The downturn of the real estate and financial markets has spurred the repositioning of existing projects and emergence of new and creative product structures which are likely to enter the market in 2010/2011. This article, written by one of the leading lawyers in this area, covers these emerging new products.

These new product types may involve conversion from one use to another, such as the conversion of whole-ownership to fractional or tenancy-in-common, or the conversion of whole-ownership to hotel use.

Some product types may be branded or involve some type of license arrangement, or be site-specific and non-branded.

Most of these new product types tend to be smaller offerings geared at the high luxury segment of the market, and targeting affluent consumers with the ability to pay cash.

From a legal perspective there are a number of state and federal laws to consider in structuring the product and the offering.

A. Conversion of Whole-Ownership to Fractional

The second home market has recently experienced an increase in conversions of wholeownership projects or units within a whole-ownership project (on a unit by unit basis) to fractional. The increasing popularity of fractionals is largely due to a tightening of the credit market and decrease in discretionary consumer spending. Further, carrying a second home in a slow rental market where there is little rental income to offset the costs of ownership, has made fractionals a more popular form of vacation ownership.

There are important legal and practical issues to consider in converting from wholeownership to fractional.

1. Zoning and Entitlements. This is a threshold legal consideration, and involves review of applicable land use and zoning ordinances, not just for permitted uses, but also for prohibited uses. Note that the state definition of timeshare may be different from or have little relationship to the definition of timeshare in local zoning ordinances. In dealing with local authorities on a conversion, important items to consider are:
1. Transient occupancy tax (TOT) revenue; fractionals typically do not generate TOT, so any plan to convert from a transient or rental use to fractional should include a proposal for payment of a TOT-in-lieu fee to make up for potential loss of this tax revenue;
2. Density of use associated with fractionals may be viewed as creating additional traffic in residential neighborhoods (negative) or as a source of additional revenue created through increased use of local commercial establishments (positive); c. Perception of conversion as decreasing available residential housing by converting single family home to vacation use.
2. CC&Rs. Private restrictions imposed through the applicable condominium declaration or master covenants may prohibit fractional interests from being created within the community or require a vote of the owners to allow fractional use. Further, in some states such as Florida, if the property which is to be converted is a condominium, unless the condominium declaration as finally recorded contains certain statutorily mandated language that expressly contemplates the creation of timeshare interests, the fractional regime cannot be legally created.


3. Additional Documentation.
1. Governing documents. Depending on the provisions of the underlying governing documents and whether the developer is still in control of the project sought to be converted, either the existing project documents can be amended to create the fractional regime or a fractional declaration can be recorded as an "overlay" to the existing whole-ownership regime. It is generally better to create a separate association for the fractional owners as additional management responsibilities typically go with fractional, such as providing and overseeing additional services and management of the reservation system.
2. Amenity membership plans. The project may provide use of resort amenities to owners through membership and use arrangements which do not contemplate fractional ownership. This may require amendment of the membership documents and overcoming complaints from existing owners that fractional ownership will create denser use of the amenities. This may depend on whether day use will be allowed and the structure of the use plan.
3. Service level. Fractional projects typically require a higher level of service than whole-ownership (e.g., daily maid service, concierge, club room service, and other hotel-type services), which will increase costs. These costs should be allocated solely to the fractional owners.
4. Reservation and use plan. The use plan/reservation procedures must be established. Establishing a use plan geared to the particular market, region and price point is one of the most critical pieces of the project. Considerations such as "floating or fixed units and use," "space-available use," and "day use" must be discussed and a program established.
5. Exchange program. Consideration of whether the project will be affiliated with an exchange company is important. There are a variety of large and small exchange companies on the market to choose from. Make sure that the resorts within the exchange are actually available for use - from a practical standpoint, very popular resorts may rarely be available for exchange or can be exchanged only with equally sought-after locations. Also note the costs associated with exchanges - affiliation fees, reservation fees and annual membership fees. Exchange documents must be provided to fractional owners.
4. Registration Requirements. Conversion to fractional ownership will require registration of the project under applicable state timeshare statutes. Also, unless the fractional product is properly structured and the purchase agreement and other documents carefully drafted, the fractional interests may also need to be registered under the Federal Interstate Land Sales Full Disclosure Act, administered by HUD. Exchange disclosures may also be required if an exchange company is involved in the offering. Consider whether nonbinding presales can be made pending completion of registration. Note that timeshare is a more highly regulated industry than whole-ownership. There are fewer exemptions from registration and registrations are more costly. Typically the disclosures required for timeshare are fairly detailed and grant purchasers a rescission right.


