Tag: Howey

Is a Cow a Security?

If the investment is a “security”, you have to comply with the Securities and Exchange Commission regulations. The seminal case is Howey, where a sponsor was selling interests in an orange grove in Florida. The sponsor was not just selling the small land parcels with orange trees on them, but also his management, harvesting and sale of the oranges. It’s more like buying shares in Tropicana, so the investment scheme was considered an “investment contract” that fell within the definition of a security.

The SEC just filed a case against Agridime. The company allowed you to make money raising cattle. Seems like an interesting idea, support farmers and make money. Maybe you even get some meat from your own cow as part of the profit? (Not sure if that was a feature.) Of course, raising cattle takes a lot of work so why not have Agrdime do the work for you.

Investors never get delivery of the cattle and investors relied on Agridime to do all the work. That sounds a lot like the orange groves in Howey. If so, that makes the cattle contract a security and triggers the many securities regulations.

One of those regulations is that you can’t engage in the general solicitation of investors. Agridime advertised its cattle contracts on its own public website and on Facebook. Those are clear violations of the securities laws.

Agridime offered a guaranteed 15-20% yearly profits. “We know it sounds too good to be true.”  

Yes, it was too good to be true according to the SEC. In the SEC complaint, the SEC alleges that the business was not profitable enough to pay those “guaranteed” returns. Agridime started using new investor money to pay returns to existing investors, instead of using the money on new cattle. It became a Ponzi scheme.

Before the SEC stepped in, North Dakota and Arizona had brought cases against Agridime to stop selling unregistered securities in their states. At least in Arizona, Agridime is taking the position that is a “registered and bonded livestock broker and marketing agency” under jurisdiction of the United States Department of Agriculture.

Now I’m scratching my head and wondering if the USDA has jurisdiction on cattle capital. Sure enough there are some regulations around custodial accounts and the payment of funds under the Packers and Stockyards Act of 1921.

I’m grabbing a bucket of popcorn to see how this one turns out.

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Ripple is Sometimes a Security (?)

The big challenge with crypto is how it fits into regulatory schemes that were drafted almost a century a go. Add in the politically driven split between the regulation of commodities by the CFTC and the regulation of securities by the SEC and you get a mess. Slap in the variable structures used by crypto issuers when selling crypto tokens and you get a tangled mess.

This challenge just got messier with the recent decision in the case of the Securities and Exchange Commission v Ripple Labs.

The definition of a “security” includes an “investment contract.” The meaning behind that term was established in the 1946 case of the SEC v. W.J. Howey. The decision created a three prong test:

(1) invests his money (2) in a common enterprise and (3) is led to expect profits solely from the efforts of the promoter or a third party.

Bitcoin largely falls outside the definition. You don’t expect a dividend on Bitcoin. You’re investing for the rise in price alone. There is no meaningful company behind it trying to find a way to make a profit. Bitcoin is more like a commodity.

Some will argue a currency. But currencies are used as a store of value to buy things. I don’t think Bitcoin is being used to buy many legal goods.

Ripple Labs comes along and sells the XRP token to generate cash to build out the Ripple platforms, some of which will use the XRP token. The facts are a bit murky about whether the XRP coin holders would get some of the profit from the Ripple platforms.

The court looked first at the past sales of XRP tokens directly to institutional buyers and decisively finds that the XRP tokens are securities. “When the value of XRP rose, all Institutional Buyers profited in proportion to their XRP holdings.” (page 18)

For some weird reason, the court then finds that indirect sales and sales on exchanges are not investment contracts. Since they were blind bid/ask transactions, the buyers didn’t know if the money was going to Ripple or to a secondary seller.

So institutional buyers get more protection than retail buyers under the court’s reasoning. That seems to be the opposite approach of the protective regulatory approach of the SEC.

That also seems weird in the reality of exchanges for “securities.” An investment would be a security if it’s bought directly from the issuer and possibly not a security if it’s purchased from a secondary seller.

Under the court’s decision, crypto is looking very good. Sales of “investment contracts” to institutional investors can rely on the private placement regime. Sales to retail investors through an exchange would not be an investment contract.

Weird result. The product’s status as a security is dependent on how it’s sold. Doesn’t sound right to me. I assume the SEC will appeal this result. I think this will just be a temporary win for Crypto.

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Can a Real Estate Lot Be a Security?

Of course the lawyerly answer is: “maybe.”

Ronald Duane Dunham challenged his criminal conviction for securities fraud, arguing that the Cherokee Village lots he sold did not qualify as securities under the California Corporation Code.

