A California federal court recently declined to dismiss an SEC lawsuit over alleged fraud and securities registration violations in the sale of general partnership interests. In denying the Defendants’ motion to dismiss, the court held that the SEC had pled sufficient facts to establish that the general partnership interests at issue in the case were securities under federal securities laws.
In 2012, the SEC filed a complaint against Louis Schooler and First Financial Planning Corporation (the “Defendants”), alleging that the Defendants defrauded investors by offering and selling approximately $50 million worth of general partnership interests without disclosing material facts regarding the true value of the underlying land, the mortgages encumbering the properties, and the timing of the transfer of ownership of the underlying land from the Defendants to the general partnerships, and in so doing had violated Sections 5(a), 5(c), and 17(a)(1) of the Securities Act of 1933, and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder.
The Defendants filed a motion to dismiss contending that the SEC failed to state a claim upon which relief can be granted because the interests offered and sold by the Defendants in the general partnerships were not securities. The court began its analysis with the Supreme Court’s holding in SEC v. W.J. Howey Co. that an interest is an investment contract, and thus a security, if it is “a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party. While noting the general presumption that general partnership interests are not securities, the court stated that the mere fact that an investment takes the form of a general partnership interest “does not inevitably insulate it from the reach of the federal securities laws. Articulating the test laid out by the Fifth Circuit decision in Williamson v. Tucker, the court noted that a general partnership is an investment contract if one of the following factors is present: (1) the general partnership agreement leaves so little in the hands of the partners that the arrangement in fact distributes power as would a limited partnership; (2) the partners are so inexperienced and unknowledgeable in the general partnership business affairs that they are incapable of intelligently exercising their partnership powers; or (3) the partners are so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that they cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.
The court analyzed each factor in turn:
- Allocation of Power. The court concluded that the SEC’s claims did not satisfy the first Williamson factor because the SEC did not sufficiently allege that the general partnership agreements left “so little power in the hands of the partners” as to render the general partnerships limited partnerships. The court found that the SEC’s allegations instead supported the conclusion that the partnership agreements afforded the partners significant legal power by providing “investors with sufficient legal authority to exercise power over the partnerships and ‘access to important information and protection against dependence on others.”
- Experience and Knowledge of Partners. The court concluded that the SEC satisfied the second Williamson factor because the SEC’s allegations supported the conclusion that the partners were so inexperienced and unknowledgeable in the general partnerships’ business affairs that they were incapable of intelligently exercising their partnership powers. The court noted that the relevant inquiry under the second factor is “whether the partners are inexperienced or unknowledgeable ‘in business affairs’ generally, not whether they are experienced and sophisticated in the particular industry or area in which the partnership engages.” According to the SEC’s allegations, the investors included a water filter salesman, a retired school teacher, and a pharmacist, and “signatory partners,” who legally assumed significant responsibilities on behalf of the general partnerships, were often unsophisticated in business affairs and unaware that they had signed material documents on behalf of the general partnerships, such as general partnership formation paperwork, bank signature cards, and purchase agreements between one of the Defendants and their respective general partnerships.
- Dependence on Managerial Ability. The court concluded that the SEC satisfied the third Williamson factor because it alleged sufficient facts to support the conclusion that the partners were so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that they could not replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers. The court noted that a relationship with the requisite dependence may exist where investors rely on the managing partner’s unusual experience and ability in running a particular business. Under the SEC’s pleadings, the properties selected and purchased were divided among several general partnerships. As a consequence, the court noted, the individual investors were dependent on the Defendants because the investors could only exercise control over their fractional portion of a real estate parcel and could only exercise general partner control and decision-making within each partnership, but not over the entire property belonging to several general partnerships. The court also pointed to the SEC’s allegations that the Defendants made certain representations and promises regarding the real estate experience of the firm and its personnel to induce reliance upon their entrepreneurial abilities and that the investors thereafter relied on and were dependent on the Defendants’ unique entrepreneurial abilities.
On the basis of the foregoing, the court denied the Defendants’ motion to dismiss.