Real Estate Investment Fraud or Securities Fraud?

Looks like a great investment?

The SEC announced an asset freeze against Western Financial Planning Corporation and its principal Louis Schooler. At first the situation sounded like a complaint against a real estate investment fund, but after reviewing the complaint, I found it to be a much more twisted tale.

The defendants have not agreed to settle with the SEC, so the statements in the SEC’s complaint may or may not be accurate. I’ll assume so for purposes of finding some lessons.

The first issue is that Western was originating land investment deals and then selling them to investors. Nothing wrong with that, except for a big disclosure issue. According to the complaint, the aggregate price paid for investors in the land ownership was far in excess of the purchase price paid by Western. In one case the investors contributed $1.85 million for an undeveloped parcel of land in Stead, Nevada that had a fair market value of $355,000.

A second issue was that Western was publishing investment brochures that hyped the value of the land and seemed to be marking the value improperly.

Defendants continue to use incomparable “comps” to solicit investors.

The complaint cites an email sent to an investor comparing Western’s land to a nearby parcel purchased by Wal-Mart. Western paid $2.50 per square foot while Wal-Mart paid over $8 per square foot. Unfortunately for the comparison, Western failed to mention that its land lacked entitlements, zoning, grading, or groundwater rights.

One thing that bothered me in the complaint was that the investments were structured as general partnerships. That seemed very old school and could open the investors to claims since the entity lacked a liability shield. Then it dawned on me: securities. Western was probably taking the position that the general partnership units were not securities.

For a general partnership, those interests are generally not securities because they fail to satisfy the “from the efforts of others” part of the test of a security. Usually all general partners have decision making power with respect to the affairs of the partnership.

According to the complaint, Schooler exercised control over the general partnerships through the use of signatory partners and secretaries.  The secretaries were Western employees who ultimately controlled the bank accounts and executed documents.

Accordingly, the investors’ purchase of GP units was an investment of money in a common enterprise, and the investors holding those units were led to expect profits solely from Defendants’ efforts in managing, overseeing, and eventually selling the underlying property, Moreover, the GP Agreements left so little power in the hands of the investors that the GPs actually distributed power and functioned as if they were limited partnerships.

Western’s website gives the partnerships a different slant:

These investment groups are created within the structure of a general partnership. Each investment group stands apart from Western Financial; we do not manage the groups. We like to think of each one as a “mini-democracy.” All decisions are voted upon by members who own interest in the partnership, and no action is taken without a vote-by-ballot. A signatory partner is selected from the members who is authorized to sign on behalf of the group, but only after a vote. No one employed by Western Financial is eligible to vote in any of the general partnerships even though they may own an interest in a partnership. [My emphasis]

It sounds very American to own a piece of a mini-democracy. But unfortunately, it sounds like the investors got a bad deal.