Tax Advice: Issues Involving Racing Partnerships

Racing partnerships are of great value to the horse industry as they increase participation and bring new fans to the sport while lowering both costs and risk exposure. Regardless of form, the collective ownership offered by racing partnerships permits individuals to participate in horse ownership by buying a fraction of a horse, therefore significantly reducing required investment and risk. An individual investor has the ability to purchase interests in several horses or several different partnerships, simultaneously increasing chances of success and reducing risk. It's an opportunity to diversify an investor's portfolio. Formal entities include limited partnerships, general partnerships, limited liability companies and co-ownership agreements. Partnerships may be comprised of a small group of friends or a widely diverse group of individuals who don't know each other and may have had no prior dealings with the racing manager or promoter. There may be two investors (owners) or 100 or more such as microshare investments by owners such as MyRacehorse.com. What is a security? A security is defined as "any investment in a common enterprise with an expectation of profits derived solely from the efforts of a promoter or third party." The Securities and Exchange Commission has long considered pooled ownership of horses with an expectation of profit as a security in no-action letters dating back to the mid-1970s. Racing partnerships generally fall into the definition of security by virtue of their centralized management, the expectation of profit from the investment, and the pooling of capital (common enterprise). Out of necessity, racing managers are typically delegated broad decision-making authority in order to manage the horses' day-to-day. Investors are generally passive (have little to no involvement at all in the decision-making process), relying instead on the expertise of the manager. In the United States, the offer and sale of securities must either be registered or exempt from registration. The larger the number of investors and the more attenuated their relationship with the racing manager, the higher the degree of risk the racing manager or promoter could be seen as soliciting the sale of unregistered securities. Beyond possible civil and criminal liability, an investor's remedy when an investment is found to be a security sold without registration or an exemption from registration, is complete rescission of the deal. In other words, the investor is entitled to the return of all money invested without regard to the current value of the horse(s). Securities laws are designed to protect investors of all sizes and to ensure the stability and integrity of the market, however that market might be defined. While media stories focus on scams, corporate failings, unsavory promoters, penny stocks, and insider trading, the regulations extend beyond big business and publicly traded companies to impact investors in, and promoters of, completely legitimate private business enterprises. Closely held businesses formed to raise capital and further a business purpose, such as racing partnerships, are subject to regulatory scrutiny. The SEC saw an active 2024 with 583 enforcement actions and orders for $8.2 billion in financial remedies. While the media extensively covers the high-profile investigations (think Solar Winds, WeWork, Bitcoin, Bernie Madoff and the like), federal and state securities regulators are also integral to day-to-day compliance and investor fraud investigations of private offerings. This isn't surprising in light of the volume of investor activity in the stock market, the volatility of the market, and the proliferation and often sudden demise of start-up companies. Such investigations often stem from tips, complaints, referrals, and whistleblowers. Exemptions As discussed above, in the U.S. the offer and sale of securities are required to be registered with the SEC and in each state in which a potential investor (to whom an offer is made) resides unless that security qualifies for an exemption from registration. Registration can be a cumbersome and expensive process. In 1980, the Small Business Incentive Act was created to purportedly provide a less-expensive route for small businesses. Many, however, say that it failed in its goal as the requirements continued to be burdensome. Two years later, the SEC adopted Regulation D, which has become the most-used exemption to registration at the federal level. Regulation D provides for exemptions of private placements or limited offerings if the offering meets certain dollar restrictions and investor qualifications. If an offering qualifies for a Regulation D exemption, a limited filing is required at the federal level. Over the intervening years, Regulation D has been modified but essentially offers three pathways to exemption from registration, Rules 504, 506(b) and 506(c), which are described generally below. Which exemption applies depends on the size of the offering and the character of the investors. Offerings cannot be divided in an effort to qualify for an exemption unless a separate business purpose exists. Otherwise, all similar purpose offerings made by an issuer within a 12-month period will be combined and considered one offering. Rules 506(b), 506(C) The most commonly used exemptions fall under Rule 506, which preempts state law registration requirements. Rule 506(b) is available to any issuer, without limit on the dollar amount of securities sold, securities can only be sold to "accredited investors" and up to 35 investors who are not. Rule 506(b) also includes a complete ban on general solicitation or advertising. To the extent any investors are not accredited investors, nonpublic issuers also must furnish to purchasers, to the extent material to an understanding of the issuer, its business, and the securities being offered, both nonfinancial statement information and financial statement information—referred to as a private placement memorandum. A material fact is one that a prudent investor would consider important in making an investment decision. For example, if the manager desires to have the authority to drop a partnership horse into a claiming race, this should be expressly noted in the agreement. In Pugliese v. Mondello, a 2008 New York case, the manager did just that and was sued by an investor who argued that the claim price was not the true