5. Lender Concerns.
   1. Partial lien releases. If there is a loan on the project, the lender will need to agree to grant a partial release of its lien upon the closing of each fractional interest sale; this will need to be negotiated. Lenders unfamiliar with fractional ownership will need to understand this product type and be willing to partially release the unit upon the sale of each fraction. If the fractional program does not succeed, this may ultimately result in the lender holding fractions in a partially sold unit - which creates a more difficult exit strategy for the lender. Establishing a pre-sale requirement for each unit may assist with this issue.
   2. Longer sell-out period. Due to the volume of inventory, a fractional project typically takes longer to sell than whole-ownership. The current lender must be willing to extend the loan's maturity to allow for a longer sell-out period.
6. Other Legal Considerations. Securities laws, telemarketing considerations, sales tax and transient occupancy tax issues, real estate licensing laws, and general consumer protection laws.

B. Reinventing Existing Entitlements.

1. Expanding Transient Use. Current entitlements may allow for transient use, but not fractional. Local authorities depend on transient occupancy tax revenue in these zones and may be reluctant to modify or interpret existing entitlements to allow for fractional use. Hybrid products which combine transient (hotel) use and fractional use may be created, such as selling a portion of a hotel unit as fractional and reserving certain periods or number of days use for transient hotel or rental use. Negotiation of payment of TOTin- lieu fees in connection with the fractional use can make up for potential loss of TOT revenue. This hybrid product may be a good alternative in a transient market.


2. Small, Exclusive Limited Offerings. Small offerings which do not fall within the state or local definition of timeshare may be allowed where a larger offering is prohibited. E.g., in California, registration is not required for timeshare plans consisting of ten or fewer timeshare interests. Thus, fractionalizing a home or unit and selling to 10 or fewer owners, will avoid falling within the definition of timeshare and state registration requirements in California. Note that state laws differ in this regard and the laws of the state where the project is located and where it will be marketed for sale should be reviewed to assure exemption from timeshare for small offerings. Also, note that the local zoning definition of timeshare may be more restrictive than the state definition and may still restrict small fractional offerings. In addition, small fractional offerings may be regulated as offerings under general real estate statutes.


3. Private vs. Public Club. Creating use rights in a private membership club also has its appeal in the current market. These offerings tend to be small, exclusive offerings which fly under the radar screen and are not publicly advertised.

C. Tenancy-In-Common Ownership of Real Estate

1. What is Tenancy-in-Common (TIC) Ownership? Tenancy-in-common (TIC) ownership is an undivided ownership in real or personal property by more than one owner. In the real estate context, TIC ownership is the undivided ownership of a lot, single family home or condominium unit by more than one owner. The concept is also used in common interest communities such as condominiums and planned communities, where the common area is held by all of the owners in the community, as tenants in common.


2. How does TIC Ownership Differ From Traditional Timeshare and Fractional? There may be several differences:
   1. With TIC ownership, the entire project (including units and common area) may be held in common by all of the owners, although the project declaration and use plan will establish relative use rights. In most fractional projects, each owner holds an undivided interest as tenants-in-common with a few owners in a particular unit, and with all owners in the common area. Often, fractional ownership is overlayed on a condominium regime, to provide an exit strategy by sale as whole-ownership in the event fractional is not working.
   2. In jurisdictions where subdivision is not allowed, TIC ownership can be an acceptable alternative to fractional ownership. Even right-to-use, non-deeded structures are becoming more commonplace in jurisdictions where subdivision is prohibited, but club or timeshare use is allowed.
   3. TIC ownership of individual residences can provide access to other sites through exchange programs without rendering the residence part of a multisite timeshare plan. Note, however, that TIC ownership of several individual homes/units within the same project would likely not be respected as separate offerings, but would be linked together as one offering.
   4. Typically TIC agreements for individual units or residences are simpler than a fractional declaration, but they still must include certain basic provisions which govern the use, governance, maintenance, management and payment of expenses pertaining to the property.
3. Legal Considerations. These offerings are typically regulated as the sale of real estate, timeshare or an undivided interest subdivision. E.g., in California, the sale of five or more undivided interests is considered the sale of an undivided interest subdivision, which is regulated by the Department of Real Estate, but to a lesser extent than timeshare. Further, certain sales of undivided interest subdivisions to experienced investors may be exempted from registration by the Department of Real Estate. Lastly, in California, to the extent the offering is of 11 or more undivided interests, it will be considered timeshare notwithstanding.

