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LENZ v. ASSOCIATED INNS & RESTAURANTS CO. OF AMERI

September 24, 1993

GORDON LENZ, individually and on behalf of NAPLES TENNIS RESORT, LTD., Plaintiff,
v.
ASSOCIATED INNS AND RESTAURANTS COMPANY OF AMERICA, AIRCOA EQUITY INTERESTS INC., TFC INVESTMENTS LTD., REALVEST INC., formerly known as FRACORP, INC., Defendants.



The opinion of the court was delivered by: KENNETH CONBOY

 KENNETH CONBOY, DISTRICT JUDGE:

 This case involves a tax shelter that never stopped losing money. In the late 1970's and early 1980's, the United States experienced a rapid proliferation of real estate limited partnerships designed to shelter taxable income. These tax shelters constituted one stimulus for the Congressional overhaul of the federal tax laws in 1986, and reform significantly limited their appeal. The legal fallout from these shelters, however, continues to be felt at every level of the nation's adjudicative fora. Accusations of fraud and mismanagement have proven rampant where real estate tax shelters are concerned. Such an allegation is before the court in this case.

 BACKGROUND

 A. The Sale

 In 1981, Gordon Lenz owned Conference Associates, an insurance company in Patchogue, New York specializing in health and other personal insurance plans for trade or professional associations, and in property and casualty insurance for businesses. His income had exceeded six figures for over five years, and in that time he had purchased several real estate investments, including two small apartment houses and a small office building. Lenz was in the 50% tax bracket and unhappy about it.

 Upon their arrival in Naples, Lenz and Rose were met by Charles Holmes, who, Lenz was led to believe, represented the general partners of the project. Holmes then conducted a tour of both the Naples Bath and Tennis Club ("NBTC"), the assets of which were to constitute the assets of the limited partnership, and an adjacent condominium project. According to Lenz, *fn1" Holmes offered a detailed description of the structure and administration of the limited partnership. Specifically, Holmes stated that the limited partnership would purchase NBTC for approximately $ 5,000,000 and the project was expected to lose money for two or three years, offering Lenz a writeoff of two times his annual investment during that time. The resort would begin to generate profits in the third year of operation and distributions of these profits would ultimately permit each limited partner to receive a cash return on their investment at or near the amount of his contribution prior to sale of the resort. These distributions were guaranteed, according to Holmes, to reach an annual rate of 10% of each limited partner's investment, and projected to rise as high as 15%. Holmes further indicated that the sale of the assets of the limited partnership for a profit was also guaranteed because a contract existed with the adjacent condominium association to purchase the project for $ 8,000,000 within any of the next five years and $ 11,000,000 during the sixth year or any year thereafter. Lenz was repeatedly told that the investment offered him a guaranteed "win-win" outcome (i.e., he could both shelter income through initial losses and gain a return on his investment through cash distributions and sale of the resort.) At the time of the tour, Lenz did not ask for or receive any financial or legal documents verifying Holmes's representations.

 During the course of Lenz's overnight stay in Naples, Holmes suggested to Lenz that he could spread his investment over five years, contributing $ 50,000 in each year. Lenz indicated that this option represented an attractive income sheltering strategy for him. In response to his expression of interest, he received one week later the subscription agreement ("Subscription Agreement"), the signature page to the partnership agreement ("Partnership Agreement"), and a partnership summary ("Summary") for Naples Tennis Resort, Ltd. ("NTR" or "the Limited Partnership").

 Lenz did not have expert advisors, attorney or accountants, review the documents. He himself reviewed the Subscription Agreement and the accounting projections contained in the Summary, which projected that the Limited Partnership would produce profits in its third year after providing initial tax shelter benefits. By signing the Subscription and Partnership Agreements on April 1, 1981, Lenz committed to purchase a 22.27% limited partnership interest in NTR for the sum of $ 245,000, comprised of $ 25,000 in cash and a $ 220,000 promissory note payable to NTR. The other limited partners were Mark Rose and M & R Equipment (a company controlled by Rose) owning together a 71.28% interest, and Kevin Bowler, who purchased a 4.45% interest.

 B. The Subscription and Partnership Agreements

 Section 12.2 of the Partnership Agreement ceded to the General Partners "full, exclusive and complete discretion in the management and control of the affairs of the Partnership." This discretion included, among other powers, the capacity to enter into mortgages, borrow money, enter into leases, commit to and pay management fees, and sell all of the partnership's property at any price deemed satisfactory to the General Partners.

