Opposition Brief — Healthcare International, Inc. v. L & B Hospital Ventures, Inc.

IN THE

Supreme Court of the Gnited S F es

OCTOBER TERM, 1989

HEALTHCARE INTERNATIONAL, INC.,

West Oaks, INC., HEALTHCARE-BROWN MANAGEMENT CoO.,

THE BROWN SCHOOLS, INC., JAMES L. Fariss, JR.,

DaAvip L. WHELAN, AND ELLIOTT H. WEIR, JR.

Petitioners,

¥i

L&B HOospiITaAL VENTURES, INC.,

LEO J. BORRELL, Bossy R. LOWRANCE,

PSYCHIATRIC ASSOCIATES OF Houston, P.A..,

AND DouGLAS B. HANSEN,

Respondents.

|

:

f ——

ES On Petition For A Writ Of Certiorari To The

% United States Court Of Appeals

For The Fifth Circuit

RESPONDENTS’ BRIEF IN OPPOSITION

V. THOMAS LANKFORD, JR.

SHARP & LANKFORD

1785 Massachusetts Ave., N.W.

Suite 400 |

Washington, D.C. 2003

(202) 745-1700

Counsel of Record

Of Counsel:

PuHitip P. SUDAN, JR.

PAUL V. CASTELLITTO

PRESS OF BYRON S. ADAMS, WASHINGTON, D.C. (202) 347-8203

, ALT ADI | ANDY

QUESTION PRESENTED

This is a federal securities fraud action brought by

the former limited partners of a bona fide limited

partnership. The district court granted summary judg-

ment and dismissed the lawsuit for lack of subject-

matter jurisdiction on the sole ground that plaintiffs’

limited partnership interests did not constitute ‘‘in-

vestment contracts.” The court of appeals reversed

and remanded, finding that plaintiffs had established

specific facts showing a genuine issue for trial. The

question presented is whether the court of appeals

correctly held that summary judgment should not have

been granted against plainwiffs in light of the abun-

dant record evidence showing that defendants con-

trolled the limited partnership and that defendants

exploited this control to deny plaintiffs access to ma-

terial information about the limited partnership.

|

il

TABLE OF CONTENTS

Page

QUESTION ‘PREGEI ECD. .coivevessncvsssscesssssacsnnrasaseosaen i

TABLE. OF COREE Se - ccccocsisescthecnscsenebuiensseuumuiousens i

TABLE OF AUTIIUIES Re cexesciencssnnimeanminnes IV

STATEMENT OF THE, CASE. cccccsscssccnsaccsveitsecvsceseecs 1

A. The Limited Partnership Agreement And

The Management Agreement Gave

Defendants Total Managerial Control

Over West Oaks Hospital ..................000. 1

B. Defendants Controlled West Oaks Hos-

pital’s Clinical Affairs. ............ccccscsscccocsses 5

C. Defendants’ Own Records Show That The

Limited Partners Admitted A Small And

Steadily Decreasing Percentage Of Pa-

tients To West Oaks Hospital ................ 8

D. Defendants’ Total Control Over The West

- Oaks Limited Partnership Enabled Them

To Defraud The Limited Partners By De-

nying Them Access To Material Infor-

mation About The Hospital .................... 10

SUMMARY OF ARGUMENT cciscsciscvectasscsscicsccsevesesets 13

ARGUMENT

I, The Court of Appeals’ Decision Does Not

Conflict With This Court’s Prior Decisions . 14

A. The- ‘Managerial Efforts’’ Test Applied

By The Court Of —— Does Not Con-

flict With Any Of This Court’s Prior

SIOCMITIOD - serssverssesrsiccasitippisigaaieedan 14

ili

B. Defendants Did Not Rebut The Presump-

tion That Plaintiffs’ Limited Partnership

Interests Are Securities .............::::cceeees

C. Defendants, Who Own and Operate

Twenty-Three Healthcare Facilities, Were

The Promoters of West Oaks Hospital ..

D. The Court Of Appeals’ Decision Is Not

Contrary To This Court’s Established

Summary Judgment Principles ...............

II. The Court Of Appeals’ Decision Does Not

Conflict With Other Federal Courts’

ate sida rehaciedcspaerdenbbanntvadeterresibenscocers

A. Plaintiffs Did Not Possess The Ability To

Control The West Oaks Limited

I ionic dininntacesininigardetebekscensesees

B. No Court Of Appeals Has Rejected The

Managerial Efforts Test ....................000

C. The Court Of —. Decision Does Not

Conflict With The Test Applied By Other

ET TENN - crcssubtbsinivdceepserecbonctecetacsnrere

NET ‘vsetivicshevesrsre cundesnitestsmestesecneeienesteceiabeces

16

20

21

22

22

24

26

27

iv

TABLE OF AUTHORITIES

CASES Page

Bailey v. J.W.K. Properties, Inc., 703 F.Supp. 478

On cis le. TTIIEE -acconsernstideecnowaancelchincdimiouieesenionsesness 26

Bender v. Continental Towers Limited Partnership,

632 F.Supp. 497 (S.D.N.Y. 1986) ................... 20

Celotex Corp. v. Catrett, 477 U.S. 317 (1986) ....... 21

Crowley v. Montgomery Ward & Co., 570 F.2d 875

CU CIEL SII Sctanietiinisdictnpnnvimineteedsentectinenignanes 24

Frazier v. Manson, 484 F.Supp. 449 (N.D.Tex.

1980), affd., 651 F.2d 1078 (5th Cir. 1981) ... 17

Goodman v. Epstein, 582 F.2d 388%7th Cir. 1978),

cert. denied, 440 U.S. 939 (1979) ......... eee 18

Gordon v. Terry, 684 F.2d 736 (11th Cir. 1982) .. 17

Hirsch v. DuPont, 396 F.Supp. 1214 (S.D.N.Y.

