In SEC v. Schooler, the U.S. Securities and Exchange Commission (“SEC”) alleged that Louis Schooler and First Financial Planning Corporation (collectively, “Defendants”) violated securities law by fraudulently selling interests, at an inflated price, in general partnerships that held undeveloped land. No. 12-CV-2164-LAB-JMA, 2012 WL 4761917 (S.D. Cal. Oct. 5, 2012). The court ruled to convert the temporary restraining order into a preliminary injunction against Defendants.
To obtain a preliminary injunction granted, the SEC must establish a prima facie case that the Defendants violated securities law and a reasonable likelihood that the violations will be repeated. Defendants asserted that the interests in the general partnerships were not securities.
The definition of security does not explicitly include interests in general partnerships. The SEC, however, asserted that the interests were investment contracts. An investment contract is a “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.”
Courts have found that interests in general partnerships are presumed not to be investment contracts. Nonetheless, the presumption can be rebutted upon a showing of:
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.
For the first factor, the SEC argued that because most of the general partnerships had over a hundred partners, thereby providing investors with no meaningful control over the investment. The Defendants submitted a sample of one of their partnership agreements with their motion to dissolve the temporary restraining order. Based on that sample agreement, the court found that the partnership members did not have so little power that they were effectively limited partners. Accordingly, the SEC did not satisfy the first factor.
For the second, the SEC asserted that the investors were inexperienced. The SEC pointed out that the interests had been marketed to the general public and produced two affidavits from investors who indicated that they did not fully understand the nature or type of the investment. The court found the evidence to be insufficient:
That [the SEC] has tracked down two who are shaky on the nature of this particular investment isn't immensely persuasive. It would be different if there were some categorical rule that members of the general public are presumed to be unsophisticated in business affairs, or investments that are the result of a mass sales pitch are presumptively securities, but the SEC doesn't point to one. As a result, the Court is left guessing, really, as to the actual sophistication of the large body of Defendants' investors. The SEC has certainly shown that it's possible [the two investors providing the affidavits] are in the majority, but this doesn't necessarily it has made out a prima facie case.
Therefore, the court found the second factor not met for preliminary injunction purposes.
For the third factor, the court noted that the general partnership did not own a full parcel of land all to itself; instead, it owned a fraction of land with other general partnerships. As the court reasoned:
Defendants' likely involvement in selling the parcel of land in which the general partnerships are invested, its pivotal operational role with respect to the general partnerships, the fractional nature of the general partnerships' interest in the land, and the apparent use of investors IRA funds, taken as whole, satisfy the Court that the SEC has made a prima facie case that the general partnership interests at stake are securities. The Court is especially persuaded by the fractional nature of the interests.
Although described as a close case, the court found that the SEC had established a prima facie case based on the third factor.
The court found that Defendants’ activities were ongoing and that there were substantial funds remaining in many of the general partnerships; therefore, there was a reasonable likelihood that violations would be repeated. With a prima facie case established and with a likelihood of repeated violations, the court granted the SEC’s preliminary injunction.
The primary materials for this case may be found on the DU Corporate Governance website.