Private lenders seeking to raise capital through hypothecation agreements, loan participations, or pooled investment funds must navigate a complex web of federal and state securities regulations. Each capital-raising structure carries distinct legal requirements, and selecting the appropriate securities exemption is a critical compliance decision that affects everything from investor eligibility to geographic reach.
This article examines the securities law framework applicable to these common private lending investment structures, including the available exemptions, their limitations, and the practical considerations that lenders and fund managers should weigh when choosing among them.
Why Hypothecations and Participations Qualify as Securities
Under federal securities law, the threshold question is whether a given investment arrangement constitutes a “security” subject to registration requirements. The U.S. Supreme Court established the foundational test in SEC v. W.J. Howey Co., which defines a security as: (1) an investment of money; (2) in a common enterprise; (3) with an expectation of profits; (4) derived primarily from the efforts of others.
California courts have applied this framework directly to fractional interests in promissory notes. In People v. Schock, the court held that fractional note interests constitute securities because investors commit capital with the expectation of returns that depend on the expertise and management of a promoter or servicing company.
The critical variable is investor control. When a promoter solicits investors to fund loans and retains management authority over the underlying collateral, the resulting hypothecation or participation interest will generally be classified as a security. Conversely, if the investor exercises active, meaningful control over the investment — including decisions about loan origination, servicing, and enforcement — a stronger argument exists that the arrangement falls outside the securities framework.
State-Level Exemptions: California Section 25102(f)
For lenders conducting limited capital raises within a single state, state securities exemptions may provide a viable path to compliance. In California, Corporations Code Section 25102(f) exempts certain offerings from state registration requirements, subject to several conditions:
- The issuer may sell to a maximum of 35 investors
- Each investor must have a pre-existing personal or business relationship with the issuer
- Investors must be purchasing for their own account (not for resale)
- The issuer may not engage in general solicitation or advertising to market the securities
- The issuer must file a 25102(f) notice with the California Department of Financial Protection and Innovation (DFPI) and pay the applicable filing fee
Other states offer parallel limited-offering exemptions with varying conditions. Delaware, for example, permits issuers to sell to no more than 25 persons within the state during any 12-month period, provided the issuer reasonably believes all purchasers are acquiring for investment purposes.
Limitations of State Exemptions for Multi-State Operations
State-level exemptions are designed for relatively small, localized transactions. When a lender’s investor base spans multiple states, reliance on individual state exemptions becomes increasingly complex and risky.
Each state maintains its own securities laws (known as “blue sky” laws), and an issuer must independently confirm compliance in every state where an investor resides. The administrative burden of tracking and satisfying varying state requirements grows substantially as the number of states increases.
Additionally, the integration doctrine poses a risk for issuers conducting multiple sequential offerings. Under this doctrine, regulators may aggregate separate transactions into a single offering for purposes of evaluating compliance with investor limits and other exemption conditions. If integrated transactions exceed the thresholds of a particular exemption, the entire offering may be deemed non-exempt.
For lenders with a growing or geographically diverse investor base, these limitations generally point toward a fund-based structure as the more sustainable compliance approach.
Fund Structures and Regulation D
Establishing a private fund under Rule 506 of Regulation D offers significant advantages for private lenders engaged in ongoing capital-raising activities. The two primary benefits of a Regulation D fund are:
Federal preemption of state securities laws. A properly structured Rule 506 offering preempts state blue sky registration requirements, meaning the fund manager does not need to evaluate and comply with individual state exemption rules for each investor. This dramatically simplifies compliance for funds with a nationwide investor base.
Exemption from SEC registration. Rule 506 provides an exemption from the registration requirements of the Securities Act of 1933, eliminating the need for a full SEC registration statement while still requiring the filing of a Form D notice.
Operational Advantages of Fund Structures
Beyond the securities law benefits, fund structures offer practical advantages for private lending operations:
- Centralized capital management. All investor capital is pooled into a single fund account, simplifying loan funding and cash management
- Streamlined loan origination. The fund serves as the lender of record, consolidating control over loan documents, collateral, and enforcement
- Passive investor status. Fund investors are passive participants whose governance rights are defined and limited by the fund’s operating agreement or limited partnership agreement
- Scalable investor base. The fund can accept new investors over time without restructuring individual loan arrangements
Investor Protections in Fund Structures
While fund structures benefit issuers through simplified compliance, investors retain important protections under federal securities law. Most notably, Rule 10b-5 of the Securities Exchange Act of 1934 prohibits fraud and material misrepresentations in connection with the purchase or sale of securities. Fund managers cannot waive or contract around Rule 10b-5 liability, and the SEC actively enforces this provision as a matter of public policy.
Fund managers must therefore maintain rigorous disclosure practices, including accurate and complete offering documents, regular investor reporting, and transparent communication about fund performance, risks, and fees.
Choosing the Right Structure for Your Lending Operation
The optimal securities compliance approach depends on several factors specific to each lending operation:
- Number of investors: Small investor bases may be served by state exemptions; larger bases favor Regulation D funds
- Geographic distribution: Multi-state investor bases strongly favor the federal preemption available under Rule 506
- Transaction frequency: One-off or occasional raises may work under state exemptions; ongoing capital needs generally require a fund
- Growth trajectory: Lenders planning to scale should consider establishing fund infrastructure early to avoid outgrowing state exemption limits
Consult Securities Counsel Before Structuring Your Raise
Securities compliance is not an area where private lenders should rely on assumptions or informal guidance. The consequences of an improperly structured offering — including rescission rights for investors, regulatory enforcement actions, and personal liability for principals — can be severe.
Geraci LLP’s corporate and securities team works with private lenders and fund managers nationwide to structure capital raises, prepare offering documents, and maintain ongoing securities compliance. Contact us at (949) 403-3488 or visit 90 Discovery, Irvine, CA 92618 to discuss your next capital raise.
