IS ACONDa"lINIUM ASECURITY?
LOWELL IJ\SLEY
As in any real estate transaction in which a building
is to be erected, acquisition of a unit in a proposed con, dominium involves several risk-bearing features.
stands to suffer a financial loss if the developer
The buyer
i~
un-
scrupulous, inadequately financed or has received poor
advice in planning the condominium.
The purpose of this paper is to determine whether or
not this risk is sufficient)or sufficiently different from
the usual real estate transaction/to subject condominium
sales to the registration requirements of the Securities
Ac t
0
f
1933. (X l)
An analysis of the question must begin with section
2 (1) of the, 1933 Act which defines a security as "any
note, stock, treasury stock, bond, debenture, evidence of
indebtedness, certificate of interest or participation in
any profit-sharing agreement, collateral-trust certificate,
preorganization certificate or subscription, transferable
share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided
interest in oil, gas, or other mineral rights, or, in general,
any interest or instrument commonly known as a 'security,'
or any certificate of interest or participation in, temporary
or interim certificate for, receipt for, guarantee of, or
warrant or r ight: ,t,-'o , subscr ibe to . or purchase" any of the
.
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2
foregoing." (2)
It is evident from this definition that
Congress intended the term "security" to cover a "number
of offerings other than those usually brought to mind by
securities traded on the various stock exchanges.
While the sale of parcels of real property are not
ordinarily considered to be within this definition of a
security, the term "investment contract" has been given
' a very broad definition and real estate interests have
often heen held to be securities. (3)
"Although no court has yet purported to set out a
definitive test for determining what interests are securities, two essential characteristics have evolved:
(1) pur-
chasers must be led to invest with the expectancy of a
return; and (2) the investor must intend to rely solely on
the efforts of others ' to realize the return.
(4)
The intention to rely on the efforts of others is
often inferred by the courts if the investor does not take
an active part in producing the expected benefit.
In
'SEC v. ' Joiner Corp (5) the defendant obtained oil leases
which required the defendant to ,dri11 a test well and the
defendant arranged with another lessee to have a well dug.
The defendant advertised by mail for , the resale of 1ease' hold 'subdivisions of ;,very , small acreage.
The advertising
emphasized the charactet:,: of the purchase as an investment
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and as a participatien in an enterprise.
The ceurt held
that the sale ef these leases censtituted the sale ef securities.
In reaching its decisien the ceurt inferred an in-
tentien to. rely en the efferts ef ethers because the
purchasers lived leng distances frem the tracts, were inexperienced in develeping, buying ·and selling eil preperty,
and ,the premeter represented he weuld resell the leases fer
the purchaser.
,T he r.,emaining
element' ef, a security--that it represent
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an interest in a plan managed fer the prefit ef the investoz:; ...-may lynQ,c lenger be an essential element ef a security. ·
This pessibility is raised by Silver Hills Ceuntry Club vs.
Sebieski.
(~).
The case invelved the sale ef charter mem"
berships in a ceuntry club which the develepers planned to.
construct.
The agreement provided that the members were to
have no rights in the income er assets of the club.
The
defendants contended that a membership was net a security
because it was purohased not fer investment but fer the use
and enjeyment ef the purchaser.
The court rejected this
contention and held the memberships were securities.
Altheughthe decision was based en state law, the ceurt
stated, in language which could apply 'to. federal securities
laws:
"..
4'
[the blue ' sky law] defines a security broadly
te : pretect the ' public against: spurie~s sche~es, hewever
4
ingen~iously
devised, to attract risk capital.. • • [the
promoters] are soliciting the risk capital with which to
. develop a business for profit.
The purchaser's risk is not
-lessened merely because the interest he purchases is labeled
. a membership.
Only because he risks his capital along with
other purchasers can there be any chance that the benefits
of club membership will materialize."
(7)
It is apparent that this risk factor could easily cause
.'all condominium
sales to, be classified as securities if this
test were adopted by the federal courts.