1975), affd., 553 F.2d 750 (2d Cir. 1977) ....... 17,18

Inforex Corp., N.V. v. MGM/UA Entertainment Co.,

608 F.Supp. 129 (C.D. Cal. 1984) 0.0... 25

Kline Hotel Partners v. Aircoa Equity Interests,

Inc., 725 F.Supp. 479 (D.Colo. 1989) ............. 24

Landreth Timber Co. v. Landreth, 471 U.S. 681

DEITIES intisicsdeaiiciaidanthioaiesdieantnialcubaiumiidaicuddaiveteinnies 25

Maritan v. Birmingham Properties, 875 F.2d 1451

SO Matis IIE sil ndibaicslatasanagsialampseibamdnipsiatiegreiace 24

Matek v. Murat, 862 F.2d 720 (9th Cir. 1988) ...... 24

Reves v. Ernst & Young, 58 U.S.L.W. 4208

IIIT dinhcncosdauMinnnundiaadontndaadtatadenbiaasinviadenessuedoes 20

Rivanna Trawlers Unlimited v. Thompson Traw-

lers, Inc., 840 F.2d 236 (4th Cir. 1988) ......... 15

SEC v. Glenn W. Turner Enterprises, Inc., 474 F.2d

476 (9th Cir.), cert. denied, 414 U.S. 821

SUUINIIIT initisnsidltin ts ss taceeshnaainiomdiannitebonenmenaniediigbenoetenste 15

TEE petenetteatniseniahsendiavinssiaeseesebsaemincesniens 14,15,20,22

Vv

Table of Authorities Continued

Page

SEC v. Koscot Interplanetary, Inc., 497 F.2d 473

CEs Ce RIT secaricvhvkustdisienedtisntelinniamanns 15,25

SEC v. Murphy, 626 F.2d 633 (9th Cir. 1980) ..... 17

Tcherepnin v. Knight, 389: U.S. 332 (1967) ............ 23

United Housing Foundation, Inc. v. Forman, 421

Ca Fe CTE ctcevincitsontniecadthcineinans 15

Williamson v. Tucker, 645 F.2d 404 (5th Cir.), cert.

denied, 454 U.S. 897 (1981) ............... 17,18,22,25,26

Youmans v. Simon, 791 F.2d 341 (5th Cir.

1986) sssscecsessceeassssecsea stlicshduitisauntaidaasaaeasaamaia 17,18

STATUTORY PROVISIONS ~™

Bit tee FE ee a 14

RECORD CITATIONS

“R.__” refers to page number in the Record

transmitted to the court of appeals.

“Pet.” refers to the page number in the

Petition for Writ Of Certiorari filed in this

case.

“App. __.” refers to the-page number in the Ap-

pendix (the court of appeals’ decision) attached

to the Petition filed in this case.

STATEMENT OF THE CASE

This lawsuit arises out of defendants’ purchase of

plaintiffs’ 25% ownership interest in West Oaks, The

Psychiatric Institute of Houston, Ltd., a Texas limited

partnership that owned West Oaks Hospital, a psy-

chiatric facility located in Houston, Texas.' Plaintiffs,

L&B Hospital Ventures, Inc., Leo J. Borrell, Bobby

R. Lowrance, Psychiatric Associates of Houston, P.A.,

and Douglas B. Hansen, are all doctors (or entities

whose principals are doctors) who are former limited

partners. Defendants, who collectively manage the

business and operations of the hospital, are the gen-

eral partner (West Oaks, Inc.), its parent company

(Healthcare), its affiliates (Brown Schools, Inc. and

Healthcare - Brown Management Co.) and its officers

(James L. Fariss, Jr., David L. Whelan and Elliott

H. Weir, Jr.).

A. The Limited Partnership Agreement And The Man-

agement Agreement Gave Defendants Total Mana-

gerial Control Over West Oaks Hospital

Douglas B. Hansen, the chief of the child psychiatry

department at Baylor University, and.three other fac-

ulty members, Leo J. Borrell, Bobby R. Lowrance

and Edward U. McReynolds (a principal of Psychiatric

Associates of Houston, P.A.), saw a need in the mid-

1970’s for an inpatient treatment facility for children

and adolescents in the Houston, Texas area. R. 779,

830-32. The doctors, who knew that they ‘“‘couldn’t

do the business parts of it,’’ searched for a partner

that could develop the project. R. 717.

'To promote clarity, petitioners shall be referred to herein as

“defendants” and respondents as “‘plaintiffs’’ or ‘‘the limited

partners” or ‘“‘the doctors.”’

The doctors wanted and needed an experienced

partner that could design the hospital, provide for

financing, oversee the construction, and administer

and manage the hospital and its operations after it

was built. R. 717-18, 780-81, 8383-34. Defendant

James L. Farris, Jr., on behalf of defendant Brown

Schools, Inc., approached the doctors about develop-

ing the proposed hospital project. R. 779-82. The en-

suing discussions led to the formation of a limited

partnership. Jd.

The West Oaks Limited Partnership Agreement was

executed on September 29, 1979, by Brown Schools,

Inc. and Drs. Lowrance, Borrell and Hansen and Psy-

chiatric Associates of Houston, P.A. R. 869. The gen-

eral partner, Brown Schools, Inc., owned a 75%

interest and managed and controlled the partnership.

R. 873. Defendants granted plaintiffs an aggregate

25% ownership interest as limited partners. /d.*

The Limited Partnership Agreement stated that the

limited partnership was being formed pursuant to the

Texas Uniform Limited Partnership Act and that the

rights and liabilities of the parties would be as pro-

vided by that statute. R. 869. Accordingly, the limited

partners’ liability for any partnership debts was lim-

ited to the amount of the limited partners’ initial

capital contributions. R. 877-78. The limited partners

could not dissolve the partnership. R. 896. Most im-

portantly, the agreement prohibited the limited part-

* The limited partnersnip was originally called Psychiatric In-

stitute of Houston, Ltd. and the general partner wes Brown

Schools, Inc.. The Limited Partnership Agreement was later

amended to substitute defendant West Oaks, Inc. as general

partner and the partnership’s name was changed to West Oaks,

the Psychiatric Institute of Houston, Ltd.

ners from exercising any management powers. It

expressly stated that “‘[t]he Limited Partners shall not

participate in the management or control of the Part-

nership’s business nor shall they transact any business

for the Partnership, nor shall they have the power

to act for or bind the Partnership, said powers being

vested solely and exclusively in the General Partner.”

