Condo Hotels: To Register as a Security Or Not to Register – Is There Really A Question?
 
October 6, 2005
 
Lynn K. Cadwalader- San Francisco
James M. "Jim" Norman- Ft Lauderdale
David Wang - Portland

These days it seems that almost every newly built hotel is in whole or part a condominium hotel. Much of the deal activity we are seeing in existing properties is part of the plan to profit from conversion to a condominium regime. Further, when the condominium structure is added to a hotel, “equity credits” earned through condominium unit pre-sales can provide debt financing of up to 90 percent of the construction costs (vs. 50-60 percent for a standard hotel), making the financing of condominium hotels very attractive.

In the condominium hotel, rental programs are essential in order to provide a sufficient number of available room nights to qualify for specific brands, and in some places, to satisfy transient occupancy or hotel-specific zoning requirements. If developers and managers had their way, participation in the rental program by condo hotel unit owners would be mandatory. Lawyers practicing in this area spend considerable time conditioning their clients and those who work for those clients against using the term “rental pool” instead of “rental program.”

Defining a Security: What’s the Big Deal?

Over the years, the entire real estate industry, and now that segment of it we call the hospitality industry, has done everything in its power to avoid the securities laws and regulations of the United States. This goes back to 1973 when the Securities and Exchange Commission (SEC) determined that selling resort condominiums through a sales pitch emphasizing economic benefits, such as the pooling of rents, mandatory participation in rental programs and even significantly restricting the owner’s use of the condominium, made the sale an “investment contract” (and thereby a security) as described in a 1946 United States Supreme Court decision known as the “Howey” case. The essence of that case is that if something is sold, whether it be stock or a condominium, under circumstances where the economic benefit to the purchaser is to come through the efforts of third parties, it is a security. If it is a security, then unless one of the very narrow exemptions exists (and they rarely do in the context of condominium hotels), then registration with the Securities and Exchange Commission is required. That process is long, expensive and requires periodic filings and disclosures.

The SEC formalized its position with respect to resort condominiums in a 1973 release, and from that point forward, attempts were made to separate the rental programs from the sale of condominiums by erecting the legal equivalent of the Berlin Wall.

Just a Rental Agreement

Since 1973, a series of “no action” letters have been issued by the SEC to various developers in response to specific inquiries regarding condominium hotel projects. These no action letters, together with the 1973 SEC release, set out the guiding principles to consider in structuring a condominium hotel as a “non-securities” offering. The end result is that in offering a condominium hotel unit, a developer cannot discuss the investment potential of the purchase (including benefits of participating in the rental program or potential appreciation in the value of the unit), cannot require that the purchaser participate in any rental program, cannot pool the rents among unit owners (rental income from each unit must be separately accounted for and allocated to the unit owner), cannot materially restrict the purchaser’s occupancy or rental of their unit, and the rental program agreement cannot be entered into until a binding purchase contract has been entered into, with all applicable rescission periods having run. The only mention of a rental program verbally or in written materials can be a statement that “ownership of a unit may include the opportunity to place your unit in a rental arrangement.”

Sound restrictive? So here’s the rub: You can’t sell a condominium hotel unit as an investment, yet purchasers of these units are purchasing them largely for investment purposes. Due to the limitations imposed by the SEC on non-securities condominium hotel offerings, and the soaring popularity of condominium hotels across geographic and hotel product lines, some developers are asking, is it worth looking at the possibility of going through the time and expense of registering with the SEC? It is important to note that this is a “sale and resale” in the United States issue. Projects offered and sold exclusively outside the United States, even if the project is located in the United States may qualify under an exemption called Regulation S if certain stringent requirements are met.

Most of the limitations in the Howey case and the SEC releases and no action letters are eliminated if the sales program for the condominium hotel units is conceded to be a security and the registration process is completed. It is obvious why that would be tempting. With registration of the condominium hotel interests, the rental program can be made mandatory. A program also can be set up where all of the owners of units pool the rental income. Owners, including those not participating in the rental program, can be limited in their use of their condominium unit to whatever degree the developer chooses through the condominium documents, rather than the far more restrictive limitations available by using the rental management agreement signed by individual, participating owners in the rental program. Finally, the sale of these units can be specifically marketed as investments with a discussion of anticipated rates of return.

The Liabilities: Federal and State

Sounds good so far? Let’s look at the downside. The sales materials will look a lot like an initial public offering prospectus. When you read the warnings and disclaimers in a typical prospectus, you wonder why anyone would be crazy enough to invest in that offering.

In large projects, periodic disclosure reports will have to be filed with the SEC, much the same as is required of large, publicly-traded companies. If the securities are not registered and not publicly traded, then there are strict limits on resale, which will make the pool of prospective purchasers much smaller, as they would be limited to accredited investors (who must have certain levels of income and assets), and general advertisement is prohibited. Another significant concern is the exposure to federal and state civil and criminal securities liability. Think of the Wall Street “perp walks” and class action suits. A further complication is that the sale or resale of the securities likely would require the involvement of registered securities broker dealers, rather than, or in addition to, real estate brokers, who are best suited to market and sell real estate products. Most scenarios would require that both be involved in sales and resales. To this point, we have talked about securities registration as a federal matter involving the SEC. Unfortunately, many states, including those which seem to be most attractive to condo hotel developers and marketing companies, also have state securities registration requirements.

In securities offerings, costs are also a major issue. For the federal filing, which requires a myriad of legal, accounting, printing, distribution and filing fees, expenses approaching or exceeding $500,000 would not be out of line. In addition, similar registration costs at the state level (depending on which and how many states are involved) could easily exceed $100,000. If the project falls into a category where the periodic reporting is also involved, then those ongoing annual expenses also must be taken into account.

What’s Next?

Is securities registration of a condominium hotel project worth considering? Certainly. Is it likely to become a common part of the condominium hotel universe? Highly unlikely.

A good case can be made that the securities laws were never really intended to regulate the sale of residential or hotel condominiums. Unfortunately, unless the laws and regulations are changed, we will remain in a “don’t become a security” mode, tip-toeing to stay within the requirements when talking about benefits of participating in a rental program and stifling any temptation to show potential investment returns.

Will the law change? Should it? It’s up to our legislators.

For more information, e-mail David Wang, Jim Norman or Lynn Cadwalader at david.wang@hklaw.com, jim.norman@hklaw.com or lynn.cadwalader@hklaw.com, respectively, or call toll free, 1-888-688-8500.