Tag: Western Financial Planning Corporation

Is The SEC “Kicking and Mutilating The Corpse”?

I have a written a few stories on the SEC’s case against Louis Schooler and his firm, Western Financial Planning Corp. The Securities and Exchange Commission brought charges against them for a real estate investment scheme. Schooler was selling general partnership interests that owned real estate using what looked like inflated valuations.

hylas

By default general partnership interests are not securities, but the judge found that a general partnership could be an investment contract (and therefore a security) if one of three 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.

Schooler has continued to fight the decision, but has been hit with having to pay $150 million in disgorgement.

The SEC took an additional approach and sought to bar Schooler from the securities industry. That raised my eyebrow because Schooler does not think he is in the securities industry. He is claiming to be selling real estate interests. I’m not sure how much the bar would work. It’s a bit of a circular argument.

It does not seem to matter because Schooler decided to take some time off and go sailing in the South Pacific on his Hylas 42 sailboat: Entertainer. I’m sure that the many people who lost money in Schooler’s investment scheme have some bad thoughts of that image of him sailing alone in the tropical breeze.

Those investors are likely believing in karma now. Schooler did not appear for the ruling. He has gone missing in the South Pacific.

That did not stop the SEC from finalizing the industry bar. It also lead to his lawyer’s charge that the SEC’s Enforcement Division “is acting out of pure vengeance and spite, akin to not only killing a person, but kicking and mutilating the corpse.”

The SEC’s response:

“[T]here has been a report that Schooler’s yacht ran aground on a reef in or around Tahiti, no remains were recovered, and no death certificate has been issued. At present the U.S. State Department considers Schooler to be missing rather than dead.

I’m sure that there are many, like me, wondering if this is straight out of a movie. Did Schooler set up an elaborate scenario to fake his own death? Latitude 38 says some circumstances of the shipwreck are suspicious.

Neither scenario does anything to help those who lost money by investing with Schooler.

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

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.

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Update: Real Estate Investment Fraud or Securities Fraud?

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

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.

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Is a General Partnership Interest a Security?

Looks like a great investment?

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.

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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.

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