R. 877.

The Limited Partnership Agreement provided that

the general partner “‘shall have exclusive authority to

manage the operations and affairs of the Partnership

and to make all decisions regarding the business of

the Partnership.’”’ R. 878. It granted the general part-

ner ‘‘the right, power and authority to do on behalf

of the Partnership all things which, in the General

Partner’s sole judgment, are necessary, proper or de-

sirable to carry out the aforementioned duties and

responsibilities.’’ Jd. Two such powers are especially

relevant to this lawsuit. First, the general partner

retained the sole discretion to determine how much

partnership cash to budget for reserves and how much

to distribute to the limited partners as profits. R. 872-

73. Second, the general partner possessed the sole

discretion to lease, sell or refinance any partnership

property. R. 878-79.

On September 29, 1979 (the same date as the Lim-

ited Partnership Agreement), Brown Schools, Inc., as

general partner, signed a Management Agreement

with Brown Schools, Inc., as manager. R. 588. The

Management Agreement provided that Brown Schools,

Inc., through a Hospital Administrator, shall ‘‘manage

all aspects of the operation of the Hospital, including

but not limited to staffing, accounting, billing, collec-

tions, setting of rates and charges and general admin-

istration.”’ R. 590. In addition, it authorized Brown

Schools, Inc. to prepare, for each fiscal year, a capital

expenditures budget, an operating budget, and a pro-

jection of cash receipts and-disbursements. R. 595-96.

In September 1981, two full years after the signing

of the Limited Partnership Agreement and the Man-

agement Agreement, West Oaks Hospital opened and

began admitting patients. Defendant Healthcare In-

ternational, Inc. (‘‘Healthcare’’?) employed Kay E.

Peck to act as Hospital Administrator. Ms. Peck tes-

tified unequivocally that, as Hospital Administrator,

“T ran the hospital.’’ R. 106. She reported to Jean

Smith, Healthcare’s Vice President for Psychiatric

Operations. R. 93. Together, they determined ‘“‘the op-

erations of the hospital, contracts, financial status,

budgets, staffing’’ and all other important matters.

R. 94-95.

Healthcare itself exercised direct control over many

crucial aspects of the hospital’s operations. Ms. Peck

testified, for example, that “‘the corporate office’’ con-

trolled the hospital’s capital expenditures, debt incur-

rence, and the amount and frequency of the limited

partners’ profit distributions. R. 106. Healthcare’s

control over the hospital’s operations was so tight

that any expenditure over $500 required its prior ap-

proval. R. 103-04. In addition, Healthcare took direct

responsibility for handling the hospital’s insurance

coverage and labor union matters, and for purchasing

the hospital’s supplies, drugs, equipment, furnishings,

materials and services. R. 97, 99.

’ Healthcare is the parent company of all the defendant cor-

porations. The individual defendants, James L. Fariss, Jr.,

David L. Whelan and Elliott H. Weir, Jr., serve as the top

officers and directors for all the defendant corporations.

5

Defendants made certain that, in accordance with

the Limited Partnership Agreement, the limited part-

ners did not participate in the hospital’s management.

As Dr. Borrell testified, defendants ‘‘want[ed] to

make sure that we remained limited partners and not

involved in the day-to-day operations.’’ R. 508. He

specifically recalled that defendants ‘‘told us as lim-

ited partners we did not have a right or obligation

nor would they allow us to participate in day-to-day

operations.” R. 512-13.

Dr. Lowrance confirmed that the limited partners

had no control over the managerial decisions of the

partnership; no control over the expenses incurred by

the limited partnership; no control over the capital

expenditures made by the partnership; and no au-

thority to incur any debt on behalf of the partnership.

R. 548-49. He testified further that the limited part-

ners depended on defendants’ managerial and finan-

cial expertise to operate the partnership. R. 549.

Dr. Hansen corroborated these facts. R. 523-526.

He confirmed that Healthcare determined the amount

and frequency of partnership cash distributions,

R. 525, and the amount the hospital charged patients

for the medical services rendered by the limited part-

ners. R. 526.

B. Defendants Controlled West Oaks Hospital’s Clinical

Affairs

The limited partners, as doctors, treated patients

at West Oaks Hospital and served on the Hospital

Credentials Committee and the Continuing Education

Committee. But the hospital's clinica! business, like

all its business, was controlled by defendants. The

general partner, West Oaks, Inc., adopted a resolution

on August 19, 1981 (just weeks before West Oaks

Hospital opened), creating a Governing Body known

as the Board of Directors and appointing defendants’

own officers and employees as the sole voting mem-

bers. R. 488. The Board of Directors controlled ‘all

aspects of the medical and administrative manage-

ment of the Hospital.’’ R. 491. It was “the final au-

thority in all Hospital and Medical Staff matters’’ and

could “‘overturn any decision of the Medical Staff.’

R. 490. Kay Peck, the Hospital Administrator and a

full-fledged member of the Board, confirmed that it

was the Board’s responsibility to ‘‘[s]et policy and

review the operations of the hospital’ and ‘‘approve

the actions of the medical staff.’’ R. 48.4

Defendants signed on December 12, 1979, a Clinical

Advisory Agreement with a professional corporation

operated by Drs. Lowrance and Borrell. R. 907. It

gave defendants the right to “institute, terminate or

change in any material respect any Hospital clinical

program”’ by giving the doctors prior notice. R. 909.

Drs. Lowrance and Borrell, in contrast, could only

“recommend” and “consult” with defendants about

“clinical issues” and “clinical programs.” R. 908.

Defendants unilaterally terminated the Clinical Ad-

visory Agreement effective December 12, 1985.

R. 615.

Defendants also signed on December 12, 1979, a

Children’s. Programs Clinical Agreement with a

~@

‘Two plaintiffs, Drs. Lowrance and Hansen, as well as

Dr. McReynolds, held ex-officio positions at various times on the

Board. Oddly, the Hospital Administrator could not ‘‘remember”’

at deposition whether these doctors had a vote. R. 48-49. As

non-voting members, plaintiffs’ positions on the Board gave them

no control over the hospital’s clinical affairs. .

professional association operated by Dr. Hansen.