Mr. Dunham got in this position by persuading a number of elderly victims to invest over a million dollars with him, ostensibly to purchase undeveloped “lots” of land in Cherokee Village, Arkansas, and/or support Dunham’s real estate development efforts there between 2004 and 2007. The lots were sold to the victims at an inflated price and marketed at times in conjunction with Ed McMahon.

The crash of 2008 happened and the victims sued to get their money back. The victims lawyer after reviewing documents from discovery thought Dunham’s actions were bad enough to warrant a criminal investigation and the District Attorney agreed. Dunham was eventually convicted.

Keith Paul Bishop highlighted this case last week: Court Rules Lot Sales Were Sales Of Securities.

” U.S. District Court Judge Gonzalo P. Curiel denied Dunham’s petition.   Citing SEC v. Schooler, 905 F.3d 1107 (9th Circ. 2018), Judge Curiel reasoned that a reasonable jury could have concluded that lots sold by Dunham were not independent real estate transactions but the sale of securities “

Mere “lots” as securities? Usually, these cases involve some form of management company, investment fund or partnership. The Denial of Habeus Corpus even cites the Schooler case where a general partnership in real estate was considered a security.

Dunham’s trial court jury had found that lots represented the victims’ “shares in [the] enterprise.”

None of the California victims had any ability to develop homes in Arkansas, and they expected “Dunham and company” to sell their lots for them. The victims were relying on Dunham to bring professional management, homebuilding, and financing experience to the project. They had no desire to live in Arkansas themselves, except possibly Marilyne who would consider it after first realizing a profit. The victims sought a return on their investment, and a profitable retirement community required a certain volume of lots to succeed. On a whole, and considering the purpose of our securities laws to protect the public from fraudulent investment schemes, the Cherokee Village lot transactions qualified as investment contracts.

Page 56 of the Writ of Habeus Corpus

The federal court agreed. There didn’t seem to be any formal agreement for the Dunham to manage the investments. But, all of the victims testified they
were told they were purchasing lots in order to be part of and profit from a future retirement development in the area. Dunham held events where he presented plans for the development and marketing campaigns after the development of the area. There was some evidence that Dunham himself thought there was a common enterprise.

This is a big extension of the Howey test to real estate. The sale of dirt in a remote area, coupled with a seller’s promises are enough to bring the transaction into the definition of “investment contract.”

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Howey Test – Framework for “Investment Contract” Analysis of Digital Assets

To show the markets that the Securities and Exchange Commission is not just about slapping around wrong-doers, but also trying to help people navigate the securities laws, the SEC’s FinHub published a framework for analyzing whether a digital asset is a security.

The framework is not intended to be an exhaustive overview of the law; rather, it is a tool to help market participants assess whether the federal securities laws apply to the offer, sale, or resale of a particular digital asset.

Did anyone find it strange that the “framework” document had not statement of the author or publisher? There is not even an SEC symbol.

That should be a warning that you can’t rely on it. It’s not official guidance. It’s not a no-action letter.

It is a comprehensive look at the Howey test in the lens of cryptocurrency. The Supreme Court’s decision in SEC v. W.J. Howey Co. found that an “investment contract” exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.  If it’s an “investment contract,” it’s a security and subject to securities laws.

The framework quickly jumps over the first two prongs of the Howey test:
the “investment of money” and “a common enterprise.” That’s true in most of the “What is a Security?” cases. 

The framework focuses on the “expectation of profits from the effort of others” prong of the Howey test. The Framework splits that into two parts.

Generally, if you make an investment you expect to make a profit. Otherwise it’s just a purchase for use. I bought a cup of coffee this morning. I had not expectation of profit. I had an expectation of getting coffee. I bought it with a stored value card from Starbucks. It’s not an investment. Those could have been Starbucks coins.

You can see an obvious problem with ICOs that talk about how much the coins are going to increase in value. That injects an expectation of profit. The framework lays out a long list of characteristics that make sit likely the SEC will see that there is an expectation of profits.

“Lambo, Lambo, Lambo” was not specifically on the list. They took a more demure “able to earn a return on their purchase.”

The framework inquiry into whether a digital coin purchaser is relying on the “efforts of others” focuses on two key issues:

  • Does the purchaser reasonably expect to rely on the efforts of an active participant in running the underlying platform?
  • Are those efforts “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,” as opposed to efforts that are more ministerial in nature?

