Properly Structured Sales and Marketing Programs for Condo Hotel Developers Are Imperative Under Salameh

by Manatt, Phelps & Phillips, LLP
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Last month the Ninth Circuit Court of Appeals issued an important opinion that could establish a safe harbor to protect condominium hotels from being characterized as securities under federal and state securities laws. In Salameh v. Tarsadia Hotels, the Court of Appeals affirmed the district court’s dismissal of the plaintiffs’ complaint, finding that the complaint did not sufficiently allege facts to support claims that condo hotel units in the Hard Rock Hotel San Diego development constituted securities under federal and state securities laws.

The Salameh case arose in December 2009, when certain Hard Rock Hotel unit owners filed suit in district court in San Diego, seeking to rescind their purchases and claiming that the units constituted securities under federal and state securities laws. In characterizing the Hard Rock Hotel units as securities, the plaintiffs alleged that the units and the optional rental management program operated by the hotel operator were offered as a single package, and, therefore, they expected to profit from their units based on the efforts of the hotel developer or hotel operator. However, most of the purchasers did not sign rental program agreements until eight to ten months after they had signed their purchase agreements.

In affirming the dismissal of the complaint, the Ninth Circuit held that the plaintiffs did not adequately allege facts demonstrating that they were offered real estate and rental program agreements as a package or that they were induced to buy the condominiums by the rental program. Reviewing the matter de novo, the court found that the plaintiffs did not allege that they were even aware of the rental program at the time they signed unit purchase agreements and therefore they could not allege that they were induced to buy the condominiums by the opportunity to participate in the rental program. The court’s ruling was underscored by the large gap in time between the plaintiffs’ execution of the real estate purchase contracts and their execution of the rental management agreements.

The court also rejected what it believed to be the plaintiffs’ strongest argument: that the real estate sale combined with external factors—such as a zoning ordinance restricting the occupancy of the units to no more than 28 days in a calendar year and requiring that the units be offered to the public for rent as part of the hotel when not occupied—gave them no choice but to sign the rental management agreement when it was later presented. Although the court described this argument as having “some force,” the court found flaws with the implicit assumption that the only viable use for the condominiums was as an investment property (citing the amicus brief submitted by Manatt on behalf of the Real Estate Roundtable and the National Association of Realtors) and posited 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.”

Although Salameh represents just one of several lawsuits filed by condominium hotel buyers since the 2008 financial crisis and the accompanying downturn in commercial and residential real estate, it is important in several respects. It is the first opinion to thoroughly examine a modern condominium hotel that, by all appearances, complied with prior SEC guidance. Next, because the Ninth Circuit is an influential court nationwide, the opinion may establish a safe harbor to protect condominium hotels from being characterized as securities under federal and state securities laws in the future. Third, the court reached its decision despite an SEC amicus brief arguing that the Hard Rock Hotel units were in fact investment contract securities, based on the totality of the facts and circumstances of the offering. Although courts often defer to the SEC’s opinions on the application of the securities laws, the court was unable to reach the same conclusion as the SEC.

Overall, we believe the decision is important to condominium hotel developers because of the many similarities between the condominiums offered at the Hard Rock Hotel and other condominium hotel developments. In those respects, the decision affirms the importance of clearly and distinctly separating the condominium sales program from any optional rental program.

However, the decision is not as far-reaching as it might initially appear because of the limited factual allegations in the record. Specifically, the court did not have the opportunity to analyze or pass judgment on the marketing model approved by the SEC in the Intrawest No Action Letter issued in 2002, which generally permits developers to make certain information about an optional rental program available to prospective purchasers prior to the execution of a unit purchase agreement. For example, Intrawest permits developers to disclose the existence of the optional rental program to prospective purchasers and introduce them to members of the developer’s rental management team to discuss the general terms of the rental program. Because the court placed significant weight on the plaintiffs’ failure to allege that they were even aware of the rental program at the time they signed unit purchase agreements, it is unclear whether a developer following the Intrawest model would qualify for the Salameh safe harbor.

Recommendations Going Forward
In light of Salameh, it is imperative that condo hotel developers continue to carefully structure their marketing and sales processes. We recommend that condo hotel developers reevaluate their current sales and marketing programs to determine whether they satisfy the conditions for the Salameh safe harbor.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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