SUPREME COURT CLOSES LOOPHOLE IN FEDERAL SECURITIES LAW

May 21, 2004

Steven P. Garmisa
Hoey & Farina Attorney
garmisa@hoeyfarina.com
1-888-425-1212

Securities laws provide a potent remedy for people who are suckered into bad deals. But first you have to prove your client invested in a "security."

Making it easier to leap this initial hurdle, Congress defined "securities" as including "investment contracts." Yet Congress left it up to the courts to figure out what qualifies as an investment contract.

Case law provided an opportunity for a sharp operator to argue that an investment promising a fixed rate of return did not qualify as an investment contract. Invoking an apparent loophole, Charles E. Edwards -- the promoter of a sale-leaseback program involving pay telephones -- argued that his program was not an investment contract because investors were promised a fixed annual 14 percent rate of return.

Edwards was the chief executive officer and sole shareholder of ETS Payphones Inc., which allegedly raised $300 million before going out of business, unable to repay its 10,000 investors.

The Securities and Exchange Commission filed a civil fraud case against Edwards, but the 11th U.S. Circuit Court of Appeals ruled the pay phone program was not an investment contract because it promised a fixed rate of return (rather than a rate that varied with success of the venture).

Slamming this loophole shut, the Supreme Court unanimously reversed. Securities and Exchange Commission v. Edwards, 2004 WL 51010 (U.S., Jan. 13). Here are some highlights of Justice Sandra Day O'Connor's opinion (with various omissions):

" 'Congress' purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called.' Reves v. Ernst & Young, 494 U.S. 56, 61 (1990). To that end, it enacted a broad definition of 'security,' sufficient to encompass virtually any instrument that might be sold as an investment."

The Securities Act of 1933, and the Securities Exchange Act of 1934, "in slightly different formulations which we have treated as essentially identical in meaning, define 'security' to include 'any note, stock, treasury stock, security future, bond, debenture ... investment contract ... [or any] instrument commonly known as a "security." ' 'Investment contract' is not itself defined.

"The test for whether a particular scheme is an investment contract was established in our decision in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). We look to 'whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.'

"This definition 'embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.'

"In reaching that result, we first observed that when Congress included 'investment contract' in the definition of security, it 'was using a term the meaning of which had been crystallized' by the state courts' interpretation of their 'blue sky.' (Those laws were the precursors to federal securities regulation and were so named, it seems, because they were aimed at promoters who 'would sell building lots in the blue sky in fee simple.' 1 L. Loss & J. Seligman, Securities Regulation 36, 31-43 (3d ed. 1998) (quoting Mulvey, Blue Sky Law, 36 Can. L. Times 37 (1916)).)

"The state courts had defined an investment contract as 'a contract or scheme for the placing of capital or laying out of money in a way intended to secure income or profit from its employment,' and had 'uniformly applied' that definition to 'a variety of situations where individuals were led to invest money in a common enterprise with the expectation that they would earn a profit solely through the efforts of the promoter or [a third party].' Howey, at 298 (quoting State v. Gopher Tire & Rubber Co., 146 Minn. 52, 56, 177 N.W. 937, 938 (1920)).

"Thus," O'Connor explained, "when we held that 'profits' must 'come solely from the efforts of others,' we were speaking of the profits that investors seek on their investment, not the profits of the scheme in which they invest. We used 'profits' in the sense of income or return, to include, for example, dividends, other periodic payments, or the increased value of the investment.

"There is no reason to distinguish between promises of fixed returns and promises of variable returns for purposes of the test, so understood. In both cases, the investing public is attracted by representations of investment income, as purchasers were in this case by ETS' invitation to 'watch the profits add up.' Moreover, investments pitched as low-risk (such as those offering a 'guaranteed' fixed return) are particularly attractive to individuals more vulnerable to investment fraud, including older and less sophisticated investors.

"Under the reading [Edwards] advances, unscrupulous marketers of investments could evade the securities laws by picking a rate of return to promise. We will not read into the securities laws a limitation not compelled by the language that would so undermine the laws' purposes."

O'Connor concluded that an investment scheme "promising a fixed rate of return can be an 'investment contract' and thus a 'security' subject to the federal securities laws."

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