If there is a key person responsible for the development of the platform and making the decisions, that makes it look an investment.

To put this framework into play the SEC also announced a no-action letter for the Turnkey Jet token sale (TKJ) and found that it would not recommend enforcement because it was not a securities offering.

In reaching this position, we particularly note that:

1. TKJ will not use any funds from Token sales to develop the TKJ Platform, Network, or App, and each of these will be fully developed and operational at the time any Tokens are sold;
 
2. the Tokens will be immediately usable for their intended functionality (purchasing air charter services) at the time they are sold;
 
3. TKJ will restrict transfers of Tokens to TKJ Wallets only, and not to wallets external to the Platform;
 
4. TKJ will sell Tokens at a price of one USD per Token throughout the life of the Program, and each Token will represent a TKJ obligation to supply air charter services at a value of one USD per Token;
 
5. If TKJ offers to repurchase Tokens, it will only do so at a discount to the face value of the Tokens (one USD per Token) that the holder seeks to resell to TKJ, unless a court within the United States orders TKJ to liquidate the Tokens; and
 
6. The Token is marketed in a manner that emphasizes the functionality of the Token, and not the potential for the increase in the market value of the Token.

The Turnkey Jet token is a stored value card saved on the blockchain instead of a central account. That’s closer to buying a cup coffee than it is to investing.

Of course, the framework is just the SEC’s view on securities law question under federal law. There are also state law analyses that need to be done.

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Yes, A Cryptocurrency Can Be a Security

Earlier this week, a federal judge denied a claim that a cryptocurrency is not a security under the federal securities law. The judge didn’t say that it was a security. Instead, he ruled that a reasonable jury could conclude that the cryptocurrency is a security.

This ruling comes from the SEC enforcement action against RECoin, the first cryptocurrency backed by real estate. It wasn’t really. RECoin never hired a broker, lawyer, or developer to acquire the real estate investments advertised in the offering of RECOin.

Maksim Zaslavskiy, the principal behind RECoin, is not strongly arguing that there was not a problem with RECoin. At this point he’s arguing that it’s not a securities problem and the SEC should leave him alone.

The ruling is not surprising. The Securities and Exchange Commission has been saying for months in public announcements and enforcement actions that ICO tokens can be securities. (although the SEC did say that Bitcoin and Ether are no longer securities.)

This one federal court judge has agreed with the SEC on this, so one point to the SEC.

The judge jumped right into the Howey test and the definition of an “investment contract.” That is a “contract, transaction, or scheme whereby a person [1] invests his money [2] in a common enterprise and [3] is led to expect profits solely from the efforts of the promoter or third party.”

As for the first prong, Zaslavskiy argued that the parties did not invest money in RECoin. They merely transferred from one medium of currency to another. The judge notes that money does not necessarily mean cash, any exchange of value is enough.

In the second prong, giving out tokens instead of stock or bonds does not make it any less a common enterprise. The tokens were supposed to be pooled to invest in real estate.

The marketing materials serve up the third prong. They pitched the RECoin as an attractive investment opportunity which grows in value. There was no element of control given to the token holders.

Zaslavskiy argues that RECoin should be considered a currency, which falls outside the definition of a security.

“He also overlooks the fact that simply labeling an investment opportunity as “virtual currency” or “cryptocurrency” does not transform an investment contract—a security—into a currency.”

The judge found no basis behind the argument, because no real estate, coins, tokens or currency of any sort ever existed in the enterprise.

It’s slowly coming, but people will start going to jail for these fraudulent coin offerings.

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HoweyCoins – The ICO I Have Been Waiting For

Initial coin offerings have been a new wave of financing.. and scams. One offering that you should look at for some lessons about coin offerings is the soon to be released Howey Coin.

HoweyCoins are the cryptocurrency for the travel industry. According to the white paper, HoweyCoins partner agreements lock in an average initial discount of 30% for airfare and 42% for hotel room rates for all HoweyCoin-denominated transactions. The agreements are not final, but once the offering is complete, they will be revealed.

This is a can’t miss investment opportunity. HoweyCoins are officially registered with the U.S. government and will trade on an SEC-compliant exchange where you can buy and sell them for profit. According to the ICO team, they “forecast a minimum growth rate of between 7% to 15% annualized, making HoweyCoins attractive for long-term investment. In addition, HoweyCoins can serve as a GUARANTEED hedge against inflation and market loss.”

