Are Condo Hotels Subject to SEC Regulations?

The latest real estate trend in the hospitality industry, across the country and around the world, is the “condo hotel.” A condo hotel resembles, and is managed and operates as, a traditional hotel, except that certain hotel rooms are offered for sale as condominium units to individual buyers. In addition, unit owners usually have the option of placing those units in a reservation system or rental program and sharing in any associated fees. The proliferation of the condo hotel is largely the result of the benefits that condo hotels afford developers, lenders, and buyers. For a developer, the condo hotel provides the opportunity to turn a quick profit upon sale of condominiums as opposed to the incremental profits traditionally associated with the cyclical hotel industry. Lenders are also more likely to support developers as a result of the potential return on investment realized with condominium sales (even prior to construction). Finally, the condo hotel is attractive to buyers seeking a residence that includes all the amenities associated with traditional hotel stays. Condo hotel purchases and sales also raise new and unresolved legal issues, particularly whether the sale of a condo hotel unit constitutes the sale of a security requiring registration and compliance with federal securities laws.

Although generally the offer for sale of real estate does not involve the offer of a security, as explained below, because a condo hotel unit is associated with a rental or management program, it can, in certain circumstances, be deemed a security. If so, unless the sale is exempted, the sale must be registered with the SEC and comply with the SEC's rules and regulations, including its anti-fraud provisions. Accordingly, developers or brokers could face serious criminal and civil liability repercussions. In addition, condo hotel sellers could be deemed securities brokers or dealers within the meaning of the Securities Exchange Act and may be required to be registered as such. Finally, if a condo sale is considered that of a security and that sale is not registered, the buyer could void the sales contract.

Is the Sale That of a Security?

Although no court has yet pronounced on whether or not a condo hotel sale constitutes that of a security, guidance can be found in a decision of the United States Supreme Court and two statements by the SEC.

First, in Securities and Exchange Commission v. W.J. Howey Co., 328 U.S. 293, 298 (1946), the United States Supreme Court stated that when, based on “economic realities,” a sales contract is “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,” that contract is an “investment contract” and, therefore, a security as defined by the SEC.

Second, in 1973, the SEC issued a release to address the “uncertainty about whether offers of condominiums and other types of similar units may be considered to be securities” (“Condominium Release”). See SEC Release No. 33-5347, January 4, 1973, 1973 SEC LEXIS 3277; 38 FR 1735. The SEC concluded that an offering of securities in the form of an investment contract will arise if the condominiums are: 1) sold with emphasis on the economic benefits to the purchaser to be derived from the managerial efforts of the promoter, or a third party from rental of the units; 2) include participation in a rental pool arrangement; and 3) require the purchaser must hold his unit available for rental for any part of the year, must use an exclusive rental agent or is otherwise materially restricted in his occupancy or rental of his unit. Nonetheless, the Condominium Release states that “an owner of a condominium unit may, after purchasing his unit, enter into a non-pooled rental arrangement with an agent not designated or required to be used as a condition to the purchase.”

Intrawest Corporation

Third, in 2002, the SEC issued a “no action” to Intrawest Corporation, a condominium hotel developer in Canada, concerning the “the offer and sale of condominium units … coupled with an offer or agreement to perform or arrange certain rental or other services for the purchaser” (Intrawest Letter at at www.sec.gov/divisions/corpfin/ cf-noaction/intrawt110802.htm) Intrawest wanted to institute a sales and promotional program for its United States developments enabling it to disclose the existence of the rental management programs as one of the services offered, without SEC registration. To that end, Intrawest represented, among other things, that: 1) under no circumstances will prospective purchasers be led to believe that they will profit from unit ownership other than by property value appreciation; 2) representatives of the rental management company would only provide information in response to specific inquiry; 3) Intrawest's rental management program would be completely voluntary and separate from the Intrawest sales program; 4) sales representatives will not receive additional compensation or other incentives for unit sales tied to rental management agreements; and 5) Intrawest will not discuss the terms of any rental management agreements until a purchase and sale agreement has been executed.

Based on the facts as presented by Intrawest, the SEC stated that Intrawest's sales and rental model did not create a security as defined by Howey and the Condominium Release because, among other things, the promotion and sale of units did not emphasize any economic benefit to the purchaser derived from managerial efforts or rentals and did not offer participation in a rental pool.

Conclusion

Although no court has yet to weigh in on the issue of whether or not a condo hotel sale constitutes that of a security, it is clear that, to avoid being deemed a security, at minimum, a condominium sale must not be tied to any pooling of rents and must be advertised, marketed, and sold as a piece of real estate, carefully avoiding associating that sale with any management or rental program. The manner of offering and the economic inducements held out to the prospective purchaser both will play an important role in determining whether the offering involves a security.

