Securities and Exchange Commission v. Schooler et al

Filing 212

ORDER Denying # 43 Defendants' Motion to Dismiss. Signed by Judge Gonzalo P. Curiel on 7/1/2013. (srm)

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UNITED STATES DISTRICT COURT

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SOUTHERN DISTRICT OF CALIFORNIA

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SECURITIES AND EXCHANGE
COMMISSION,

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Plaintiff,

v.

LOUIS V. SCHOOLER and FIRST
FINANCIAL PLANNING
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Financial Planning Corporation,
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Defendants.

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Case No. 3:12-cv-2164-GPC-JMA
ORDER DENYING
DEFENDANTS’ MOTION TO
DISMISS
[Dkt No. 43]

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INTRODUCTION

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Before the Court is Defendants Louis V. Schooler and First Financial Planning

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Corporation d/b/a Western Financial Planning Corporation’s (collectively

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“Defendants”) Motion to Dismiss.1 (Dkt No. 43.) Defendants seek dismissal under

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Federal Rule of Civil Procedure 12(b)(6) on the basis that the Securities and Exchange

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Commission (“SEC”) has failed to state a claim upon which relief can be granted

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because the interests offered and sold by Defendants in general partnerships are not

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securities. As such, Defendants contend the SEC does not have statutory authority to

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The parties’ Joint Motion for Extension of Time to File a Responsive Pleading, (Dkt No. 41),
is GRANTED.
3:12-cv-2164-GPC-JMA

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bring its claims against Defendants. Having considered the parties’ submissions and

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for the reasons set forth below, the Court hereby DENIES Defendants’ Motion

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to Dismiss.

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BACKGROUND

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On September 4, 2012, the SEC filed a complaint against Defendants, alleging

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Defendants have violated and continue to violate the anti-fraud and registration

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provisions of the federal securities laws. (Dkt No. 1, Compl. at 1, 16-19.) The same

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day, the SEC also filed an ex parte application for a temporary restraining order

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(“TRO”) and, among other requests, orders freezing assets and appointing a temporary

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receiver. (Dkt No. 3.) Judge Burns granted all relief sought by the SEC. (Dkt No. 10.)

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The SEC Complaint alleges, inter alia, that since 2007, Defendants defrauded

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thousands of investors by offering and selling approximately $50 million worth of

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general partnership units (“GP units”)—i.e., interests in general partnerships organized

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by Defendants—without disclosing material facts regarding the true value of the

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underlying land, the mortgages encumbering the properties, and when ownership of the

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underlying land was transferred from Defendants to the general partnerships (“GPs”).

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(Compl. at 10.) Specifically, the SEC contends Defendants have violated and continue

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to violate Sections 5(a), 5(c), and 17(a) of the Securities Act, 15 U.S.C. §§ 77e(a),

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77e(c), 77(q)(a); Section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b); and Rule 10b-

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5, 17 C.F.R. § 240,10b-5. (Id. at 19.)

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On September 11, 2012, Defendants filed a motion to dissolve or modify the

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TRO, which was denied on September 13, 2012. (Dkt Nos. 14, 18, 22.) Judge Burns

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held a hearing on September 17, 2012, on his order to show cause re converting the

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TRO into a preliminary injunction. (See Dkt No. 30.) Defendants’ primary argument

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in opposing the preliminary injunction was that the interests in the GPs organized by

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Defendants are not securities, and therefore the SEC lacks enforcement authority to

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bring this action. (Dkt No. 21, Resp. to TRO Mot. at 9-22.) After briefing by the

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parties and oral argument, Judge Burns converted the TRO into a preliminary
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injunction on October 5, 2012. (Dkt No. 44, “PI Order.”) Based on his finding that the

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GP units sold by Defendants are securities, Judge Burns concluded the SEC had met

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its burden of establishing a prima facie case that Defendants have violated and continue

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to violate securities laws. (Id. at 21-22.)

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Also on October 5, 2012, Defendants filed the instant Motion to Dismiss on the

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basis that the GP interests at issue in this case are not securities. (Dkt No. 43 at 1.) The

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SEC responded that, having satisfied the more stringent standard for issuance of a

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preliminary injunction, the SEC’s allegations, taken as true, clearly withstand

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Defendants’ Rule 12(b)(6) motion. (Dkt No. 55, Resp. to Mot. Dism. at 1.)

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LEGAL STANDARD

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A motion to dismiss under Federal Rule of Civil Procedure 12(b)(6) tests the

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sufficiency of a complaint. Navarro v. Block, 250 F.3d 729, 732 (9th Cir. 2001).

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Dismissal is warranted under Rule12(b)(6) where the complaint lacks a cognizable

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legal theory. Robertson v. Dean Witter Reynolds, Inc., 749 F.2d 530, 534 (9th Cir.