…

Hopefully, you have noticed a few things that might make you not click on the the button to buy the HoweyCoins. Bonus points if you recognized “Howey” as the seminal court case that sets the test for whether an investment is a security. Hopefully you noticed the “registered with US government” as red flag that this company is doing something wrong with this offering. Of course the high returns, and guarantee of success are hallmarks of problematic offerings. But if not, go ahead and click on the button.

This is a new type of performance education by the Securities and Exchange Commission. Clearly, the SEC is focused on the fraud and securities-law violations of coin offerings. If you are involved in such an offering, you should be worried. The SEC spent some time, money and energy on putting together the HoweyCoins website. You can be certain that the SEC is devoting much more time, energy and money into investigating ICO fraud and securities law violation.

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Is a TIC a security?

TIC refers to Tenancy in Common, not the blood-sucking insect. A TIC is a completely legal way of owning real estate that has been around for hundreds of years. When one of the parties owning real estate dies, that ownership interest passes to that owner’s heirs. The alternative is joint tenancy, in which case when the part owner dies, the remaining owners get that ownership interest. If you’re married, you probably own your home in a joint tenancy. (There is also a tenancy by entirety for married couples that operates like a joint tenancy, but also limits the sale of an interest without your spouse’s consent.)

There is a market for TICs in commercial real estate because of Section 1031 of the tax code that allows for tax-deferred exchanges. If you sell commercial real estate and don’t want to pay taxes immediately on the gain, you can buy a replacement piece of real estate and defer the gain. The problem is finding a replacement and finding one at an equivalent price. Fractional TICs were developed allowing an owner to more easily achieve tax-deference.

The problem with TICs has always been avoiding the treatment of the interest as a security. This goes back to the Howey definition of a “investment contract” as “investment in a common enterprise with the expectation of profit to be derived through the essential managerial efforts of someone other than the investor.”

For a fractional TIC, there is a common enterprise. The investor’s ownership interest is combined with the other fractional owners. There is an expectation of profit. Given that the real estate needs to be managed, there is generally some sponsor exerting some level of control over the real estate on behalf of the TIC owners. A lessee does not want to have to negotiate of dozens of TIC owners when entering into a lease.

The key is giving the TIC owners enough control so that they are not solely relying on the “managerial efforts of others” for the real estate investment to be successful.

Many TIC investments involve real estate with a long lease to a credit tenant. So even though the TIC owners have a say in management, there is little management that needs to be done.

One of the dangers to the sponsor is that the TIC owners will claim that the TICs are securities, giving the TIC owners additional right, if the investment goes south.

That is what happened in the Highwoods case in Durham, North Carolina. NNN Realty bought a property, largely leased to a credit tenant and set up a TIC syndication.

To avoid the treatment of the TICs as securities, the affiliated agreements granted some control to the TIC owners. The Management Agreement for the Durham Property gave the TICs the ability to hire and fire the property manager, the leasing agent, and the asset manager. It also allowed the TICs to control the Durham Property’s expenditures by approving budgets. However, firing the asset manager, an affiliate of the sponsor, involved paying expenses and would trigger a default under the mortgage loan.

The TIC owners claim that they were induced to purchase interests in the Durham Property by materially false statements or omissions in a private-placement memorandum concerning the probability that the Durham Property’s primary credit tenant would renew its leases. The primary credit tenant’s leases were critical to the Durham Property’s value, as demonstrated when that tenant later terminated its leases and the Property went into foreclosure.

The lawsuit was filed in North Carolina so the challenge to the TICs as securities was based on North Carolina law.

North Carolina’s Rule 06A.1104(8)(a) requires both a “common enterprise” and “the expectation of profit to be derived from the essential managerial efforts of someone
other than the investor.” “Essential” management does not necessarily connote “exclusive” management. 18 N.C. Admin. Code 06A.1104(8)(a) (emphasis added). Rule 06A.1104(8)(b) does not expressly require a “common enterprise,” but it contemplates a scenario where at least a portion of the value provided by the investor is subjected to the risk of an enterprise in which the investor “does not receive the right to exercise practical and actual control over the managerial decisions of the enterprise.”

The PPM stated as a risk-factor on reliance on management:

[a]ll decisions regarding management of the Company’s affairs . . . and the management of the Property, will be made exclusively by the Manager, the Property Manager and their Affiliates, and not by any of the Members or the Purchasers. Accordingly, no person should purchase LLC Units unless that person is willing to entrust all aspects of management of the Company to the Manager and management of the Property to the Property Manager.