The recent case of Mr. Steak, Inc. v.River City Steak,
Inc. (8) indicates that the federal 'c ourts might adopt the
test of Sobieski if the court felt it was necessary to protect . the investor '.
Mr. Steak, Inc. (Steak) sued River City Steak (River)
for breach of its ·franchise agreement when River defaulted
on rental and insurance payments.
River counter-claimed
arguing that Steak in effect sold it a security without the
benefit of a Securities. Act registration because the terms
of the franchise amounted to an investment contract.
The court held 'that the franchise agreement was not a
. security • . .The rationale for ' the decision was based on the
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franchises , potEmti~~to - cont~ol . the ' busi'n ess which the
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~ourt
felt placed it beyond the role of an investor.
~ascontrasted
This
with the usual investor--promotersituation
· w~erethe skill ot' ingenuity of the investor does not determine the success or failure of the venture and where
the investor's fortunes parallel those of the promoter.
The court also considered the "risk capital" argument
derived from Sobieski as a valid test for a security but
implied that this test was only to be used if the financial
· position of the franchisor was such that the venture was
highly spec,u lative.
While almost all condominium developments in the
United states are entirely owner-occupied units, (9) there
is a growing trend among builders to utilize in their mar- .
keting campaign the economic advantage to the owner of
renting his unit when it is not occupied by the owner.
This is particularly true in areas that are traditionally
· vacation or leisure oriented areas. . The rental approach
expands the potential market in these areas to include outof-state purchasers who can only be present in the vacation
area for a small fraction of the year and to wealthy individuals who are highly tax conscious.
They not only are
allowed deductions for +eal property taxes and mortgage
interest but also .insurance, · maintenance and other dequqtior.s allowed for income producing property for the portion
of year that
ii
is ac~ually r~nted.
6
In the usual rental agency agreement the managing
agent is designated as the owner's representative to lease
their units to third parties.
All owners who participate
are usually part of a rental pool to assure equality in
the income received from all rentals.
The following ex-
cerpt from the sales brochure of a Florida condominium is
illustrative of the promotional material describing such
a plan.
(10)
• AFFECT OF AVERAGE OCCUPANCY ON INDIVIDUAL INVESTOR
WITH A 66% OCCUPANCY RATE
', 1.
Cost , of Unit ••••••••••••• '••••• '••• ,••••••
Cash investment ••••••••••••••••••••••
$22p125.00
Mortgage--21 years at 6%
,
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Annual Rental Income, I at, 66%
Occupancy ••••••••••••••••••
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t
•
$8,080.00
3. , Expenses Deductib~e from
Annual Income
'
Maintenance ••••••• '....... ...~ .,'. , ;$ :' 660.00
Property Taxes ••••••••••, •• '.' •• "
648.00
Insurance •••••••••••••••••• ~~
132.00
Interest on Mortgage ••••••••• $1,312.00
Total Deductible Expenses.,. ',. $2,752.00
4. , Mortgage Amortization (An
increase in Equity not , ,
deductible from Income). n
4A.
, 5.
533.00
•••
Total Fixed Expenses ........... $3,285.00
Depreciaton (Example 1st
year) (200% Declining B~lance)
1,397.00
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Total Operating Costs •••• ~~.
Less , non-deductible Items
of Mortgl:igeAmortization...
6.
$29,500.00
7,375.00
'
~ $4,682.00
533.00
Total'Dedu6tibile Items....... .$4,149.00
7
Annual Rental Income ••••••••••••••••••• '•• $8,080.00
Total Deductible Items ••••••••••••••••••• 4,149'.00
~ 7.
Before Tax Profit •••••••••••.•••••••••••• $3,931.00
8.
Percentage of Profit on Invested Cash:
Before Tax Profit
3931 '
Cash Invested
~ = 53.4%
9.
Percentage of Profit on Total Capital Commitment:
'Before Tax Profit
3931
Total Commitment
29,500 = 14%
I t :.would , seem : that ::any:-sa1e :::made as a result of this
type of promotional campaign has the essential characteristics of a security.