D. Club Structures Combining Hotel and Residential Product.

1. Combining Hotel Inventory and Residences Within a Club Structure. Creative structures which combine unrented luxury hotel inventory with luxury residential units, will likely hit the market in the 2010/2011 timeframe. These structures are being created as a reaction to low hotel occupancy, a stagnant residential sale market, the failure of condo hotels as a viable product type, and an attempt to maximize current project revenue on a short-term basis to make it through the recession.


2. How Will These Offerings be Structured and Regulated? There are a number of different structural alternatives, which will determine how the product is regulated. Regulation may be as timeshare, as a travel club, as a security, or not at all.


3. Some Examples:
   1. Hybrid Hotel Inventory. Brands may expand their repertoire of "hotel" inventory by including luxury residences (non-condo hotel) as available rooms under the umbrella of their reservation system. The hotel reservation system will be a onestop shop to reserving a variety of accommodations. If the residences are owned by the hotel owner and are not offered for sale, there is no offering to regulate. Due to brand standard and other considerations, these offerings will likely initially involve smaller boutique brands.
   2. Points Based Club. Depending on the structure, this product may be regulated as timeshare or as an exchange company.
   3. Travel Club. If structured as the purchase of discounted transient use, this offering will not be regulated as timeshare, but will be subject to general consumer protection laws.
   4. Short Term Product (1-3 year term). The offering may be exempt from timeshare or subject to less regulation, depending on the jurisdiction.
   5. Day Use Club Product. This product may allow access to certain facilities and amenities on a day-use basis, with rental of units available at discounted rates to club members.
   6. Destination Club. If structured as a destination club, the offering may be unregulated, depending on the jurisdiction.
4. This is not Condo-Hotel. These new products are not condo hotel, which involves the sale of a residential unit with the offer to rent the unit as hotel inventory.


5. Brand Considerations. What is the brand standard for this type of product? To the extent branded, the brands involved will need to stretch their definition of brand standard to allow for independent hotels and properties. Minimum structural standards such as life safety will be required, as well as a base level of operational and service standards, but there will be more flexibility to allow for specialized nuances of particular locations, allowing for a more personal level of service which varies from location to location and takes into account the attributes of iconic individual properties.

E. Private Placements. Club/fractional offerings may be structured as investments offered through a private placement to a limited number of accredited investors.