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1984); see Neitzke v. Williams, 490 U.S. 319, 326 (1989) (“Rule12(b)(6) authorizes a

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court to dismiss a claim on the basis of a dispositive issue of law.”). Alternatively, a

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complaint may be dismissed where it presents a cognizable legal theory yet fails to

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plead essential facts under that theory. Robertson, 749 F.2d at 534. While a plaintiff

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need not give “detailed factual allegations,” a plaintiff must plead sufficient facts that,

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if true, “raise a right to relief above the speculative level.” Bell Atlantic Corp. v.

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Twombly, 550 U.S. 544, 545 (2007).

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“To survive a motion to dismiss, a complaint must contain sufficient factual

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matter, accepted as true, to ‘state a claim to relief that is plausible on its face.’”

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Ashcroft v. Iqbal, 129 S. Ct. 1937, 1949 (2009) (quoting Twombly, 550 U.S. at 547).

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A claim is facially plausible when the factual allegations permit “the court to draw the

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reasonable inference that the defendant is liable for the misconduct alleged.” Id. In

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other words, “the non-conclusory ‘factual content,’ and reasonable inferences from that

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content, must be plausibly suggestive of a claim entitling the plaintiff to relief.” Moss
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v. U.S. Secret Service, 572 F.3d 962, 969 (9th Cir. 2009). “Determining whether a

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complaint states a plausible claim for relief will . . . be a context-specific task that

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requires the reviewing court to draw on its judicial experience and common sense.”

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Iqbal, 129 S. Ct. at 1950.

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In reviewing a motion to dismiss under Rule 12(b)(6), the court must assume the

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truth of all factual allegations and must construe all inferences from them in the light

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most favorable to the nonmoving party. Thompson v. Davis, 295 F.3d 890, 895

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(9th Cir. 2002); Cahill v. Liberty Mut. Ins. Co., 80 F.3d 336, 337-38 (9th Cir. 1996).

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Legal conclusions, however, need not be taken as true merely because they are cast in

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the form of factual allegations. Ileto v. Glock, Inc., 349 F.3d 1191, 1200 (9th

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Cir. 2003); W. Mining Council v. Watt, 643 F.2d 618, 624 (9th Cir. 1981). When ruling

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on a motion to dismiss, a court may consider the facts alleged in the complaint,

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documents attached to the complaint, documents relied upon but not attached to the

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complaint when authenticity is not contested, and matters of which the court takes

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judicial notice. Lee v. Los Angeles, 250 F.3d 668, 688-89 (9th Cir. 2001).

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DISCUSSION

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Sections 2(a)(1) of the Securities Act and 3(a)(10) of the Exchange Act include

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investment contracts in their definitions of a “security.” 15 U.S.C. §§ 77b(a)(1) &

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78c(a)(10). An investment contract is “a contract, transaction, or scheme whereby a

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person invests his money in a common enterprise and is led to expect profits solely

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from the efforts of the promoter or a third party.” SEC v. W.J. Howey Co., 328 U.S.

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293, 298-99 (1946). The requirement that profits be expected “solely” from the efforts

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of a promoter has been liberally construed; the Ninth Circuit has even done away with

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the term “solely” altogether for the purpose of determining whether an investment is

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a security contract. See Burnett v. Rowzee, 2007 WL 2809769, at *4 (C.D. Cal.

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Sept. 26, 2007) (citing Hocking v. Dubois, 885 F.2d 1449, 1455 (9th Cir. 1989)).

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Rather, the question is “whether the efforts made by those other than the investor are

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the undeniably significant ones, those essential managerial efforts which effect the
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failure or success of the enterprise.” SEC v. Glenn W. Turner Enters., Inc. 474 F.2d

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476, 484 (9th Cir. 1973).

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The Supreme Court has emphasized that “economic reality is to govern over

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form and that the definitions of the various types of securities should not hinge on

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exact and literal tests.” Williamson v. Tucker, 645 F.2d 404, 418 (5th Cir. 1981) (citing

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Int’l Brotherhood of Teamsters, Chauffeurs, Warehousemen & Helpers of America v.

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Daniel, 439 U.S. 551, 558 (1979); United Housing Foundation, Inc. v. Forman, 421

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U.S. 837, 848 (1975); Tcherepnin v. Knight, 389 U.S. 332, 336 (1967)). While there

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is a general presumption that GPs are not securities, “the mere fact that an investment

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takes the form of a general partnership or joint venture does not inevitably insulate it

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from the reach of the federal securities laws.” Williamson, 645 F.2d at 422.

