Pooling Investments Without Drowning in Liability: Securities Laws Compliance for Informal Investments Pools


Mutual funds pool billions of dollars and make millions of investments.  If these large-scale investments do not strictly adhere to certain rules and statutes, they may be ordered to return investors’ money or pay government fines.

In contrast, many private investments arise from informal pools of funds from friends, family, neighbors and colleagues.  A few (or few dozen) people or firms might informally throw some money in the hat to buy a piece of a private venture.  The investment could be a small piece of commercial real estate.  Or a technology start-up.  Or stake in a local bank. 

Commonly, behind these informal collective investments is the “promoter” – the person who found the investment, calls the friends, distributes the financial information, and collects the money to purchase the real estate or equity interests.  Unlike a mutual fund professional, this promoter likely has another job and the investment is simple.  However, if the informal investment group combines enough money, the promoter may accidentally trigger federal and state securities laws meant to regulate formal investment pools and mutual funds. 

Promoters of these pooled financings can heed a few basic rules and guidelines to avoid triggering an avalanche of disclosure and compliance requirements.

Comply with Private Placement Rules.  The sale of interests of a collective investment must comply with the same private placement rules applicable to any firm selling stock or bonds.  These include rules regarding disclosures of investment details, restrictions on the number of non-wealthy accredited investors, advertising, and investment resales.  Promoters of the investment pool should also adhere to guidelines about “testing the market.”  And yes, the pooled interests may very well constitute securities.  See Money Lost, Money Found: Bringing Back Shareholders Burned by Early Stage Investing from the Summer 2010 edition of the BWM&S Bulletin.

Create an Entity to Pool Cash and Sign Agreements.  In general, individual promoters of an informal investment pool benefit from establishing a separate holding entity.  First, this helps shield the promoter from many (but not all) personal liabilities.  More directly, the promoter will not personally sign the agreements making the investment, but will sign on behalf of the new holding entity.  Second, a separate entity is like a vessel into which each investor’s funds may be pooled, allocated and recorded.  Logistics such as establishing a bank account are better accomplished with a different entity with its own identification number and identity.

Avoid Becoming an Accidental Investment Company.  Under the wrong circumstances, an innocent pool of investments can fall into the quicksand of investment company regulations.  These rules require the informal investment group to behave like a multi-billion dollar mutual fund.  If the promoter receives any type of compensation, whether cash or an enhanced return on equity, the pool may be deemed to be “in the business of investing or trading securities.”  The result: tons of detailed disclosure; onerous registration filings, with information about investments, entity structure, and personal details regarding management; and severe restrictions on fund management.

The informal investment pool should ensure that it can use one of two exemptions or exclusions from the Federal Investment Company Act.  First, the investment pool may avoid classification by selling interests to 100 or fewer investors.  This 100-investor limit can easily increase or decrease, depending on how some detailed rules treat investors related by blood, or held through holding companies.  Second, the investment pool may be exempt if it only accepts “qualified purchasers” as investors.  These are individuals with more than $5 million in investments, or one who is responsible for an investment pool of at least $25 million. 

Avoid Being an Accidental Investment Adviser.  After dodging the investment company bullet, the promoter will then need to escape the investment adviser regulations.  The Federal Investment Advisers Act of 1940 imposes rules on persons or entities that are in the business of providing investment advice to other persons.  This could include investment advice to a single entity, such as the investment pool.  Or, the promoter could be deemed to be providing investment advice to the participants.  As with the investment company rules, the investment adviser requirements apply to persons “in the business” of providing investment advice.  Unfortunately, the rules define “business” broadly – any compensation, direct or indirect, and in any form, may convert the hobby into a regulated business.  The registration requirements as an investment adviser are much less burdensome than for an investment company.  However, for someone corralling friends and acquaintances, any kind of registration is a throbbing compliance headache.

To avoid the full-blown registration requirements, pools should raise less than $150 million.  Even then, however, some limited registration is required.  The SEC staff has indicated that it might completely exempt advisers who provide guidance to holders of less than $25 million in investments.

In addition to these federal rules, however, promoters should heed state “baby” versions of the federal adviser regulations.  In general, the promoter may create a single holding entity, declare it as its only “client,” and qualify it for state exemptions for advisers serving five or fewer clients.  Some states establish a higher or lower number of clients to qualify for the exemption.

Look for Special Rules for Special Investments and Holding Companies.  Unusual situations may be good news or bad for legal compliance.  If the organizers qualify as a family office under the new rules, it may be fully exempt from investment adviser regulations.  Persons raising more than about $25 million, and who plan to invest in operating companies, might be prudent to investigate qualification with the federal government as a Small Business Investment Company.  This provides certain tax incentives, access to low-cost federal loans and other benefits.  On the downside, however, special investments such as commodities or options may trigger rules of the Commodities and Futures Trading Commission.  This is an entirely separate set of rules and traps to consider if the pool includes these kinds of investments.

In general, promoters who follow a few guidelines can avoid the nightmares of compliance and liability.   However, organizers of informal funds who completely ignore these rules risk triggering an avalanche of regulatory and legal problems.  A quick regulatory check can be an easy life saver at the investment pool.

Craig McCrohon is a Corporate and Securities attorney at Burke, Warren in Chicago.  He specializes in stock offerings, venture capital and acquisitions, as well as bank regulatory counseling.  You may contact him at cmccrohon@burkelaw.com or 312-840-7006.

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