The latest real estate trend in the hospitality industry, across the country and around the world, is the “condo hotel.” A condo hotel resembles, and is managed and operates as, a traditional hotel, except that certain hotel rooms are offered for sale as condominium units to individual buyers. In addition, unit owners usually have the option of placing those units in a reservation system or rental program and sharing in any associated fees. The proliferation of the condo hotel is largely the result of the benefits that condo hotels afford developers, lenders, and buyers. For a developer, the condo hotel provides the opportunity to turn a quick profit upon sale of condominiums as opposed to the incremental profits traditionally associated with the cyclical hotel industry. Lenders are also more likely to support developers as a result of the potential return on investment realized with condominium sales (even prior to construction). Finally, the condo hotel is attractive to buyers seeking a residence that includes all the amenities associated with traditional hotel stays. Condo hotel purchases and sales also raise new and unresolved legal issues, particularly whether the sale of a condo hotel unit constitutes the sale of a security requiring registration and compliance with federal securities laws.

Although generally the offer for sale of real estate does not involve the offer of a security, as explained below, because a condo hotel unit is associated with a rental or management program, it can, in certain circumstances, be deemed a security. If so, unless the sale is exempted, the sale must be registered with the SEC and comply with the SEC's rules and regulations, including its anti-fraud provisions. Accordingly, developers or brokers could face serious criminal and civil liability repercussions. In addition, condo hotel sellers could be deemed securities brokers or dealers within the meaning of the Securities Exchange Act and may be required to be registered as such. Finally, if a condo sale is considered that of a security and that sale is not registered, the buyer could void the sales contract.

Is the Sale That of a Security?

Although no court has yet pronounced on whether or not a condo hotel sale constitutes that of a security, guidance can be found in a decision of the United States Supreme Court and two statements by the SEC.

First, in Securities and Exchange Commission v. W.J. Howey Co. , 328 U.S. 293, 298 (1946), the United States Supreme Court stated that when, based on “economic realities,” a sales contract is “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,” that contract is an “investment contract” and, therefore, a security as defined by the SEC.

Second, in 1973, the SEC issued a release to address the “uncertainty about whether offers of condominiums and other types of similar units may be considered to be securities” (“Condominium Release”). See SEC Release No. 33-5347, January 4, 1973, 1973 SEC LEXIS 3277; 38 FR 1735. The SEC concluded that an offering of securities in the form of an investment contract will arise if the condominiums are: 1) sold with emphasis on the economic benefits to the purchaser to be derived from the managerial efforts of the promoter, or a third party from rental of the units; 2) include participation in a rental pool arrangement; and 3) require the purchaser must hold his unit available for rental for any part of the year, must use an exclusive rental agent or is otherwise materially restricted in his occupancy or rental of his unit. Nonetheless, the Condominium Release states that “an owner of a condominium unit may, after purchasing his unit, enter into a non-pooled rental arrangement with an agent not designated or required to be used as a condition to the purchase.”

Intrawest Corporation

Third, in 2002, the SEC issued a “no action” to Intrawest Corporation, a condominium hotel developer in Canada, concerning the “the offer and sale of condominium units … coupled with an offer or agreement to perform or arrange certain rental or other services for the purchaser” (Intrawest Letter at at www.sec.gov/divisions/corpfin/ cf-noaction/intrawt110802.htm) Intrawest wanted to institute a sales and promotional program for its United States developments enabling it to disclose the existence of the rental management programs as one of the services offered, without SEC registration. To that end, Intrawest represented, among other things, that: 1) under no circumstances will prospective purchasers be led to believe that they will profit from unit ownership other than by property value appreciation; 2) representatives of the rental management company would only provide information in response to specific inquiry; 3) Intrawest's rental management program would be completely voluntary and separate from the Intrawest sales program; 4) sales representatives will not receive additional compensation or other incentives for unit sales tied to rental management agreements; and 5) Intrawest will not discuss the terms of any rental management agreements until a purchase and sale agreement has been executed.

Based on the facts as presented by Intrawest, the SEC stated that Intrawest's sales and rental model did not create a security as defined by Howey and the Condominium Release because, among other things, the promotion and sale of units did not emphasize any economic benefit to the purchaser derived from managerial efforts or rentals and did not offer participation in a rental pool.

Conclusion

Although no court has yet to weigh in on the issue of whether or not a condo hotel sale constitutes that of a security, it is clear that, to avoid being deemed a security, at minimum, a condominium sale must not be tied to any pooling of rents and must be advertised, marketed, and sold as a piece of real estate, carefully avoiding associating that sale with any management or rental program. The manner of offering and the economic inducements held out to the prospective purchaser both will play an important role in determining whether the offering involves a security.