Back in June, we reported that the SEC was showing some interest in the dismissal in Salameh v. Tarsadia Hotels. Nonetheless, we were surprised when we reviewed “What’s New at the SEC” and saw that the SEC had filed a friend of the court brief in favor of the plaintiff purchasers. In stating its interest in the case, the SEC reported that it was concerned that:
"The district court’s holding on the investment contract issue, unless reversed . . . would impermissibly allow a promoter to avoid the coverage of [the securities laws] by (1) artificially dividing a single investment transaction into ostensibly separate parts, and (2) including written disclaimers that falsely state that there is no investment expectation."
A Single Transaction?
In granting its dismissal in Tarsadia, the U.S. District Court for the Southern District of California determined that plaintiffs could not credibly allege the existence of a single “investment contract” given the 8 to 10 month gap between the plaintiffs’ execution of the purchase agreements and the rental management agreements.
The SEC argues in its brief that, in reaching this conclusion, the court “failed to appreciate the broader realities underlying the arrangements between the parties.” Specifically, the SEC argues that the hotel regime documents effectively denied the plaintiff purchasers any meaningful use or control of their hotel rooms, instead reserving that control to the hotel operator at inception. The SEC also points out that this allocation of control was consistent with the developer’s plan to operate “a functioning, economically viable hotel.” The SEC concludes as follows:
"The fact that Tarsadia did not make the Rental Management Agreement available until a year after the room sales is of little or no consequence. This is particularly so given that the Hotel was still under construction throughout the entire period in question, and did not finally open until several months after Tarsadia formally offered the rental management program. Tarsadia’s ability to delay having the plaintiffs actually execute the Rental Management Agreement should not disguise the economic and practical reality here: Tarsadia’s operation of a rental management program was at all times here a necessary and essential component of the room sales, making the two a single transaction or package."
Expectation of Profit?
The dismissal in Tarsadia was also based upon the court’s conclusion that the plaintiff purchasers could not demonstrate any reasonable expectation of profit because the purchase agreements contained express representations that there was no investment intent.
In disputing this conclusion, the SEC again argued that the court was missing the forest for the trees. Contractual language notwithstanding, the court should have recognized that the purchasers were “led to expect profits from the defendants’ efforts.”
"The danger with the district court’s approach lies in the fact that, were it allowed to stand, it could provide an easy mechanism for those seeking to avoid the protections that the securities laws afford investors. It is essential, therefore, that written representations or warranties not trump the economic and practical realities of a transaction that otherwise qualifies as an investment contract."