11 July 2013
In Asia, we have been seeing more strata-sale of hotels by property developers in recent years. This usually involves a developer selling hotel units to individual purchasers who then put the hotel units back into the hotel inventory to be rented out to third-party guests. Such individual purchasers receive the benefit of any rental profit from the operations of the hotel.
In Hong Kong, the first time a developer sold units of a hotel located in Hong Kong to individual purchasers ended up in the unwinding of the sale as the Securities and Futures Commission (SFC) asserted that the developer had not obtained the necessary approvals from the SFC. The SFC considered the sale to be a Collective Investment Scheme (CIS) as defined in the Securities and Futures Ordinance (SFO). This article discusses the recent unwinding of the sale of the Apex Horizon hotel in Hong Kong and its implications for hotel developers and operators.
Summary of the Apex Horizon sale
In February 2013, Hong Kong property giant Cheung Kong sold 360 hotel units at the Apex Horizon hotel to individual purchasers. The SFC formed the view that the offer to purchase hotel units at the Apex Horizon was an invitation to acquire an interest in or to participate in a CIS under the SFO. This requires the SFC's approval in respect of promotional materials prior to the sale. Prior approval had not been sought. The SFC accordingly took the view that the sale was unauthorised. Cheung Kong avoided legal proceedings by agreeing with the SFC to unwind the sale. This meant that Cheung Kong would refund to purchasers deposits and part payments in respect of the units together with interest at 2 percent per annum above the prime rate plus HK$10,000 to each purchaser for legal and other expenses. However, more than 27 purchasers who resold their units to a third party through confirmor transactions might suffer more losses. It remains to be seen whether these sellers of the confirmor transactions would claim more compensation from Cheung Kong.
What is a Collective Investment Scheme in Hong Kong?
The SFO provides that a CIS has the following four key elements:
- it is an arrangement in respect of a property, which includes land in Hong Kong or elsewhere;
- participants do not have day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions in respect of such management;
- the property is managed as a whole by or on behalf of the person operating the arrangements or the contributions of the participants and the profits or income from which payments are made to them are pooled; and
- the purpose or effect of the arrangement is for participants to participate in or receive profits, income or other returns from the property.
The SFO contains certain exceptions to the above such as employee investment schemes and certain types of franchise arrangement.
There is an important point to note in relation to the third element above. Whether or not the rental income is pooled or unpooled does not make a difference, as long as the property is managed as a whole by the developer or an operator on behalf of the developer. Pooling of rental income usually means that the rental income from all the hotel units is pooled together and, after deducting expenses, distributed to the individual owners based on unit size and other relevant factors. Unpooled rental income means each individual owner receives rental income from his specific unit only, after deducting expenses applicable to that unit.
In the Apex Horizon sale, the rental income was unpooled and the sale and purchase agreements between the purchasers and Cheung Kong provided that the hotel units were to be sold subject to the hotel operation agreement with the hotel operator. The SFC took the view that all the essential elements of a CIS existed. In particular, the SFC pointed out that the day-to-day management of the hotel was to be in the hands of a separate operator appointed to operate the hotel and which would control key functions such as allocation of guests to rooms.
Why do developers strata-sell their hotels?
Strata-sale of branded hotels has historically been fraught with difficulties in many countries. That is why most international hotel operators have been reluctant to agree to such a structure. Some of the difficulties include having to comply with the regulatory regime in the relevant countries and operators losing control over the physical quality of the property due to certain statutory rights of individual owners, therefore putting their brand at risk. In some jurisdictions, it is hard for the developer to ensure that all individual owners of the hotel comply with their obligations to maintain the hotel at the required standard. There may also be concerns that the majority owners may seek to remove the operator.
Then why have developers and operators still been willing to adopt this structure recently? For developers, this is a good way to finance a project. It usually takes many years for a hotel developer to recoup its initial investment in a hotel, but strata-selling a hotel enables a developer to receive significant cash injection early on. Cheung Kong raised around HK$1.4 billion from the sale. In many instances, the developer may seek to retain ownership of some or a majority of the units to mitigate the risks discussed above. For operators, although it is riskier than managing a hotel solely owned by one party (i.e., the developer), sometimes they may agree to a strata-sale structure as a way to win a management contract noting that some competitors will avoid this approach.
Implications for hotel developers and operators
Although the Apex Horizon case was not tested in the Hong Kong courts, it would seem that what industry players usually call a strata-sale of a hotel would normally contain all the four elements of a CIS discussed above. Accordingly, the SFC's authorisation of the advertising and marketing materials would be required, unless the project falls within the exceptions in the SFO. The materials are required to contain sufficient details of the features of the CIS as well as the risks involved. These requirements are aimed to ensure that members of the public are properly and accurately informed about the key features of a securities product when making a decision to invest.
If you are a developer or operator planning a strata-sale structure for your hotel project, obviously you will need to obtain legal advice at an early stage regarding whether your proposed sale will likely fall within the meaning of a CIS under the SFO in Hong Kong or may be subject to similar regulatory regimes in other countries.
One important point to note is that the provisions of the SFO cover "land in Hong Kong or elsewhere". So even if your project is located outside Hong Kong, if you plan to market your sale to Hong Kong investors, you will still need to consider if it will amount to a CIS. If it does, you will have to factor in the extra time and costs involved for obtaining such approvals.
If you are not sure whether your proposed strata-sale of hotel units amounts to a CIS in Hong Kong and you do not wish to dive into the preparation of detailed advertising and marketing materials to comply with the approval requirements of a CIS, what can you do? In Hong Kong, there is no established channel available to obtain any clearance from the SFC regarding whether a proposed sale amounts to a CIS that precedes formal submission of the advertising materials for the SFC's approval. However, that does not prevent you from writing to the SFC, providing the details of the proposed sale and asking for its confirmation on whether the sale would amount to a CIS in the SFC's view. It remains to be seen whether the SFC will commit to any formal confirmation in this regard. If strata-sale of hotels becomes more popular in Hong Kong, perhaps the government can consider empowering the SFC with the ability to provide such confirmations. In the meantime, caution is required in strata-selling hotel units or other similar products to the Hong Kong market.
For more information, you can refer to the SFO and the Code on Unlisted Structured Investment Products (available on the SFC's website) which contains guidelines for the authorisation under the SFO of a CIS and other unlisted structured investment products and the issue of offering documents and advertisements to the public in Hong Kong.