for using advertisements so long as the ad itself does not solicit investment funds and newcomers are given plenty of time to make their membership decision. Clearly, from a legal standpoint, it would not be prudent to ask newcomers to contribute money or make any kind of financial commitment at the first meeting they attend. Normally a group would not be tempted to do this anyway. Most groups, in the interest of insuring the compatibility of everyone involved, specifically provide a waiting period ranging up to several months before they accept prospective members as full members.

In the final analysis, compliance with securities laws will provide little solace if a project fails. As Dan Nachbar of the Pioneer Valley group points out, there is no way to do a cohousing project risk-free: "If things fall apart there will be hell to pay." Nachbar believes that an excessive focus on legal structures sometimes reflects the ambivalence people have about living in community. "People are concerned about excessive community and possible intrusions on privacy," he says. "Some of us get the willies about too much community, and that's what gets expressed in discussions of legal structure, because legal structures are about boundaries."

To avoid the kinds of problems that securities laws are designed to address after the fact, Nachbar recommends that each group (1) assemble an experienced and competent development team and (2) keep members well informed during each step along the way. "If you don't have a solid team, you're never going to make up for it by putting together a complicated disclosure memorandum."

Nachbar says the development team at Pioneer Valley engendered great confidence among the members. "By the time real money hit the table, our path was clear -- there was nothing in the way of our success." He adds that the development committee provided detailed weekly minutes to every member of the group.

In summary, cohousing groups should always strive to provide as much information as possible about a project before accepting money from newcomers, and they should be careful about the use of advertising. However, they can avoid the time and expense of complying with very specific disclosure requirements by working with their attorneys to ensure that memberships are not viewed as securities. Failing that, they can minimize or eliminate formal disclosure requirements by qualifying for an exemption from securities registration under Regulation D.

 

References:

Bell, Robert. Structuring Real Estate Joint Ventures. New York: John Wiley & Sons, Inc., 1992.

Butcher, A. Allen. Community, Inc.: Legal Incorporation for Intentional Community. Denver, Colorado (self-published by author), 1992.

Christian, Diana. "Legal Options for Communities." Growing Community, April, 1993.

Jarchow, Stephen P. Real Estate Syndication: Securitization After Tax Reform. New York: John Wiley & Sons, 1988.

Kirkpatrick, David. Legal Issues in the Development of Housing Cooperatives. Berkeley: National Economic Development and Law Center.

Rosenthal, Sherri Zann. "Limited Liability Corporation: Legal Structure for Cohousing." CoHousing, Summer, 1994, p. 3 of Southern regional insert.