1. When is a Club Offering Considered a Security? In the context of club memberships, there are three tests which the courts have used in determining whether a class of membership is considered a security under section 2(a)(1) of the Securities Act of 1933, as amended (the “Securities Act”). If any of these test are met, then the offering is considered a security:
1. The first test examines the pertinent class of membership and evaluates whether it possesses the basic characteristics traditionally associated with “stock,” including (i) negotiability; (ii) the ability to be pledged or hypothecated; (iii) voting rights; (iv) the right to receive dividends or an apportionment of profits; and (v) the ability to appreciate in value. This test is met if the sale is made based on representations that the Club membership will appreciate in value or is offered with a guaranteed return on investment.
2. The second traditional test for “securities” was enumerated by the Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). There, the Supreme Court noted that an “investment contract” security exists in any contract or scheme where a person invests his money in a common enterprise and expects to make a profit solely from the efforts of a third party who is a promoter or is responsible for management. I.e., where a primary motive for the purchase of a Club membership is an expectation of profit from the actions of the Club (the purchaser is a passive investor).
3. The third traditional test was first articulated by the California Supreme Court in Silver Hills Country Club v. Sobieski, 55 Cal. 811, 361 P.2d 906 (1961). Subsequently adopted by other courts, the test requires that the seller solicit “risk capital for which to develop a business for profit.” 361 P.2d at 908. This test is met if the purchase money funds are paid to the Club (not held in escrow) prior to completion of all of the promised club facilities or used to construct the facilities. In such case the use of capital is considered "at risk."
2. Reg D Private Placement as an Alternative to Registration. If the offering is considered a security, it can be structured as a "private placement" or exempt offering under Regulation D promulgated by the Securities and Exchange Commission (SEC). Regulation D is a series of six rules, Rules 501-506. Rules 504-506 set out specific offering exemptions, with Rule 506 being the most popular because the offering has no dollar limitation. Rule 506 provides an exemption for offerings sold to not more than 35 non-accredited purchasers and an unlimited number of accredited investors. An "accredited investor" is a purchaser whose net worth either individually or jointly with their spouse equals or exceeds $1 million, or whose income is in excess of $200,000 in each of the two most recent years and who reasonably expects income in excess of $200,000 in the current year (or $300,000 jointly with their spouse). While the threshold for an accredited investor is fairly low, making the exemption attractive, general advertising or solicitation is prohibited which significantly restricts marketing efforts. Thus, private placements are more appropriate for smaller exclusive offerings made to high net worth individuals with a pre-existing relationship to the issuer. A Private Placement Memorandum and Subscription Agreement are typically given to purchasers, which provide some description and disclosures regarding the offering. These documents are much simpler and provide much less information than what is typically required in a timeshare filing under state laws.


3. Relationship to Real Estate Laws. While a Club offering structured as a private placement may technically still be considered a real estate or timeshare offering, state regulators are less likely to require registration under real estate statutes if the offering is considered a security subject to Reg D.

F. Expansion of Recreational Amenity Memberships to Include Residential Use.

1. Adding Residences or Cottages to your Golf Membership Club, Beach Club or Amenity Club. Golf membership clubs and other private amenity clubs have had a difficult time over the past years supporting operational and maintenance costs through membership. This is particularly true with private clubs which do not allow public play to offset these costs. This situation has been further exacerbated by member defaults in payment of dues and high resignation rates. Increasingly, private clubs are being forced to consider creative ways of reducing maintenance and operations costs. To the extent the club owns vacant land, we are increasingly seeing Clubs consider developing this land as an integrated program with the Club.


2. Zoning and Entitlements. Key to this concept is obtaining appropriate entitlements. While some Clubs may not allow residential development, residential use as incidental to private Club use may be allowed.


3. How to Structure a Residential Membership Category. Development is typically some sort of residence, cottage or condominium, which is either sold as deeded real estate with a mandatory membership attached, or is owned by the Club with use rights granted through creation of a separate category of Residential Club Membership which allows exclusive use of a residence for a certain number of nights per year in addition to golf and other Club privileges.


4. Public vs. Private Membership. To the extent the residential use of Club residences is to be offered to only Club members, then a private membership class is preferable due to the ability to control membership and the residential facilities. However, if reaching a broader group of potential purchasers is the goal, then offering residential memberships to the public is the best structure. Note that there are limitations on the ability to control club memberships when selling to the public, whereas with a truly private club, membership approval can be discretionary. However, note that while private club documents may make sale of a residence contingent upon approval of the purchaser as a Club member, there are legal limitations on the ability of the Club to actually disapprove a purchaser for Club membership. For example, if a nexus is created between a private Club and the public (e.g., via bank financing of membership interests, registration with the Department of Real Estate, or leasing of city property to the golf course), the Club will not be able to arbitrarily disapprove Club members.

SURVIVAL IN THIS MARKET REQUIRES:

• Creative ideas and structuring
• Thinking outside of the box
• Establishing new relationships
• Re-thinking and re-inventing your product

Lynn Cadwalader

Lynn K. Cadwalader is a partner in the San Francisco Office of Holland & Knight, and co-chair of the firm's Global Hospitality Resort and Timeshare Group. She is admitted to the bar in both California and Colorado, and maintains an active practice in the U.S., as well as in Latin America, the Caribbean and Asia.