A Solution to Legal Problems Associated with Condo Hotels
- Jun 18, 2014
A series of complex legal issues have historically made it challenging to sell condominium hotel units. Now, the Jumpstart Our Business Startups Act and Rule 506(c) adopted by the Securities and Exchange Commission provide an effective solution.
Specifically, the problems previously stemmed from a need to balance the desires of developers and branded hotel companies to ensure hotel room inventory, while still meeting the demands of potential buyers to understand the economics of and restrictions imposed by the rental programs. At the same time, there was a need to avoid the sales being classified as securities. Lawyers struggled to satisfy all of these demands and complete the sales, but the reality never worked.
One of the most vexing issues has been the attempt to separate the real estate sales from the offerings of the rental management programs. Various “bright lines” were established, including waiting until the applicable real estate sale rescission period had expired before providing the details of the rental program. This created additional challenges as brokers in the secondary market disseminated the details of the rental program during the separation period.
In a recent case, Salameh v. Tarsadia Hotel, the Ninth Circuit Court of Appeals determined, notwithstanding an amicus brief filed by the SEC, that the sale of the hotel condominiums and the subsequent entry into a rental management agreement did not constitute the sale of a security. Although the case is helpful to developers and flags, a significant point is that the rental management agreements were executed, in certain cases, 15 months after the purchase agreements. In other words, the basic needs to ensure inventory and understand the programs were not satisfied until long after the purchase decisions had been made. We believe that the JOBS Act and Rule 506(c) can provide an easily implemented path to the sale of condo hotel units and render moot the troubling issues of separating the sales of the condo units and the introduction of the rental program evident in Tarsadia.
New SEC Rules
The new rule, which went into effect Sept. 23, 2013, allows issuers of securities to engage in “general solicitations” and “general advertisements” in connection with unregistered securities offerings. As a result, developers may now disclose the details of the rental programs including splits, use restrictions, and projections, before selling the units. In short, the amendment will allow developers to take almost all of the actions previously prohibited, including offering mandatory rental programs and those that “pool” revenues of individual guest rooms with those of other rooms.
Sales of such securities may only be made to persons who the issuers have taken reasonable steps to “verify” are “accredited investors.” Accredited investors are generally defined as those with certain levels of income or net worth.
Securities Broker-Dealer Requirements
Any offering of condominium units together with a rental management program requires the engagement of a licensed real estate agent to sell the condominium unit and a licensed broker-dealer to sell the rental management programs. To ensure that sales of condominium hotel units do not violate the applicable real estate and securities brokerage requirements, the real estate agent and sales personnel should discuss the real estate portion of the transaction and refer the proposed purchaser to the licensed broker-dealer to discuss the components of the rental program.
In order to take advantage of amended Rule 506, issuers will be required to take reasonable steps to verify that all purchasers in the offerings are “accredited investors.” The SEC has adopted an objective, principles-based approach to verification that allows issuers to apply sliding-scale diligence standards to their verification procedures, requiring less stringent standards where the circumstances make it more likely that the purchasers are in fact accredited investors. In addition, the SEC has provided for certain nonexclusive safe harbors that allow issuers of securities to be deemed to satisfy the verification requirements of Rule 506 if they take the following steps to verify the net worth or income of investors who are natural persons:
Obtain copies of Internal Revenue Service forms (e.g., Form W-2, 1099, 1040) that indicate the purchasers’ income for the two most recent years and a representation from the purchasers that they expect to reach the necessary income levels to qualify in the current year as accredited investors;
Obtain copies of bank statements, brokerage statements and other statements indicating the value of such persons’ assets (or a portion thereof), consumer reports from consumer reporting agencies confirming the purchasers’ liabilities, and representation from purchasers that they have disclosed all liabilities necessary to make determinations of their worth; or
Obtain written confirmation from registered broker-dealers, registered investment advisers, licensed attorneys, or licensed certified public accountants indicating that reasonable steps have been taken to verify the purchasers’ status as accredited investors.
Many foreign buyers may be reluctant to disclose their net worth or income. In such cases, the principles-based approach adopted by the SEC would allow issuers to take into account other factors to verify the foreign purchasers’ accredited investor status, including for example the purchase of condominium hotel units with high purchase prices without debt financing.
Disqualification of ‘Bad Actors’
The SEC also adopted new “bad actor” rules that will prohibit issuers from relying on Rule 506 if the issuers, their officers or directors, any owners of 20 percent or more of the issuers’ outstanding voting securities, or certain other persons affiliated with the issuers or involved in the offerings, have been subject to any convictions or restraining orders related to the purchase or sale of securities.
The Offering Process
In addition to advertisements and other marketing efforts, potential purchasers would be provided with an offering memorandum describing, among other things, the nature and amount of “securities” being sold, the management company and the developer, the material terms of the rental program, the potential income opportunity represented by the rental program (including projections and other forward-looking information) and the material risks involved in making an investment in the rental program. The offering memorandum would serve a dual purpose: helping satisfy the disclosure requirements under applicable securities laws while also providing information that investors want prior to making investment decisions. As with any offering of securities, brokers and other representatives of issuers would be prohibited from deviating from the printed offering memorandum when speaking with potential investors.
Although there is no specified minimum level of information to be included in the offering memorandum, the anti-fraud provisions of the federal securities laws require that the offering memorandum does not contain any material misstatements or omit any material information.
If approached in this way, the JOBS Act and Rule 506(c) can provide a powerful solution to the legal issues that have historically impeded the sales of condominium hotel units.