2 September 2011

Investors rights in fractional ownership schemes

There has recently been much adverse publicity regarding the financial and legal status of fractional ownership schemes and investments.

Fractional ownership essentially pertains to co-ownership or collective ownership and is synonymous with the concept of "property syndication". The term fractional ownership of property implies that all the owners will share the use as well as the costs of the asset ie the property, such use normally being regulated by means of a so-called "usage roster".

The concept of fractional ownership is not a legal concept, it is a commercial concept. The legal title that an investor acquires for his or her right of use of the property, will depend on the legal vehicle which is used to structure the scheme. Examples are sectional titleschemes, share block schemes, leases, partnerships, trusts or membership of a club.

Current developments

It appears from media reports that some fractional ownership schemes may have incurred liabilities (eg mortgage bonds, or have existing mortgage bond obligations or liabilities) about which the investors and creditors have no knowledge.

The risk then exists that a creditor (eg mortgage holder) may foreclose on the fractional ownership company that owns the underlying property in question, resulting in a forced sale or liquidation.

Rights of investors

The question arises as to what rights and security investors have in respect of their investments in this situation. This to some extent depends on the nature and structure of the underlying investment.

Two common scenarios are:

  • the investor subscribes for shares and the cash flows to the company upon registration of the share in the investor's name; and
  • the investor purchases the shares from an existing shareholder/seller

The first scenario may be problematic for a fractional ownership scheme. Section 11 of the Share Block Control Act, 59 of 1980 (SBCA) does allow for the sale of shares to the public, subject to the stringent and detailed disclosure requirements in terms of the SBCA.

Most fractional ownership schemes are structured on the basis that the property (in respect of which the investor enjoys the use) is owned by a special purpose private company. Shares are generally issued in the share block company to shareholders or investors who purchase, and thereafter become owner of such shares, as opposed to a timeshare scheme where the investor simply has the right of use without ownership, although it may practically amount to the same thing.

Share block companies are generally operated by a board of directors. In most instances, the board is appointed by the agents responsible for promoting and selling the fractional ownership scheme. The agents may also subscribe for shares themselves and become co-shareholders.

The legal position and the various legal relationships, obligations and duties are governed by, among others, the following:

  • Memorandum of Incorporation of the Company
  • Shareholders Agreement (if applicable)
  • Sale Agreement
  • Use Agreement
  • Share Block Control Act, 59 of 1980
  • Property Time - Sharing Control Act, 75 of 1983
  • Companies Act, 71 of 2008

Importantly, all this legislation contains extremely strict and stringent requirements governing the full disclosure of all relevant information to all potential investors in timeshare and fractional ownership schemes.

If the provisions of the relevant statutes and agreements are not strictly complied with, the entire investment transaction may be void or voidable at the instance of the investor. Parties who fail to comply may also be guilty of criminal offences.

Banks and other creditors should exercise caution when lending money to fractional ownership companies and should ensure that all the legislative requirements are complied with before they do so.

In terms of Section 8 of the SBCA and Section 115 of the Companies Act, a company is required to obtain the permission of 75% of shareholders before disposing of the whole or greater part of its assets. Section 14 of the SBCA also provides that a share block company shall not increase its loan obligation or encumber any of its assets unless approval by a resolution of at least 75% of the shareholders, excluding the share block developer, has first been obtained.

Any funds raised from the encumbrance of the assets of the share block company should be used for bona fide lawful company purposes and not for any other unrelated purpose.

Given the current rumours in the market place, it appears that various properties owned by fractional ownership companies may have been encumbered without the knowledge of investors, or existing encumbrances and obligations have not been adequately serviced by the fractional ownership operators, notwithstanding an obligation on them to do so.

The net effect is that shareholders risk losing their investment as lenders may foreclose on the share block companies, or the companies may be liquidated and the properties realised and sold on auction to settle the liabilities. As a result, the investors may be left with little more than a claim in the sale in execution or against the insolvent estate of the company in liquidation (assuming a subscription scenario). Investors may also have claims against the directors of the company personally for reckless trading, or against the administrators should contractual obligations not have been complied with.

Any claims against a share block company in liquidation would normally be concurrent claims only and would not enjoy any preference in terms of the provisions of the Insolvency Act. This may result in the investor receiving, at best, a dividend after other preferred and administrative creditors have been paid.

The position is worse for investors who have bought shares in the scheme from an existing shareholder, whether it be a developer or subsequent shareholder. Those investors may not even have a claim against the company in liquidation. They may only have a claim (as shareholders) for their pro-rata share of any free residue remaining in the insolvent estate after secured and preferred creditors, and the liquidators have been paid.

To the extent that any investments were paid into an attorney's or estate agent's trust account, it is possible that a refund can be obtained from the attorney or estate agent directly. In the event that any trust monies may have been misappropriated for unlawful purposes, an investor might also have a claim against the relevant fidelity fund.

All investors/shareholders are entitled to information concerning the affairs, financial status and well-being of the legal vehicle they have invested in.

If investors have concerns, they would be well-advised to make the necessary financial and other enquiries from the directors and auditors of any company in which they have invested. They should also insist on regular, continued and adequate financial reporting by the board of directors and/or its duly appointed agents or administrators so as to ensure that they are fully informed of the true status of their investments. They should also obtain a Deeds Office search to confirm that the property is unencumbered.

When fully informed, investors will be in a position to establish whether the necessary statutory and contractual regulations have been complied with for the scheme in which they have invested.

If they have not been fully complied with, the transaction as a whole might be void from inception, or voidable in the hands of the investor. The legislation also provides for civil liabilities and serious criminal sanction.

Investors would be wise to obtain independent professional advice if they are concerned about their investments in timeshare or fractional ownership schemes.

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