Regulations for Condominium Hotels Los Angeles County Bar by alicejenny


									                practice tips                                                                                    BY DEBORAH M. ROSENTHAL AND DANIEL L. BROWN

                Regulations for Condominium Hotels

                CONDOMINIUM HOTELS are one of the most popular real estate
                trends in the hospitality industry, proliferating throughout the coun-
                try and around the world during the past decade. Yet many real estate
                attorneys, developers’ counsel, and hospitality counsel do not know
                how to create what are commonly referred to as condo hotels, why
                they are a popular financing and development model, or how to
                address the Securities and Exchange Commission implications of
                these vehicles.
                    A condominium is an “[o]wnership of a separate interest (the
                Unit) coupled with a fractional undivided interest in the common
                areas owned either as tenants in common or through an
                Association.”1 While a condominium hotel generally looks and
                operates just like a traditional hotel—with specified hotel rooms,
                or “units,” owned by individuals—no standard definition of a con-
                dominium hotel exists. In fact, the term “condo hotel” is often used
                indiscriminately to refer to a number of variations on the theme. For
                example, at some condominium hotel properties, certain rooms are
                designated for rental to transient hotel guests, while other rooms
                are designated as condominium units to be owned by individuals
                who do not participate in any of the services or receive any of the
                amenities provided to the traditional hotel guests. The most com-
                mon type of condominium hotels, however, are those in which cer-
                tain units in a hotel are designated as condominiums to be owned
                by individuals who participate in all the services of the hotel. And
                within this type of condominium hotel, individuals might own a unit
                as a primary residence, benefit from the hotel’s services, and be
                unable to rent out the unit to transient guests. In others, the con-
                dominium owner purchases his or her unit primarily as an invest-
                ment vehicle or vacation home, renting out the unit during some or
                all of the year.
                    In California, creating a condominium hotel requires a subdivi-
                sion map approved by a local government pursuant to the Subdivision
                Map Act.2 In addition to local regulations governing construction of
                the hotel project, each of the condominium units is considered a sep-
                arate parcel, which must meet local government conditions for design       of property under California law.
                and improvement of the development. These conditions can be exten-            The first condominium hotels were reportedly built in Miami
                sive, requiring dedications, off-site construction, payment of fees, and   Beach in the early 1980s. However, the popularity of condominium
                preparation of CC&Rs.                                                      hotels took off in the late 1990s as developers aggressively started sell-
                    In addition, the sale or lease of five or more condominium units       ing condominium hotel units, attracted by the potential for up-front
                also falls under the jurisdiction of the State Department of Real Estate   fees from condominium purchasers prior to the completion of a
                (DRE), pursuant to the Subdivided Lands Law. Subdivisions that fall        hotel project. Through the sale of condominium units, developers could
                under DRE jurisdiction cannot be offered for sale or lease until the       obtain financing for hotel construction or renovation projects even
                DRE has confirmed that they meet all statutory requirements—               prior to construction. Preselling condominium units also helped
                known as affirmative standards—for intended use of the property.
                The DRE issues a Conditional or Final Public Report detailing              Deborah M. Rosenthal is a partner in the Real Estate, Land Use and Natural
                information about the project that must be disclosed to all pur-           Resources and Environmental Practice Group in the Orange County office of

                chasers, including a description of the proposed management of the         Sheppard Mullin Richter & Hampton LLP. She represents landowners and devel-
                project. Because a condominium is an interest in property, developers      opers throughout California. Daniel L. Brown is an associate in the Antitrust
                are subject to all normal land use requirements, and purchasers are        Practice Group in Sheppard Mullin’s New York office. He also practices in the
                entitled to the full array of legal protections applicable to the sale     areas of hospitality, contract, fraud, fiduciary duties, and class actions.

