Securities Regulation Daily Undisclosed non-cash capital contributions and founder’s fee constituted fraud
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Thursday, May 18, 2017

Undisclosed non-cash capital contributions and founder’s fee constituted fraud

By John M. Jascob, J.D., LL.M.

A real estate developer’s failure to disclose that he had not made his initial capital contribution in cash and that a contract authorized him to receive a $400,000 founder’s fee constituted material omissions in violation of the Washington State Securities Act. Affirming the ruling below, the Washington Court of Appeals held that the plaintiff investor filed his lawsuit within the Act’s statute of limitations period and reasonably relied on the developer’s misrepresentations or omissions when making his own capital contributions to the project (Newcomer v. Cohen, May 16, 2017, Melnick, R.).

Capital contributions, loans, and founder’s fee. The defendant had solicited the plaintiff to invest in a large, upscale multifamily apartment complex to be built in Tacoma, Washington. Under the final contract between the parties in 2005, the plaintiff, the defendant, and the defendant's business partner each owned approximately 30 percent of the LLC which developed and owned the property. The LLC agreement provided that "money" and "property" could be contributed and applied to a member’s capital account. Although an earlier draft provided that $350,000 of the managing members’ initial $800,000 capital contribution would be in the form of "deferred equity," the final agreement contained nothing about whether future services or deferred equity could comprise part of a member’s capital account.

The plaintiff ultimately contributed approximately $2.3 million to the project in four capital calls. Although the first phase of the project was initially successful, the investors lost their contributions after the project ran into financing difficulties. The plaintiff then filed suit for fraud under the Washington securities laws, alleging that he would not have made his initial contribution or continued investments in the project if he had known that: (1) a portion of the defendant’s initial capital contribution was paid in deferred equity; (2) an entity owned by the defendant had loaned $359,000 to the project and was repaid days after the plaintiff made his second capital contribution; and (3) that a contract for services between the defendant’s management company and the project entity authorized a $400,000 founder’s fee to the defendant.

Statute of limitations. The appellate court first ruled that the facts before the jury supported its verdict that the plaintiff filed his lawsuit prior to the running of the Act’s three-year limitations period. Among other things, the jury heard evidence that the defendant repeatedly failed to disclose that his initial capital contribution was not fully made in cash, despite repeated inquiries from the plaintiff. These misrepresentations continued as late as the fall of 2013, after the plaintiff hired an attorney to investigate. The jury also heard evidence that the plaintiff and other investors had no knowledge or notice of the founder’s fee until the parties were in discovery. Accordingly, sufficient evidence supported the jury’s verdict that the defendant filed his lawsuit within the statute of limitations.

Materiality and reliance. Next, the appellate court concluded that sufficient evidence existed to persuade a rational juror that the defendant made material misrepresentations or omissions, and that the plaintiff reasonably relied on them when making his capital contributions. The jury heard expert testimony that the form of the plaintiff’s initial capital contribution, e.g. cash vs. non-cash, was a material fact that a reasonable person would want to know about prior to investing. And although the LLC agreement provided that the defendant could borrow money on behalf of the LLC without notice, the jury also heard evidence that an investor would want to know about the loan because the company’s debt would assist an investor in deciding whether or not to make additional capital contributions. Based on the evidence presented at trial, therefore, sufficient evidence supported a finding that the defendant violated the Washington securities laws.

The case is No. 48233-9-II.

Attorneys: Philip Albert Talmadge (Talmadge/Fitzpatrick/Tribe) for William Newcomer and 2009 Newcomer Family, LLC. Bradley Bishop Jones (Gordon Thomas Honeywell LLP) for Michael Cohen and Ken Thomsen.

MainStory: TopStory FraudManipulation NewsFeed WashingtonNews

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