The Ninth Circuit Concludes That Condo-Hotel Units At The Hard Rock Hotel Are Not A Security

Author(s): Lynn T. Galuppo, Ali P. Hamidi, Jonathan S. Kitchen, Frederick H. Kranz, Arthur O. Spaulding, Jr.

Source: CCN Client Alert

8/16/2013

On August 13, 2013, the Ninth Circuit issued it's long-awaited decision in Salameh, et al. v. Tarsadia Hotels, et al., (9th Cir. 2013), ruling that the sale of the condominium-hotel units at the Hard Rock Hotel in San Diego is not the sale of a security. The three-judge panel upheld the federal district court’s dismissal of the plaintiffs’ claims for violation of federal and state securities laws and common law, and entered judgment in favor of Cox, Castle & Nicholson’s developer-defendants. 

In December 2009, the Salameh action was commenced by a group of purchasers of the condo-hotel units at the Hard Rock in San Diego, on behalf of a putative class. The Hard Rock Hotel is located at the entrance of the historic Gaslamp District in downtown San Diego, and has 420 guestrooms, all of which are condo-hotel units. Sales of the condo-hotel units began in 2006, and most of the escrows closed in 2007. Those owners who opted to have the hotel operator manage the rentals of their individual units entered into a separate agreement, the rental management agreement.

The core allegations of the plaintiffs’ claims is that they were fraudulently induced into purchasing the condo-hotel units that were, in reality, the sale of unregistered securities. In the context of this case, the plaintiffs asserted that the purchase of the condo-hotel units was packaged together with the rental management agreement, thus joining the two aspects together as a common enterprise. As a result, they argued this created an investment contract, as established under the U.S. Supreme Court decision of SEC v. W.J. Howey Co., 328 U.S. 293 (1946), and its progeny.

To establish a security under Howey, a plaintiff must show: (1) an investment of money, (2) in a common enterprise, (3) with an expectation of profits produced by the efforts of others. To meet this criteria, the plaintiffs argued that the economic reality of the transaction mandated that they enter into the rental program to be run by the hotel, they were subject to a 28-day occupancy restriction imposed by the City of San Diego, they were not issued keys to their individual units, and were dependent upon others to manage their units.

The plaintiffs relied largely on a prior Ninth Circuit decision, Hocking v. Dubois, 885 F.2d 1449 (9th Cir. 1989)(en banc). The Ninth Circuit contrasted the facts of the Hocking case to those of the Salameh case.

The Hocking case involved a rental pool arrangement immediately offered after buyers purchased in a condominium project in Hawaii. The Hocking court held that genuine disputed material facts existed as to whether the sale and the rental agreements were presented as one package.

The Ninth Circuit distinguished Hocking and Salameh on the facts, namely that the rental management program was offered to purchasers eight months to fifteen months after signing the purchase and sale agreement by two different entities, there were no allegations in the complaint to establish that the two agreements were part of the same transaction or promoted together, and there were no allegations that purchasers were told of investment-like profits. Additionally, the rental program at the Hard Rock is not a pooling arrangement. Based on those distinctions, the Ninth Circuit concluded that the plaintiffs failed to allege the existence of an investment contract, and, thus, there was no security.

The Salameh ruling provides much needed guidance for hospitality developers working in the condo-hotel and fractional ownership space. Prior to this decision, condo-hotel developers relied upon SEC guidelines to navigate through this unsettled area of law. Condo-hotel developers now have solid criteria to implement in their condo-hotel sales programs.

The Salameh decision stands as a clear statement that if the two economic events - the sale of the unit and the entry into an agreement to join a rental management program - are separated in time and are not coupled by reason of communications made during the sales process, no security is present. While the decision establishes this significant precedent, it leaves unanswered what disclosures may be made about the rental program at the time of sales. The Ninth Circuit also cautioned that the time-gap between the two agreements may not be dispositive in every case.

Developers will continue to need to be cautious about the content of their representations to a purchaser at the point of sale, and avoid promoting the purchase of the condo-hotel unit or fractional ownership by reference to the potential for income from rentals to be handled under a rental management agreement with an affiliated entity. Also, it is clear from the ruling that the length of time that elapses between the date on which the purchase agreement becomes enforceable by the developer and the date on which the buyer signs a rental management agreement did matter to the panel.
 
Cox, Castle & Nicholson’s partner, Frederick Kranz, argued the Salameh case before the Ninth Circuit.