                10 Los Angeles Lawyer January 2009
developers obtain loans because the developer          others are individual unit owners or repre-       Disabilities Act and must ensure the avail-
or lender no longer needed to rely solely on           sented by condominium associations? How           ability of disabled-access condominium units.6
the financial projections of incremental prof-          would a brand management company enforce
its associated with hotel room rentals tradi-          its brand standards, and upgrades of those        Unit Sales and Securities Laws
tionally associated with the cyclical hotel            standards, against individual condominium         While all these issues present challenges for
industry.                                              owners? How would a management agree-             those involved in condominium hotel projects,
    Moreover, condominium hotel units                  ment obtain approvals, if necessary, from         perhaps the inquiry most frequently posed as
reportedly command a 30 to 40 percent pre-             each condominium owner? Would owners              condominium hotels gain in popularity is
mium over the sale of traditional residential          place a sufficient number of their condo-         whether the sale of a condominium unit might
condominiums. The opportunity to realize a             minium units into the hotel’s reservation         constitute a sale of a security under federal
quick return on investments even prior to              pipeline to maintain the profitability of the      securities laws. Sale of a condominium hotel
construction caused condominium hotels to              hotel for the management company? How             unit could be governed by both state DRE and
sprout up throughout the country, and they             would conflicts between management com-            federal SEC regulations. The issue of whether
have been particularly attractive to buyers in         panies and homeowners’ associations be            the sale of a condominium unit is governed
the luxury segment.                                    resolved?                                         by federal securities laws is significant because
    In addition, many potential buyers were                Others have noted that traditional legal      of the potential implications for condominium
lured by the attraction of purchasing a con-           documentation applicable to hotels and con-       hotel business practices and the potential lia-
dominium hotel unit, often in a luxury hotel           dominiums—such as management agreements           bilities and remedies available to buyers and
or resort destination, as an investment based          for hotels and residential condominium asso-      sellers of condominium hotels. This important
on the potential for appreciation of the unit          ciation documents—would be unworkable             issue might soon be resolved as the result of
and receipt of fees from rental of the unit to         for condominium hotels. The unique nature         an explosion of recent (but not unexpected)
transient hotel guests. Indeed, the luxury seg-        of a condominium hotel requires that hospi-       lawsuits7 in which condominium hotel buy-
ment of the condominium hotel industry                 tality attorneys become well versed in laws       ers—perhaps motivated by the state of the real
received another boost when brand man-                 applicable to condominiums, and attorneys         estate market or a realization that their con-
agement companies and celebrities jumped on            for condominium hotel owners, managers,           dominium hotel units might not achieve
the condominium hotel bandwagon, lending               and developers must become familiar with          expected investment returns—are relying on
their popular names and/or management                  local government rules for zoning, impact         federal securities laws to seek rescission of
expertise and track records to condominium             fees, and, in some cases, unique rules applic-    their purchase and sale agreements and to pur-
hotel projects. For example, George Clooney,           able to condominium hotels. In California,        sue other available remedies.
Michael Jordan, and others become involved             any guidance concerning the development of            The offer for sale of real estate generally
with luxury condominium projects, some of              a condominium hotel must be informed by an        does not involve the offer of a security.
which have been canceled.3 Hotel manage-               understanding of potentially applicable rules     However, because a condominium hotel unit
ment companies, from boutique hotel oper-              and regulations promulgated by the local          might be associated with a rental or man-
ators to most of the major hotel brands, have          city or county exercising jurisdiction over       agement program, it can, in certain circum-
condominium hotels in their pipelines, includ-         the hotel site, as well as the applicable regu-   stances, be deemed a security. If so, unless the
ing Hilton, Hyatt, Ritz-Carlton, Four Seasons,         lations of other agencies—such as the             sale is exempted, the sale must be registered
and Starwood.4                                         California Coastal Commission—for hotels          with the SEC and comply with the SEC’s
    Finally, from a lifestyle perspective, it is not   located in the Coastal Zone.5                     rules and regulations, including its disclo-
surprising that condominium hotels have                    Many local governments have clear zon-        sure and antifraud provisions.8 As a result, if
been particularly attractive to buyers in the          ing regulations and controls for hotels and for   the sale of a condominium hotel unit is
luxury segment. After all, who has not imag-           traditional residential condominiums as well      deemed to be the sale of a security, the level
ined living in a hotel and partaking in all its        as special rules for timeshare developments.      of disclosure required for condominium hotel
amenities, such as valet parking, room service,        But just as many local governments do not         promotional materials will likely increase
on-site restaurants, spas, and much more?              define “condominium hotel” in their zoning         drastically, as the condominium hotel pro-
In contrast to a traditional residential con-          codes, thereby creating confusion whether a       moter will become an issuer of securities sub-
dominium, condominium hotel unit owners                condominium hotel is a permitted use and          ject to the antifraud provisions promulgated
also benefit from living in a residence man-            whether a condominium hotel should be sub-        by the SEC.9 For the condominium hotel unit
aged by a world-class team, making repairs             ject to residential or commercial develop-        buyer, the purchase of the unit becomes an
and providing day-to-day management exper-             ment standards and exactions.                     investment decision, with the protections
tise that might typically be the domain of a               Moreover, developers, management com-         afforded under applicable securities laws.
condominium association.                               panies, and their attorneys involved in con-          Moreover, if the securities laws apply,
                                                       dominium hotels must now become familiar          and if developers or brokers do not comply
Issues for Owners, Developers, and                     with the bylaws of homeowner associations,        with the additional requirements applicable
Managers                                               as well as local rules concerning minimum         to the sale of securities, they could face seri-
When the increase in condominium hotels                required occupancies for unit owners and          ous criminal and civil liabilities.10 Condo-
became a frenzy in the late 1990s, many                maximum stays for transient guests. Some of       minium hotel sellers also could be deemed
industry observers expressed concern about             the new issues concerning condominium             securities brokers or dealers within the mean-
a number of potential issues that might arise.         hotels have likely been worked out by the var-    ing of the Securities Exchange Act and may
This was because the concept of the condo-             ious stakeholders in condominium hotels,          be required to be registered. Finally, if a con-
minium hotel is unlike prior trends in the             and others have required a judicial resolution.   dominium sale is considered a security and
hospitality industry, such as timeshares and           For example, a federal district court held        the sale is not registered, the buyer could
fractionals. For example, how would man-               that condominium hotels are required to           void the sales contract.
agement companies manage properties in                 comply with the accessible construction               The definition of a “security,” as developed
which some tenants are transient guests and            requirements of the Americans with                by the courts, is derived from the economic