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A GP is an investment contract—and thus a security—if one of the following

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factors is present: (1) the general partnership agreement leaves so little in the hands of

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the partners that the arrangement in fact distributes power as would a limited

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partnership; (2) the partners are so inexperienced and unknowledgeable in the general

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partnership business affairs that they are incapable of intelligently exercising their

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partnership powers; or (3) the partners are so dependent on some unique

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entrepreneurial or managerial ability of the promoter or manager that they cannot

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replace the manager of the enterprise or otherwise exercise meaningful partnership or

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venture powers. Id. at 422-24; see also Koch, 928 F.2d at 1477-78 (expressly adopting

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the Williamson test for investment contracts); Hocking, 885 F.2d at 1460. To

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determine whether investors expected profits solely from efforts of a promoter or third

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party and whether investments in GPs are investment contracts, courts can look to

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promotional materials, oral representations by promoters at the time of investment, and

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the practical possibility of investors exercising powers pursuant to partnership

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agreements. Koch v. Hankins, 928 F.2d 1471, 1476 (9th Cir. 1991)

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The Court finds the SEC has met its burden of pleading sufficient factual matter,

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accepted as true and in light most favorable to the nonmoving party, to “state a claim
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that is plausible on its face.” Iqbal, 129 S. Ct. at 1949. Furthermore, having already

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obtained a preliminary injunction, the SEC has presumptively met its burden under

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Rule 12(b)(6). See, e.g., Motorola, Inc. v. Pick, 2004 WL 5472092, at *3 (C.D. Cal.

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June 22, 2004) (denying motion to dismiss following a grant of preliminary injunction

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on the basis that plaintiff “easily met the less stringent burden of Rule 12(b)(6) having

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met its burden on a motion for preliminary injunction”). Although the presence of any

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one factor under Williamson renders a GP interest an investment contract, the Court

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concludes the SEC has pled sufficient facts to establish the second and third factors.

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I. Allocation of Power

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The Court concludes the SEC’s claims do not meet the first Williamson factor

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because the SEC does not sufficiently allege the GP agreements “leave so little power

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in the hands of the partners” as to render the GPs limited partnerships. Williamson,

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645 F.2d at 422-24. The first factor addresses “the legal powers afforded the investor

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by the formal documents without regard to the practical impossibility of the investors

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invoking them.” Koch, 928 F.2d at 1478.

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Here, although partners may, in reality, lack any real power over the partnerships

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due to the size and structure of the GPs, the partnership agreements clearly afford the

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partners significant legal power. The SEC acknowledges the GP agreements purport

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to give general partners control over the partnerships by, for example, disallowing

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Defendants from voting and assigning Signatory Partners to sign documents or to take

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necessary actions on behalf of the partnership. (Compl. ¶¶ 24-25.) Therefore, the

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Court finds the GP agreements provide investors with sufficient legal authority to

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exercise power over the partnerships and “access to important information and

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protection against dependence on others.” Koch, 928 F.2d at 1479. As such, the SEC’s

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allegations are insufficient to satisfy the first Williamson factor.

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II. Experience and Knowledge of Partners

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The Court finds the SEC has pled sufficient facts to satisfy the second

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Williamson factor. The relevant inquiry under the second factor is “whether the
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partners are inexperienced or unknowledgeable ‘in business affairs’ generally, not

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whether they are experienced and sophisticated in the particular industry or area in

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which the partnership engages.” Holden, 978 F.2d at 1121; Koch, 928 F.2d at 1479.

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Whether investors lack business expertise and what effect any lack of expertise has on

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investors’ ability to exercise their partnership powers intelligently are questions of fact

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to be resolved by the fact finder. Koch, 928 F.2d at 1479.

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The SEC alleges GP investors were often unsophisticated in business affairs.

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(Compl. ¶ 26.) Investors included a water filter salesman, a retired school teacher, and

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a pharmacist. (Id.) The SEC further alleges that even signatory partners—who legally

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assumed significant responsibilities on behalf of the GPs—were often unsophisticated

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in business affairs and unaware they had signed material documents on behalf of the

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GPs, such as GP formation paperwork, bank signature cards, and purchase agreements

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between Western and their respective GPs. (Id.) Although Defendants may prove to

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the contrary at a later stage in these proceedings, the Court finds the SEC has alleged

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sufficient facts to satisfy the second Williamson factor.

