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The managing partner of a private investment group can be sued under the Investment Advisers Act if he was paid a cut of the firm’s profits every year, issued annual reports to his fellow investors and exercised exclusive control over the portfolio, a federal judge has ruled. In her 19-page opinion in Securities & Exchange Commission v. Saltzman, U.S. District Judge Anita B. Brody refused to dismiss the SEC’s claims that James S. Saltzman violated Section 17(a) of the Securities Act and Section 10(b) and Rule 10b-5 of the Exchange Act — commonly referred to as the antifraud provisions — as well as a claim that Saltzman violated the Investment Advisers Act. In the suit, SEC attorneys Gary E. Jackson and Celeste Chase allege that Saltzman violated the partnership agreement of Saltzman Partners L.P. — a private investment partnership formed in 1992 that includes 36 limited partners — by taking out large loans for himself and failing to disclose that fact to the other investors. Saltzman was both the managing general partner and a limited partner who had exclusive control over the partnership’s investment portfolio, bank account and brokerage accounts. In return for his services as managing partner, the SEC says, Saltzman received an annual performance fee equal to 20 percent of the difference between the current cumulative portfolio value as of the end of any fiscal year and the preceding highest cumulative portfolio value. Between 1985 and 2000, Saltzman earned at least $1.3 million in performance fees. In 1994, the SEC alleges, Saltzman began taking out loans from the partnership in violation of the partnership agreement. From 1994 to February 2000, Saltzman allegedly took out several loans totaling $1.78 million. The partnership agreement authorized the managing general partner to make loans to any requesting partner, including himself. However, such loans had to meet the requirements of the partnership agreement — that the aggregate principal amount of loans outstanding to any partner could not exceed 50 percent of the partner’s capital account; that loans were to bear interest, payable monthly; that loans were due and payable no later than 60 days after the end of the fiscal year in which the loan was made; and that all loans had to be requested in writing and evidenced by a note. As managing general partner and the person who provided information about the partnership to current and prospective investors, the SEC alleges, Saltzman knew or was reckless in not knowing the terms of the partnership agreement and therefore knew or was reckless in not knowing that his personal loans violated the agreement. Saltzman knowingly violated several of the agreement’s loan requirements, the suit alleges, and therefore misappropriated $1.78 million from the partnership. The suit says Saltzman’s loan total of more than $1.2 million exceeded 50 percent of his capital account balance of $564,484 in December 1997, which would have permitted him to take out only $282,242 in loans. Although his capital-account balance did not increase over the next two years, Saltzman continued to take out loans from the partnership, the suit says, bringing his total up to $1.78 million by February 2000. Saltzman also did not make any interest payments on the loans, the suit says, and he did not repay outstanding loan balances within 60 days of the end of the fiscal year in which the loans were made. Finally, the SEC alleges that Saltzman did not execute the documentation necessary to evidence the loans and never securitized his loans. By failing to repay the money, the suit says, he misappropriated from the partnership and defrauded the limited partners. Just two days before the SEC filed suit, the partnership amended its agreement to authorize unsecured loans to the managing partner of up to $2 million. It also removed Saltzman from the position of managing general partner and put its accounts in the stewardship of an independent accounting firm. Saltzman’s lawyers — Frederick D. Lipman, Alexander D. Bono, Timothy D. Katsiff and Jerome J. Reynolds of Blank Rome Comisky & McCauley — moved to dismiss the suit or, in the alternative, for a more definite statement. The SEC’s first claim, they argued, did not even state a cause of action. And since Saltzman does not meet the legal definition of an “investment adviser,” they said, he cannot be sued under the Investment Advisers Act. But Judge Brody found that the SEC met its burden for pleading both claims. Under the materiality standard of the antifraud provisions of the Securities Act, Brody found that the SEC needed to show only that a material fact was not disclosed to the investors. “The standard is objective; it does not matter whether the limited partners of Saltzman L.P. actually would have considered Saltzman’s misrepresentations material to their investment decisions. The standard only requires a substantial likelihood that disclosure of the omitted facts would have been viewed by a reasonable investor as having significantly altered the ‘total mix’ of information made available,” Brody wrote. According to the complaint, she noted, Saltzman Partners had assets of about $7.9 million. But Saltzman allegedly diverted $1.78 million — more than 20 percent of the fund — to himself and never disclosed that fact to the other partners. “A jury could decide that the misrepresentations alleged by the SEC are material to a reasonable investor in Saltzman Partners,” Brody wrote. But Saltzman’s lawyers argued that the SEC failed to meet the “scienter” requirements for such a claim. Citing the 3rd Circuit’s 1997 decision in In Re: Burlington Coat Factory Securities Litigation, Saltzman’s defense team argued that it is not enough for the SEC to generally allege scienter. The suit must allege facts sufficient to give rise to a “strong” inference of scienter, they said. But Brody found that the SEC had met the strict Burlington Coat test. “The complaint alleges that Saltzman was the managing general partner and the person who provided information about the partnership to both the limited partners and prospective investors. From those facts one can infer that Saltzman knew the terms of the partnership agreement, including the requirements for loans to partners, and therefore knew that his personal loans violated the agreement,” Brody wrote. “The complaint also alleges that Saltzman was responsible for distributing the partnership’s annual financial statements, and that he knowingly and intentionally created false and misleading financial statements for fiscal years 1998 and 1999. Furthermore, the facts suggest that Saltzman, knowing he had violated the partnership agreement, had both a motive to conceal his loan situation, and, as the partner who distributed the financial statements, the opportunity to misrepresent the true state of the partnership’s investment portfolio,” she wrote. If those facts are believed, Brody said, a jury could find “conscious or reckless behavior” by Saltzman. Saltzman also challenged the SEC’s pleading of “reliance” by the investors, noting that the suit didn’t name a single investor. But Brody found that Saltzman was clearly noticed on the claim. “By identifying the set of investors who relied on Saltzman’s alleged misrepresentations — the limited partners — the SEC complaint states reliance with sufficient particularity,” Brody wrote. “The allegations do not suggest a case of mere mismanagement, as the defendant would have me believe; rather, the SEC presents a set of facts which, if substantiated, show that Saltzman made material misrepresentations and omissions, with scienter, in connection with the offer, sale, or purchase of securities.” Denying his request for a more definite statement, Brody found that while the suit doesn’t name any of the defrauded investors, Saltzman nonetheless “cannot claim that the complaint is too vague and ambiguous to allow a responsive pleading.” Finally, Saltzman argued that the SEC had not sufficiently alleged that he, for compensation, engaged in the business of investment advising. Brody found that while the 3rd Circuit has never addressed the question, the 2nd Circuit has considered a case in which general partners of an investment partnership were sued under the Investment Advisers Act. In Abrahamson v. Fleschner, the 2nd Circuit found that the general partners received “compensation” for managing the partners’ investments, where, like Saltzman, they earned a fee equal to 20 percent of the firm’s net profits and net capital gains for each year. Brody said the Abrahamson court held that the defendants “engaged in the business of advising others” because they issued monthly reports, on which the limited partners could be expected to rely in making their decisions to reinvest in the partnership fund. The court also held that the general partners are “investment advisers” because they manage the funds of others for compensation. Under that test, Brody said, Saltzman, too, qualifies as an investment adviser because he issued annual financial statements on the performance of the partnership fund and generally was the person who provided information about the partnership to current and prospective investors. “As the Act intended to embrace those who wield power over their clients’ money, as Saltzman did over the investments of the limited partners, the facts alleged qualify Saltzman as an investment adviser,” Brody wrote.

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