The reliance on others is present
in the rental agency agreement to establish this element
because the owners usually live long distances from the
' condominium~,
are often inexperienced in developing and
renting real estate, and the promoters rent and manage the
property for the absentee owners.
The requirement that it represent an interest in a plan
managed for the profit ,of others would seem to be relatively
' easy to establish by merely introducing the promotional
brochure as evidence.
Agencies other than the courts who , are responsible
for the control of securities sales have also indicated
that plans' utilizing a rental agencY , agreement in apartment
' or condominium development may ' be: E1ubject ' to registration
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requirements. ;, For example,
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rulin<;1 ,of ' the Attorney General
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of Hawaii recognized that a condominium sale is ordinarily
not the sale of a security but recognized that it could be.
" • • • if there is an agreement between the owners and the
developer to rent the apartments rather than occupy them,
we feel the agreement becomes a common enterprise for profit.
It the :. p1an is to have the developer or some other person
manage this rental operation, investors would be 'led to
expect profits solely from the efforts of the promoter or
some third party' which is an 'investment contract' within
Sec. 199-1(1), Revised Laws of Hawaii 1955, as amended.
SeE.C. v. Howey, 328 u.S. 293 (1946).
Whatever the form
of the evidence of participation in the management agr.eement, it should
b~
treated as a 'security,' since it is
'immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in
the physical assets employed in the enterprise.
v II
((I).
The Securities and Exchange Commission has also indicated that developers. should make a thorough investigation
before they use a profit sharing agreement in the sale of
real estate.
In
a Securities and Exchange Release the Commission said:
"Under the Federal Sec.u rities Laws, an offering of limited
partnership intere~~sand interes~sin' jointot profit sharing real estate ventures. ·generallY constitutes an offering
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of a 'profit sharing agreement' or an 'investment contract'
which is a 'security' within the meaning of Section 2(1)
of the Securities Act of 1933.
th~t
The Supreme Court has said
an 'investment contract, transaction or scheme whereby
a person invests money in a common enterprise and is led to
expect profits from the efforts of the promoter or a third
party. 1/ In other words, the investor provides the capital
and shares in the risk and the
profits~
the promoter or
third party manages, operates and controls the enterprise,
, usually without active ' participation on the part of the
, investor.
Any such investment contract is also deemed to
be a security under the laws of Maryland, Virginia and the
District of , Columbia, as is explained hereafter.
"The investor's interest in the enterprise ~ay be evidenced by formal certificates or by part ownership of the
assets used in the enterprise. , In
determin~ng
what is an
,investment contract, substance and economic reality prevail
over the form of the transaction involved.
Interests in
novel and uncommon ventures fit the broad definition of an
'investment contract.' ' irh~refore, if' the promoters of a
real estate syndication offer investors the opportunity to
, share in the profits of real estate syndications or similar
'
,
ventures, particularly when
~here ' is , ~o,
active participa-
tion' in the mariagement and operation of ,the scheme on the
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.part of the investors, the promoters are, in effect, offer~nga
'security.'
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"'When these securities are offered publicly by the use
' of the mails or any means or instruments of transportation
or communication in interstate commerce, they are required
to be registered with the Commission under Section 5 of
, the Securities Act of 1933, unless an exemption from the
registration requirements is available.
Generally, any
offering of these securities through newspapers, magazines
. or other advertising media would be a public offering which
, is subject to registration." (12)
On April 12th of .1967 the S.E.C. obtained a permanent
injunction restraining the Flagship Motor Hotel of Ocean
City, Maryland, Inc., and related parties, from violation
of the registration and anti-fraud provisions of the 1934
,Act in the offer and sale of units with a rental contract
in the hotel and any other securities venture.