12 Los Angeles Lawyer January 2009
realities test established by the U.S. Supreme
                                                      ARBITRATOR AND MEDIATOR
Court. In SEC v. W. J. Howey Company,11
the Supreme Court applied what it termed                 Is this your client...
                                                     • In the entertainment or related
“economic realities” and found that “a con-           industry?
tract, transaction or scheme whereby a per-          • Prefers a solution to a dispute
                                                      rather than litigation?
son invests his money in a common enterprise         •Willing to arbitrate or mediate
and is led to expect profits solely from the           the dispute, but wants a neutral
                                                      person who knows the industry
efforts of the promoter or a third party” is          and understands it?
an “investment contract” and, therefore, a
security.12                                                        Dixon Q. Dern
    The California Supreme Court has estab-           310.557.2244
lished the “risk capital” test13 in addition to                           Over 25 years
Howey. Despite the different formulations of         Arbitration and mediation experience for the entertainment
                                                                     industry and other disputes.
Howey and the risk capital test, the U.S.                Experience + Knowledge = “DERN” good results!
Supreme Court has noted that the risk capi-
tal test is an “approach that is virtually iden-
tical to the Howey test.”14 The risk capital test
analyzes whether the funds in a given venture
will be used to develop or acquire the busi-
ness or enterprise in which the interest is
offered. If that test is satisfied, then the inter-
est is deemed to be a security. The extent of
the development of the business at the time
the interest is purchased would therefore be
an important factor when determining
whether the sale of a condominium hotel
unit is deemed to be a security.
    However, no case law currently exists to
definitively answer the question of whether a
condominium hotel sale constitutes a security.
Most commentators thus have looked to two
statements by the SEC for guidance: a 1973
SEC Release and a 2002 “no action” letter.
    In 1973, the SEC issued a release to
address the “uncertainty about whether offers
of condominiums and other types of similar
units may be considered to be securities.”15
The SEC concluded that an offering of secu-
rities will arise if the condominiums:
• Are sold with an emphasis on the eco-
nomic benefits to the purchaser that will
derive from the managerial efforts of the pro-
moter or a third party from rental of the
• Include participation in a rental pool
• Require the purchaser to make the unit
available for rental for any part of the year,
use an exclusive rental agent, or otherwise
materially restrict occupancy or rental of
the unit.
    Nonetheless, the 1973 release states that
“an owner of a condominium unit may, after
purchasing his unit, enter into a non-pooled
rental arrangement with an agent not desig-
nated or required to be used as a condition
to the purchase.”
    In 2002, the SEC issued a “no action” let-
ter to Intrawest Corporation, a condominium
hotel developer in Canada, concerning “the
offer and sale of condominium units…coupled
with an offer or agreement to perform or
arrange certain rental or other services for the
purchaser.”16 Intrawest wanted to institute a

