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News July 31, 2017 Issue

Real Estate Investment Strategies in Offering Docs Must be Clear and Followed

If your private fundís offering documents state that your fund will invest only in real estate, be aware that those are not just words. Stepping outside the parameters of your fundís stated investment strategy may lead to trouble, both for the fund and for the fund manager. This is also true with unclear and/or inconsistent investment strategy wording between your private placement memorandum and other fund documents. Language, it turns out, matters.

California-based advisory firm Landwin Management and its founder/indirect†majority owner Martin Landis found out just that. They settled allegations on July 6 with the SEC that they deviated from the investment strategy stated in their fundís PPM and other offering documents. While they had to pay a relatively modest civil money penalty of $75,000, both were censured and will have to hire an independent monitor to look over their shoulder until the fund in question ceases operations.

Landis formed the fund in March 2006. During that year and in 2007, he and his firm sold interests in the fund, ultimately pooling over $20 million from 327 investors Ė including Landis himself, who invested $3.2 million, according to the SECís administrative order instituting the settlement.

The fundís guidelines entitled Landwin and Landis to receive performance-based profit sharing income of 30 percent of all distributions after fund investors receive their capital contributions plus a 7 percent†return. Landwin and Landis controlled the fundís operations and the selection of investments, the agency said.

Investments: Stated and otherwise

The problem, at least from the SECís point of view, was with the investment strategy as described in the fundís PPM and the advisory firmís investment decisions.

Under the fundís PPM and other offering documents, the advisory firm "í[g]enerally . . . will seek to acquire a portfolio of real estate and/or real estate-related investments . . . .,í" the SEC said, quoting from the documents. The PPM offered example investments that included mortgage loans and investments in real estate shopping centers, office buildings, industrial properties, multi-family properties, and mixed-use properties.

From April 2007 through August 2014, it appeared that Landwin and Landis spent a lot of time doing just that. They "invested in real estate-related opportunities for the fund by a) purchasing almost $5.84 million in limited partnership interests in two Landwin-managed limited liability companies that hold commercial real estate†assets, b) using almost $2.7 million to loan money to real estate-related entities, and c) investing almost†$4 million in a commercial property," the agency said.

Unfortunately, if the SEC is to be believed, those were not the only investments they made.

"From at least June 2011 through August 2014," the agency said, "Landwin and Landis also used up to†$2.4 million in fund cash to purchase short-term bank, corporate and sales tax revenue bonds and preferred and common shares of stock that were unrelated to real estate." The SEC noted, for example, that in 2014 the fund acquired about $1.1 million Ė which represented about 5 percent of the fundís money Ė of non-controlling interests in a variety of industries, including oil and gas, media, nutrition, insurance and financial companies.

"The fundís offering documents did not authorize†investments in anything other than real estate-related opportunities and did not disclose any potential risks associated with investments other than real estate," the agency said.

Nor did Landwin and Landis disclose to investors that they invested fund assets in companies other than those that were real estate-related, according to the administrative order. This is where the issue of consistency among fund documents comes in. "Although Landwin sent out newsletters to the fund investors describing the fundís real estate investments, the newsletters failed to discuss the non-real estate investments," the SEC said. "Similarly, while annual financial statements sent to investors included line items for Ďsecurities in brokerageí and dividends, Landwin and Landis did not disclose that the securities were stock and bonds unrelated to real estate."

"This case shows that lack of explicit disclosure can create issues for advisers when they are assessing their discretion to manage client assets as stated in governing documents," said Paul Hastings partner Tram Nguyen.

"It seems like the Division of Enforcement is seriously focused on even the slightest infractions," said Pasquarello Fink partner William Haddad. "Here, there is no allegation of any investor loss and there is no allegation of fraud. Despite those facts, the SEC imposed a $75,000 civil money penalty and required the company to hire an independent monitor at significant cost. "

"You have to stick with what you promised," said Ropes & Gray counsel Jeremiah Williams. "Advisers need to be very careful that they are investing in accordance with their stated investment strategy."

"Landwin Management and Landis, as the managers of the fund, were sitting on a large amount of cash while searching for attractive real estate investments. At the recommendation of the fundís brokers, and in order to increase returns for investors, funds were invested in money market funds and some stocks and bonds," said the attorney representing the advisory firm and its founder. In doing so, he said, "the firm made more money for investors than if he had simply left the money in cash."

The defense attorney also noted that the SEC made no allegations that Landwin Management or Landis did anything for their personal benefit or with wrongful intent, and that in settling with the SEC, the advisory firm and its founder neither admitted nor denied the SECís allegations. According to the attorney, Landwin Management and Landis believe it was "in the best†interest of investors to pay a $75,000 civil money penalty rather than enter into protracted litigation, and none of the settlement money came from the fund."

Investment company registration

Unfortunately for Landwin and Landis, the agencyís investment strategy allegations did not stop with the question of whether the strategy was followed. Another alleged ramification was that the investment decisions also allegedly led to the fund not being registered with the Commission as an investment company.

"Advisers need to ensure that they comply with the Ďtechnicalí requirements under the Investment Company Act if they want to avoid registering their investment funds with the SEC," said Nguyen.

Section 3(a)(1) of the Investment Company Act defines an investment company as being, among other things, an issuer that, according to the administrative order, "íholds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, owning, holding or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuerís total assets .í"

Landwin appeared to at least initially be on track to†doing just that. The SEC noted that the fundís PPM said that Landwin "íwill not cause the [fund] to be engaged primarily in the business of investing in securities, nor will it knowingly permit the [fund] to invest in, own or hold securities having a value exceeding 40 percent of the value of the total assets of the [fund]."

As it turned out, however, "the fundís investments in real estate-related partnership interests, mortgage loans and publicly traded stocks and bonds each fall†under the definition of a security in Section 3(a)(2) of the Investment Company Act," the SEC said. Whatís more, the agency said, "beginning in January 2011 through September 2015, between 48 percent and 100 percent of the fundís total assets (exclusive of government
securities and cash items) were comprised of investment securities."

The fund did not fit into a statutory exemption or†exclusion that would have allowed it not to register as an investment company, nor did it seek an order from the SEC declaring that it was primarily engaged in a business that was not Investing, reinvesting, owning, holding or trading in securities, the agency said. "Thus, the fund should have registered with the Commission as an investment company."

Ironically, said Williams, if the fund had registered with the SEC, it would have been easier for it to change its investment strategy through filing an amended registration statement. For private funds that are not registered, changing investment strategies is more difficult, as investors may have expectations as to how long their money may be illiquid, as would be the case with many real estate investments, he said.


As part of the settlement, Landwin and Landis were both said to have willfully violated Section 206(2) of the Advisers Act, which prohibits fraud; Section 206(4) and its Rule 206(4)-8, for making untrue statement of material fact; and with causing the fundís violation of Section 7(a) of the Investment Company Act for failing to register as an investment company.