Are Investment Clubs Legal?

Are investment clubs legal? I certainly hope so, as I am a partner in two, including one for nearly 30 years. Joking aside, the business of buying, holding and selling securities is legal. Investment clubs engaged in this activity would be legal. Additionally, some investment clubs are formed to engage in the buying, holding and selling of real estate. As this is a legal activity, the investment clubs engaged in this activity are also legal. Instead let’s talk about something more nuanced, let’s talk about investment clubs limiting their activity to securities. 

While forming an investment club may be legal, the organizational form a club takes and how it operates may cause it to run afoul of some laws. There are three laws governing the operation and regulation of entities engaged in the securities industry which may affect investment clubs.The first is the Securities Act of 1933, as amended (15 USC §§ 77a thru 77aa). The second is the Investment Company Act of 1940, as amended (15 USC §§ 80a-1 thru 80a-64). The thirdis the Investment Advisers Act of 1940, as amended (15 USC §§ 80b-1 thru 80b-21). The full text of these laws can be found on the Investor.gov website of the Securities and Exchange Commission (SEC). Scroll down to the Statutes section of the web page.

Another useful resource I frequently access is the Legal Information Institute (LII) at Cornell University, which allows you to search the U.S. Code using LII. The three laws combine for about 225 pages. Most clubs don’t have an attorney practicing securities law as a member, so finding the sections of these laws that could affect investment clubs would be daunting. Fortunately, the SEC has an Investor Bulletin that explains the relationship of the SEC, securities law and investment clubs on their website. As I’m not an attorney, I relied on the SEC website for guidance on investment clubs and securities law. Let’s review what the SEC has to say.

The Securities Act of 1933, the rules thereunder, and case law defines a security and the conditions under which a security must be registered with the SEC. It’s possible that ownership interests in an investment club could be considered a security. The key point is whether ownership interest in an investment club is an “investment contract.” A person purchasing an investment contract expects to profit from the efforts of others. If all members of an investment club are active in the running of the club, including selecting investments, ownership interests in the club would probably not be considered a security.

However, quoting the SEC website, “If the club has even one passive member, it may be issuing securities.” This warning is one reason BetterInvesting and myICLUB recommend clubs require participation in club operations. Not only does it make the work lighter, but it also contributes to being exempt from some SEC regulationby affecting the choices of “entity type” for an investment club. Investment clubs should avoid any type of entity that has passive members if they want to avoid registering their ownership interests as a security with the SEC. These would include the Limited Partnership entity and the manager-managed Limited Liability Company entity. 

Note: The club would never be a security – it is only its ownership/membership interests that could be. If the club invests in securities and its membership’s interests are securities, the club itself could be an investment company. An investment club has even more work to do if it doesn’t want to be regulated by the Investment Company Act of 1940. An investment club needs to follow specific rules to be exempt from registering as an investment company. On its website the SEC lists three conditions that would require a club to register as an investment company:

1. Invests in securities;
2. Issues membership interests that are securities under the Securities Act of 1933;
3. Does not qualify for any exclusion from the definition of an investment company.

Requiring active participation from all members helps remove the second condition from consideration. The SEC site also mentions an exemption for a “private investment company” not required to register. Most investment clubs should qualify for this exclusion from SEC registration as an investment company, as long as the club: 

1. Doesn’t have more than 100 members and
2. Doesn’t make, nor proposes to make, a public offering of its securities.

The first prohibition is easy to accomplish, but at least some clubs are ignorant of this condition. I have seen several clubs with more than 100 members in the past. The second prohibition may be a bit trickier. A public offering may include maintaining a publicly available website or other public notice that indicates the club is looking to add members. The SEC recommends consulting a securities attorney if a club has engaged in or plans to engage in such public notices. Individual circumstances may still allow a club to be exempt from registration as an investment company in this case. An analysis of the club’s situation will be required to determine if registration is necessary. Consequently, to be safe, don’t publicly advertise membership opportunities in your club.

Investment clubs may also have exposure to regulation under the Investment Advisers Act of 1940. Compliance with this law and avoidance of regulation should be straightforward. Simply put, don’t compensate any member for investment advice. Receiving compensation for investment advice requires the recipient to register as an investment adviser. Spread the work of finding new investments among all members. It’s a bad idea to rely on a single member for investment ideas under any circumstance.

While not specifically addressed on the SEC website, I also wouldn’t have the club function as a stock advisor to an individual or another club. This would avoid the possibility of the club acting as an investment adviser requiring registration. Remember the BetterInvesting mantra, “Do your own analysis!”

Recognize also that the recommendation to avoid registration as an investment adviser is a best practice for investment clubs for both BetterInvesting and myICLUB. Model partnership agreements, from both organizations, include clauses indicating that no partner should be compensated for their efforts for the club, other than reimbursement for expenses incurred. Spreading the work among members, including security analysis and recommendations, has been BetterInvesting’s advice since its inception. 

While investment clubs are legal, clubs need to pay attention to how they are organized and run to avoid problems regarding rules and regulations governing stock investment clubs. Here are some dos and don’ts for clubs to follow to help avoid problems:

• Do have all members participate in all club operations, especially investment selection.
• Do limit members to under 100.
• Do not pay members for club work, especially investment selection.
• Do not publicly advertise membership opportunities in your club.
• Do not have passive members.
• Do not use an organizational type that requires passive members (remember limitedpartnerships and manager-managed LLCs have passive members).

Avoiding additional regulation by the SEC should be the goal of the majority of investment clubs.However, your club may wish to operate in such a manner that registration with the SEC is required. This is basically what Warren Buffet did with his first investment vehicle, Buffet Associates, Ltd. Buffet Associates was Warren Buffet’s original partnership. It was organized as a limited partnership. According to its partnership agreement, “The character of the business to be carried on shall consist of the buying and selling, for the account of the partnership, of stocks, bonds and other securities, commodities and other investments.” 

I found no SEC actions against the partnership and no mention of any actions taken against it within internet searches. Buffet’s earliest partnership could easily have been considered a type of investment club. Yet as a very well-known investment vehicle and with no SEC actions, registration under one or more of the mentioned securities laws was probably done. This brings up one last, very important, “do” – DO consult a competent professional with knowledge of securities law if you are unsure of your club’s status regarding registration with the SEC and compliance with securities law.

I have covered federal regulation of investment clubs. There are also state securities laws and regulations to consider. There is not space enough to cover all the states. The SEC does give help here also. On the SEC website related to investment clubs is a link to find who to contact for information on state securities law. The link leads to the website of the North American Securities Administrators Association (NASAA). The NASAA website includes a map of the U.S., click on the state of interest to find contact information. I also discovered a search using “[state name] securities regulator” was useful. 

Finally, the law is an evolving thing. What was considered settled law can be reinterpreted. Amendments to existing law can be passed. An example related to investment clubs is part of the tax law. When my club started 30 years ago, it was accepted that most investment clubs organized as general partnerships met the requirements to elect to be exempt from filing IRS form 1065. A club needed to file an initial 1065 and an election document to be exempt in the future. 

A few years later, the IRS issued a revision that most investment club partnerships do not meet the requirements to make the election to be exempt from filing form 1065. Clubs that had made the election were fortunate, in this case. Those that had been granted an exemption were grandfathered into the old interpretation. Any investment partnerships, based on the BetterInvesting model, formed after the new interpretation were required to file IRS form 1065 every year with no ability to elect out of filing. It’s important to regularly check for amendments and new interpretations of securities laws. The SEC website and its website for retail investors, Investor.gov, are good places to start.