Condo Hotel Branding: Benefits and New Risks with Rule 506(c) - Condo Hotel Projects Sold as Exempt Securities Require Informed Decisions by Brand Operators

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HIGHLIGHTS:

  • Condominium hotels are experiencing renewed interest, buoyed by the rising tide for real estate generally as well as the favorable trends for financing under the Securities and Exchange Commission's new Rule 506(c) that allows "general solicitation," including use of protected websites, for exempt offerings by developers under specified conditions.
  • While there may be attractive new options for financing condo hotel projects under Rule 506(c), before brand operators lend their names to a project it is important that they consider both the expanded potential and the new hazards where the units to be offered and sold are not only real property interests but also securities under federal and state law.

Condominium hotels are a subject of renewed interest, buoyed by the rising tide for real estate generally. These projects are also encouraged by favorable trends for financing under the SEC's new Rule 506(c) that allows "general solicitation," including use of protected websites, for exempt offerings by developers under specified conditions. Brand operators who are thinking of putting their flags on projects offered and sold under Rule 506(c) may wish to consider both the advantages and potential hazards associated with the new financing options.

Before Rule 506(c) became effective in September 2013, developers typically attempted to structure sales of condo hotel units in a way that would prevent the transactions from being deemed offers or sales of "securities." Developers relied on standards for avoiding "investment contract" status derived from the U.S. Supreme Court's Howey test and the SEC's 1973 Condominium Release and 2002 Intrawest no-action letter. the requirements generally consist of avoiding:

  • emphasis on the economic benefits to the purchaser from the managerial efforts of the promoter
  • mandatory participation in a unit rental program
  • pooling of rental revenues and expenses

Unfortunately, there are no bright line tests for meeting these standards, and in practice there is pervasive uncertainty. An August 2013 decision – favorable for developers – by the U.S. Court of Appeals for the Ninth Circuit in Salameh v. Tarsadia Hotel, involving the Hard Rock Hotel in San Diego, turned on an unusually large gap in time (two years) between transfer of the units and execution of rent-pooling agreements and provided little in the way of useful guidance for other developers. A transaction which falls short must be registered as a security unless an exemption is available. However, before Rule 506(c) there was no exemption for a transaction using "general solicitation" – which includes newspapers, the Internet and most other forms of advertising. As a result, relatively few successful condo hotel deals were done.

SEC Rule 506(c) now allows "general solicitation," including via the Web, for certain exempt offers and sales in which all purchasers are "accredited investors." This has created a surge of new "crowdfunding" websites for commercial real estate. It has also caught the attention of condo hotel developers since it may provide a way to make offers and sales of units as "securities" that are entitled to an exemption from registration with the mandatory rental programs and pooling arrangements generally thought to be necessary for economic feasibility – provided that the offers and sales are made in compliance with all requirements of Rule 506(c).

Risks Associated with Condo Hotel Units Sold as Securities

Before leaping in, however, brand operators who are thinking about lending their names to condo hotel projects offered and sold under the new rule may wish to consider some additional risks arising from the circumstance that these offers and sales will be securities under federal and state law. The brand operator will, in most cases, want to take all appropriate steps to minimize the chance that it might be considered a "controlling person" of the issuer, with potentially increased liability to investors (unit purchasers). Proper structuring of the brand management contract can usually minimize this risk, but operators should be aware of the possibility that in the course of future investor claims there could be attempts by purchaser plaintiffs to bring brand operators within the scope of the parties alleged to be liable for securities law violations, which would bring into play a multitude of potential remedies and penalties. In addition, the security fraud provisions under Rule 10b-5, with its traditionally broad construction, will apply to all exempt offerings under Rule 506(c).

In addition, brand operators will want to consider the risk that the developer or others involved in offers and sales of the units may fail to comply with all of the requirements for the exemption under Rule 506(c). There are a number circumstances under which there may be failure to comply, including:

  • inadequate or improper disclosure in the offering literature
  • failure to comply with restrictions on the proper means for "general solicitation" (for instance, failure to provide proper controls to ensure that a website used as a platform does not result in sales to non-accredited investors)
  • failure to take proper steps to verify the accredited status of unit purchasers
  • deficiencies with respect to the licensing and compensation of sales personnel under federal and state law

As a part of its evaluation of a proposed brand management arrangement, the operator will therefore need to take into account the potential consequences for the project, and for the expected benefits under the brand management contract, if the developer/owner runs afoul of the securities laws.

Even with Rule 506(c) Compliance Disputes Can Be Costly and Injurious to the Brand

An analysis of potential scenarios would also factor in the anticipation that even if there has been compliance with Rule 506(c) and the developer does ultimately prevail in litigation, the scope of potential purchaser claims is greatly expanded, disputes are likely to be more onerous and costly, and claims alleging securities fraud may embroil the brand name in undesirable public attention.

While there may be attractive new options for financing condo hotel projects under Rule 506(c), before brand operators take the plunge and lend their names to a project it is important that they consider both the expanded potential and the new hazards where the units to be offered and sold are not only real property interests, but also securities under federal and state law.

To ensure compliance with Treasury Regulations (31 CFR Part 10, §10.35), we inform you that any tax advice contained in this correspondence was not intended or written by us to be used, and cannot be used by you or anyone else, for the purpose of avoiding penalties imposed by the Internal Revenue Code.

Topics:  Commercial Real Estate Market, Condominiums, Crowdfunding, Financing, General Solicitation, Hospitality Industry, Hotels, Real Estate Development, Real Estate Investments, Rule 506(c), SEC, Securities

Published In: General Business Updates, Communications & Media Updates, Finance & Banking Updates, Commercial Real Estate Updates, Securities Updates

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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