                                                                            Los Angeles Lawyer January 2009 13
         — EXPERT WITNESS —                                                                                                     sales and promotional program for its U.S.
                                                                     TRUST DEED FORECLOSURES                                    developments that would disclose the exis-
 • Reports, evaluations conclusions on Real Estate                   “Industry Specialists For Over 18 Years”                   tence of the rental management programs as
   Transactions.                                                                                                                one of the services offered. It sought to do this
 • Appraisals Land value property value-Develop-
   ment-process, permits.
                                                                        Witkin Eisinger we specialize in the Non-Judicial
                                                                     Atreal and&personal property secured by real property
                                                                        Foreclosure of obligations
                                                                                                   (mixed collateral).
                                                                                                                                without an SEC registration. To that end,
 • Condemnation, governmental zoning,                                                                                           Intrawest represented, among other things,
   bureaucratic abuses and takings.                                  When your client needs a foreclosure done profession-      that 1) under no circumstances would
 • Real Estate Development and usage in the                          ally and at the lowest possible cost, please call us at:
                                                                                                                                prospective purchasers be led to believe that
   California Coastal Zone.                                                     1-800-950-6522
                                                                      We have always offered free advice to all attorneys.      they will profit from unit ownership other
 COVERING: Practice, contracts, sales agreements, state required D
 disclosures. Single Family Residences, Land Development, Land                                                                  than by property value appreciation, 2) rep-

                                                                      &         WITKIN
 Use Vested Rights Easements, Ingress, Egress, Encroachments.
                                                                                                                                resentatives of the rental management com-
         BATES EXPERT WITNESS                                                                                                   pany would only provide information in
             Professional Excellence – Realtor
          TEL: 310.739.4886 • FAX: 310.456.1599
                                                                                EISINGER, LLC                                   response to specific inquiries, 3) Intrawest’s
               EMAIL:                                                RICHARD G. WITKIN, ESQ. ◆ CAROLE EISINGER                  rental management program would be com-
       29575 Pacific Coast Hwy, Ste A, Malibu, CA 90265
                                                                                                                                pletely voluntary and separate from the
                                                                                                                                Intrawest sales program, 4) sales representa-
                                                                                                                                tives would not receive additional compen-
                                                                                                                                sation or other incentives for unit sales tied
                                                                                                                                to rental management agreements, and 5)
                                                                                                                                Intrawest would not discuss the terms of any
                                                                                                                                rental management agreements until a pur-
                                                                                                                                chase and sale agreement was executed.
                                                                                                                                    Based on the facts presented by Intrawest,
                                                                                                                                the SEC stated that Intrawest’s sales and
                                                                                                                                rental model did not create a security as
                                                                                                                                defined by Howey and the 1973 release
                                                                                                                                because, among other things, the promotion
                                                                                                                                and sale of units did not emphasize any eco-
                                                                                                                                nomic benefit to the purchaser derived from
                                                                                                                                managerial efforts or rentals and did not
                                                                                                                                offer participation in a rental pool.17
                                                                                                                                    No court has yet to weigh in on the issue
                                                                                                                                of whether the sale of a condominium hotel
                                                                                                                                unit constitutes a security. However, at a
                                                                                                                                minimum, to avoid being deemed a security,
                                                                                                                                a condominium hotel unit sale must not be
                                                                                                                                tied to any pooling of rents and must be
                                                                                                                                advertised, marketed, and sold as a piece of
                                                                                                                                real estate. Further, the sale must be structured
                                                                                                                                carefully to avoid any association with a
                                                                                                                                management or rental program. While dis-
                                                                                                                                putes requiring a resolution of this issue may
                                                                                                                                be determined on a case-by-case basis, the
                                                                                                                                manner of an offering and the economic
                                                                                                                                inducements held out to prospective pur-
                                                                                                                                chasers will be critical to the determination
                                                                                                                                of whether a condominium hotel unit sale
                                                                                                                                constitutes the sale of a security. Dissatisfied
                                                                                                                                buyers have begun the rush to the court-
                                                                                                                                house to test the theory that condominium
                                                                                                                                hotel unit sales are securities, so promoters of
                                                                                                                                condominium hotels must be scrupulous with
                                                                                                                                their sales efforts.
                                                                                                                                    Indeed, disgruntled condominium hotel
                                                                                                                                owners and investors are relying on federal
                                                                                                                                and state securities laws in an attempt to
                                                                                                                                rescind their purchase agreements and seek
                                                                                                                                damages. A federal district court case in
                                                                                                                                Florida filed by the owners of condominium
                                                                                                                                hotel units at the Clearwater Cay Clubs
                                                                                                                                Resort in Clearwater, Florida, alleges that
                                                                                                                                the resort’s vendors and developers violated
                                                                                                                                federal securities laws and Florida state secu-
                                                                                                                                rities laws by fraudulently inducing them to

