Mountain Law: Beware: Real estate sales may violate securities law
Mention securities and most people are likely to think of stocks and bonds. So it might be surprising to hear that sale of real estate can also be considered a securities transaction. This is important because, if a transaction is found to involve the sale of a security, the seller may be required to comply with a wide range of registration and disclosure requirements imposed by securities laws. Failure to comply may subject the seller to severe civil and criminal penalties.
An illustrative case involved a Breckenridge condominium project developed by the Ford Hill Investment Company in 1971. A family called the Lowerys bought a condominium in the project and were required as part of the deal to execute an exclusive management and rental agreement with the developer. Among other things, the agreement: (a) designated Ford Hill as the exclusive agent for managing and renting the units; (b) required the Lowerys to give prior notice in writing before they could use their unit; (c) required the Lowerys to furnish and maintain their unit in a “first-class” condition; (d) required the Lowerys to pay for marketing and promotions that were carried out by Ford Hill; and (e) provided for Ford Hill to be paid a percentage of the gross rentals in addition to the marketing fee. The Lowerys purchased their unit primarily for profit and secondarily for their own recreation. When the unit did not make as much rental income as they expected, the Lowerys sued to cancel the contract under securities laws. On appeal, the Colorado Supreme Court was asked to decide whether the sale of the condominium was sale of a security (and thus whether the contract could be cancelled). The court held that a security includes “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” Applying this test to the facts, the court concluded that the sale of the condominium had involved the sale of a security … and it permitted the Lowerys to get their money back.
The Lowery case shows the general rule that if real estate is offered in connection with certain services or promoted as an investment opportunity, it may be considered a securities transaction. The Securities and Exchange Commission (SEC) has issued the following further guidance concerning sale of condominiums:
Condominiums, coupled with a rental agreement, will be deemed to be securities if they are offered and sold through advertising, sales literature, promotional schemes or oral representations which emphasize the economic benefits to the purchaser to be derived from the managerial efforts of the promoter, or a third party designated or arranged for by the promoter, in renting the units.
The SEC has specified that the following will be considered sale of a security: (1) rental pool arrangements; (2) rental or similar arrangements which require the purchaser to hold the unit available for rental any part of the year; (3) arrangements that require the purchaser to use an exclusive rental agent; or (4) arrangements which otherwise materially restrict occupancy or rental of the unit.
A person who has purchased real estate under a contract with any of these characteristics may have remedies available under securities law to recover money paid toward the investment. Developers of real estate (and their agents and brokers) should consider ways to avoid liability under securities laws such as incurring the time and expense to register the project; deemphasizing potential economic benefit that could be derived from a purchase; and not tying rental and management contracts to purchase contracts.
Noah Klug is principal of The Klug Law Firm, LLC, a general law practice in Summit County emphasizing real estate, litigation and business law. He may be reached at (970)468-4953 or Noah@TheKlugLawFirm.com.
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