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Monaco (Sanders) decision – village units not a security

by Stephen on March 5th, 2018


At the end of last month, the Court of Appeal released a decision overturning the High Court on the question of whether purchasers were entitled to escape their purchases of units in the Monaco Hotel and Resort development near Nelson on the basis that the purchase agreements constituted void allotments of securities under the Securities Act 1978. The result of the earlier High Court decision was that the sole director of the developer was ordered to repay the subscriptions (i.e. the purchase price plus interest).

The key issue on appeal was whether the offers to sell the units in the Monaco development amounted to offers of (participatory) securities. There were five subsidiary issues addressed by the Court of Appeal including whether the default in repayment of subscriptions was due to any misconduct or negligence on the part of the director – thereby blocking the relief available to the director in terms of the proviso in section 37(6) of the Securities Act.


The back story and the legacy of Securities Act issues affecting the Monaco development is a long one. A potted history of the relevant parts of that back story for the purposes of this note is:

• In 2003, the hotel component of the development was marketed using a standard form “hotel lease” – providing for a rental based on the gross unit revenue pooled from all hotel units. After deduction of costs and a management fee, the pooled revenue would be allocated based on the purchase price paid for a particular hotel unit expressed as a percentage of the total purchase price for all hotel units.

• Income pooling was then identified as a Securities Act issue and, in 2005, the Securities Commission granted an exemption for participatory securities for the proportionate ownership scheme offered under the hotel lease. The exemption was supported by an enforceable undertaking – requiring the re-offer of the hotel units to those who had applied for them. (The Court of Appeal judgment notes that all parties, including the Securities Commission, regarded the income pooling arrangements under the hotel lease as giving rise to the Securities Act issue and that there would be no such issue if the income for each unit was accounted for separately).

• The Monaco development had run into financial problems and further funding was needed. Westpac Bank (and subsequently Lombard Finance) agreed to provide this funding on the condition that the question of the income pooling under the hotel leases was addressed – and an individual accounting structure was adopted for the leases offered in connection with the sale of all further units. This led to the “cottage lease” being developed in 2005 – which was used for all subsequent sales.

• The purchasers only acquired their individual units for which separate certificates of title were issued. They did not acquire any estate or interest in the associated amenities.

• The cottage lease provided for a rental stream calculated by:

o aggregating the revenue actually received for letting the particular unit; and
o deducting outgoings relating to the unit and outgoings relating to the conduct of the business from the unit (which included a 20% management fee).

• Because the hotel manager as lessee managed all of the units and guest allocation, the cottage lease contained a provision requiring it to use reasonable endeavours to ensure that the allocation is fair and equitable. This was relied on by the investors to support their argument that individual unit owners had rights to participate in the earnings of other unit owners in the same complex and the offers therefore amounted to securities for the purposes of the Securities Act.

• In 2013, five years after settling the purchase of their units, the investors issued proceedings against Monaco and its sole director. They did not claim that there had been any pre-contractual misrepresentation in the forecast returns or any breach of the leases. Instead, their sole claim was that the offer inviting them to purchase units subject to the cottage lease was an offer of a ‘participatory security’ to the public in breach of the Securities Act because there was no authorised advertisement or registered prospectus and no statutory supervisor was appointed. They sought a declaration that the purchase agreements and the leases were invalid and of no effect and an order requiring Monaco (as the issuer) and Mr Sanders (as director) to repay the subscriptions being the purchase price paid by them.

• In 2016, the High Court found that the offers to purchase units in the resort subject to a cottage lease constituted offers of participatory securities – and that Mr Sanders had not proved that there was no negligence or misconduct on his part in failing to repay the subscriptions. Accordingly, the Judge found that Mr Sanders was liable to repay the subscriptions plus interest calculated in accordance with the Securities Act. In a separate judgment – the High Court declined to make a relief order under s 37AH of the Securities Act.

Key issue – did the offers to purchase units subject to the cottage lease constitute offers of participatory securities under the Securities Act?

The definition of ‘security’ includes the right to participate in any earnings of any other person. In its judgment, the Court of Appeal referred to the critical issue as being whether the guest allocation clause (in the cottage lease) confers a right on individual unit owners to participate in the earnings derived not only from their own unit but also from guests occupying other units in the same complex. In concluding that the answer is “no”, the Court of Appeal noted that:

• The only earnings to which a unit owner was entitled is the rent payable under the cottage lease for their particular unit. The initial base rent, if one is payable (which was optional – at the request of the investor) was limited to a return of 8% on the purchase price of the specific unit for 2 years after settlement. Thereafter, the rent payable for each unit was limited by the revenue derived from letting that unit. The earnings achieved from letting other units in the same complex do not form part of the rent calculation and were irrelevant to the rental assessment.

