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Securities and Exchange Commission v. Schooler

United States District Court, S.D. California

October 5, 2012

SECURITIES and EXCHANGE COMMISSION, Plaintiff,
v.
Louis SCHOOLER and First Financial Planning Corporation d/b/a Western Financial Planning Corporation, Defendant.

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[Copyrighted Material Omitted]

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Molly M White, Sara D. Kalin, Securities and Exchange Commission, Los Angeles, CA, for Plaintiff.

Eric Hougen, Law Offices Of Eric J. Hougen, Edward G Fates, Allen Matkins Leck Gamble Mallory & Natsis, San Diego, CA, for Defendant.

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PRELIMINARY INJUNCTION ORDER

LARRY ALAN BURNS, District Judge.

The SEC filed a complaint against Schooler and Western Financial on September 4, and on September 6 it applied for a temporary restraining order. The Court entered a TRO that same day. After denying Defendants' motion to dissolve the TRO and hearing oral argument— after which the parties attempted to reach a settlement and failed— the Court must now decide whether to convert the TRO into a preliminary injunction.

As the Court explains in some detail below, it will grant the SEC's motion for a preliminary injunction, but on a more limited basis than it tentatively offered at the preliminary injunction hearing.

I. Legal Standard

In the typical case, " [a] plaintiff seeking a preliminary injunction must establish that he is likely to succeed on the merits, that he is likely to suffer irreparable harm in the absence of preliminary relief, that the balance of equities tips in his favor, and that an injunction is in the public interest." Winter v. Natural Res. Def. Council, Inc., 555 U.S. 7, 20, 129 S.Ct. 365, 172 L.Ed.2d 249 (2008). This is the standard the Defendants would have the Court apply. Not only that, but Defendants urge the Court to, in essence, stack standards. Because the SEC would have to make its case at trial by " clear and convincing evidence," Defendants argue that the SEC must now establish not only that it is likely to succeed on the merits, but that it is likely to do so by clear and convincing evidence. [1]

The SEC is of a very different mind. It isn't, after all, the typical private litigant, but a " statutory guardian charged with safeguarding the public interest in enforcing the securities laws." SEC v. Mgmt. Dynamics, Inc., 515 F.2d 801, 808 (2d Cir.1975). Indeed, the Second Circuit in Mgmt. Dynamics called it a " crucial error" to " assum[e] that SEC enforcement actions seeking injunctions are governed by criteria identical to those which apply in private injunction suits." Id. at 808. It explained that while injunctive relief in private actions is " rooted wholly in the equity jurisdiction of the federal court," SEC suits for injunctive relief are " creatures of statute." Id. That's true. See 15 U.S.C. §§ 77t(b), 78u(d). The statutes, however, don't provide the exact standard to be applied; they merely authorize district courts to grant injunctive relief " upon a proper showing."

What is the standard, then, if not the Winter standard? According to the SEC, it need only establish: (1) a prima facie case that Defendants have violated the securities laws; and (2) a reasonable likelihood that their violations will be repeated. There is some authority for this. See SEC v. Unique Fin. Concepts, Inc., 196 F.3d 1195, 1199 n. 2 (11th Cir.1999)

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( " Under 20(b) of the Securities Act of 1933, and Section 21(d) of the Securities Exchange Act of 1934, the SEC is entitled to a preliminary injunction when it establishes the following: (1) a prima facie case of previous violations of federal securities laws, and (2) a reasonable likelihood that the wrong will be repealed." ); SEC v. Bravata, 763 F.Supp.2d 891, 918 (E.D.Mich.2011) (applying Unique Fin. Concepts standard); SEC v. Homestead Props., L.P., 2009 WL 5173685 at *2 (C.D.Cal. Dec. 18, 2009) (same); SEC v. Shiner, 268 F.Supp.2d 1333, 1340 (S.D.Fla.2003) (same); SEC v. Phoenix Telecom, LLC, 239 F.Supp.2d 1292, 1296 (N.D.Ga.2000) (same). The Court will follow this precedent.[2]

II. Discussion

The big issue in this case is whether interests in the general partnerships organized by Defendants are securities, which they must be in order to trigger the SEC's enforcement authority. If they are, Defendants are certainly on the hook for the unregistered offer and sale of securities, and, depending on the facts, they may be on the hook for securities fraud as well. At the preliminary injunction hearing, the

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Court indicated a willingness to: (1) make a preliminary finding that the general partnership interests are securities; and (2) grant injunctive relief on that limited basis. This way, the SEC could get its injunctive relief (and accompanying asset freeze), while the Defendants would be spared the embarrassment of a judicial finding, albeit a preliminary one, that they'd possibly engaged in fraud.

The basis for the Court's Order is divided into two parts. First, the Court summarizes the law on when general partnership interests qualify as securities. Here, the seminal case is Williamson v. Tucker, 645 F.2d 404, 418 (5th Cir.1981), which articulated a three-factor test for making this determination. Second, the Court applies the Williamson test to the facts of this case and determines whether the SEC has made out a prima facie case that the general partnership interests sold by Western are securities.

A. Legal Background

From the beginning, the Defendants have taken the firm position that the general partnership interests are not securities. Most recently, Defendants argued 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." (Doc. No. 34 at 2-3.) That's true. See 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." ); 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." ); 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, and therefore has limited independent force. Here's why. The securities laws define " security" to include 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, 298-99, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946). This requirement— that profits be expected " solely" from the efforts of the promoter— " has been given a liberal reading." McConnell, 574 F.Supp. at 784. Emphasizing this point, the Ninth Circuit has even dropped the term " solely" from the investment contract test. See Burnett v. Rowzee, 2007 WL 2809769 at *4 (C.D.Cal. Sept. 26, 2007) (citing Hocking v. Dubois, 885 F.2d 1449, 1455 (9th Cir.1989)). The question is " whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which effect the failure or success of the enterprise." SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476, 482 (9th Cir.1973). And most importantly, " [t]he Supreme Court has repeatedly emphasized that economic reality is to govern over form and

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that the definitions of the various types of securities should not hinge on exact and literal tests." Williamson, 645 F.2d at 418; see also Howey, 328 U.S. at 298, 66 S.Ct. 1100 (" Form was disregarded for substance and emphasis was placed on economic reality." ).