R. 917. It provided that Dr. Hansen shall perform the

“clinical services” necessary to operate the children’s

program at the hospital. R. 918. Like the Clinical Ad-

visory Agreement, defendants expressly reserved the

right ‘‘to. discontinue or change’’ the children’s pro-

gram. R. 919.

Defendants entered into another agreement with

Dr. Hansen, effective June 1, 1985 (nearly four years

after West Oaks Hospital opened), whereby he served

as the hospital’s Medical Director. R. 949. The agree-

ment provided that Dr. Hansen “shall report to and

be under the direction of the administrator of Hos-

pital.’”’ R. 951. The other limited partners held. sub-

ordinate Unit Medical Director positions on

comparable terms.

The Medical Director position was subject to the

Clinical Advisory Agreement, which gave defendants

the right to “terminate or change in any material

respect the authority or duties of the Medical Direc-

" tor’ on prior notice. R. 909. In addition, the Clinical

Advisory Agreement gave defendants the right to ter-

minate the Medical Director on prior notice. R. 908.

It also provided that the hospital shall not hire any

Medical Director not approved by the doctors and

shall terminate any Medical Director on prior notice

from them. Jd. This power was limited by another

agreement between the parties which provided that

the doctors shall have the right to review and approve

the hiring of the Medical Director only “‘[s]o long as

such actions do not adversely affect Doctors’ status

as limited partners.” R. 823.

Kay Peck, the Hospital Administrator, acknowl-

edged that the limited vartners lacked ‘“‘clinical con-

8

trol.”’ R. 105. She recalled that the limited partners

often told defendants that they “‘wanted to be on the

management committee and the Board and the long-

range planning committee of the hospital and HII

[Healthcare]. And they wanted to be in charge of

professional staff relationships and they wanted to

supervise all AHP’s [Allied Health Professionals],

nurses, and admitting staff.’’ R. 102. Defendants re-

fused the limited partners’ demands, including voting

membership on the Board of Directors which con-

trolled all medical and staff matters, because ‘‘[t]hat

was not a good idea.”” Jd. Ms. Peck admitted that

she “‘couldn’t permit that as administrator.”’ R. 105.

C. Defendants’ Own Records Show That The Limited

Partners Admitted A Small And Steadily Decreasing

Percentage Of Patients To West Oaks Hospital

Plaintiffs contributed to West Oaks Hospital’s suc-

cess “bly working hard’as doctors and doing good

patient care,” and by advising the hospital on its

clinical programs and related matters. R. 791. In ad-

dition, plaintiffs contributed to the hospital’s revenues

to the extent they admitted patients there for treat-

ment.

The doctors speculated at deposition about the per-

centage of the hospital’s revenues they generated

through patient admissions. R. 789-90, 931. That tes-

timony was uninformed (and erroneous) guesswork,

however, inasmuch as the hospital management had

always withheld this information from the limi‘ed

partners. Dr. Borrell made this clear when

defendants’ counsel interrogated him:

Q: Are the percentages that you have given me,

the 30 to 50 percent, is that what you believed

were your contribution to the revenues?

A: No. That’s what I’m saying. ... We were ask-

ing for that information and the hospital would

not give us that information.... And they took

the position that was really not information that

limited partners had privy to.

Q: Did they say why you weren’t, as limited part-

ners, entitled to that information?

A: They said that was the operations of the hos-

pital. Because we were limited partners, we didn’t

have any rights to have information which they

decided we shouldn’t have regarding the opera-

tions.... R. 509-11.

In contrast, defendants themselves compiled West

Oaks Hospital’s admissions statistics in February 1986

(a few weeks before defendants purchased plaintiffs’

limited partnership interests). R. 58&60, R. 642-44.

Those statistics, taken from the hospital’s own rec-

ords, show the exact percentage of admissions at-

tributable to the doctors during the four full years

that they held limited partnership interests:

1982 1983 1984 1985

Hansen 0% 0% 0% 0%

Borrell 12% 7% 8% 3%

Lowrance 8% 5% 4% 1%

Parikh 8% 7% 6% 3%

Boylston 4% a 00% 1%

Olsson 0% 0% 0% .60%

Bohnn 1% 33% 25% 0%

10

These figures show that the percentage of patient

admissions attributable to the limited partners was

small at the start, became smaller, and eventually -

became negligible. In sum, the doctors made a small

and steadily decreasing contribution to the hospital’s

success.

D. Defendants’ Total Control Over The West Oaks Lim-

ited Partnership Enabled Them To Defraud The Lim-

ited Partners By Denying Them Access To Material

Information About The Hospital

Defendants’ control over West Oaks Hospital grew

increasingly hostile throughout 1985. Defendants ad-

vised Drs. Lowrance and Borrell on September 12,

1985, that the hospital was exercising its right to

unilaterally terminate the Clinical Advisory Agree-

ment. R. 615. In addition, the limited partners had

longstanding concerns about the way the general

partner was managing the hospital’s finances.

Defendants refused the limited partners’ repeated re-

quests to distribute more profits or to refinance the

hospital to make more cash available. R. 532-34, 536-

40.

The parties held meetings throughout January-

March, 1986, to discuss these problems. The outcome

was that defendants offered to purchase the doctors’

limited partnership interests. Defendants, who con-

trolled the management and operations of the hospital

at all times, provided the limited partners with vir-

tually no financial information at these meetings.

R. 229.

The term$ and conditions of the purchase trans-

action are set forth in the counterpart Agreements

For Sale And Assignment Of Limited Partnership In-

11

terest In West Oaks, The Psychiatric Institute of

Houston, Ltd., each, dated March 21, 1986. R. 137.

The parties to the Agreements For Sale are the lim-

ited partners and the self-styled ‘“Healthcare Group”’:

defendants Healthcare, Healthcare-Brown Manage-

ment Company, and West Oaks, Inc. The sale agree-

ments provided that defendants shall pay a total of

$12 million for the limited partners’ aggregate 25%

ownership interest in West Oaks Hospital.

The $12 million purchase price for the limited part-

ners’ 25% interest indicates a $48 million overall value

for the hospital. The doctors did not, and could not,

know whether $12 million was a fair price, however,

because, as limited partners excluded from the hos-

pital’s management and denied access to essential in-

formation, they did not know the hospital’s value.

