In a case of first impression, the DC Circuit held in a 2-1 decision that limited partnership units are securities under the federal securities laws using the investment contract test of SEC v. W.J. Howey Co., 328 U.S. 293 (1946). Liberty Property Trust v. Republic Properties Corporation, Case No. 08-7095 (D.C. Cir. Decided Aug. 21, 2009). Both the district court and the dissent however, question this result because the two individual defendants in the case were also behind the plaintiff entities. In a case which is predicated on a non-disclosure claim, the district court judge and the dissent point out that in fact there can be no non-disclosure by definition.

The complaint centers on a transaction between a public REIT, Republic Property Trust, and a limited partnership it formed, Republic Property Limited Partnership (“partnership”) and Republic Properties Corporation (“corporation”). The corporation entered into an agreement with the City of West Palm Beach to design and construct a mixed use development for the city (“development contract”). In connection with that deal, the corporation, and the two real estate developers who formed and controlled it, Richard Kramer and Steven Grigg, entered into an agreement with Raymond Liberti, a commissioner of West Palm Beach and a member of the Community Redevelopment Agency, to serve as a consultant. Subsequently, the development contract was sold to the partnership in return for about $1.2 million worth of units in that partnership.

Several months later, Mr. Liberti became the target of a federal corruption investigation and eventually pleaded guilty to criminal charges. When the city notified the corporation that it intended to cancel the development contract, the partnership ended its involvement with the agreement.

The partnership and the REIT brought suit against Republic Properties Corporation and Messrs. Kramer and Grigg under Section 10(b) claiming that the defendants failed to disclose the relationship with Mr. Liberti. That relationship was material to the transaction in which the partnership acquired the development contract, the suit claims.

The district court concluded that there was no securities transaction because Messrs. Kramer and Grigg are on both sides of the transaction. The two developers along with a third, Mark Keller, formed the REIT. In addition, Mr. Kramer served as chairman of the trust’s board of trustees and Mr. Grigg was vice chairman, president, and chief development officer.

The DC Circuit reversed. The majority focused on the application of Howey and if the limited partnership units were securities. While some circuits have held that limited partnership interests are securities under the test, the DC circuit had not previously ruled on the question. Under that test, the question is whether there is an investment contract which involves a contract or transaction whereby a person invests his or her money in a common enterprise and is led to expect profits solely from the efforts of others. Here, viewing the transaction from the prospective of the investor, the court concluded that the units are in fact investment contracts and thus securities.

In reaching its conclusion, the court noted that in effect the district court had pierced the veil of two entities to reach its conclusion about the individuals being on both sides of the deal. The district court found that Messrs. Ramer and Grigg effectively controlled the partnership because it is controlled by the REIT which the two men control. At the same time they also control Republic Corporation so in fact there was no lack of disclosure and no investment contract, according to the district court. The circuit court however, noted that “appellees point to no cases where defendants have avoided liability–under the securities laws or elsewhere–on the basis of their own control, pervasive or otherwise. We see no reason to pioneer a new application of that limited doctrine on the facts before us.”

Senior Circuit Judge Randolph disagreed. The key to the Howey test is reliance solely on the efforts of others. Here, the profitability of the limited partnership depended on the efforts of Messrs. Kramer and Grigg, not others. The dissent went on to note that the Supreme Court crafted the Howey test in view of one of the main purposes of the federal securities laws which is that those who invest and rely on the efforts of others receive full and fair disclosure regarding the securities they purchase. Indeed, ”[t]o hold — as the majority does — that Kramer and Grigg had a legal obligation to provide information to themselves is to render the securities laws senseless.”

Analyzing Liberty Properties in terms of reliance and the need for the protections of the federal securities laws, rather than focusing on the question of an investment contract seems consistent with the unique facts of this case. As the dissent makes clear, if in fact both sides of the transaction had the same information, there is no disclosure issue. The reliance issue here, however, is not so much in terms of Howey and making profits as on the question of disclosures in the deal. Viewed in this context, the precise nature of the units and if in fact they are securities is not the critical question. Reliance is key. The related question is if the protections of the securities laws are even necessary under the circumstances here. See, e.g. Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 128 S.Ct. 761 (2008) (discussing reliance and need for securities law protections).