Indeed, " [a] scheme which sells investments to inexperienced and unknowledgeable members of the general public cannot escape the reach of the securities laws merely by labeling itself a general partnership or joint venture." Williamson, 645 F.2d at 423. See also Holden v. Hagopian, 978 F.2d 1115, 1119 n. 3 (9th Cir.1992) (" In determining whether interests are investment contracts, we focus on the economic realities of the underlying transaction and not the name it carries." ). The definition of an investment contact must therefore be " flexible rather than ... static" and " capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of other on the promise of profits." Howey, 328 U.S. at 299, 66 S.Ct. 1100.

The Fifth Circuit in Williamson devised an operational test for an investment contract that's since been widely followed.

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.

Williamson, 645 F.2d at 424. The Ninth Circuit has expressly adopted the Williamson test. See Koch v. Hankins, 928 F.2d 1471, 1476-78 (9th Cir.1991). Under this test, it's important to recognize, the focus is on investors' expectations when they originally invest, not " what actually transpires after the investment is made, i.e., whether the investor later decides to be passive or to delegate all powers and duties to a promoter or managing partner." Id. at 1477; Holden, 978 F.2d at 1119 n. 6; Merchant Capital, 483 F.3d at 756 (" We analyze the expectations of control at the time the investment is sold, rather than at some later time after the expectations of control have developed or evolved." ). This principle descends from the statement in Williamson that " [a]n investor who is offered an interest in a general partnership or joint venture should be on notice ... that his ownership rights are significant, and that the federal securities acts will not protect him from a mere failure to exercise his rights." Williamson, 645 F.2d at 422.

In applying the Williamson test, the Court must look beyond the general partnership agreements themselves, " to other documents structuring the investment, to promotional materials, to oral representations made by the promoters at the time of the investment, and to the practical possibility of the investors exercising the powers they possessed pursuant to the partnership agreement." Koch, 928 F.2d at 1478; Merchant Capital, 483 F.3d at 756 (" Consistent with Howey' s focus on substance over form, we look at all the representations made by the promoter in marketing

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the interests, not just at the legal agreements underlying the sale of the interest." ).

B. The Williamson Test

The presence of any one Williamson factor renders an investment contract a security. Merchant Capital, 483 F.3d at 755. And while technically the factors aren't exhaustive, courts have certainly treated them as such in making the determination with which this Court is now faced. See, e.g., Merchant Capital, 483 F.3d at 757-66 (considering each Williamson factor in sequence before concluding that partnership interest was a security); Koch, 928 F.2d at 1478 (We therefore ... apply all three Williamson factors in evaluating whether the investors expected profits produced by the efforts of others so as to satisfy the third element of Howey. " ).

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."

This first Williamson factor " is addressed to the legal powers afforded the investor by the formal documents without regard to the practical impossibility of the investors invoking them." Koch, 928 F.2d at 1478. If investors' powers are merely theoretical, even, their general partnership interest may still not qualify as a security on this factor. See Holden, 978 F.2d at 1119-20 (" Under the first prong of the Williamson test our inquiry is limited to an examination of the legal powers afforded the investor by the partnership agreement and other formal documents that comprised the partnership agreement or arrangement." ).

In the Court's judgment the SEC's analysis of this factor misses the mark. Rather than focus on the formal documents of the general partnerships and assess the investors' power vis-a-vis that of Defendants, the SEC highlights how little control the so-called " Signatory Partners" exercised in reality, and their relative lack of sophistication. It also highlights how little the general partnerships required of the investors, which is obviously a separate question from what their formal powers were under the general partnership agreements.

The SEC's best argument here is that the mere size of the general partnerships cuts against any claim on the part of Defendants that the investors maintained meaningful control over their investments. The court in Williamson did recognize that " one would not expect partnership interests sold to large numbers of the general public to provide any real partnership control; at some point there would be so many partners that a partnership vote would be more like a corporate vote, each partner's role having been diluted to the level of a single shareholder in a corporation." Williamson, 645 F.2d at 423. There are still a couple of problems. First, the number of investors in a general partnership has little to do with the formal powers that are given to the investors in the partnership documents. Second, Williamson also recognized that a large number of general partnership interests " might well" be evidence of an investment contract, meaning there is rigid rule with respect to partnership numbers. For example, the Ninth Circuit in Koch faced 35 general partnerships comprising a total of 160 investors, collectively operating a jojoba plantation, and it found that " [e]ven though each investor's absolute control is reduced by the voting structure, the general

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partners as a legal matter do have the sort of influence [within] the partnership] which generally provides them with access to important information and protection against a dependence on others." Koch, 928 F.2d at 1479 n. 12 (internal quotations omitted).

Defendants emphasize that they are non-voting members of any general partnership in which they hold an interest, and that " any and all voting members have the ability to engage and direct the partnership in whatever direction they desire." (Doc. No. 21 at 11.) For example:

Partnerships are provided all contact information for one another to facilitate communication. And any partner may initiate a ballot for a partnership vote on any matter by simply submitting a request to the partnership secretary. The secretary has no discretion regarding any ballot request— she simply serves as a messenger coordinating the efficient distribution ...

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