 The Partnership Agreement also obligated the General Partners to certain procedures in distributing net proceeds from extraordinary events and making information available to the limited partners. Specifically, § 8.3 stated that:

 
All net proceeds received by the Partnership from extraordinary events (i.e., the net proceeds from any indebtedness, refinancing, sale . . . or other disposition of all or any substantial part of the Partnership's property) . . . shall be distributed in the following order:
 
(a) To the payment of all debts., liabilities, or obligations of the Partnership, other than in respect to those set forth in (b) through (f) below;
 
(b) Then, to the setting up of any reserves which the General Partners deem reasonably necessary to provide for all contingent or unforeseen liabilities. . .
 
(d) Then, pro rata 1% to each of the General Partners and 98% to the Limited Partners in proportion to their respective Partnership Interests, until such time as 100% of the cash capital contribution of all Partners are returned. . .
 
(f) Thereafter, pro rata 25% to each of the General Partners and 50% to the Limited Partners in Proportion to their respective Partnership interests.

 Section 10 of the Partnership Agreement provided that the books and records of the Limited Partnership would be available for review, that each partner would be furnished with annual reports and tax information, and that any other information requested by a limited partner as to the partnership and its activities, would be provided to such limited partner.

 Both the Subscription and Partnership Agreements provided that the Limited Partnership was to be governed by Oklahoma law.

 C. Structure and Operation of the Limited Partnership

 The original general partners of the Limited Partnership ("General Partners) were TFC Investments, Ltd. ("TFC") and Associated Inns and Restaurants Company of America ("Associated Inns"). In July 1984, Associated Inns' general partnership interest was transferred, by consent of all general and limited partners, to Aircoa Equity Interests, Inc. ("AEI"). Associated Inns later merged with another corporation, and the surviving entity was renamed Aircoa Hospitality Services, Inc. ("AHS").

 The Partnership Agreement also provided for various management fees and expenses, including: 1) 4% of gross revenues to general partner Associated Inns (later Aircoa) to manage the club facilities; 2) $ 25,000 per year to Frates Corporation for administrative, accounting, and other administrative supervision of the Partnership's affairs; and 3) An equity placement fee equal to 6% of the Limited Partners' capital contributions to Asset Management, Inc., a company affiliated with the General Partners.

 D. The Financial History of the Limited Partnership

 As one might deduce from the existence of this litigation, the Limited Partnership never turned the corner to profitability. NTR operated at a loss from 1981 through 1989. *fn3" The project was hampered by heavy local competition from other resorts and such inherent limitations on the revenue generating potential of a tennis club as the number of courts available and court time allocable in a single day.

 During this period, the General Partners entered into several significant transactions affecting the Limited Partnership. First, on October 2, 1986, the lease agreement was extended for a period of seven years under the same rental terms. Second, general partner Aircoa Equity, on behalf of the Limited Partnership, modified between 1986-1988 the original mortgage that the Limited Partnership had assumed upon its purchase of NBTC. In October 1986, the General Partners refinanced the original mortgage, with a new mortgage issued in favor of Citizens and Southern National Bank of Collier County ("C & S") for $ 2.95 million. Proceeds of the refinancing were used to repay the original mortgage, fund closing costs, purchase furniture, fixtures, and equipment, and provide working capital for the tennis club. In September 1987 the General Partners obtained an additional C & S issued and a $ 300,000 credit line from C & S, the proceeds of which were used to construct additional tennis facilities as NBTR. Lenz was not notified of the above transactions nor did he receive any distributions as a result of their occurrence.

 In early 1988, the General Partners decided to sell NBTC and began sales efforts which lasted for just under two years. On December 4, 1989, the property was sold for $ 2,814,776. The purchase price was insufficient to cover all debt on the property; therefore, an affiliate of AEI paid off $ 245,000 of NTR debt to enable the sale to proceed. Lenz and other limited partners were notified of the sale within ten days. As a result of the sale, Lenz was required to declare $ 502,000 in "phantom income" for the 1989 tax year, thereby incurring tax liability in the amount of $ 179,975.

