Revak v. SEC Realty Corp.
18 F.3d 81, 1994 WL 55044 (1994)
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Rule of Law:
The sale of real estate, such as a condominium unit, does not constitute the sale of an 'investment contract' and therefore is not a 'security' under federal securities laws unless the transaction satisfies the 'common enterprise' prong of the Howey test, which requires horizontal commonality through the pooling of assets and sharing of profits among investors.
Facts:
- SEC Real Estate Corp. ('SEC Realty') developed and marketed a 484-unit condominium project in Chattanooga, Tennessee, called Lake Park Condominiums, primarily to New York investors.
- The marketing materials highlighted potential tax advantages, rental income, and capital appreciation upon resale.
- SEC Realty offered buyers the option to use an affiliated management company, Harvey Freeman & Sons, Inc., to handle services like advertising, leasing, and maintenance.
- The Offering Plan, prepared by the law firm Dearborn & Ewing, disclosed an oil and gas lease on the property but failed to mention a gas well that had been drilled on the site in 1972.
- The actual promissory notes and deeds of trust that purchasers signed at closing contained terms less favorable than the sample documents provided in the Offering Plan, such as shortening the default notice period.
- Each condominium owner was solely responsible for the rents and expenses of their individual unit; there was no pooling of funds or pro-rata sharing of profits or losses among the various owners.
- The purchasers' promissory notes and deeds of trust were subsequently assigned to Boatmen’s Bank and Sovran Bank.
- Most purchasers did not retain their own counsel for the closings.
Procedural Posture:
- New York investors filed a putative class action lawsuit against SEC Real Estate Corp., its law firm, and others in the United States District Court for the Western District of New York.
- The complaint alleged violations of federal securities laws, RICO, and common law fraud, and also sued two banks for rescission of debt instruments.
- The district court, in a series of orders, granted summary judgment in favor of the defendants, dismissing all of the plaintiffs' claims.
- The district court found that the sales were 'securities' but dismissed the securities claims on other grounds, such as the statute of limitations and a failure to show loss causation.
- The district court dismissed all other claims, including the common law fraud and RICO claims.
- The purchasers (plaintiffs-appellants) appealed the district court's final judgment dismissing their entire complaint to the United States Court of Appeals for the Second Circuit.
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Issue:
Does the sale of condominium units, marketed with an emphasis on economic benefits and with an optional management agreement, constitute the sale of an 'investment contract' and therefore a 'security' under federal securities laws when there is no pooling of rents or sharing of profits among the unit owners?
Opinions:
Majority - Jacobs, J.
No. The sale of these condominium units is not an investment contract and therefore not a security because the arrangement lacks a 'common enterprise.' To qualify as a security under the three-part test from SEC v. W.J. Howey, Co., a transaction must involve (1) an investment of money, (2) in a common enterprise, (3) with profits expected solely from the efforts of others. This court holds that a 'common enterprise' requires 'horizontal commonality,' where investors' fortunes are tied together through the pooling of assets and pro-rata distribution of profits. Here, the purchasers' fortunes were independent; one could profit while another incurred a loss, and there was no sharing of rental income or expenses. The court explicitly rejects the 'broad vertical commonality' standard—which only requires that investors' fortunes be linked to the promoter's efforts—because it improperly merges the second and third prongs of the Howey test. Because there was no horizontal commonality, the transactions were not securities, and the federal securities and RICO claims fail. The common law claims also fail due to a lack of causation for the altered documents and no duty to disclose the gas well under Tennessee real estate law.
Analysis:
This decision significantly clarifies the definition of a 'common enterprise' under the Howey test within the Second Circuit, cementing the requirement for 'horizontal commonality.' By rejecting the more lenient 'broad vertical commonality' standard, the court makes it more difficult for purchasers of individual real estate assets to bring claims under federal securities laws, even when the properties are marketed as passive investments with optional management services. The ruling reinforces the distinction between a typical real estate purchase and a security, limiting the scope of federal securities fraud protections to schemes that involve the actual pooling of investor funds and shared risk. This creates a higher bar for plaintiffs in similar real estate investment cases and provides greater certainty for developers regarding their disclosure obligations.