Therefore, the limited partners insisted that

defendants include the following representation and

warranty in the sale agreements:

Disclosure. The Healthcare Group has dis-

closed to [the limited partners] all material

inforrnation regarding the Partnership, its

operations and [the limited partners’] Own-

ership Interest.’’ R. 150.

The sale agreements expressly stated that the limited

partners are “‘relying’’ on this particular represen-

tation and warranty being ‘‘true and correct.” R. 158.

At the closing on March 28, i986, defendants certi-

fied that the representation and warranty of full dis-

closure that the Healthcare Group had made in the

sale agreements remained true as of that date. R. 169.

In fact, as the limited partners later learned,

defendants’ representation and warranty was false

12

when it was made (as was the certification). The re-

cord shows that, in November 1985, defendants began

secretly considering the formation of a real estate

investment trust (““REIT’’) called HealthVest, a fi-

nancing vehicle which involved the sale-and-leaseback

of several Healthcare facilities, including West Oaks

Hospital. R.171. Defendants had already commis-

sioned an appraisal by. Valuation Counselors, the na-

tion’s leading hospital valuation firm, that showed, as

of October 31, 1985, that West Oaks Hospital had an

$88,207,000 *business enterprise value. R. 172, 177.

The Valuation Counselors’ report defined ‘‘business

enterprise value”’ as ‘“‘what a prudent investor would

be willing to pay for ownership of [the] business en-

terprise.’”’ R. 176.

The record further reveals that, on March 3, 1986

(three weeks before the parties closed the Agreements

For Sale), defendants submitted to Smith Barney,

Harris Upham & Company, the REIT underwriter, a

five-year forecast for West Oaks Hospital’s operations

which projected steadily increasing revenues and

earnings. R. 179. Defendants provided these same fi-

nancial projections to Valuation Counselors, which

used them to prepare an updated appraisal that

showed, as of March 14, 1986 (two weeks before the

parties closed the Agreements For Sale), that West

Oaks Hospital had an $84 million business enterprise

value. R. 189, 191. Ray Moore, Valuation Counselors’

executive vice-president, testified that Valuation

Counselors could not have made an accurate appraisal

of West Oaks Hospital’s value without the financial

projections defendants had provided him, but had con-

cealed from the limited partners during the negoti-

ations. R. 248-49.

’

13

It is undisputed that defendants did not disclose

the REIT, the financial projections or the two ap-

praisals to the limited partners prior to the March 28,

1986, closing of the sale agreements. R. 223, 225, 253-

55, 259-61, 266. Accordingly, plaintiffs did not suspect

they had been cheated until defendants later issued

a prospectus in connection with HealthVest’s initial

public offering. The prospectus, which defendants filed

with the Securities Exchange Commission on May 29,

1986, expressly incorporated the March 14, 1986, ap-

praisal by Valuation Counselors that valued West Oaks

Hospital ai $84 million. R. 205-07. Plaintiffs there-

after commenced this action.

SUMMARY OF ARGUMENT

The federal securities laws are meant to protect

investors who cannot protect their own interests in

a venture because they are excluded from its man-

agement. The courts presume that limited partners

are protected by the federal securities laws because

limited partners generally lack management power

and control.

Here, the district court granted defendants’ motion

for summary judgment and dismissed the case for

lack of subject-matter jurisdiction on the sole ground

that plaintiffs’ West Oaks limited partnership inter-

ests did not constitute “‘investment contracts.’’ On

appeal, the Fifth Circuit reversed and remanded, find-

ing that ‘‘the plaintiffs have established specific facts

showing a genuine issue for trial.’’ App. at A7.

Defendants’ petition for a rehearing en banc was de-

nied.

This case warrants no further review. First, it was

correctly decided. The district court plainly erred in

14

disregarding the abundant record evidence showing

that defendants alone managed and controlled the lim-

ited partnership. Second, the test applied by the court

of appeals—a gloss on the Howey test—does not pose

a conflict among the federal courts. Indeed, the court

of appeals has applied the same test for the past

fifteen years and this Court has never taken excep-

tion. Third, this case turns solely on its facts. The

court of appeals specifically identified seven triable

issues raised by plaintiffs’ evidence. App. at A5-A7.

ARGUMENT

I. The Court of Appeals’ Decision Does Not Conflict

With This Court’s Prior Decisions

Defendants assert that the court of appeals’ deci-

sion conflicts with this Court’s prior decisions. This

contention is without merit.

A. The ‘‘Managerial Efforts’’ Test Applied By The

Court Of Appeals Does Not Conflict With Any Of

This Court’s Prior Decisions

The Securities Exchange Act of 1934, 15 U.S¢C.

§ 78 c(aX(10), defines the term ‘“‘security’’ to include

investment contracts. This Court, in SEC v. W.J.

Howey Co., 328 U.S. 298, 298 (1946), stated that an

investment contract was ‘‘a contract, transaction or

scheme whereby a person invests his money in a com-

mon enterprise and is led to expect profits solely from

the efforts of a promoter or a third party.”’

Ail the courts of appeal agree that, in light of the

remedial nature of the federal securities laws and the

statutory policy of affording broad protection to the

public, the word “solely” in the Howey test should

not be read as a strict or literal limitation. See, e.g.,

15

Rivanna Trawlers Unlimited v. Thompson Trawlers,

Inc., 840 F.2d 236, 240 n.4 (4th Cir. 1988) (collecting

cases). The Fifth Circuit, in particular, has long in-

terpreted the Howey test to mean that an investment

contract exists where ‘“‘the efforts made by those other

than the investor are the undeniably significant ones,

those essentiai managerial efforts which affect the

failure or success of the enterprise.’’ See SEC v. Kos-

cot Interplanetary, Inc., 497 F.2d 473, 483 (5th Cir.

1974); accord, SEC v. Glenn W. Turner Enterprises,

Inc., 474 F.2d 476, 482 (9th Cir.), cert. denied, 414

U.S. 821 (1978).

The ‘‘management efforts” test, which the court of

appeals applied in this case, does not conflict with

Howey. To the contrary, as this Court recognized in

United Housing Foundation, Inc. v. Forman, 421 U.S.

837, 852 (1975), the touchstone of the Howey test is

“an investment in a common venture premised on a

reasonable expectation of profits to be derived from

the entrepreneurial or managerial efforts of others.”’

