Let me tell you something I’ve seen play out more times than I’d like to count. A private lender builds a solid book. Good borrowers, good collateral, solid returns. The pipeline gets bigger than the balance sheet, so the lender starts calling investors. “Hey, I’ve got a great deal, want to take a piece?” The investor says yes, money moves, everybody’s happy.
Until they’re not.
What that lender just did, whether they realize it or not, is sell a security. And doing it without the right structure is one of the most expensive mistakes a private lender can make.
You Sold a Security. Yes, You Did.
This is the conversation I have with lenders constantly, and there’s always pushback. “It’s not a security, it’s a loan participation.” “It’s a trust deed investment.” “We’re co-lending.” The labels don’t matter. The Supreme Court settled this decades ago.
Under the Howey test (SEC v. W.J. Howey Co., 328 U.S. 293 (1946)), when someone invests money in a common enterprise and expects profits derived from the efforts of others, that’s a security. The Reves family resemblance test (Reves v. Ernst & Young, 494 U.S. 56 (1990)) catches notes and loan instruments separately. If your investor is writing a check and waiting for you to underwrite, service, and enforce the loan, every element is satisfied. Period.
I’m not being academic here. This is what state regulators and the SEC look at when they open an investigation, and the label on your document doesn’t slow them down for a second.
The Real Cost of Getting This Wrong
The pitfalls aren’t hypothetical. I’ve represented lenders on both sides of these problems, and the consequences compound fast.
Rescission. An investor who purchased an unregistered security has the right to demand their money back plus interest. Not just unhappy investors. All of them. Under Section 12(a)(1) of the Securities Act and analogous state statutes, this right can persist for years. Imagine a lender with 40 investors across 15 loans getting hit with rescission demands after a single default. That’s not a bad quarter. That’s an existential event.
Personal liability for control persons. Securities law pierces the entity. Section 15 of the Securities Act and Section 20 of the Exchange Act impose liability on “control persons,” which means the principals, the managers, and anyone directing the operation. Your LLC is not a shield here.
Anti-fraud exposure under Rule 10b-5. This one applies regardless of whether you have an exemption. Every material misstatement, every omission, every risk you glossed over in a phone call or an email is potential liability. Did you tell the investor the borrower had experience when they didn’t? Did you skip the part about the junior lien? Did you fail to mention that you’re also the property manager? These aren’t technicalities. They’re the factual predicates for fraud claims.
Regulatory enforcement. California’s DFPI, the Texas State Securities Board, Florida’s OFR: these offices have active enforcement divisions and private lending is on their radar. Investigations lead to cease-and-desist orders, fines, and referrals that can affect every license your business touches.
Reputational damage. Once you have a regulatory action on your record, raising institutional capital becomes dramatically harder. Warehouse lenders and fund-of-funds allocators ask about enforcement history in their diligence questionnaires, and a “yes” answer is usually disqualifying.
All of this from selling pieces of loans without the right paperwork. The economics of the deal can be perfect, and it still blows up.
The Loan Participation Agreement Question
Loan participation agreements come up in almost every one of these conversations. Lenders like them because they’re simple: one agreement per loan, the investor takes a beneficial interest, you keep servicing. No offering documents, no subscription agreements, no Form D filing. Quick and clean.
And for certain transactions, they genuinely work. When a private lender sells a participation to another institutional lender or a family office that’s conducting independent credit analysis, the securities argument weakens considerably. The buyer isn’t passive. They’re a co-lender in substance. That’s the banking model, and it has decades of precedent supporting it.
The problem is that most private lenders aren’t selling to banks and family offices doing their own underwriting. They’re selling to individual investors: dentists, retirees, small business owners who trust the lender’s judgment and have no intention of independently analyzing the collateral. Those investors are passive. They’re relying entirely on the lender’s expertise. And that means the participation agreement, no matter how well drafted, is the wrapper around an unregistered security.
It gets worse when you cross state lines. A participation sold within a single state might qualify for an intrastate exemption. The moment your investor is in a different state, you’ve triggered federal jurisdiction and the blue sky laws of every state where an investor resides. Each state has its own registration requirements, its own exemptions, and its own enforcement apparatus. A lender selling participations to passive investors in five states isn’t running one program. They’re running five separate unregistered offerings.
The operational challenges compound too. Multiple beneficial owners on a deed of trust creates real problems at foreclosure. You need consent, and the participation agreement better have clear intercreditor language, or you’re stuck negotiating with your own investors when the borrower stops paying.
Participations have their place. That place is narrow, institutional, and typically intrastate.
Why the PPM Changes Everything
A Private Placement Memorandum paired with a Regulation D exemption solves every problem I just described, and it does it nationally.
Rule 506 offerings are “covered securities” under the National Securities Markets Improvement Act of 1996 (NSMIA), codified at Section 18 of the Securities Act. That single provision preempts states from requiring registration or imposing substantive review on your offering. States retain notice filing authority (typically a copy of Form D plus a small fee), anti-fraud jurisdiction, and broker-dealer oversight. That’s it. One offering structure, every state in the country.
But federal preemption is only part of the value. A well-drafted PPM builds the defensive infrastructure that protects the lender when things go sideways, and in private lending, things eventually go sideways. The PPM discloses risk factors, conflicts of interest, fee structures, manager background, and loan-level specifics in writing. The subscription agreement memorializes the investor’s acknowledgment that they received and reviewed all of it. That paper trail is the difference between surviving an investor complaint and writing a seven-figure settlement check.
Why a Private Lender Actually Wants This
I emphasize “wants” because too many lenders treat the PPM as a regulatory tax. Something you do because a lawyer told you to. That’s the wrong framing entirely.
A PPM is operating infrastructure. It standardizes your investor onboarding so you can bring in new capital without reinventing the wheel every time. It defines the manager’s authority clearly, which means you can make servicing decisions, approve modifications, and execute workouts without polling your investors. It gives institutional allocators and warehouse lenders the documentation they expect to see, which opens doors that stay closed to lenders running informal programs. And it lets you raise capital from anywhere in the country under one consistent framework, which is the difference between a regional operation and a national platform.
The lenders I work with who build a proper PPM early don’t just avoid problems. They grow faster, raise more capital, and spend less time managing investor relationships because the structure handles it. The ones who wait until a regulator or an angry investor forces the conversation spend more money fixing the problem than they would have spent doing it right from the start.
The Bottom Line
Fractionalizing loans is how private lenders scale. It’s a good business model and it generates strong returns for investors. But the moment you sell a piece of a loan to a passive investor, you’ve entered securities regulation, and the rules apply whether or not you’ve acknowledged them.
The PPM isn’t a burden. It’s the tool that lets you do this legally, efficiently, and at scale. It’s the difference between a business that grows and a business that’s one phone call from a regulator away from unwinding.
If you’re fractionalizing loans today without one, the best time to fix it was before your first sale. The second-best time is now.
About the Author
Anthony Geraci is the CEO of Geraci LLP, a law firm specializing in real estate finance, private lending, fund formation, and securities compliance. Geraci LLP serves as outside counsel to private lenders and fund managers nationwide. For more information, visit geracillp.com.