The court realized that the documents around the ownership of the TIC gave the TIC more control than that risk factor warns.

The court looked to SEC v. Merchant Capital, LLC  (483 F.3d 747) involving the treatment of general partnership interests as investment contracts under the federal securities laws. That court came up with six factors that would make a general partnership interest more like a limited partnership interest or investment contract:

(1) the partners’ ability to elect the managing general partner was not meaningful, because the vote had to be made at the time of investment, and the promoter was the only nominee;

(2) the limitation on removing the managing general partner for cause by unanimous vote effectively meant that the managing general partner could not be removed;

(3) the various investors were geographically diverse and had no meaningful opportunity to develop relationships;

(4) the investors’ potential liability was limited to the amount that each investor invested, with no vicarious liability for the acts of other investors;

(5) the right to approve expenditures, while facially significant, was diluted by the managing general partner’s ability to control information;

(6) the investors had no particular expertise in the business in which they invested.

The NNN court found these factors instructive and ruled the TIC interests could qualify as securities. The court denied the summary judgment on this issue request by the sponsor.

On appeal, the North Carolina Secretary of State and the North American Securities Administrators Association want the appellate court to rule that the TICs are securities in this case.

So clearly, TICs can be securities.

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Initial Coin Offerings and the Securities Laws

Regulators have been trying to figure out what to do with the new currencies coming to the marketplace. Bitcoin was the vanguard, bringing its blockchain technology into the public’s view. The Securities and Exchange Commission has issued a Report of Investigation that provides some insight into when these currencies and their rollouts are going to violate securities law.

I find Bitcoin’s distributed ledger technology called the blockchain to be intriguing. Bitcoin as a currency has its problems. The wild swings in its conversion rate make it look more like a commodity than the steady values expected of a currency. In the US we have distinct regulatory structures between commodities and securities.

(Speaking of currency, if you have some extra currency then use it to fight cancer. Support my Pan-Mass Challenge Ride.)

The SEC took a close look at the initial coin offering of DAO Tokens to see if it violated securities laws. The first test was whether the DAO Tokens were securities. The short answer is yes.

The hurdle with rolling out new virtual currencies is getting enough into circulation at launch to make them useful of enough to act like a currency. Bitcoin has been out long enough and is widely used enough that it has passed this hurdle. But the first person with a Bitcoin couldn’t do much with it.

I think it’s important to note that the DAO Tokens that are the subject of the report are not the virtual currency. The DAO Tokess were used to fund the enterprise that was intended to fund projects involving the Ether currency and the Etherium blockchain.

The DAO was essential a venture capital organization and the DAO tokens were the capital commitments. Fund managers will tell you right off the bat that the partnership interests in a venture capital fund are securities.

In looking at the DAO tokens, the SEC went right to the Howey test.

Participants invested money. Of course, cash is not the only way to invest. For the DAO tokens, the investors used Ether which has value and easily meets this prong of the test.

Participants had a reasonable expectation of profits. The DAO organization was set up as a venture capital endeavor and explicitly stated that DAO token holders would share in profits from any of the projects that generated revenue.

The difficult part of the prong was the “managerial efforts of others.” DAO token holders had voting rights but the promoter, Slock.it, was key to moving the enterprise forward according to the SEC. DAO would have “Curators” instead of managers who would chose the projects for voting by the DAO token holders.

Slock.it chose the initial batch of Curators.  Token Holders could vote to replace a Curator. But the decision to send the proposal to a vote is subject to approval of the Curators.  Curators had the responsibility and power to “(1) vet Contractors; (2) determine whether and when to submit proposals for votes; (3) determine the order and frequency of proposals that were submitted for a vote; and (4) determine whether to halve the default quorum necessary for a successful vote on certain proposals. Thus, the Curators exercised significant control over the order and frequency of proposals, and could impose their own subjective criteria for whether the proposal should be whitelisted for a vote by DAO Token holders.”

The SEC went on further to conclude that the DAO Token voting rights are closer to those of corporate shareholder, than an active participant in the management.

If the DAO Tokens are securities then the whole securities law regulatory regime applies unless there is an exemption for the offering of the DAO Tokens. The sponsors took no steps to limit the offering in a manner consistent with a offering exemption.

In the end, it was not the initial coin offering that was a problem, it was the offering of interests in the organization behind the coins that was a problem.

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Help me fight cancer by donating your real currency through one of the links below.