In short, the court of appeals’ test is nothing more

than a gloss on the basic Howey test.

Defendants’ focus is not really on the test applied

in this case, but rather the test as applied in this

case. Defendants assert there was ‘‘overwhelming and

undisputed evidence”’ that plaintiffs had substantial

control over the hospital’s operations and made sub-

stantial contributions to its success. Pet. at 12. The

court of appeals, however, concluded otherwise based

on its review of the record. It specifically identified

seven triable issues raised by plaintiffs’ evidence

showing:

(1) that the Limited Partnership Agreement

gave defendants sole control of the hospital;

16

(2) that defendants excluded the limited part-

ners from participating in the hospital’s day-

to-day operations;

(3) that defendants did not give the limited

partners any access to business or financial

information about the hospital’s operations;

(4) that defendants did in fact control the

hospital to the exclusion of the limited part-

ners;

(5) that the Management Agreement speci-

fied that operational control resided with

defendants;

(6) that defendants’ own admissions figures

reveal that plaintiffs made a meager contri-

bution to the hospital’s success; and

(7) that the Hospital Administrator con-

firmed that defendants alone ran the hospi-

tal.

App. at A5-A7. In view of all this evidence showing

that defendants alone managed and controlled the

partnership’s business, the court of appeals correctly

concluded that the summary judgment should not have

been granted.

B. Defendants Did Not Rebut The Presumption That

Plaintiffs’ Limited Partnership Interests Are Secu-

rities

The fact that West Oaks Hospital operated at all

times as a bona fide limited partnership is sufficient

reason, in itself, to deny defendants’ petition. Gen-

erally, the courts presume that limited partnership

interests are investment contracts. See, e.g., William-

17

son v. Tucker, 645 F.2d 404, 423-24 (5th Cir.), cert.

denied, 454 U.S. 897 (1981); SEC v. Murphy, 626 F.2d

633, 640-41 (9th Cir. 1980); Hirsch v. Dupont, 396 F.

Supp. 1214, 1227 (S.D.N.Y. 1975), aff'd, 553 F.2d 750

(2nd Cir. 1977). Limited partners need the protections

of the federal securities laws because they have ‘“‘little

or no authority to take an active part in the man-

agement of the partnership.”’ Youmans v. Simon, 791

F.2d 341, 346 (5th Cir. 1986); see also Gordon v.

Terry, 684 F.2d 736, 741 n. 5 (11th Cir. 1982) (‘‘Lim-

ited partnership interests are generally held to be

securities interests because the limited partners have

no voice in management decisions’’).

Defendants now “suggest’”’—for the first time in

this litigation—that West Oaks Hospital was not a

bona fide limited partnership. Pet. at 14. This sug-

gestion is without merit. To rebut the presumption

that plaintiffs’ limited partnership interests are se-

curities, it was necessary for defendants to prove that

plaintiffs actively participated in the management and

control of West Oaks Hospital. Defendants did not,

and could not, meet this burden.°

‘The courts—including the Fifth Circuit—will uphold a sum-

mary judgment dismissing a federal securities law action for

lack of subject-matter jurisdiction where the record shows that

the limited partnership was a sham or the limited partners con.

trolled the venture’s management. See, ¢.9., Gordon v. Terry,

684 F.2d at 741 n.5; Frazier v. Manson, 484 F.Supp. 449

(N.D.Tex. 1980), aff'd, 651 F.2d 1078 (5th Cir. 1981). But here,

defendants never once contended that the West Oaks limited

partnership did not operate as a ‘bona fide limited partnership,

nor that plaintiffs acted as de facto general partners, nor that

plaintiffs should forfeit the limited liability normally accorded to

limited partners.

18

The question whether a limited partnership interest

is an investment contract depends, in the first in-

stance, on an examination of the limited partnership

agreement itself. Youmans v. Simon, 791 F.2d at 346-

47; Williamson v. Tucker, 645 F.2d at 424 & n. 14.

An examination of the way the West Oaks Limited

Partnership Agreement distributed management

power and control proves, beyond any doubi, that it

was an investment contract.

First, the West Oaks Limited Partnership was

formed pursuant to the Texas Uniform Limited Part-

nership Act. R. 869. Limited partnerships formed in

accordance with a state’s limited partnership act are

considered investment contracts ‘‘as a matter of law.”

Goodman v. Epstein, 582 F.2d 388, 397, 406-08 (7th

Cir. 1978), cert. dented, 440 U.S. 939 (1979). The

reason is that the limited partnership statute itself

prohibits the limited partners from taking part in the

management of the venture. Hirsch v. DuPont, 396

F.Supp. 1214, 1227 (S.D.N.Y. 1975), affd., 553 F.2d

750 (2d Cir. 1977) (citing parallel New York statute).

Defendants here did not argue, and there is no evi-

dence to show, that the West Oaks Limited Partner-

ship violated any aspect of the Texas limited

partnership statute.

Second, the West Oaks Limited Partnership Agree-

ment contained all the requirements for a genuine

limited partnership. The limited partners’ liability for

the partnership’s debts was limited to the amount of

the limited partners’ initial capital contributions. R.

877-78. The limited partners could not work a dis-

solution of the partnership. R. 896. Most importantly,

the agreement strictly prohibited the limited partners

from exercising any management powers. It expressly

19

provided that ‘‘[t]he Limited Partners shall not par-

ticipate in the management or control of the Part-

nership’s business, . . . said powers being vested solely

and exclusively in the General Partner.”’ R. 877.

Third, the West Oaks Limited Partnership Agree-

ment vested ‘“‘the exclusive authority to manage the

operations and affairs of the Partnership and to make

all decisions regarding the business of the Partner-

ship” in the defendant general partner. R. 878.

Fourth, the West Oaks Limited Partnership Agree-

ment gave the general partner the sole discretion to

determine how much partnership cash to budget for

reserves and how much to distribute to the limited

partners as profits. R. 872-73. It also gave the general

partner the sole discretion to lease, sell or refinance

any partnership property. R. 878-79.