The Com-
mission's complaint alleged that the defendants had sold
"investment contracts;" Le., interests in a proposed resort
motor-hote~,
service.
together with rental f management and other
Moreover, "investors were solicited on the basis
that an investment in the pr6posed ,motor' hotel would return
"
to ·them sufficient income to pay all ·monies due , on their
, investment 'and, in ' addition, ' wouldYi~ld'· profits ..in the form
.
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of a cash return or a vacation at little or no cost."
Such
a sale, without prior registration pursuant to Section 2(1)
of the Securities Act, was challenged as unlawful and ultimately led to a consent decree. (13)
These illustrations indicate that marketing programs
6f condominiums which utilize rental agency features raise
a strong possibility that the registration requirements of
,the securities laws
app1y~
However, most condominiums do not utilize rental agency
agreements but are occupied by the owners as their permanent
homes.
But tne cases would seem to indicate that they will
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not be concerned with the fact that these are purchases for
homes if they feel there is a need to protect the purchaser
and the characteristics of a 'security are present.
When the developer receives an investment of capital
from the purchaser in exchange for the developer's promise
to build, the facts are very similar to Sobieski and the
benefits
deri~ed
from a home aDe obviously more substantial
than those from a membership in a country club.
However q it is difficult to distinguish this from the
conventional subdivision development of single family dwellings, though it ' might be argued that the ' sale of a condominium unit is not ' a ': simp1e ,i ': typica1 real , estate trans, action. ,
12
If the condominium is already constructed and there is
merely a sale and delivery of the deed there would seem to
be no risk involved unless the developer has promised to
perform additional acts.
(14)
Additional acts such as con-
structing .a recreational area, paying assessments of unsold
units on the common elements or selling the other units on
similar terms, however, make the situation very similar to
Sobieski.
The owner'ship of the common elements and the relationship of the owners under the management agreement also create
features which may have the characteristics of a security.
The common elements are owned by all unit-purchasers
without, the , right of severance. (15)
There
is no expec-
tation of monetary gain present but this element would be
unnecessary under the Sobieski test.
However, the unit owner
has all the rights and privileges in the common elements
that he expects to receive from the developer when he pur, chases the unit.
Therefore, it would seem that common
,ownership of , the common elements would not create an expectation of future benefits which
under the 1933
would~~quire
registration
Act~'
The managementt ,agreemertt"
,
however ', presents more diffi,
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cult problems~ ' It:' 'is ' a contract whic? "'i s ' a part of the
or ig inal purchase and is , nci>t:. ;hegotiabiEl ia~,ter the purchase.
(16)
13
The terms of the management agreement may be extremely
important to the realization of the benefits and enjoyment
which
~he
unit owner expects to receive from his ownership.
If the management board has broad discretion to, regulate
the manner in which the unit owner may live, the benefits
derived may be more dependent on the management board decisions than on the decisions of the unit owners. (17)
This then is very similar to the relationship between a
shareholder and a corp-oration.
However, it seems that the
purchaser receives an immediate quid pro
ments paid to management in the
fo~m
~
for the assess-
of benefits for which
he would otherwise have to pay for on his own.
It can ,be seen then that it is difficult to determine
whether or not the sale of an owner occupied condominium
unit is subject
tb ', ~ registration
under the 1933 Act.
If it
were to be declared a security, it would seem to be because
money is supplied for an operation in which the purchaser
has a fractional, continuing beneficial interest , ~nd ,· : that
the operation is managed by others who d'e termine the benefits to be received by the purchaser.
Whether or not the sale of a condominium interest constitutes the sale of a security also seems to depend more
upon the point in time when the interest is offered for sale
and , the type of agreement utilized. ," It seems that this is
"
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a matter which should be resolved by the legislative bodies
before it becomes necessary for the courts to decide the
issue.
Resolution by the courts would result in so many
uncertainties that it would be impossible fora developer
to know whether or not his development was subject to the
registration requirements.
Also the registration require-
ments are often so oomplex and expensive that smaller condominium units could not be built unless they qualified for
an exemption under the 1933 Act.
