Ninth Circuit Affirms a General Partnership Interest is a “Security”

A recent decision from the US Ninth Circuit Court of Appeals provides yet another window into how a “security” will be defined by the courts here in California. See Securities & Exchange Comm’n v. Schooler, Case No. 16-55167 (US 9th Cir. September 26, 2018). Securities are governed by both federal law such as the Securities Act of 1933 and by state law under the California Securities Act of 1968.

Both federal law and state law contain a long list of financial instruments that are considered “securities.” The most commonly known example of a “security” is stock in a corporation. However, the law is expansive and the courts have defined “security” broadly. As courts have said, the definition must be “… capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” Rather than look to the specific list in the various statutes, the courts look to three primary factors or elements including:

• Whether money is being invested and “at risk”
• Whether the “investor” has an expectation of profits and
• Whether the investment is “passive” — that is, the return on investment is the result of other people’s work and effort

In the Schooler case, the Ninth Circuit upheld a ruling in favor of the Securities & Exchange Commission (“SEC”), the federal agency tasked with enforcing federal securities laws. In general, if one is offering or selling securities, there must be a registration for the securities or an exemption to the registration requirement. The SEC had charged Schooler with violating this registration requirement.

For nearly 30 years, Schooler ran a company that bought real estate. His company would buy the properties, then have the properties transferred to various general partnership businesses. Then Schooler would sell fractional interests in the various partnerships. The real estate purchased tended to be in undeveloped areas where development was expected. The expectation was that, as development began to occur, the properties would increase in value — that is, these partnership interests were speculative investment. Schooler marketed the general partnership interests to people in California and nationally. As one can probably guess from the above-listed three elements, Schooler’s general partnership interests seem to fit the definition of “security.”

That is what the trial court held on summary judgment pleadings and the Ninth Circuit affirmed. The Ninth Circuit started its opinion by stating that one cannot “dress up” a security the “trappings of a general partnership interest” and avoid the requirements of the securities laws.

Under normal circumstances, buying into/investing in a general partnership would not trigger the securities laws. That is, normally a general partnership interest is not a security. But the Schooler general partnership interests were not of the normal kinds. The court identified these facts showing why these were “securities” not true “general partnership interests”:

• Schooler, personally and through Western, exercised near total control over the investments including which properties to buy
• The “partners” paid for their partnership interests and signed partnership agreements, but the agreements did not become legally effective until Schooler put the “effective date” on the agreements
• Between payment and when Schooler dated the agreements, the “partners” had no ability to exercise any sort of control or management over the investments
• Schooler hand-picked his “general partners”
• The “partners” stated that this lack of control — passive arrangement — was what many expected

For all these reasons, the court affirmed that Schooler’s general partnership interests were “securities” and, as such, Schooler was in violation of the federal securities laws. Under these facts, Schooler was also in violation of California law.

Contact San Diego Corporate Law

If you would like more information, contact attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard provides legal services related to business law, private securities offerings/sales, the sale/purchase of a business, and mergers and acquisitions. Mr. Leonard can also assist with setting up a new corporate entity, annual corporate maintenance, and can help review and draft business contracts. Mr. Leonard can be reached at (858) 483-9200 or via email.

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