Second Circuit Appellate Court Strikes Down Bodansky, Making it Unwise For Developers to Combine ILSA Exemptions


On March 15, 2011, the United States Court of Appeals for the Second Circuit (the “Second Circuit Court”) confirmed the advice we have consistently provided to our condominium developer clients:  it is not prudent for developers selling pre-construction units in condominiums with more than 99 units to rely on a combination of exemptions available under the Interstate Land Sales Full Disclosure Act (“ILSA”).  This practice, commonly known as “piggybacking” ILSA exemptions, despite being fraught with peril, is often mistakenly used by developers who believe the practice exempts them from ILSA’s registration requirements.  The Second Circuit Court resoundingly held against the developers of 5th on the Park Condominium and One Hunters Point Condominium (collectively the “Developers”), both of whom incorrectly sought to piggyback ILSA exemptions. 

 

This landmark decision has created a situation where most pre-construction condominium buildings that will contain more than 99 units will need to be registered with the Office of Interstate Land Sales Registration (“OILSR”) before a developer sells the first unit.  Developers who still wish to piggyback ILSA exemptions are now faced with substantial hurdles to qualify.  This decision will also affect dozens of similar ILSA cases across the country, in particular, several cases in the NYC-area that had been stayed pending the findings of the Second Circuit Court.  Simply put, failure to properly register with the OILSR will be very costly to developers who attempt to circumvent the registration requirements of ILSA or fail to consider the effect of ILSA before sales start.

 

Developers of both pre-construction condominiums and subdivisions that have relied on the piggybacking of ILSA exemptions should pay careful attention to this decision or they could be returning purchaser deposits years after their initial sales.

 

Previously, the Developers acknowledged that they had not registered their condominiums and had not distributed a HUD property report to purchasers – a requirement for OILSR-registered communities under ILSA.  In addition, the Developers offered units in condominiums that were each scheduled to contain more than 100 units and the units sold were not complete at the time of purchase.  Despite these facts, the Developers were able to convince district court judges in both of their cases that they were properly exempt from ILSA.  On January 29, 2010, the district court hearing Bodansky held that because the 5th on the Park developer had obtained a temporary certificate of occupancy (“TCO”) prior to selling more than 100 units in the 5th on the Park Condominium, that the sale of these units were exempt under the 100-Lot Exemption (15 USC 1702(b)(1)) and the balance of the units were exempt under the Improved Lot Exemption (15 USC 1702(a)(2)). Similarly, on March 12, 2010, the district court hearing Borden East, relying mostly on the Bodansky decision, held in favor of the developer of the One Hunters Point Condominium who had also sold less than 100 units in One Hunters Point and Hunters View Condominiums prior to obtaining a TCO and argued that the sale of its units were all exempt under a similar piggybacking scheme. 

 

Argued in tandem on January 10, 2011, the Second Circuit Court reviewed the Bodansky and Borden East cases.  The Second Circuit Court explained that the principal issue in both of these cases was at what point does a developer qualify for ILSA’s 100-Lot Exemption.  Specifically, should qualification for the 100-Lot Exemption be measured from when a developer sells its 100th non-exempt unit which would be some undefined date in the future?  The Second Circuit Court said “No!”  As a result, due to the unavailability of the 100-Lot Exemption to the Developers, they were not able to successfully piggyback ILSA’s Improved Lot Exemption to cover all the remaining unsold units.

 

The district courts also failed to consider the fact that their holdings meant that the initial purchasers of the first 99 units in pre-construction condominiums would never know if they had rights under ILSA.  For example, the initial purchasers at these condominiums would not be able to enforce their ILSA rights in the future if a developer sold more than the maximum amount after the short statute of limitation had run (2 years for right of rescission and 3 years for right of action).  These were issues picked up on by the Second Circuit Court which held that purchasers of these pre-construction condominium units were, “…entitled to know at the time of contract signing, or at a statutorily defined period thereafter, whether developers must provide them with a property report disclosing information…” about their purchase Id. at 3.  As such, the Second Circuit Court went on to explain that, “[w]hether a lot is exempt under the 100-Lot Exemption is determined as of the time a purchaser or lessee signs a contract to purchase or lease that lot.  The 100-lot exemption is not determined at an uncertain date in the future when the developer actually sells or leases (or conclusively does not sell or lease) 100 or more non-exempt lots.”  Id.   As such, the Second Circuit Court held that whether a developer is exempt from ILSA must be determined at the outset of sales, rather than at an indeterminate point in the future when a developer has made its 100th sale.  This is what we have told our clients for years.

 

It should also be noted that the Second Circuit Court took great care in explaining its justification for overturning the Bodansky and Borden East decisions.  By examining the history of ILSA, as well as Congress’ intent in its passage, the Second Circuit Court crafted a decision that sought to implement Congress’ intent while using the language of ILSA itself.  For this reason, the Second Circuit Court explained that it had more than enough support for its holding, thus declining the need to determine the level of deference it should afford to HUD’s interpretations of ILSA via HUD’s regulations, interpretative guidelines and advisory letters.

 

The Second Circuit Court also specifically declined Borden East’s request to deny relief to the plaintiff-purchasers, due to their failure to specifically allege fraud.  The Second Circuit Court explained that “…Congress gave purchasers an exclusive right to revoke and did not provide for affirmative defenses other than the revocation and limitation periods.”  Id. at 21.

 

Contrary to the advice that the Developers likely received from counsel, we have been advising our developer and financial institution clients that the piggybacking of ILSA exemptions could be problematic if litigated and advised the prescience of registrations to ensure ILSA compliance.  Unfortunately, some developers, such as the Developers in the Bodansky and Borden East cases, relied upon ill-conceived advice that such a registration was completely unnecessary.  Common factors cited by developers and some local counsel include the hesitation to provide consumers with additional disclosures, a 7-day rescission period and the unwillingness to pay the additional cost of filing a registration.  For the Developers, those decisions have turned out to be “penny-wise and pound foolish”.  Having understood the lack of clarity in this approach, we have routinely advised clients that the cost of a HUD registration (generally in the $15,000-$20,000 range for an initial submission) is an insignificant amount to spend to protect against rescission claims years later.  We also advise them that allowing a purchaser 7 days to rethink their purchase is easier to deal with than giving them up to three years to cancel their contract if they fail to properly exempt themselves.

 

Although the ultimate outcomes of the Bodansky and Borden East cases remains to be seen, it has been made perfectly clear by the Second Circuit Court, as well as a number of other courts before it, that residential developers and especially condominium developers must approach the use of ILSA exemptions with extreme caution.  Developers should employ competent counsel to review the availability of ILSA exemptions to ensure that proper procedures are in place to effectively utilize them. While we sympathize with the Developers of these two high-end New York condominium projects who feel they were dealing with nothing more than cases of buyers’ remorse, we are relieved that we have not advised clients to take such a risky approach to ILSA compliance. 

 

With experience in dealing with ILSA and ancillary interstate land sales matters dating back to the inception of these laws, Carmel & Carmel PC is available to assist real estate developers and related investors and lenders in compliance, litigation defense and other problems relating to these areas of the law.  We advise our clients that a prudent and economical compliance process is an insurance policy against wholesale rescission claims that can occur years later.

 

If you have any questions on these cases or if you would like to discuss ILSA compliance issues with someone in our office, please contact Frank Carmel at fcarmel@carmel.us or 202.237.1775.

2011-03-17