• The Court continued by saying that the revenue component of the rent calculation is restricted to the revenue actually received from letting the particular unit. The guest allocation clause does not alter this. It expresses what would otherwise be an implied obligation on the part of the manager to allocate guests to units on a fair and equitable basis, subject to guest preference and selection.

• This provision goes some way to ensuring that each unit owner has an equal opportunity to earn revenue from their unit. However, the revenue achieved from letting a particular unit depended on a range of factors including its location, whether it is on the ground floor or an upper level, whether it has one or two bedrooms and the nature of the facilities provided.

• Also, while the rent for each unit will inevitably depend on the success of the resort as a whole, this does not mean that an individual unit owner has a “right” to participate in any earnings other than those generated from his or her particular unit. If the cottage lease conferred a right to participate in the earnings of another then this “right” would be enforceable – but there was no such enforceable right. For example, a breach of the guest allocation clause could result in a damages claim against the manager – but it would not result in a claim against other unit owners for a share of the earnings achieved from letting their units (and it did not permit earnings to be re-allocated among unit owners).

• The fact that some costs were shared was irrelevant. The definition of “security” relevantly focuses on earnings, not outgoings.

Could the director prove that the default in repayment of the subscriptions was not due to any misconduct or negligence on his part in terms of the proviso to section 37(6) of the Securities Act?

The Securities Act provides that allotments of a security offered to the public for subscription without a registered prospectus are invalid – and the issuer is obliged to return any subscriptions received for such securities as soon as reasonably practicable. If any subscriptions are not repaid within two months of receipt, the issuer and all directors of the issuer are jointly and severally liable to repay them together with interest. Whilst the liability of the issuer is absolute (subject to any relief order made under sections 37AC or 37AH) individual directors are not liable if they can prove that the default in repayment was not due to any misconduct or negligence on their part.

The Court of Appeal noted that there are two issues to the director’s defence:

• First, whether there was misconduct or negligence on the part of the director; and

• Secondly (if so) whether there was a sufficient causative link between that misconduct or negligence and the default in repayment — was the default in repayment due to that misconduct or negligence?

Finding that the High Court only considered the first of these questions, the Court of Appeal noted that it was clear from the evidence that the director genuinely believed that offers of units subject to the cottage lease would not pose any issue under the Securities Act. He had good grounds for that view – as the whole purpose of replacing the hotel lease with the cottage lease was to avoid any issue arising under the Securities Act. Mr Sanders was entitled to have confidence that this had been achieved. Lawyers for other interested parties, including those for one of the investors, Westpac Bank and Lombard Finance plainly all thought so. The financiers would not have been prepared to advance further funding if they had been concerned that ongoing sales and leases would be void with all purchase moneys being repayable with interest. And the Securities Commission clearly thought that the problem arose because of the pooling arrangements under the hotel lease and would not arise if earnings for each unit were accounted for separately.

As a result, the Court of Appeal did not accept that the director was negligent in holding the belief that unit sales subject to the cottage lease were not securities and there was no obligation to refund the purchase prices paid. The Court also noted its view that, even if the director ought to have followed up on a suggestion in his own legal advice that a staff solicitor investigate further, there was no reason to suppose that such investigation would have reached a different view – so any claim of negligence, by not making further enquiry, cannot be regarded as causative of the default in repayment.

Concluding comments

The concept of a ‘participatory’ security, as a sort of catchall for investment offerings that are not equity or debt securities, has been replaced (largely by managed investment products) as a result of the transition from the Securities to the FMC Act. However, the concept of participating in the capital, assets, earnings, royalties, or other property of another person is still relevant to determining what is a ‘security’ and therefore an ‘investment product’ for the new regime under the FMC Act.

As a result, there may still be occasions where developments are funded by means of offering an interest in an asset that involves the sharing of overhead (costs). Various forms of property or infrastructure development are the most likely candidates for such an offer. Consequently, where the structure confines the entitlement of an investor to an identifiable (silo’d) income stream that is restricted to the earnings from their asset – then the Court of Appeal judgment indicates a navigable pathway to ensuring that the rights on offer are not a ‘scheme’ that is subject to the disclosure and other compliance obligations imposed by the FMC Act.

In addition, the Court of Appeal’s findings on a director’s entitlement to relief, where they can point to an absence of misconduct or negligence, when a director of an issuer had good grounds to believe (based on both professional advice and the absence of a causative link between the director’s conduct and the specific default complained of) continues to be relevant to a number of the defence provisions that have been carried over to the FMC Act.

Further information

If you would like more information about any of the matters discussed in this note, please contact me.

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