14 Los Angeles Lawyer January 2009
invest in condominium hotel units. 18                    .com/EN-press-hot-concept-condo-hotel-condhotel-           (9th Cir. 2003).
                                                         condo-hotel-condotel.html.                                 9 See  id.
Specifically, the plaintiffs allege that the defen-       5 See David Waite, The Condo Part of Condo Hotels;         10 See id.
dants promised them “substantial profits”                 A Primer on How to Create a Common Interest                11 SEC v. W. J. Howey Co., 328 U.S. 293 (1946).

from the investments through guaranteed                  Development, THE GLOBAL HOSPITALITY ADVISOR, Feb.          12 Id. at 298-99.

income from a pool of short-term rental units            2005, available at http://www.hotel-online                 13 Silver Hills Country Club v. Sobieski, 55 Cal. 2d 811

as well as capital appreciation due to a large-          .com/News/PR2005_1st/Feb05_CondoHotelPrimer.htm            (1961).
                                                         l; see also Memorandum from Peter M. Douglas,              14 Reves v. Ernst & Young, 494 U.S. 56, 64 (1990).
scale conversion/development. Based on the                                                                          15 SEC Release No. 33-5347, 38 Fed. Reg. 1735 (Jan.
                                                         Executive Director, Cal. Coastal Comm’n to Local
allegation that the sale of a condominium                Gov’t Planning Directors and Interested Persons (Dec.      4, 1973).
hotel unit constitutes a security, the plaintiffs        26, 2006), available at          16 Intrawest Corp., SEC No-Action Letter, 2002 SEC

allege that the units were required to be reg-           /legal/condo-hotels.pdf.                                   No-Act. LEXIS 787 (Nov. 8, 2002).
                                                         6 Access 4 All, Inc. v. The Atlantic Hotel Condo. Ass’n,   17 Id.
istered with the SEC. Since they were not, the
                                                         Inc., 2005 U.S. Dist. LEXIS 41602 (S.D. Fla. 2005).        18 Slayter v. DC 701, LLC, 2008 U.S. Dist. LEXIS
plaintiffs are seeking damages. Similar law-             7 See, e.g., Mastrella v. WCI Communities, Inc., Case      68159 (Mid. D. Fla. 2008).
suits are being reported with increasing fre-            No. 9:08-cv-80055 (S.D. Fla. Jan. 23, 2008); Spradlin      19 See Irwin W. Sandmann, When a Condo Hotel
quency. Plaintiffs are alleging the violation of         v. Trump Ruffin Tower I LLC, Case No. 2:08-cv-             Implosion Appears Imminent, What Can Be Done?,
federal securities law by the sale of condo-             01428 (Nev. Dist. Ct. Sept. 22, 2008).                     Aug. 29, 20007,
                                                         8 See, e.g., SEC v. McCarthy, 322 F. 3d 650, 652-53
minium hotel units as investments without the                                                                       /4hots_fshw.php?mwi=2327.
units being registered with the SEC. They
are seeking monetary damages and the rescis-
sion of their purchase agreements.19
    If the SEC’s 1973 release and 2002 “no
action” letter are reliable guides, the success
of the recent lawsuits alleging violations of
securities laws will depend on whether the
promotion and sale of the condominium
hotel units emphasized any economic ben-
efit to the purchaser derived from manage-
rial rental efforts. If buyers, as alleged in the
Clearwater Resort lawsuit, were led to
believe that the purchase of a condominium
hotel unit would generate guaranteed income
from rental arrangements, courts may well
find that federal securities laws apply and
were violated.
    The craze for condominium hotels has
led many to question the viability and
longevity of this type of real estate vehicle and
to ponder the potential implications of fed-
eral and state securities laws. The first law-
suits in which unhappy condominium hotel
unit buyers allege that they purchased unreg-
istered securities are certain to be closely
watched by attorneys, purchasers of condo-
minium hotels, developers, and management
companies. A court decision holding that a
sale of a condominium hotel unit constitutes
a security would be significant and would
alter the current practices of those involved
in condominium hotels—including, but not
limited to, developers and management com-
panies.                                         ■

1 CIV.  CODE §1351(f).
2 GOV’T   CODE §66426.
3 See, e.g., Associated Press, George Clooney-backed

condo project sold, MSNBC, June 5, 2006,; Alyson
McCarthy, Michael Jordan’s Aqua Blue Project
Cancelled, June 30, 2005, available at http://
ClientType =Printabl; Braden Keil, Raging ‘Nobu’ll:
De Niro To Launch Hotel, N.Y. POST, May 1, 2008,
available at
4 See, e.g., Robyn Taylor Parets, Why Condo Hotels Are

a Hot Concept, May 1, 2005, http://www.condhotel

                                                                                                                                         Los Angeles Lawyer January 2009 15

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