June 3, 2009

Gentry Ruling Suggests Developers Must Be Prepared to Articulate a Legitimate Business Purpose for Stacking ILSA Exemptions

Holland & Knight Alert
Melissa S. Turra

Stacking exemptions under the Interstate Land Sales Full Disclosure Act (ILSA) has been an accepted practice, both by practitioners and by HUD, without the expectation of a developer having to articulate the reasons why the stacking was done.

In February 2009, however, the practice of creating two contracts for two sets of buyers – so that the first 99 purchasers of units within a condominium would sign a contract that complied with the Fewer than 100 Lot Exemption to ILSA, and the remaining purchasers would sign a contract that complied with the Improved Lot Exemption to ILSA – was called into question.1 The United States District Court for the Southern District of Florida held that if a developer attempted to stack exemptions under ILSA without a “legitimate business purpose,” the stacking would be deemed to have been undertaken for the sole purpose of evading the requirements of ILSA, and both sets of contracts would be deemed subject to ILSA.

Issues Addressed in Gentry

In Gentry v. Harborage Cottages-Stuart, LLLP, the developer had two purchase contracts that it used in its Harborage Yacht Condominiums project: one that complied with the Improved Lot Exemption and another that complied with the 100 Lot Exemption.2 The language that precedes both exemptions in Section 1702 of ILSA states that “[u]nless the method of disposition is adopted for the purpose of evasion of this chapter…” The court in Gentry analyzed what constitutes evasion under Section 1702 of ILSA; it also examined whether the seller’s use of two separate purchase contracts, which resulted in the project being largely exempt from ILSA’s requirements, constituted a method of disposition that was adopted for the purpose of evading ILSA’s requirements.

The court first looked to the Supplemental Information to Part 1710: Guidelines for Exemptions Available Under the Interstate Land Sales Full Disclosure Act (Guidelines) and found that the examples set forth in the Guidelines make it clear that a seller may take intentional steps to ensure that a subdivision meets the requirements of an exemption: “…[T]he mere fact that a developer structures the sales of a subdivision in a way that makes the project exempt from [ILSA] is not, without more, sufficient to conclude that the seller has taken such action for the purpose of evading [ILSA’s] requirements.”3 The court rejected the Eighth Circuit’s finding that a seller’s actions only constituted evasion if the seller’s attempt to fulfill the requirements of an exemption to ILSA was accompanied by fraudulent intent. It stated that Congress gave no indication that evasion should be construed as equivalent to fraud, nor do the Guidelines provide any indication that there must be fraud to trigger the evasion provision. The court wrote that to require fraud in order to find evasion would narrow the definition of evasion and thus reduce the applicability of this principle, which acts to limit the scope of all ILSA exemptions.

Instead, the court ruled that a distinction needed to be drawn between “conduct which has as its primary object avoidance of [ILSA’s] requirements and conduct that seeks to meet the requirements of an exemption for some legitimate business purpose.”4 Although the court ruled that the threshold for establishing a legitimate business purpose may be low, it still found that there must be “some factual evidence demonstrating that the method of disposition has some bona fide, real world objective that manifests a legitimate business purpose.” Id. The court of appeals further stated that requiring that a seller act pursuant to a legitimate business purpose also resonates with the Guidelines and the examples of stacking of exemptions set forth therein.

Avoiding ILSA Requirements

The examples set forth in the Guidelines involve situations where either certain lots were exempt because there were already finished homes on the lots (which fell within the Improved Lot Exemption), and the remaining homes qualified for the 100 Lot Exemption – or where certain lots were exempt because they had preexisting residential structures and the other lots were to be sold to contractors or reserved for the developer to construct homes, leaving the rest of the lots to qualify for the 100 Lot Exemption. Neither the Gentry case nor the Guidelines provide guidance as to how many homes must be built in order to fall under the example, or how far in the past the homes must have been built in order to be considered “preexisting residential structures.”

Ultimately, the court found in Gentry that the two separate purchase agreements were used primarily to avoid compliance with ILSA’s requirements. Because the seller had set forth no explanation for why the provisions of the two contracts differed in significant ways,5 the court said, it is evident that the contracts were drafted so as to avoid ILSA’s requirements.

An Unclear Threshold for Establishing a Legitimate Business Purpose

Although the court of appeals set forth a great deal of analysis as to why a legitimate business purpose should be required before exemptions to ILSA can be stacked, it did not provide a clear explanation as to why the examples set forth in the Guidelines do show legitimate business purposes but the facts of the Gentry case did not. Given that the developer in Gentry did not attempt to put forth any evidence of a legitimate business purpose, it is not clear how low the threshold is for establishing a legitimate business purpose. As noted by the court, the Guidelines do not provide an exhaustive list of situations in which stacking of exemptions would be acceptable.

Although it is unclear how the Gentry case will be applied in the future, in light of this case, a developer must be prepared to articulate its reasoning behind its choice to stack ILSA exemptions. Only time will tell what explanations will be accepted as a legitimate business purpose.

These are the two exemptions that the developer in the case at hand was attempting to stack. However, there are a number of other exemptions to ILSA, which arguably could be stacked, albeit now potentially only by showing a legitimate business purpose.

Our position that both contracts complied with the applicable exemptions is solely based upon the facts set forth in the opinion issued by the court; we have not reviewed either contract at issue in this case. However, the court appears to find that the contracts complied with the exemptions and the discussion centers on the reasons for the seller having had two separate contracts.

Gentry, 2009 WL 689714, at *5.

Id. At *6.

The court noted that contract #1 required the seller to complete construction within two years while contract #2 did not. Further, contract #2 denied the buyer the opportunity to seek specific performance, while contract #1 did not (allowing contract #1 to qualify for the Improved Lot Exemption). The court also cited the default provision when citing the differences between contract #1 and contract #2.

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