This is also an area
that the Securities and Exchange Commission would not seem
to be prepared for and that any regulations on the sale of
condominium units should be under the control of the real
property sections of state law.
However, if legislatures are reluctant to impose controls on the sale of these units and there should be substantial losses bY , investors or :purchasers, then the Security
and Exchange Commission would probably not wait for any
iudicial or
legislati~e action~
(18) ,
Therefore, it appears that any devei'loper who is planning to d'e velop a "condominium unit should carefully evaluate '
'.
'
his plan to aV6id ' any, p6Ssibility ' ~r ' at :least determine
whether
or 'notL',he:: ' might, b~ ' l~~b;e :. unde~' : " thesecurities
acts.
FOOTNOTES
1~
15 U.S.C. §77 (1964) Referred to hereafter as the
1933 Act.
2~
15 U.S.C. §77b(1) (1964). The definition of security
in the Securities Exchange Act of 1934, 15 U.S.C.
i78c(a) (10) is "virtually identical" to that contained
in the 1933 Act. Tcherepnin v. Knight, 389 U.S. 332,
336-37 (1967).
3 • . SEC v. W. J. Howey Co., 328 U.S. 293 (1946); SEC v.
Joiner Corp., 320 U.S. 344 (1943); Oil Lease Servo
Inc. V. Stephensbn, 162 Cal. App.2d 100, 327 P.2d
628 (1958); People v. Yant, 26 Ca1.App.2d 725, 80
P.2d 506 . (1938). Contra, State v. Hirsch, 101 Ohio
App. 425, 131 N.E.2d 419 (1956).
~, 4.
, People v. Syde, 37 Cal.2d 765,235 P.2d 601 (1951);
Austin v. Hallmark Oil Co., 21 Ca1.2d 718, 134 P.2d
777 (1943); Lewis v. Creasey Corp., 198 Ky. 409, 248
S.W. 1046 (1923); State V. Silberberg, 166 Ohio 101,
139 N.E.2d 342 (1956); Osuna v .~. Russell, 176 Cal.
App.2d' 110, 1 Cal. Rptr. 289 (1959); People v. Steele,
2 Cal. App.2d 370, 36 P.2d 40 (1934); 1 Loss, Securities Regulation 491 (2d ed. 1961).
5. · 320 U.S. 344 (1943).
6. · 55 Ca1.2d 811, 361 P.2d 906, 13 Cal. Rptr. 186 (1961) •
.. Referred to hereafter as Sobieski.
7.
55 Ca1.2d at 814, 815, 361 P.2d at 907, 90S, 13 Cal.
Rptr. at 187, 18B.
S.
460 F.2d 666 (10th eire 1972).
9.
This article is written on the assumption that the
reader is familiar with the characteristics of a condominium. , For general information on the condominium
concept, see Condominium--Home Ownership for Megalopolis,
61 Michig~ri D~; Rev. 1207, practicing Law Institute,
Cooperatives and. Condominiums, (Monograph) (1969) . '
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10..
For a reprint of the complete brochure covering this
condominium project, see Practicing Law Institute,
Cooperatives and Condominiums (Monograph), 357-63
(1969) •
11.
1 Loss, Securities Re~ulation 486 (2d ed. 1961).
12.
"Securities Act of 1933 Release No. 4877; Maryland
Securities Act Release No.1; Virginia Securities Act,
Release No.1; and District of Columbia Securities
Aqt Release No.9" (Aug. 8, 1967).
,13.
Securities and Exchange Commission, Litigation Release
No. 3691 (April 13, 1967).
14.
The Sobieski decision implicitly excluded the sales
of interests in existing facilities where the risks
of defective operation and failure of cooperation are
also present. Nevertheless, some condominiums have
proved unsuccessful; in the main these ventures appear
to have been poorly planned or merchandised. After
one such collapse, a study disqlosed that the market
aimed at simply did not exist in the parti~ular communi ty. Excessive land costs', an over-supply of rental
apartments in the vicinity, and failure to provide
modern conveniences, have also proved damaging. Institutional lenders, anticipating possible marketing difficulties, frequently insist upon stand-by plans for
.
conversion to a rental property. Failure of a development to come to a fruition as a condominium is not
too tragic an occurrence, provided the builder is stable
or has not made use of the purchaser's money to finance
construction. But where the building corporation .is
a mere shell and buyers' funds have been utilized, their
investment may be lost to mechanics' liens and a construction loan foreclosure.