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III. Dependence on Managerial Ability

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The SEC’s allegations also sufficiently establish the third Williamson factor. A

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GP interest is an investment contract if the partners are so dependent on some unique

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entrepreneurial or managerial ability of the promoter or manager that they cannot

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replace the manager of the enterprise or otherwise exercise meaningful partnership or

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venture powers. Williamson, 645 F.2d at 423-24. A dependency relationship may exist

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where investors rely “on the managing partner’s unusual experience and ability in

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running [a] particular business.” Id. at 423. It is insufficient that “partners in fact rely

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on others for the management of their investment; a partnership can be an investment

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contract only when the partners are so dependent on a particular manager that they

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cannot replace him or otherwise exercise ultimate control.” Id. at 424. However,

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“[e]ven the most knowledgeable partner may be left with no meaningful option when

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there is no reasonable replacement for the investment’s manager.” Id.
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Defendants contend that partners were not so dependent on Defendants’

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managerial and entrepreneurial skills such that partners could not replace Defendants

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or otherwise exercise any meaningful partnership powers because Defendants merely

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performed administrative duties and because returns on the GPs’ investments were

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solely a function of market appreciation. (Dkt No. 43-1 at 10.) Defendants argue that

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the SEC has failed to plead facts supporting a finding that there is no reasonable

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replacement for Defendants. (Id. at 11.) The Court concludes, however, that the SEC

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has alleged sufficient facts suggesting that investors are so dependent on Defendants

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such that investors did not, and do not, have any meaningful alternatives other than to

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rely on Defendants.

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A. Fractional Ownership of Land

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The SEC alleges that, because Schooler divided the properties he selected and

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purchased among several GPs, individual investors could only exercise control over

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their fractional portion of the parcel, forcing them to depend upon Defendants. See

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Koch, 928 F.2d at 1480 (holding that because each individual partnership had only a

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fractional interest in a jojoba plantation, “it would be difficult if not impossible for an

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investor to affect the management of the plantation as a whole”). The SEC pleads

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sufficient facts supporting a finding that a similar situation exists in this case. The SEC

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alleges Defendants formed more than 100 GPs and that each land deal involved

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multiple GP offerings. (Compl. ¶¶ 18, 23.) For example, the Complaint alleges that

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four separate GPs hold the Borda property, two GPS hold the Pyramid Highway

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property, and four GPs will hold the Stead property once all of the offerings close.

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(Dkt No. 1, ¶¶ 45, 53, 61.) This suggests that, as a practical matter, investors were, and

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are, dependent on Defendants because each partner may only “exercise general partner

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control and decisionmaking within each partnership” but not over the entire property

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belonging to several GPs. See Koch, 928 F.2d at 1480. As such, the pleaded facts,

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taken as true, sufficiently establish that investors were ultimately dependent on

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Western to sell their respective properties because the consent of all partnerships
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invested in those respective properties was required.

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B. Defendants’ Unique Expertise

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In determining whether investors depend on the unique expertise of the

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promoter, courts may consider “the representations and promises made by promoters

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or others to induce reliance upon their entrepreneurial abilities.” Gordon v. Terry, 684

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F.2d 736, 742 (11th Cir. 1982) (finding that the third Williamson factor was met where

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promoter of land syndications represented to investors that, because of his expertise

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and experience with the central Florida real estate market, he could realize a substantial

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profit for investors by buying and reselling undeveloped land); see also SEC v.

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Merchant Capital, LLC, 483 F.3d 747, 756 (11th Cir. 1982) (reviewing representations

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made by the promoter and not just the legal agreements underling the sale of interests

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in determining investors’ expectations of control); Koch, 928 F.2d at 1478 (considering

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representations made to investors in determining whether a transaction is a security);

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Hocking v. Dubois, 885 F.2d 1449, 1457 (9th Cir. 1989) (noting that in attempting to

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determine whether a scheme involves a security, inquiry is not limited to contracts but

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should include a thorough examination of Defendants’ representations to induce

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investment).

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The SEC pleads sufficient facts in support of its allegation that investors were

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induced to purchase GP units based on representations regarding Defendants’ unique

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expertise. The SEC alleges, inter alia, that Western represented to investors that the

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firm had decades of experience putting together real estate syndications involving

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undeveloped land in California, Nevada, and Arizona and that Western had an

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impressive track record. (Compl. ¶ 30.) The SEC further alleges that Western’s sales

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managers told a Western salesman during training that Schooler used his extensive

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experience in the industry to buy land at a very steep discount, and that Western was

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able to pass this discount on to investors. (Id. at 16, ¶ 65.) These allegations are

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sufficient to demonstrate that Defendants’ representations regarding their expertise

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with the types of real estate transactions involved here induced investors’ reliance on
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Defendants’ unique entrepreneurial abilities, and investors thereafter relied on and

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were dependent on Defendants’ unique entrepreneurial abilities.

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In sum, the Court concludes the SEC has sufficiently pled violations of Sections

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5(a), 5(c), and 17(a) of the Securities Act, 15 U.S.C. §§ 77e(a), 77e(c), 77(q)(a);

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Section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b); and Rule 10b-5, 17 C.F.R.

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§ 240,10b-5.
CONCLUSION

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For the reasons set forth above, IT IS HEREBY ORDERED that Defendants’
Motion to Dismiss is DENIED.
DATED: July 1, 2013

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HON. GONZALO P. CURIEL
United States District Judge

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