Back in September, the SEC announced an asset freeze against Western Financial Planning Corporation and its principal Louis Schooler for a $50 million real estate fraud. That caught my eye because the SEC has little jurisdiction over real estate. The structure of the real estate investments went a long way to try to be not securities. I assumed the defendants would start out of the gate by arguing that the interests were not securities. That turned out to be true. But a California federal judge rejected the argument that the land investments didn’t count as securities.
Attorneys for Schooler had filed a motion to dismiss the suit and argued that the interests Schooler sold to investors were general partnership interests. Schooler argued that the general partnership interests were entitlements to land, rather than traditional securities. Without a characterization as securities, Schooler’s alleged failure to disclose material facts to investors would be outside the SEC’s enforcement authority.
Judge Gonzalo P. Curiel laid out the three factor test from Williamson v. Tucker for whether a general partnership is an investment contract, and therefore a security:
A GP is an investment contract—and thus a security—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.
Judge Curiel found that the interests satisfied the second and third tests.
I don’t think this makes every real estate partnership interest a security. But it is a very fact dependent analysis. As you get more investors in the partnership and complicate the structure and management, the investment starts looking more like a security than a real estate investment.
However, the standard of review for the motion to dismiss is a based on an assumption that the SEC’s factual allegations are true and are viewed in the light most favorable to the SEC. If the case proceeds, the SEC will need to prove the allegations.
According to the SEC complaint, Schooler was marking up the price paid for the land investments. 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.