Condo-Hotel Unit Sales, Rental Programs and Securities Laws
A Recent Ninth Circuit Court Decision Gives Guidance
By Arthur Spaulding, Jr. Partner, Cox, Castle & Nicholson LLP | October 20, 2013
During the past 40 years, developers of a variety of real estate products have struggled to obtain clear direction regarding how to sell real estate products such as condominiums and fractional interests, where the possibility exists that the buyer/owners might rent those products out as an ownership strategy. At the heart of the issue is the concern that the sale of real estate might be deemed to be the sale of an "investment contract" which would bring the real estate product under the definition of a "security" under federal and state securities laws. Of course, whether a security is involved in a transaction involving a real estate sale is one that depends on the relevant facts in a given sale. As a technical legal matter, the question about whether an "investment contract" is present was considered by the United States Supreme Court in its landmark holding in SEC v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946), where the Court held that an "investment contract" for purposes of the Securities Act means "a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party..." [Emphasis added.] See also United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 452 (1975).
As a general matter, the sale of real estate does not present facts and circumstances which would lead to the conclusion that a security is present, where the buyer purchases the property for his personal use and enjoyment and does not part with his money because he has an expectation that the property is going to increase in value or is going to provide him with a positive return on the money used to buy the property. In addition, the potential for a buyer to receive other kinds of benefits from the purchase of real estate, such as the deductibility of mortgage interest or the potential for increases in value due to the vagaries of the real estate market, are insufficient to transform an otherwise conventional real estate transaction into an investment contract.
Notably, however, the question of whether or not the buyer's potential to receive proceeds from the rental of real estate might transform a conventional real estate transaction into an investment contract, has been one of the thornier issues facing developers who wish to market real estate products that are likely to be rented. Put another way, does the potential to rent real estate and to receive proceeds comprise a class of potential "profits" that might create an investment contract?
This question was first raised publicly with the Securities and Exchange Commission in 1973, and has been extant for sellers of condominium units in condominium hotels and fractional interests for the last 40 years. This summer's important ruling by the United States Court of Appeals for the Ninth Circuit in the case of Salameh, et. al. v. Tarsadia Hotels, et. al., Case No. 11-55479 (August 13, 2013) addresses this issue in some important respects. We will examine that ruling in detail in a moment, but a review of the SEC's prior positions on this issue will help place this issue in the proper context.
In 1973, the SEC issued Release No. 33-5347 regarding the offering of condominium units for sale in a program in which those units would be included in a developer operated rental management program that would enable condominium unit owners to have a management company rent their units to hotel guests. At issue was the question of whether or not the availability of the rental opportunity would convert what was otherwise the sale of real estate into the sale of a security requiring registration of the offering as a security under federal securities laws. The Release reads in pertinent part:
"[T]he offering of condominium units in conjunction with any one of the following will cause the offering to be viewed as an offering of securities in the form of investment contracts:
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