The economic tumult of the last few years has driven

Turnover and Conversion Transactions Legal Issues, Challenges and Opportunities for Clubs and Developers The economic tumult of the last few years has driven club developers to make unprecedented changes in their exit strategies. Owners of private clubs (not owned by members) are selling to member groups, and developer-controlled member-owned clubs are looking at early or delayed turnover transactions. The good news about today s economy is that there are some great deals available for members that can benefit the developer as well. Conversion at a great price that relieves a developer from funding shortfalls, early turnover in exchange for concessions from the developer, and other similar transactions are possible. Member ownership and control can mean more robust membership sales immediately after turnover or conversion. In addition, members may amend the bylaws and other club documents in ways that the developer cannot. For example, a member-owned club can amend its bylaws with a member vote to change redemption rights in certain circumstances. Conversion and Turnover are used interchangeably by some to refer to the members taking over control and/or ownership of their club. For this article, conversion refers to the change of ownership and control from developer to the members (where the members did not own the club, even if they had a refundable initiation fee). Turnover refers specifically to a member-owned club that is under developer control that transitions to member control. There are some similarities between these two transactions and some important differences. In today s economy, some developers are now considering conversion when it was not originally intended in their documents, and turnovers are being either accelerated or delayed to address the parties specific circumstances. B Y R O B Y N N O R D I N S T O W E L L, E S Q. FALL 2010 CLUB DIRECTOR 19

Changes to Redemption Rights Many clubs with a refundable initiation fee are structured so that when a membership is resold the resigning member receives eighty percent (80%) of the thencurrent initiation fee. A number of clubs have some variation on that structure, providing a slightly higher or lower refund percentage or tying the percentage to the purchase price rather than the resale price. Some clubs that are not member-owned treat the initiation fee as a deposit that is refundable after thirty years or upon earlier reissuance. Many of those clubs provide a one hundred percent (100%) refund. Clubs that are not member-owned have less opportunity to restructure the redemption process. In member-owned clubs, the members can vote to amend their bylaws and, if allowed by securities law and state law, can modify their redemption rights. Some clubs are modifying redemption rights for economic and other reasons. Below are examples of some transactions that change refundability that might be considered by a club in appropriate circumstances. These transactions are very state law specific and can involve securities issues, so each transaction will have unique issues. From Refundable to Non-Refundable. Some clubs are eliminating refundability, either because they need the entire initiation fee or they believe the refundable price point is too high to attract new members. Going forward, when memberships are resold the club receives the entire initiation fee. Some clubs find that eliminating any refundability reduces protection against having members walk away with no notice, which can create budget challenges. Others find that eliminating refundability generates a positive reaction from existing members, because financial resources previously used for refunds can be redirected to critical capital improvement projects. From Non-Refundable to Refundable. Clubs that add a refundable feature to their initiation fee believe it supports member retention if members have skin in the game to protect against members walking away. Some clubs require six months or a year of advance notice for a resignation, during which time the member must continue to pay dues and can use the club. The refund incentivizes the members to fulfill that obligation or can be withheld to pay any outstanding member obligations. Clubs that add refundability believe it creates more of an ownership mentality and allows the club to increase their initiation fee. However, the long term obligation to pay each exiting member is a significant financial liability and can impact membership sales and resignations in the future. Clubs considering this alternative should weigh their options carefully. Reduce Refund. Some clubs have amended their bylaws to reduce the refund obligation. This has been absolutely necessary where multiple levels of refund resulted from bylaw changes during developer control. This bylaw change may eliminate a club s obligation to refund more than it receives from reissuing the resigned membership. In other clubs, the transfer fee (the portion of a new initiation fee that is retained by the club when the balance is repaid to the exiting member) has been increased over the years to address the club s capital needs. Transfer fees sometimes range from ten to fifty percent of the initiation fee. Whether a club can adopt this change with respect to all members or just with respect to new members going forward is a matter of state law, but could not be applied to existing members during developer control. Declining Redemption Amount. For a tax-exempt club, reducing a member s refund right over time may be justified since part of a member s capital contribution can be amortized over the period they use the club facilities. (Note, however, that declining 20 CLUB DIRECTOR FALL 2010

