The Securities and Exchange Commission brought charges against Cay Clubs Resorts and Marinas and several of its executives for defrauding investors. The case caught my eye because it involved real estate and would likely play a role in my continuing quest to figure out what’s a security.
The defendants have not settled with SEC, so I’ll be assuming the allegations in the complaint are true for this analysis.
Executives of Cay Clubs Resorts and Marinas raised more than $300 million from investors to develop resorts in Florida and Las Vegas. They promised investors a guaranteed 15% return through a two-year leaseback agreement and future income through a rental program. The developments didn’t succeed, so the investment turned to a ponzi scheme. New investments were used to ay the 15% return to earlier investors.
A with most investment frauds, the executives spent lavishly with the investors’ money. They bought homes, planes, cars, and boats. At least they diversified and spent some of the cash on buying gold mines, coal refining machinery, and a rum distillery.
That all sounds like investment fraud. But the charges are under sections 5(a), 5(c), and 17(a) of the Securities Act and 10(b) of the Exchange Act. The SEC is saying that the defendants sold securities, and did so fraudulently. They were selling real estate interests, or at least what looked like real estate.
According to Cay Clubs’ marketing materials, the Company would finance the purchase of the properties, renovation of the units, and development of the luxury resorts with funds raised from investors through the sale of units, which ranged in price from $300,000 to more than $1 million, and a required membership fee ranging from $5,000 to $35,000 per unit.
Cay Clubs promised a 15% return by leasing back the units from the buyers. The materials stated the leaseback was optional, but 95% of the investors entered into the arrangement. To participate, purchasers would have to pay a membership fee in excess of $5,000. The 15% return would be needed by the investors to cover carrying costs. Cay Clubs even managed to find lenders who would provide 100% mortgage financing.
During the leaseback, purchasers were restricted from using their units. They could only use the units for 14 days per year. Cay Clubs owned the common areas and controlled access to the units. Cay Clubs had a right of first refusal on the sale of a unit. Cay Clubs controlled the renovation of the resorts and the units. Under the master leasing program, Cay Clubs would rent out the units, with 65% going to the unit owner.
You can go back to the Howey case and use the four part test to determine if there is an investment contract, where there is
- an investment of money,
- a common enterprise,
- a reasonable expectation of profits, and
- a reliance on the entrepreneurial or managerial efforts of others.
This reminds me of the Boutique Hotel case. In that case the judge found that the investment was not an investment contract because the owners were not required to participate in the rental program. An owner could chose to not rent out its condominium or rent it out on its own. That means the business arrangement did not have a reliance on the entrepreneurial or managerial efforts of others. Therefore it was not an investment contract.
That distinguishes the Boutique Hotel arrangement from the one being contested in the Salameh / Hard Rock San Diego case. Hard Rock San Diego restricted the rental program to the one run by the seller/issuer. That was found to be an investment contract.
The Hard Rock case is still under appeal and the Boutique Hotel case is still running its course, so those are ones to keep en eye on.
Sources:
Doug,
Maybe they are looking at this from the perspective that these are like limited partnership interests If you look at it Cay Clubs was the General Partner and the investors were limited partners who had to put up specific funds and could only use the property for certain time periods.
When you think back to the late 80’s when limited partnerships were the thing, you had deals just like this.
Kevin –
The SEC is clearly looking at the substance over the form. This case and the others I mentioned may give some clarity as to what features turn the substance of the deal into a securities transaction.
I think it comes down to how much control the investor/property owner will have over the property. It’s hard to tell from the complaint.
I’m also taking a look at the old SEC Release 33-5347 with the SEC’s view on when a real estate development becomes a security.
Doug,
Once you read the SEC Release, and compare the Cay facts to that release, it is clear that the SEC is spot on in calling this a securities transaction. I point to Page 3 and the following:
” …condominiums, coupled with a rental arrangement, will be deemed to be Securities if
they are offered and sold through advertising, sales literature, promotional schemes or oral representations which emphasize the economic benefits to the purchaser to be derived from the managerial efforts of the promoter, or a third party designated or arranged for by the promoter, in renting the units.
In summary, the 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:
1. The condominiums, with any rental arrangement or other similar service, are offered and sold with emphasis on the economic benefits to the purchaser to be derived from the
managerial efforts of the promoter, or a third party designated or arranged for by the
promoter, from rental of the units.
2. The offering of participation in a rental pool arrangement; and
3. The offering of a rental or similar arrangement whereby 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.”
I can see where you think about the fact that the sale involves real estate. But here the SEC is also looking at the underlying aspects of the inducement for the sales and the pooling aspects of the sale.