The potential application of federal and state securities laws to the sale of condominiums when coupled with the opportunity to participate in a rental program (sometimes referred to as a "condohotel," "condominium hotel," or "whole ownership rental program") has long posed significant challenges for developers. For many years it has been common practice for developers to avoid selling securities at all costs. This article describes recent changes in federal securities laws that change the analysis of this issue significantly.
The analysis prior to new federal Rule 506(c)
Prior to the effectiveness of Rule 506(c) of federal Regulation D in September 2013, if an offering of condominium hotel units were to constitute a securities offering, the offering would generally have been required to be registered with the Securities and Exchange Commission (SEC) as a public offering. Although the offering could in theory have proceeded as a private placement to accredited investors (i.e., investors meeting minimum income, net worth or, for non-individuals, asset tests), the marketing of condominium hotel projects has been reliant on media advertising and exposure to the public through broker networks. Such broadly communicated marketing messages constitute "general solicitation and advertising" within the meaning of federal Regulation D and until recently were prohibited in connection with an offering under Rule 506 of federal Regulation D, the exemptive rule typically relied upon to conduct a private placement. Consequently, as a practical matter, hotel condominium offerings could not be conducted as exempt offerings within the United States. Because the alternative, conducting a public offering, involves a protracted and expensive registration process with the SEC, as well as the imposition of a variety of restrictive rules for communicating with investors, developers have had no choice but to ensure that condominium hotel offerings did not constitute securities.
At the same time, avoiding the application of securities laws requires a structure that is also fraught with challenges. SEC guidance published in 19731, which continues to outline the relevant considerations in determining whether a condominium hotel offering will be viewed as an offering of securities, indicates that a securities offering is likely when any of the following factors is present:
- The condominiums, with any rental or similar arrangement, are offered and sold with emphasis on the economic benefits to the purchaser to be derived from the efforts of the promoter (or a third party designated or arranged for by the promoter) in renting the units
- Revenues from various units are pooled
- The purchaser is required to hold the unit available for rental for any period of time or to use an exclusive rental agent or is otherwise restricted in its occupancy or rental of the unit
The most prevalent pitfalls of offering condominium hotel units in a manner that appropriately addresses these restrictions are:
- The lack of certainty as to the number of condominium units that will participate in a voluntary rental program and managing the leverage entailed in threats of defection from the rental program
- The prospect of outside rental programs creates numerous challenges including the accommodation of outside housekeeping staffs and onsite responsibility for guests of outside programs
- A lack of transparency with respect to the anticipated costs and benefits of participation in the rental program, which frequently results in purchaser dissatisfaction based on unrealistic expectations concerning economic performance
- The inability to pool the operating revenues and expenses of participating units creates a series of operational complexities, including those associated with ensuring fairness in connection with the rotation and complimentary use of rental units that have differing levels of appeal to transient occupants
The effect of new Rule 506(c)
After years of struggling with the negative repercussions of selling a condominium intended for transient occupancy that is not a security, revisions to Rule 506 adopted pursuant to the Jumpstart our Business Startups Act of 2012 (JOBS Act) have opened the door to the offering of condominium hotel units by permitting general solicitation and advertising in a Rule 506 private placement as long as any purchasers who invest in the offering are accredited investors. This revision makes it feasible to structure a condominium hotel product as a securities offering (i.e. by including a mandatory rental program or a pooling of revenues and expenses and/or by emphasizing the economic benefits of participation) and market the offering through traditional media and broker channels without being subject to a costly and time-consuming SEC securities registration process. The accredited investor tests for individuals are currently set at levels2 that are not likely to exclude a significant segment of purchasers who would otherwise fall within a developer's target market for a condominium hotel project3.
Specifically, new Rule 506(c) permits an unregistered offering to be conducted using general solicitation and advertising provided the following requirements are met:
- The investment may only be sold to accredited investors. Although a traditional Rule 506 private placement permits the inclusion of up to 35 non-accredited investors in the offering (subject to the satisfaction of disclosure and investor sophistication requirements), all purchasers in a Rule 506(c) offering must be accredited investors (or reasonably believed to be so).
- Reasonable steps must be taken to verify accredited investor status. Rule 506(c) provides "safe harbor" methods for satisfying this requirement that vary depending on whether the accredited investor is qualifying on the basis of the income test or the net worth test. The income test verification procedures include the examination of IRS documentation coupled with the receipt of investor representations. The net worth test verification procedures include the examination of bank, brokerage and/or other asset statements and credit reports coupled with the receipt of investor representations. Safe harbor verification can also be established on the basis of a confirmation by a registered broker dealer, SEC-registered investment advisor, licensed attorney, or certified public accountant that the investor has been determined to be accredited through reasonable verification procedures, and such third party verification avoids the need for individual investors to disclose sensitive tax and financial documentation to a condominium hotel sponsor.
