In a case involving the offering of 450 condominium hotel units and a rental program at the Hard Rock Hotel in San Diego, California, the Ninth Circuit Federal Court of Appeals found in favor of the sponsor and upheld the real estate purchase and sale agreements as just that, a real estate contract and not a security or investment contract subject to the Securities Act of 1933, as amended.  The case was being carefully watched not so much because it presented novel issues, but because the SEC submitted an amicus brief, as a friend of the Court, in which the SEC suggested the Court adopt a sweeping view of the future operations of the various units being sold, suggesting that if the goal was for the units to be operated as a hotel, then the venture was a security.

The sponsor created and documented the condominium offering that was the subject of the case. While the case, Salemeh et al v. Tarsadia Hotels, et al. has been the subject of many reports, there are some unique perspectives on the case’s importance to the resort real estate industry that merit further attention.

The Court in Salemeh held that the plaintiffs did not adequately allege facts showing that they were offered real estate and rental management contracts as a package or that they were induced to buy condominiums by the offer of the rental management agreement.  Accordingly, the Court found, the buyers made a decision to acquire real estate that was not dependent or conditioned upon the offering of a rental program.  The fact that a subsequent rental program was offered to purchasers, did not change the characterization of the purchase.  The Court also rejected the plaintiffs’ argument that the only viable use for a condominium unit, which is restricted to prohibit full time owner’s use, is to rent it through a developer’s rental program.  On this issue, the Court expressly noted that “…there is no plausible reason why there cannot be a viable market for owner occupied hotel condominiums for use as short term vacation homes.” As a result, the structure which was designed by GT was validated.

The case was considered de novo requiring the Court to thoroughly review the state of federal securities law as applied to condominium unit offerings and make its own decision rather than merely affirm or deny the lower court’s decision.  As a result the Court undertook a review of the body of applicable law and explained its conclusions carefully.

The Court strongly reaffirmed prior case law, particularly Hocking v. Dubois, 885 F2nd 1449 (9th Cir.  1989) (en banc) and reinforced the power of the courts over regulatory agencies as the final arbiters of the law in this area.  While the sale of real estate, even real estate being bought for investment purposes, is generally not considered a security, in Hocking v. Dubois, 885 F.2d 1449 (9th Cir. 1989), the court held that an investment contract exists if there is “(1) an investment of money, (2) in a common enterprise, (3) with an expectation of profits produced by the efforts of others.  In a condominium hotel, when applied to a condo-hotel offering, there is a risk that if the sale of the condominium unit is so entwined with the offering of the rental program – the means by which the buyer can rely on the rental program to create a revenue stream from the unit, then the sale of the unit is such that the buyer may be buying an expectation of a financial return.

The case made it clear that condominium unit offerings associated with rental programs can be real estate offerings if properly structured.  Key guidelines stated or implied by the court for structuring hotel condominium units associated with voluntary rental programs included the following: (i) separating the timing of condominium sales contracting from disclosure of a rental program and its terms, to eliminate the rental program serving as an incentive to buy, (ii) neutralizing any means of persuading a buyer to buy using discussion and information about an offered rental program, and (iii) inclusion of effective investment disclaimers.  With proper care and compliance with the applicable legislation and judicial interpretations, condominium unit offerings with voluntary rental programs remain a viable option when considering development and marketing strategies for a hotel with for-sale components.