Finally, the Management Agreement provided that

defendants shall “‘manage all aspects of the operation

of the Hospital.’ R. 590. The Hospital Administrator,

Kay E. Peck, testified that “I ran the hospital’’ sub-

ject to Healthcare’s close supervision. R. 106. The

doctors’ deposition testimony confirmed that

defendants actually did control the hospital. R. 508,

512-13, 523-26, 548-49.

The court of appeals specifically cited this evidence

in its decision. App. at A5-A7. Defendants simply ig-

nore it. Since the record shows that West Oaks Hos-

pital operated as a bona fide limited partnership,

plaintiffs’ limited partnership interests should be

treated as securities as a matter of law.

20

C. Defendants, Who Own and Operate Twenty-Three

Healthcare Facilities, Were The Promoters of West

Oaks Hospital

Defendants describe plaintiffs (Drs. Lowrance, Bor-

rell and Hansen), together with Dr. McReynolds, as

the “promoters” of West Oaks Hospital. Pet. at 3-6.

They note that, between 1976-1979, the doctors con-

tacted various healthcare management companies, in-

curred professional fees, and filed a certificate of need

in connection with a visionary hospital project.

Promoters, for purposes of the federal securities

laws, are those individuals whose efforts result in

“the organization of a business’’ and without whose

efforts ‘“‘the investments would be virtually worth-

less.”’ Bender v. Continental Towers Limited Part-

nership, 632 F.Supp. 497, 501 (S.D.N.Y. 1986). The

record shows that it is defendants, and not plaintiffs,

who fit this definition.®

Plaintiffs’ idea for a psychiatric hospital for children

and adolescents remained just that—a ‘‘notion’’—until

defendants approached the doctors and, in September

1979, formed the West Oaks limited partnership. R.

713. Until then, the doctors had not made any prog-

ress toward the realization of the hospital project; to

the contrary, as defendants note, they faced the loss

of $120,000 in sunk costs. All plaintiffs had after

spending three years and much money was the same

dream they had when they started.

® Defendants never define the term ‘“‘promoter.’’ Instead, they

cite a long passage from Reves v. Ernst & Young, 58 U.S.L.W.

4208 (1990), addressing the question whether a demand note

should be treated as a security. Reves has no bearing on this

case: indeed, the Court stated there that ‘‘the Howey test is

irrelevant to the issue before us today.” Id. at 4211 n.4.

—_—_—_

}

21

Even the district court recognized that the doctors

“wanted and needed’ an experienced partner that

could design the hospital, acquire the land, arrange

for financing, oversee the construction, and admin-

ister and manage the hospital and its operations after

it was built. R. 8; see also R. 717-18, 833-34, 780-81.

It was defendants who provided all those essential

services with respect to West Oaks Hospital and made

it a viable enterprise. Indeed, the June 19, 1979, let-

ter of intent between plaintiffs and defendants spe-

cifically stated that ‘“‘Brown will be responsible for

arranging financing, developing and operating the

Hospital.”” R. 823.

Defendants are a large and aggressive healthcare

enterprise which owns and operates 23 facilities across

the country. R. 263-64. As general partner, defendants

did what the doctors could not do—organize West

Oaks Hospital. It was defendants who promoted West

Oaks Hospital to the limited partners.

D. The Court Of Appeals’ Decision Is Not Contrary To

This Court’s Established Summary Judgment Prin-

ciples

Defendants assert that the court of appeals’ deci-

sion is contrary to the summary judgment principles

set forth in Celotex Corp. v. Catrett, 477 U.S. 317

(1986), because plaintiffs allegedly failed to come for-

ward with any probative evidence on the investment

contract issue. This contention utterly ignores the re-

cord.

The court of appeals expressly recognized that this

case was governed by Celoter. App. at A8. Applying

the Celotex standard, the court of appeals specifically

identified seven triable issues of fact raised by

22

plaintiffs’ evidence. Jd. at A5-A7. In view of this evi-

dence, the court of appeals correctly concluded that

the summary judgment should not have been granted.

II. The Court Of Appeals’ Decision Does Not Conflict

With Other Federal Courts’ Holdings

Defendants assert that the court of appeals’ deci-

sion conflicts with other federal courts’ holdings.

These alleged conflicts do not exist.

A. Plaintiffs Did Not Possess The Ability To Control

The West Oaks Limited Partnership

Defendants rightly commend the court of appeals’

decision in Williamson v. Tucker, 645 F.2d 404 (5th

Cir.), cert. denied, 454 U.S. 897 (1981), for its

“thoughtful analysis of the application of Howey to

partnership interests.” Pet. at 21-22. They mistakenly

assert, however, that the court of appeals’ decision

in this case conflicts with the principles laid down in

Williamson.

The court of appeals’ decision in this case was

plainly guided by Williamson. In fact, just like

defendants, the court of appeals commended William-

son for its “thoughtful” analysis. App. at A5. In par-

ticular, it cited Williamson for the proposition that

the federal securities laws do not protect investors

who retain ‘‘control’’—i.e., “the power over the in-

vestment and the access to information about it which

is necessary to protect against any unwilling depend-

ence on the manager.” Jd. Applying this standard,

the court of appeals then proceeded to identify the

specific evidence plaintiffs had presented showing that

the limited partners lacked this control. Jd. at A5-A7.

Therefore, defendants’ assertion that there is ‘“‘no dis-

pute’ that plaintiffs possessed meaningful powers ig-

23

nores both the court of appeals’ opinion and the

record. Pet. at 22.

Furthermore, the facts which gave rise to this law-

suit show that defendants used their control over

West Oaks Hospital to defraud the limited partners.

First, defendants refused the limited partners’ re-

peated requests to distribute more profits or to re-

finance the hospital. Then defendants terminated the

Clinical Advisory Agreement. Faced with these in-

creasingly hostile management actions, the doctors

decided to accept defendants’ offer to purchase their

limited partnership interests. What the doctors did

not (and could not) know, however, was that

defendants had concealed the following material in-

formation during the negotiations: (i) that defendants

planned to sell West Oaks Hospital to a real estate

investment trust they had secretly formed; (ii) that

defendants had prepared a forecast of the hospital’s

operations which projected steadily increasing reve-

nues and earnings for the 5-year period following the

sale of plaintiffs’ limited partnership interests; and

(iii) that defendants had commissioned two independ-

ent appraisals that valued West Oaks Hospital at $84-

$88 million, some $40 million more than defendants

led the limited partners to believe the hospital was

worth.