 E. Plaintiff's Relationship With The General Partners

 Relations between Lenz and the General Partners soured rapidly after his initial investment in the Limited Partnership. In 1981 and 1982, the General Partners were late in sending Lenz the K-1 tax forms necessary for filing his income tax returns. Lenz, moreover, had begun to deal with other real estate limited partnerships *fn4" and his experiences led him to believe that the General Partnership had not provided him with the proper documentation for his investment (e.g., he had been given no offering memoranda). After significant difficulty in obtaining responses to his inquiries, Lenz managed to obtain from David Rose, an employee of Fracorp, a variety of documents concerning NTR, including the full text of the Partnership Agreement.

 These documents failed to reassure Lenz regarding NTR. By 1984, the Limited Partnership had begun to lose money beyond the point at which it was originally projected to become profitable. Lenz began persistently questioning David Rose as to when the project would start to turn a profit. On October 26, 1984, Rose forwarded to Lenz a letter stating that the Limited Partnership was projected to continue losing money at least through 1986. At this point, Lenz was so dissatisfied with his investment that he consulted with Martin Licht, Esq., an attorney specializing in tax shelter litigation, but chose not to pursue legal action at the time.

 On November 13, 1984, Lenz wrote a scathing letter to Rose, demanding further information regarding when the Limited Partnership would become profitable because Holmes had initially represented that NTR constituted a conservative investment with absolute safety of principle and a guaranteed 10% annual rate of return. Lenz also requested to know when the General Partners intended to sell NTR at the profit that Holmes had guaranteed. David Rose's response, dated February 7, 1985, reiterated the loss projections contained in his previous missive, and further stated:

 
While we expect that a future appraisal will yield a sales price in excess of our $ 5,000,000 basis, we won't know that until 1987 when the actual results of our operations for 1986 are complete. Therefore, any specific projection of net sales results at this time would be speculative at best. (emphasis added)

 Upon reviewing financial statements of NTR which accompanied Rose's February 7 letter, Lenz suspected that the General Partners were intentionally generating losses through NTR:

 
I guess [the financial statements] also represented if in fact the business was collecting $ 480,000 in rent and it had a loss at the end of the year, that it wasn't running itself in a way that businesses normally do, trying to produce a profit, so that they [could] pay me the money that they promised to pay me when I first went in.

 Lenz deposition p.303. Despite this suspicion, and the fact that by December 1985 he had become "very disenchanted with the investment as a whole," Id., p. 361 Lenz largely ceased further communication with the General Partners or other action concerning NTR until after the Limited Partnership's sale in December 1989. In March 1986, Lenz received an excerpt from an article in the New York Times depicting the conviction of Holmes for fraud in Tulsa, but did not choose to contact the General Partners in response to it. In fact, after a series of phone calls on one day in late 1986 or early 1987, *fn5" Lenz had no more contact at all with the General Partners' representatives, aside from the periodic tax/financial information he received from the Limited Partnership.

 In May 1990, Lenz initiated this lawsuit.

 F. Procedural History of This Action

 Plaintiff's complaint contains both federal and state claims for relief. In substance, Lenz contends that the defendant General Partners defrauded him in his 1981 purchase of his limited partnership interest by intentionally misrepresenting the security and future profitability of the investment. The defendants' intent from the outset, according to plaintiff, was to milk the resources of the Limited Partnership for the benefit of defendants' other projects, particularly the condominium association adjacent to NBTC. This systematic looting is alleged to have in fact taken place throughout the duration of plaintiff's investment. It included the lease extension and mortgage modifications described above, which plaintiff alleges did or should have generated proceeds to be distributed to the limited partners pursuant to the Partnership Agreement.

 Formally, plaintiff has alleged violation of Section 10(b) of the Securities Exchange Act of 1934 ("the 1934 Act"), and Rule 10(b)(5) promulgated thereunder. Plaintiff also asserts claims of breach of fiduciary duty, conversion, negligence, and a demand for an accounting under Oklahoma law. He sues both in his individual capacity and derivatively on behalf of the Limited Partnership.

 By order dated November 14, 1991, the court held defendants TFC and Realvest in default for having failed to obtain counsel, and barred them from participating in the action in any way. The complaint, however, appeared to assert that all defendants were jointly liable; therefore, Lenz's motion for a default judgement against TFC and Realvest was denied.

 Defendants have moved for summary judgement, arguing inter alia that plaintiff's federal securities law claims are time-barred and the court lacks supplemental or diversity jurisdiction over the state law claims. Plaintiff has cross-moved for partial summary judgement granting an accounting. For the reasons set forth ...


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