redemption may create a taxable event for a club that is not tax exempt.) As an example, a member might receive a partial refund during the first ten years and no refund thereafter. Whenever clubs have varying refund obligations to the members, accounting challenges are created. At any given time, the next several memberships to be reissued from the resigned list might have vastly different refund obligations. Some clubs have had robust membership sales that created a cash crunch for the club whose refund obligation exceeded the new purchase price for multiple sales in a row. Increasing Redemption Amount. Clubs that begin with little or no refund and increase the refund to a larger percentage of the initiation fee do so in consideration of a member s long-term use of the club, assessments, spending for catering and guest fees, etc. As mentioned with declining redemption, unequal payment obligations can create accounting challenges over time. Minimum Membership Periods. Some clubs provide a refund on initiation fees only after the member has remained in good standing for a minimal period of time. For the initial period after it is adopted, this may reduce the number of resignations. However, it is not clear that there will be a significant difference in the future. Other Possibilities. Some clubs have had success asking current members to donate their refund rights in exchange for nominal consideration. Again, clubs that are not tax-exempt should evaluate the tax consequences of this option. In addition, clubs that allow memberships to be transferred to a surviving spouse or family member could consider stripping redemption rights at that time of transfer. Caution: The membership modifications described above have tax and legal ramifications for any specific club and should be evaluated by appropriate tax and legal counsel. This articles looks at legal issues, challenges and opportunities related to both the turnover process and the conversion process. The sidebar article (page 20) explains ways member-owned clubs are modifying their redemption structures to address the current economy and plan for a strong financial future. While every club is unique and circumstances can vary widely, every turnover or conversion transaction has as a primary goal securing a positive future for the club. This can be accomplished by focusing on steps that: Address long-range development of the club with a wellplanned strategy; Preserve and protect the rights of the club s membership; Create added value for the members club experience; and Recognize the developer s desired financial objectives. Club Turnover The turnover transaction in a member-owned club should be simpler than conversion. Typically, the club s documents anticipate the developer forming a member-owned club ( Club, Inc. ) as a non-profit corporation in the club s state. The developer is usually required to convey the club assets to Club, Inc. and Club, Inc. then sells memberships to the members. Club, Inc. should already be the contracting party on the club s leases and contracts, and should hold its important licenses and permits. The developer then continues to control the club s board of directors and management and, upon the occurrence of a triggering event, turns control of the board over to the members. If the developer properly set up and executed his plan, the assets will already be titled in Club, Inc. Technically, the turnover transaction is simply the resignation of the developer-appointed board members and the election by the members of a new board of directors. However, sometimes a developer does not properly execute this plan. Another challenge is that members almost universally have requests at turnover (some reasonable and some not so reasonable). An example of a reasonable request is asking the developer to clean up the bylaws and other membership documents. The developer may have retained the right to make nonmaterial modifications to the bylaws, whereas bylaw amendments FALL 2010 CLUB DIRECTOR 21