Plaintiffs had access to none of this information

because defendants had excluded them, as limited

partners, from the management and control of the

hospital. It is precisely these facts, which illustrate

defendants’ total control over West Oaks Hospital,

which reveal the “economic reality’ of the West Oaks

limited partnership. Tcherepnin v. Knight, 389 U.S.

332, 336 (1967).

24

B. No Court Of Appeals Has Rejected The Managerial

Efforts Test

Defendants assert that other federal courts have

rejected the managerial efforts test. Pet. at 23. They

rely especially on Maritan v. Birmingham Properties,

875 F.2d 1451 (10th Cir. 1989).

The Tenth Circuit did not reject the managerial

efforts test in Maritan. To the contrary, it reiterated

that the managerial efforts test has been the rule in

the Tenth Circuit since Crowley v. Montgomery Ward

& Co., 570 F.2d 875, 877 (10th Cir. 1975). The court

added, however, that the test should be applied mind-

ful that “[t]he principal purpose of the securities act

is to protect investors by promoting full disclosure of

information necessary to informed investment deci-

sions.”” 875 F.2d at 1457, quoting Matek v. Murat,

862 F.2d 720, 728 (9th Cir. 1988). Therefore, the

focus should be on “‘access to information about the

investment” as well as “managerial control.’”’ Jd. The

court stated that ‘‘the terms of governing agreement’’

between the parties was a critical factor in making

these determinations. Jd. at 1458; see Kline Hotel

Partners v. Aircoa Equity Interests, 'nc., 725 F.Supp.

479, 481 (D.Colo. 1989) (‘“The Tenth Uircuit has joined

other circuits in focusing on access to information as

well as managerial authority’’).

The court of appeals’ analysis in this case comports

in every respect with Maritan’s gloss on the man-

agement efforts test. Here, as mentioned earlier, the

court of appeals recognized that the key factor in

applying the managerial efforts test was whether the

limited partners had ‘‘the power over the investment

and the access to information about it which is nec-

essary to protect against any unwilling dependence

25

on the manager.” App. at A5, quoting Williamson v.

Tucker, 645 F.2d at 424. Furthermore, the court of

appeals paid special attention to the terms of the

Limited Partnership Agreement and the Management

Agreement, which gave defendants sole control over

the partnership and information about the partner-

ship. App. at A5-A7.

Another case defendants rely on heavily is Inforex

Corp., N.V. v. MGM/UA Entertainment Co., 608

F.Supp. 129 (C.D. Cal. 1984). There, the district court

held that the percentage-of-the-profits clauses in the

agreements signed by actor Sean Connery in connec-

tion with several James Bond films should not be

treated as investment contracts. The district court

said that its holding was limited to those particular

facts: “The Court is simply stating that performing

the role of James Bond in James Bond films is as

. undeniably significant to the films’ success or failure

as the production, distribution, or marketing of the

films.’’ Jd. at 133. The district court’s broader view—

that ‘‘any active participation directed toward secur-

ing the profitability of the venture’’ disqualifies an

agreement as an investment contract—finds no sup-

port in the case law. Jd. To the contrary, the courts

generally agree that investors who contribute to a

venture’s success may invoke the protections of the

federal securities laws so long as they do not control

its management. See SEC v. Koscot Interplanetary,

Inc., 497 F.2d at 480-83 (collecting and discussing

cases); see also Landreth Timber Co. v. Landreth, 471

U.S. 681, 693 (1985) (“‘we cannot agree ... that the

Acts were intended to cover only ‘passive inves-

tors’’’). In short, the Jnforex decision cannot serve

26

as the basis for a perceived conflict among the federal

courts on this issue.

C. The Court Of Appeals’ Decision Does Not Conflict

With The Test Applied By Other Federal Courts

Defendants assert that the test generally applied

to determine whether an investment contract exists

was “best stated’ in Batley v. J.W.K. Properties,

Inc., 703 F.Supp. 478, 480 (W.D.Va. 1989). Pet. at

26. Putting aside the question whether Bavley de-

serves the preeminence defendants confer upon it, the

fact remains that the district court in Batley and the

court of appeals here undertook exactly the same

analysis.

The district court in Batley correctly observed that,

in determining whether plaintiffs’ interests should be

treated as investment contracts, ‘‘the dispositive issue

is what control plaintiffs had and could have exer-

cised.”’ Jd. at 480. The court stated that it must focus

on ‘“‘the management contract which structured the

rights of the parties in this venture.”’ Jd. The parties’

allocation of ‘‘the power to make or control significant

decisions” was the key factor in determining which

party had “the ultimate control.”’ Jd. at 494, 495.

Once again, the court of appeals in this case un-

dertook exactly the same inquiry. It too stated that

the key factor was whether plaintiffs retained “‘ulti-

mate control’’—i.e., “‘the power over the investment

and the access to information about it which is nec-

essary to protect against any unwilling dependence

on the managers.” App. at A5, quoting Williamson

v. Tucker, 645 F.2d at 424. In making this deter-

mination, the court of appeals focused primarily on

the Limited Partnership Agreement and the Manage-

27

ment Agreement. It observed that these agreements

gave defendants the sole control over the partnership

and sole control over information about the partner-

ship. Id. at A5-A6. It observed further that plaintiffs’

deposition testimony confirmed that the hospital was

in fact operated in accordance with these agreements.

Id. Finally, it observed that the Hospital Administra-

tor testified that defendants controlled the hospital.

Id. at 7. In view of this evidence, the court of appeals

correctly concluded that plaintiffs had established spe-

cific facts showing a genuine issue for trial. Jd.

CONCLUSION

The Court should deny the petition for a writ of

certiorari. This case should proceed to trial.

Respectfully Submitted,

V. THOMAS LANKFORD, JR.

SHARP & LANKFORD

1785 Massachusetts Ave., N.W.

Suite 400

Washington, D.C. 20036

(202) 745-1700

Counsel Of Record

Of Counsel:

PHILIP P. SUDAN, JR.

PAUL V. CASTELLITTO