Tag: Salameh

Failing to Turn Real Estate Into a Security

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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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SEC Charges Real Estate Executives with Investment Fraud

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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

  1. an investment of money,
  2. a common enterprise,
  3. a reasonable expectation of profits, and
  4. 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.

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Is it a Security?

In my ongoing quest to distinguish what’s a security and what’s not a security, a new case came down from Missouri on the topic. Disgruntled purchasers of condominiums at the Branson Landing Hilton Promenade Boutique Hotel felt they got a bad deal and sued the seller/issuer to get their money back: Obester v. Boutique Hotel (.pdf)

The owners claim the seller/issuer represented that the condominiums would be rented out and they would receive a portion of the profits, generating substantial revenue. I assume the investment did not turn out to be a financial windfall. According to the claim, the hotel rented its inventory of unsold units at a discounted rate.

Fee simple ownership of the “bricks and mortar” of real estate is not a securities transaction. “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.

As with the Hard Rock San Diego case still working its way through the federal courts in California, combining the sale of real estate with a management agreement starts making the real estate look like a security.

In the Boutique Hotel case, the court goes back to the Howey case and uses a four part test to determine if there is an investment contract, where there is

  1. an investment of money,
  2. a common enterprise,
  3. a reasonable expectation of profits, and
  4. a reliance on the entrepreneurial or managerial efforts of others.

The court draws a distinction between a vertical commonality and a horizontal commonality to create a common enterprise. Vertical looks at the relationship between the seller and the purchaser. Horizontal focuses on the pooling of interests among investors. It’s an interesting way to look at the analysis, but it ends up not being decisive to the court.

What kills the securities claim is that 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.

That distinguishes the arrangement from the one being contested in the Salameh / Hard Rock San Diego case. San Diego restricted the rental program to the one run by the seller/issuer. Under San Diego zoning, the units had to be sold for non-residential use and be managed as part of the hotel.

These cases do little to help me decide when an interest in a manager-managed limited liability company is a security. But it’s clear that there is still a big gray space between what is a security and what is not a security.

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When is Real Estate a Security?

Fee simple ownership of the “bricks and mortar” of real estate is not a securities transaction. “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. One of the latest cases to address the difference is Salameh v. Tarsadia Hotels 2011 U.S. Dist. LEXIS 30375, on appeal to the Ninth Circuit.

One of the seminal cases is SEC v. W.J. Howey Co., 328 U.S. 293 (1946). That case involved an offering of units of a citrus grove development, coupled with a contract for cultivating, marketing, and remitting the net proceeds to the investor. They held that it was an offering of an “investment contract” within the meaning of that term as used in the provision of § 2(1) of the Securities Act of 1933 defining “security” as including any “investment contract,” and was therefore subject to the registration requirements of the Securities Act.

Even though decades have passed, the line is bit a clearer, but still muddy as the Salameh case illustrates. The developer of the Hard Rock Hotel in San Diego used a condominium- hotel ownership structure to help provide capital.  The purchase/investment turned out to be a bad one, so they 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 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 issues are not that new. The Securities and Exchange Commission noted the problem as far back as 1973 when it issued Release No. 33-5347 which had guidelines on the applicability of federal securities laws to the sales of condominiums and units of real estate development.

The investors/purchaser lost the court case.  The court The case is now under appeal and there are numerous other issues involved in the case so we may not any new insight on when an investment in real estate becomes an investment in a security.

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