Turnover is usually scheduled based on a triggering event set forth in the club s documents. Common triggers include a specific date, the sale of a certain number of memberships or lots, or the club achieving break even operations for a stated period of time. after turnover require a member vote. Therefore, immediately prior to turnover, the developer can amend and restate the bylaws to remove all the duplicative provisions. Developer bylaws often go on at length to explain before turnover this will be the case and after turnover this will be the case. A developer can remove all of the before turnover language, often cutting the length of the documents in half (while increasing understandability fifty percent!). Another reasonable request might be that the facilities be inspected and repaired. If the club documents call for the developer to fund any operating shortfalls prior to turnover, then arguably any failure to maintain the facilities might have been for budgetary reasons. More challenging member requests sometimes include asking the developer to make financial payments at turnover that are not required by the documents or to relinquish rights to the proceeds of unsold memberships. Turnover is usually scheduled based on a triggering event set forth in the club s documents. Common triggers include a specific date, the sale of a certain number of memberships or lots, or the club achieving break even operations for a stated period of time. In cases where a developer is funding shortfalls and the triggering event has been delayed indefinitely due to membership and lot sales stalling, the developer is often willing even hopeful to complete early turnover. Depending on the specific circumstances, a developer may be willing to offer the club a low interest loan, or convey to the club some or all of his or her rights to the proceeds from the unsold memberships, or make other accommodations depending on the specific circumstances. In other cases, either the developer or the members, or both, may prefer to delay turnover even after the triggering event has occurred. This can happen when the developer has not sold all the memberships or lots, and prefers to control the club and fund shortfalls to protect the developer s investment in the unsold assets. Changing course from the club s documents will require negotiation and usually a member vote, so it is important to understand the members rights and any requirements under state law and the club s documents. Experienced club counsel can help the developer and the member groups zero in on the key issues that need to be addressed and resolved in an amicable manner, so that turnover can be properly completed and the club can be successful going forward. Club Conversions As noted earlier, conversions involve a change in both ownership and control of the club from developer to members. Conversion transactions are more complicated for two key reasons: (1) usually the Club, Inc. entity has not been formed for the member group; and (2) the new club is taking on a going concern business with all of its complexities. There are many opportunities to make mistakes or create challenges in a conversion transaction. In order for the members to purchase the club, a nonprofit corporation formed under the laws of the state where the club is located generally must be formed to assume title of the club s assets. That entity issues memberships to the members. It has governing documents such as bylaws and is subject to the state s statutes governing nonprofit corporations. Issues can develop when conversion is triggered by the club s original documents if the developer treats the formation of the entity as a nonissue, or if the developer assumes that after the triggering event the members will organize and buy the club. Similar issues can also occur in developer owned clubs where the members have a right of first refusal. Issues related to the member s nonprofit entity can be complex. In the convertible equity club where many provisions are set forth in the membership documents, the developer is often not clear regarding how the members transition to the new club and what happens to members who do elect to join the new club. However, when conversion is not planned in the original documents but is something brought forward by the members, the members can be very clear on their priorities and intentions. In that case, they are not handcuffed by the developer s documents or arguments. In any conversion, the members often make it up as they go along, giving weight to what seems important at the time, their current priorities, and what seems fair. This can unintentionally 22 CLUB DIRECTOR FALL 2010

MAKE A PROFITABLE INVESTMENT WITH A WINE LOCKER OR CELLAR trample upon the rights of certain classes of members. This is especially problematic when the members negotiating team is self appointed or developer appointed rather than member elected. Securities Issues and Other Complications Securities issues may also be a consideration for a newly formed club entity. The members ownership interest must be properly created and documented to comply with applicable law and any representations to the members. The Securities and Exchange Commission (SEC) has issued no action letters that are followed by the majority of states, but these no action letters almost exclusively have been written with respect to new clubs, not converting clubs. It is essential that the new entity comply with all federal and state securities laws, or request a no action letter from the SEC regarding its specific circumstances. As noted earlier, nother complication of the conversion process is that the member club is buying a going concern. This means they are buying a piece of real estate with all of the attendant issues, such as title, survey, environmental and water issues. They are also buying a going business that has issues with respect to employees, licenses, permits, cash reserves, insurance, accounting and the like. This requires that the members engage a variety of professionals to ensure that the new entity is properly formed, properly governed, and buys the assets it intends to buy without taking on unnecessary liability. Any club facing the opportunity or requirement to transition to member ownership and control should begin with careful legal and financial planning. The current economy presents unique opportunities for improved outcomes, but these can only be achieved through careful planning, negotiation and execution. This article is intended for general information purposes only and not as specific legal advice. Clubs are urged to consult appropriate club counsel concerning any specific legal questions and issues that may exist. Robyn Nordin Stowell is a partner in the law firm of Holme Roberts & Owen LLP in Scottsdale, Arizona. She is an NCA board member and serves on NCA s Legal/Legislative Committee. Robyn may be reached at (480) 624-4550 or by e-mail at robyn.stowell@hro.com Allow members to store wine bottles in your clubhouse with wine lockers Store retail wine bottles in a custom cellar or cabinet Let us create the perfect wine storage solution for you FREE custom cellar design! CAN BE BUILT TO MATCH YOUR CLUBHOUSE FURNISHINGS 1-800-777-VINO 17621 S. Susana Rd. Rancho Dominguez, CA 90221 FALL 2010 CLUB DIRECTOR 23