- The SEC's "bad actor" prohibitions, adopted concurrently with the adoption of Rule 506(c), prevent any issuer (whether or not engaging in general solicitation) from relying on Rule 506 to conduct an offering exempt from registration if at the time securities are sold the issuer, any director, executive officer or other officer participating in the offering, promoter, placement agent, or 20% owner of outstanding voting equity has, after the effective date of Rule 506(c), been convicted of or enjoined from committing certain securities-related legal violations or becomes subject to professional debarment imposed by the SEC, the Commodities Futures Trading Commission or certain other regulatory agencies. It is incumbent upon issuers in Rule 506 private placements to conduct due diligence to ensure that the registration exemption has not been compromised by the participation of bad actors.
- There is a likelihood of future rulemaking concerning Rule 506(c) that would not substantially impact the advantages of Rule 506(c) to condominium hotel developers and other project sponsors.4
As with other Rule 506 offerings, condominium units purchased in a Rule 506(c) offering would be "covered securities" under the National Securities Markets Improvement Act of 1996 (NSMIA) and as such would be exempt from most state regulation related to the offering and sale of the securities themselves (although, as discussed below, state securities considerations would continue to apply to the sales personnel involved in marketing the units). State notice and filing fee requirements continue to apply to "covered securities" under NSMIA.5
Additionally, and consistent with other Regulation D offerings, conducting an offering pursuant to Rule 506(c) does not eliminate the application of a variety of provisions of the federal securities laws, including:
- The anti-fraud provisions of Rule 10b-5 -The issues associated with the anti-fraud provisions are generally addressed through risk factors and other disclosures typically contained in a private placement memorandum. Offering documents will need to be carefully reviewed for material misstatements or omissions, which can give rise to significant liability on the part of the issuer, parties controlling the issuer and other participants in the offering.
- Regulation of sales personnel -Sales personnel involved in the offering of a security are regulated pursuant to both federal and state law. Although the market may respond to a demand for salespeople licensed in connection with the sale of both real estate and securities, neither real estate brokerage nor securities firms typically have people that are dual licensed. The financial burden of both real estate brokerage commissions and securities commissions is an important issue for consideration. It is also worth noting that, to the extent a broker-dealer is involved in the offering, the broker-dealer will be subject to various communications rules promulgated by FINRA and the placement memorandum will be required to be filed with FINRA.
- Public reporting requirements - Although not relevant in most projects, it is worth noting that the entity owning a condominium hotel could be required to file reports with the SEC as a public company, and comply with numerous additional provisions of the federal securities laws (including the Sarbanes-Oxley Act) applicable to reporting companies, if on the last day of any fiscal year there are more than 2,000 registered owners or more than 500 registered owners that are non-accredited investors (including as a result of subsequent transfers) and the issuer has more than $10 million in total assets.
- Restricted securities - Despite the SEC's relaxation of the general solicitation and advertising rules, securities sold pursuant to Rule 506 – including those sold in a Rule 506(c) offering – are "restricted securities" for purposes of Rule 144, which it is prudent to conform to in most instances when reselling securities acquired in unregistered transactions. In general, the purchaser of an individual condominium unit who is unaffiliated with the issuer would be able to resell the unit freely after the expiration of a one-year holding period, and subsequent unaffiliated holders would be able to resell freely without any holding period. Prior to the expiration of the initial one-year holding period, the unaffiliated unit owner could resell the purchased unit in a valid private placement.6 Private resales during the holding period might not be practical, however, because Rule 506(c) does not give resellers (as opposed to issuers) the ability to engage in general solicitation, and traditional resale methods, such as newspaper advertising and real estate listings, would presumably be unavailable.
A sponsor proposing to offer condominium hotel units in the form of securities will also have to consider the typical requirement of securities broker dealers that they be indemnified against costs, expenses and other liabilities arising from the offering. The negotiation of such indemnities, and in particular the identification of a creditworthy party to stand behind the indemnities, may prove to be a significant issue when engaging intermediaries to market Rule 506(c) offerings.
Although the potential to structure condominium hotels as securities does not address every challenge associated with this real estate product, it does radically simplify the use of a condominium hotel structure where "for sale" transient real estate product otherwise makes sense. It seems clear that a developer will want to seriously consider a Rule 506(c) offering in many unbranded condominium hotel or whole ownership rental program projects. It seems equally clear that the largest brands will not be managing or branding hotels utilizing a condominium hotel structure for all or most of their guest rooms. What occurs in between these two ends of the spectrum is yet to be seen.