Is a General Partnership Interest a Security?

When the SEC announced an asset freeze against Western Financial Planning Corporation and its principal Louis Schooler, I was a bit troubled by the structure of the investments in question. The firm had structured the real estate investment vehicles as general partnerships. The presumption is that a general partnership interest is not a security. So if the investments are not securities, then there can’t be securities fraud, and the Securities and Exchange Commission loses the case.

During the temporary restraining order hearing, the court was willing to accept that the interests could be securities and granted the temporary injunction and asset freeze. The court recently ruled on whether to convert the temporary restraining order into a preliminary injunction. The ruling has a detailed discussion of the law on when a general partnership interest is considered a security. In my ongoing quest to find the line between what’s a security and what’s not, I spent a few minutes looking at the decision.

The defendants make the argument that “the case law over many decades has consistently held that there is a presumption that (1) interests in general partnerships are not securities, and (2) interests in raw land held solely for market appreciation are not securities.”  The court agreed and cited three key cases.

1. SEC v. Merchant Capital, LLC, 483 F.3d 747, 755 (11th Cir. 2007) “A general partnership interest is presumed not to be an investment contract because a general partner typically takes an active part in managing the business and therefore does not rely solely on the efforts of others.”
2. Shiner, 268 F.Supp.2d at 1340 “The general rule is that units in general partnerships are not investment contracts and therefore not securities under federal law.”)
3. McConnell v. Frank Howard Allen & Co., 574 F.Supp. 781, 784 (N.D. Cal. 1983) “There is persuasive authority for the position that if an investor in a real estate syndicate expects profits to come solely from the general appreciation of property values, then the investment is not a security.”

But like any presumption, the presumption that general partnership interests aren’t securities can be overcome.  The securities laws define “security” to include an “investment contract” and general partnership interest could be considered an investment contract.  The Supreme Court, in 1946, defined an investment contract as “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.” SEC v. W.J. Howey Co., 328 U.S. 293(1946). The requirement that profits be expected “solely” from the efforts of the promoter has been given a liberal reading and has largely dropped the term “solely” from the investment contract test.

The Court summarizes the law on when general partnership interests qualify as securities and labels Williamson v. Tucker, 645 F.2d 404, 418 (5th Cir. 1981) as the seminal case. In Williamson, the Court devised a three part operational test for an investment contract.

A general partnership or joint venture interest can be designated a security if the investor can establish, for example, that
(1) an agreement among the parties leaves so little power in the hands of the partner or venturer that the arrangement in fact distributes power as would a limited partnership; or
(2) the partner or venturer is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers; or
(3) the partner or venturer is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.

In application of that test to this case, the SEC failed to meet the requirements of the first two tests, leaving the last test as the finale in the decision. Western Financial argued “that there’s no possibility for dependency because all the general partners do is invest in raw land and wait for it to appreciate in value.”

The SEC countered by focusing on the exit, arguing that it was up to Schooler and his firm to find suitable purchasers of the property. The defendants fought back and said that any offer to purchase would be forwarded to the partners to approve. In a telling piece of testimony, the Western Pacific employee said that was the procedure, but he had never put it to test because he had “never seen an offer during my time with Western ever come out.” That’s bad, but not necessarily securities fraud.

Ultimately, the court was most influenced by the parcels of land being owned by more than one partnership sponsored by Western Financial. The effect is that the partnership only owns a fractional interest in the land, making each partnership more dependent on Western and Schooler to manage the investment, at least with respect to the inter-partnership dealings.

At least for this court, the interests in a general partnerships that hold raw land are more likely to be considered not securities. Developed land has an operational side that would required management.  But having multiple general partnerships own the undeveloped land in common swings the interests back to the securities side.

Sources:

• SEC v. Schooler: Real Estate Investment Fraud Shut Down by Sarah Emery in the Race to the Bottom
• Preliminary Injunction Order in SEC v. LOUIS SCHOOLER AND FIRST FINANCIAL PLANNING CORPORATION D/B/A WESTERN FINANCIAL PLANNING CORPORATION, Case No. 12-CV-2164-LAB-JMA. United States District Court, S.D. California.
• Real Estate Investment Fraud or Securities Fraud?
  
• SEC Shuts Down San Diego-Based Real Estate Investment Fraud
• SEC Complaint against Western Financial Planning Corporation and Louis V. Schooler
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