How Municipal Ordinances Can Make Condo Hotels "Securities" - Investment Law Blog

It seems that as fast as condo hotel building approvals are requested, municipal governments are responding with new ordinances to regulate these multi-use projects. In some cases, these increasingly detailed ordinance provisions are counterproductive both to the sale and operation of the condo hotel. But developers must be cautious about how they get involved in the adoption of municipal ordinances, or they run the risk of converting the offering of their condo hotel units into an offering of “securities” under federal securities law. This is a potential disaster for developers.

Participating in the Ordinance Process

Developers should be careful about working with city building authorities to craft ordinances that may provide flexibility or solve certain hotel operating issues by limiting owner use and occupancy rights. The Securities and Exchange Commission has said that restrictions on condo hotel owner use imposed by a pre-existing ordinance will not cause a project to be a security. However, if a developer uses the ordinance process to create restrictions on an owner’s use, its possible that the SEC (or a court) could decide that the restrictions imposed by the ordinance were in fact caused by the developer’s own actions, rendering the condo offering a “security.” Condo hotel developers can probably work to reduce municipally imposed restrictions on developers and owners, but these issues should be brought to the attention of officials in a conceptual way, so as to improve their understanding of condo hotels rather than providing the city with drafts of the developer’s desired ordinance provisions.

Placing Restrictions on Unit Owners

Overly restrictive use and rental conditions on condo-hotel unit owners in an ordinance could, under certain conditions, result in the condo hotel units being characterized as “securities” under federal and/or state securities laws. Although the SEC has issued “no action” letters where zoning ordinances have placed restrictions on owners, it has stated recently, in informal advice, that it will examine the totality of all restrictions and requirements on unit owners, including those imposed by zoning ordinances, in determining when condo units will be deemed “securities.” Developers should not assume that any restriction on unit owners contained in a zoning ordinance will automatically be acceptable to the SEC or other authorities in determining whether the condo units are securities.

Requiring Branded “Four-Star” Designation

One recently proposed ordinance would have required every condo hotel to be operated under a “brand” included in the “Upscale Segment” or “Luxury Segment” and, upon completion, to meet the published requirements to receive a rating of no less than a Mobil 4-star or AAA 4-diamond designation. There are many legitimate reasons that condo hotels may desire to be owner-managed, rather than managed by a “brand.” In addition, most hotels that are regarded as luxury hotels are not, in fact, holders of the actual designation from Mobil or AAA. Cities should be cautioned against placing undue restrictions upon the developer or creating unrealizable expectations for unit owners.

Regulating Common Area Ownership

One recent proposed ordinance required that the common areas of the condo hotel be owned by the developer or an entity other than the condo hotel unit owners. However, the condominium regulations of some states require that common areas be owned by a Homeowners Association, or at least have the possibility of transfer to an HOA upon certain events. This provision could cause the condo hotel to violate provisions of state law and perhaps fail to receive approval for sale to purchasers in one or more states. Regulating Hotel Management Agreements

Another recent proposed ordinance required that a condo hotel HOA enter into a management agreement with a hotel manager for at least five years. However, the condominium regulations of some states limit the duration of contracts that may be entered into by an HOA. In addition, some hotel operators may not agree to enter into a management agreement with an HOA, although they might agree to a management agreement with the developer and the individual unit owners. Management agreements are best left to the hotel professionals that enter into them and existing state laws.

Regulating Budgets and Other Operating Matters

Some ordinances require the developer to submit budgets for the condo hotel HOA to maintain the hotel. These ordinances assume that the HOA will be responsible for maintaining the hotel, but that is not the case in all circumstances. The standards for operating condo hotels, including the budgeting process, are undergoing significant changes within the industry and cities should not impede the process by micro-managing condo hotel operational matters.

Regulating With Care

Cities have legitimate reasons for imposing ordinances that protect their economic interests. But how cities address condo hotel regulation—and how developers participate in the process—can spell success or failure for all involved. Bad ordinances with unnecessary and ill-conceived restrictions will discourage good condo hotel projects that could otherwise contribute to a city’s economy. Good ordinances will benefit not only the cities themselves, but developers, residential unit buyers and the traveling public.

Catherine DeBono Holmes is the chair of JMBM’s Investment Capital Law Group, and has practiced law at JMBM for over 30 years. She specializes in EB-5 immigrant investment offerings and hotel and real estate transactions made by Chinese investors in the U.S. Within the Investment Capital Law Group, Cathy focuses on business formations for entrepreneurs, private securities offerings, structuring and offering of private investment funds, and business and regulatory matters for investment bankers, investment advisers, securities broker-dealers and real estate/mortgage brokers. Contact Cathy at CHolmes@jmbm.com or 310.201.3553.