value of the horse. The manager prevailed with the court holding that the decision was made for a legitimate business interest and "absent evidence of bad faith, fraud, self-dealing, or other misconduct." However, the time and expense of litigation could have been avoided if the agreement had included language expressly granting or denying such decision-making authority. What is in the governing document is critical and very specific to the particular type of partnership and the objectives of the investors and managers. As mentioned above, Rule 506(b) includes a complete ban on offering-related general solicitation or advertising, including on websites. Public relations-type websites or ads are generally acceptable such as promoting a racing stable generally and past successes. However, current offerings with details on horses and prices should not be posted on websites or elsewhere. The SEC has provided guidance with respect to the ban of general solicitation in the context of racing partnerships. In 1982, the SEC declined to issue a "no action" letter finding that the mailing of a racing partnership brochure to members of the Thoroughbred Owners and Breeders Association, the placing of the brochure on car windshields at fall public auctions, and the placement of an ad in a prominent Thoroughbred magazine violated the prohibition on general solicitation. The term "accredited investor" is defined in Rule 501(a) of Regulation D as any person within certain defined categories, or a natural person whose individual net worth or joint net worth with that person's spouse or spousal equivalent exceeds $1 million, had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse or spousal equivalent in excess of $300,000. If the interest is purchased through an entity such as a limited liability corporation, all members of the LLC must be accredited if the LLC is to be considered an accredited investor. In general, issuers relying on Rule 506(b) are able to rely on investor representations that they are accredited investors. Rule 506(c) is available to any issuer without limit on the dollar amount of securities sold. While Rule 506(c) permits general solicitation, it limits security sales solely to accredited investors. In addition, issuers are required to perform some level of due diligence on investor representations that they meet the accredited investor standard. While no disclosures are mandated under Rule 506(c), offerings are subject to the anti-fraud provisions of the federal securities laws and issuers generally prepare a private placement memorandum or something similar. Rule 504 While not available to all issuers, Rule 504 provides a safe harbor for offers and sales of securities not exceeding $10 million in any 12-month period without limitation on the number or type of purchaser. Although no disclosure is mandated, issuers often prepare offering materials or a private placement memorandum due to anti-fraud provisions of the federal securities laws and provide some basic disclosures to investors concerning the issuer's business and financial condition, the terms of the securities being offered, and the risks of participating in the offering. There is no preemption under Rule 504, therefore state securities law compliance is required in every state where an offer to an investor is made (so-called "Blue Sky Laws"). Most states put their own unique spin on the federal statutes and regulations and therefore are nonuniform. As a result, if an issuer offers to investors in 20 states, the issuer's attorney should review the securities laws in each of those states for compliance. If an offering is made on the internet, the offer is considered to have been made in all 50 states. As a result, issuers interested in 50-state offerings should carefully consider the applicability of rule 506(c), which has the advantage of state law preemption and permits general solicitation. Providing Financials Overstating potential financial outcomes is also a recipe for trouble. If financials are provided in the form of pro-formas with the offering documents, the financials should represent a range of possible and conservative outcomes. One often-used practice is to show at least three versions; one losing money, one breaking even, and one making a modest profit based on reasonable assumptions. In Roman's v. Shearson Lehman Hutton (a 1991 case brought in the First Circuit), investors in a horse breeding limited partnership sued, alleging "fraudulently induced investments through misrepresentations and omissions in the offering materials that falsely inflated the partnership's financial potential." The court dismissed the claims on procedural issues but misleading or overly enthusiastic financial predictions are frequently the source of litigation. Similarly, in Bruce v. Martin, a 1989 New York case, a group of investors involved in 25 related limited partnerships, sued the general partners alleging the limited partnership was a pyramid scheme and claiming fraud (misleading financials and other fraudulent behavior). The case was settled after the court acknowledged that the acts by the general partners resulted in plaintiff's losses. Racing Clubs Racing clubs (organized as not-for-profit social clubs) are rising in popularity and price entry very low typically without additional carrying expenses. Formed for entertainment and without a profit motive, these clubs fall outside of the definition of a security and are focused on the experiential, educational, and social elements of the sport. The clubs encourage participation and provide unique opportunities to visit the backstretch of the racetrack, meet trainers and other owners, and hopefully experience the exhilarating feeling of a racehorse finishing first! These are great first experiences that draw new owners and participants to the sport. Partnerships provide both entertainment and sometimes profit to the investors. However, partnerships should be carefully structured with professional guidance in order to protect both the issuer and the investors and to comply with state and federal law. Laura D'Angelo is a partner in the Lexington office of Dinsmore and concentrates her practice in corporate, equine and gaming law. David Lavan is a former Special Counsel at the U.S. Securities and Exchange Commission, a partner in the Washington, D.C., office of Dinsmore and is nationally recognized for his expertise in U.S. securities law and regulation.