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Doug

Are Oil and Gas Investments “Securities”?

oil well and compliance

The Securities and Exchange Commission brought an enforcement action against Jeffory D. Shields, GeoDynamics, Inc., and several other business entities affiliated with Mr. Shields, alleging securities fraud. The businesses are oil and gas exploration and drilling ventures and Mr. Shields, as managing partner of GeoDynamics, marketed the interests Joint Venture Agreements. The district court granted defendants’ motion to dismiss and the SEC appealed. The point of contention was that despite their labels, are the JVs actually “investment contracts” and therefore “securities” subject to federal securities regulations.

The District Court dismissed the action because it concluded that the JVs were not investment contracts. The appeals court was not willing to draw a bright line in the sand that the JVs were not “investment contracts.” The SEC wins the appeal and goes back to court to prove that the JVs are securities.

It sounds like Mr. Shield’s strategy was fraudulent. Even the appeal court call his business a “boiler room” making hundreds of calls a day promising annual returns between 256% and 548%. But the SEC does not have jurisdiction over all frauds. It only has jurisdiction over securities fraud.

The investment was structured as a general partnership with GeoDynamics as the managing venturer. The offering documents state that the interests are not securities. The partners grant broad powers to GeoDynamics with the sole power to bind the partnerships.

Investors had the right, by 51% vote to remove GeoDynamics as the managing venturer and to terminate the partnership. The investors also had certain right to call meetings and to inspect records.

The court goes back to the Howey test of “whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.” (328 U.S. at 301). It uses the variation on the third prong of whether the investment was “premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” Hous. Found., Inc. v. Forman, 421 U.S.  at 852.

The court starts with a strong presumption that a general partnership interest is not a security. But then goes on to three examples of when a general partnership interest can be a security:

(1) an agreement among the parties leaves so little power in the hands of the partner or venturer that the arrangement in fact distributes power as would a limited partnership; or

(2) the partner or venturer is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers; or

(3) the partner or venturer is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manger of the enterprise or otherwise exercise meaningful partnership or venture powers.

The appeals court found enough to state that the presumption that investments were not securities. It did not go so far as state that the investments were securities or that they were not securities. It’s back to court with a small victory for the SEC. The case offers a great summary of the testing of general partnership interests as securities.

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Image is Pumpjack located south of Midland, Texas by Eric Kounce

Failing to Turn Real Estate Into a Security

hrsd_logo

Fee simple ownership of the “bricks and mortar” of real estate is not a security. “The offer of real estate as such, without any collateral arrangements with the seller or others, does not involve the offer of a security.” As you move further away from that model, you move closer and closer to the ownership a security than the ownership of real estate. The line between the two is not a bright line.

A transaction that looks nothing like a sale of stock and involving such diverse items as citrus groves and vacation homes may qualify as a sale of a security under federal law.

There has been a recent ruling in case battling over that line. In Salameh v. Tarsadia Hotels, the purchasers of real estate are suing the developer of the Hard Rock Hotel in San Diego. The project was a condominium- hotel ownership structure to help provide capital.  The purchase/investment turned out to be a bad one, so the purchasers sued the developer.

Their claim was that a series of documents, including the Purchase Contract, the Unit Maintenance and Operations Agreement, and the Rental Management Agreement turned the ownership of the hotel/condo interest into a “security” and not the mere ownership of real estate. Since the securities were not registered, they could seek rescission. In this case, the ownership and control issues were not just split into separate documents, some of the documents were entered into at significantly different times.

The purchasers lost the case and appealed. They just lost the appeal.

The Ninth Circuit Court of Appeals affirmed the ruling from the district court.  The Court distinguished these facts from Hocking v. Dubois, 885 F.2d 1449 (9th Cir. 1989)  in which it had found that there was a general issue of material fact whether the sale of a condominium along with a rent-pooling arrangement constituted a security.

In Hocking, the the purchaser would not have made the real estate investment but for the availability of the rental pool arrangement. The sale of the real estate was coupled together with the management and income sharing that made the real estate investment look more like a security.

In contrast, the Salameh plaintiffs failed to allege facts showing that the real estate was coupled together with the management and income sharing as a package. The hotel developer pointed out in its pleading that the rental management agreements were executed eight to fifteen months later.

The ruling is another loss for the SEC in this edge between real estate and securities. The SEC had filed an amicus brief that relied on its 1973 Guidelines as to the Applicability of the Federal Securities Laws to Offers and Sales of Condominiums or Units in a Real Estate Development (Securities Act Release No. 33-5347 (Jan. 4, 1973) as the standard.

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