So It’s a Security, But Maybe the Private Placement Was Okay?

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Looks like a great investment?
Looks like a great investment?

The tale of Western Financial Planning Corporation and Louis Schooler first caught my eye because the Securities and Exchange Commission brought charges against a real estate company. I stuck with the story because Western Financial tried really hard to structure the investments to avoid being considered securities. Even thought it tried really hard, a court still found that Western was selling securities. Having lost that battle, Western is staying on step ahead of the SEC charges. Western is claiming that the investments were sold through a good private placement.

Western had structured the real estate investment vehicles as general partnerships and sold those partnership interests to investors. 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. Western lost the securities argument and the court found that the interests met the Williamson v. Tucker, 645 F.2d 404, 418 (5th Cir. 1981)  three part operational test for an “investment contract” as a security.

Western would lose on the charge of selling an unregistered security unless it could find an exemption from registration. The firm argued that the sale of interests qualified for the exemption under Rule 506. Western managed to hold on a bit longer and managed to survive to continue the fight. The SEC failed to prove that the sale failed the Rule 506 tests.

The main parts of the Rule 506 exemption are:

  1. There must be no more than 35 purchasers who are non-accredited.
  2. The non-accredited investors must have the knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.
  3. The interests can not be offered for sale by general solicitation or general advertising (from Rule 502).

The first stumbling block is whether there was one long continuous sale of interests or merely several separate sales. 17 C.F.R. §230.502(a) sets out a five factor test for whether the separate sales should be “integrated” into one long continuous sale:

(a) Whether the sales are part of a single plan of financing;
(b) Whether the sales involve issuance of the same class of securities;
(c) Whether the sales have been made at or about the same time;
(d) Whether the same type of consideration is being received; and
(e) Whether the sales are made for the same general purpose.

Although Western sold 23 different properties and 86 general partnerships, the court found that they were sold close enough together to be integrated into one offering. Point to the SEC. As a result of losing that point, Western does not get up to 35 non-accredited investors for each general partnership, but only 35 against all of them.

The SEC made a mistake and had no evidence about the net worth of the investors. The SEC did not prove that there were more than 35 non-accredited investors. That leaves a dispute of material fact which means you don’t get summary judgment, but a trial instead.

The court draws an interesting distinction in general solicitation and notes the SEC’s no-action letter: E.F. Hutton&Co., No-Action Letter, 1985 SEC No- Act. LEXIS 2917 (Dec. 3,1985).  A general solicitation for clients does not turn into a general solicitation for securities as long as a “sufficient time” passes between establishment of the relationship and the offer.

Western argues that its extensive use of cold calls, networking groups, and mailings by an affiliate was merely to solicit clients for the affiliate and not to sell Western’s securities. The SEC failed to provide sufficient evidence that there was insufficient time.

Largely, this is matter of pleading and the SEC failing to put together the right evidence to win on summary judgement. The court is allowing the SEC to refile the motion and fix the evidence mistakes.

This just goes to the charge of selling unregistered securities. It’s not addressing any actual fraud by Western.

Sources:

Author: Doug Cornelius

You can find out more about Doug on the About Doug page

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