Practicing Law Institute,
Cooperatives and Condominiums 305 (1969).
· 15.
See Hemingway, Condominium and the Texas Act, 1 Houston
226(1966), for a discussion of condominum
ownership of the common elements and the management
. agreement in Texas.
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~Rev.
16.
Id.
17.
An exampl~ , f,ront a typical: management, agreement indicates
.this type 'of . hrpaCl , :po,w er,s.
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Limitation on Use of Units and Common Area. The Units
and Common Area shall be occupied ,and used as follows:
(a) Except in the case of commercial Units, no
Owner shall occupy or u~e his Uni~, or permit the same
or any part thereof to be occupied or used for any purpose other than as a private residence for the Owner
and the Owner's family or the Owner's Lessees or guests.
(b) There shall be no obstruction of the Common
Area. Except in the case of designated storage areas,
nothing shall be stored in the Common Area without the
prior consent of the Management Committee.
(c) Nothing shall be done or kept in any Unit or
in the Common Area which will increase the rate of
insurance on the Common Area, without the prior written
consent of the Management Committee. No Owner shall
permit anything to be done or kept in his Unit or in
the Common Area which will result in the cancellation
of insurance on any , Uni t or any part of the Common At,ea,
or which would be in violation of any law. No waste
will be committed 'in the' Common Area.
(d) No sign of any kind shall be displayed to the
public view on or from"iany Unit or the Common Area,
without the prior consent of the Management Committee.
(e) No animals, livestock or poultry of any kind
shall be raised, bred, or kept in any Unit or in the
Common Area, except that dogs, cats or other household
pets may be kept in Units, subject to rules and regulations adopted by ,the Management Committee;
(f) No noxious or offensive acti~ity shall be
carried on in any Unit or in the Common Area, nor shall
anything be done therein which may be or become an
annoyance or nuisance to the other OwnersJ
(g) Nothing shall be altered or constructed in or
removed from the Common Area, except upon the written
consent of the Management Committee;
(h) There shall be no violation of rules for the
use of the Common Area adopted by the Management Committee and furnished in writing to , the Owners, and the
,Management Committee is authorized -to adopt such rules.
18
(i) None of the rights and obliqations of the Owners
created herein, or by the Deed creat:ing the condominiums
shall be altered in any way by encroachments due to settlement or shifting of structures or any other cause.
There shall be valid easements for the maintenance of
said encroachments so long as they shall exist; provided,
however, that in no event shall a valid easement for
encroachment be created in favor of an Owner or Owners
if said encroachment occurred due to the willful conduct
of said Owner or Owners.
Practicing Law Institute, Cooperatives and Condominiums,
502 · (1969) •
IS.
Speaking before the Fourth National Real Estate Con. ference, SEC Chairman William J. Casey said uniform
regulation" of ' the fast .... growing rea.l ' estate :··tax shelter
area is required. He indicated that the report of
SEC's Real Estate Advisory Committee, due within the
next few weeks, will recommend creation of a permanent
body to harmonize the morass of conflicting requirements. Casey said it was possible that a real estate
syndication complying with SEC disclosure requirements
would be violating state reguirements. New rules will
be issued to clarify the intrastate and private offering exemptions, but Casey warned many unregistered real
estate syndications that their reliance on those exemptionsmay be unwarranted. . He called on state securities administrators to hold off implementing new rules
on real estate tax shelters until uniformity can be
certain. Casey also urged more regulation of sales practices and sales and promotional compensation.
Reported in Securities Regulation Report, . Prentice
Hall,· October 4; 1972. .
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