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UNITED STATES DISTRICT COURT In Re BENNETT FUNDING GROUP, INC. ———————————————————— THIS DOCUMENT RELATES TO
All Actions |
X |
96-Civ-2583 (JES) |
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BRIEF OF THE SECURITIES AND
EXCHANGE COMMISSION, AMICUS CURIAE
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Local Counsel Barry W. Rashkover
Securities and Exchange |
RICHARD A. WALKER
PAUL GONSON
ERIC SUMMERGRAD
LESLIE E. SMITH
Securities and Exchange Commission |
TABLE OF AUTHORITIES
CASES
Bailey v. J.W.K. Properties, Inc.,
904 F.2d 918 (4th Cir. 1990)
Chemical Bank v. Arthur Andersen & Co.,
726 F.2d 930 (2d Cir.), cert. denied,
469 U.S. 884 (1984)
Connors v. Lexington Insurance Co.,
666 F. Supp. 434 (E.D.N.Y. 1987)
Cunningham v. Brown,
265 U.S. 1 (1924)
Diaz Vicente v. Obenauer,
736 F. Supp. 679 (E.D. Va. 1990)
El Khadem v. Equity Securities Corp.,
494 F.2d 1224 (9th Cir.), cert. denied,
419 U.S. 900 (1974)
Exchange National Bank v. Touche Ross & Co.,
544 F.2d 1126 (2d Cir. 1976)
Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce,
Fenner, & Smith, Inc.,
756 F.2d 230 (2d Cir. 1985)
Glen-Arden Commodities, Inc. v. Costantino,
493 F.2d 1027 (2d Cir. 1974)
Gordon v. Terry,
684 F.2d 736 (11th Cir. 1982), cert. denied,
459 U.S. 1203 (1983)
In re Hedged-Investments Associates, Inc.,
84 F.3d 1281 (10th Cir. 1996)
People v. White,
124 Cal. App. 548, 12 P.2d 1078
(Dist. Ct. App. 1932)
Pollack v. Laidlaw Holdings, Inc.,
27 F.3d 808 (2d Cir. 1994)
RTC v. Stone,
998 F.2d 1534 (10th Cir. 1993)
Revak v. SEC Realty Corp.,
18 F.3d 81 (2d Cir. 1994)
Reves v. Ernst & Young,
494 U.S. 56 (1990)
SEC v. Aqua-Sonics Products Corp.,
687 F.2d 577 (2d Cir.), cert. denied,
459 U.S. 1086 (1982)
SEC v. Brigadoon Scotch Distributors, Ltd.,
388 F. Supp. 1288 (S.D.N.Y. 1975)
SEC v. C.M. Joiner Leasing Corp.,
320 U.S. 344 (1943)
SEC v. Cross Financial Services,
908 F. Supp. 718 (C.D. Cal. 1995)
SEC v. Energy Group of America, Inc.,
459 F. Supp. 1234 (S.D.N.Y. 1978)
SEC v. Eurobond Exchange, Ltd.,
13 F.3d 1334 (9th Cir. 1994)
SEC v. Glenn W. Turner Enterprises, Inc.,
474 F.2d 476 (9th Cir.), cert. denied,
414 U.S. 821 (1973)
SEC v. International Loan Network, Inc.,
968 F.2d 1304 (D.C. Cir. 1992)
SEC v. Koscot Interplanetary, Inc.,
497 F.2d 473 (5th Cir. 1974)
SEC v. Life Partners,
87 F.3d 536,
reh'g denied, 102 F.3d 587
(D.C. Cir. 1996)
SEC v. Pinckney,
923 F. Supp. 76 (E.D.N.C. 1996)
SEC v. W.J. Howey Co.,
328 U.S. 293 (1946)
Tcherepnin v. Knight,
389 U.S. 332 (1967)
United Housing Foundation, Inc. v. Forman,
421 U.S. 837 (1975)
STATUTES
Bankruptcy Code of 1978, 11 U.S.C. 101 et seq.
Section 362, 11 U.S.C. 362
Securities Act of 1933, 15 U.S.C. 77a et seq.
Section 2(1), 15 U.S.C. 77b(1)
Section 12(1), 15 U.S.C. 77l(1)
Section 12(2), 15 U.S.C. 77l(2)
Section 15, 15 U.S.C. 77o
Securities Exchange Act of 1934, 15 U.S.C. 78a et seq.
Section 3(a)(10), 15 U.S.C. 78c(a)(10)
Section 10(b), 15 U.S.C. 78j(b)
Section 20(a), 15 U.S.C. 78t(a)
Rule under the Securities Exchange Act of 1934, 17 C.F.R. 240.01 et seq.
Rule 10b-5, 17 C.F.R. 240.10b-5
MISCELLANEOUS
Black's Law Dictionary 1060 (6th ed. 1990)
Joseph C. Shenker & Anthony J. Colletta,
Asset Securitization: Evolution, Current Issues
and New Frontiers, 69 Tex. L. Rev. 1369 (1991)
2 Louis Loss & Joel Seligman, Securities Regulation,
(3d ed. 1989)
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UNITED STATES DISTRICT COURT In Re BENNETT FUNDING GROUP, INC. ———————————————————— THIS DOCUMENT RELATES TO
All Actions |
X |
96-Civ-2583 (JES) |
BRIEF OF THE SECURITIES AND
EXCHANGE COMMISSION, AMICUS CURIAE
STATEMENT OF THE ISSUE ADDRESSED BY THE COMMISSION
The Commission will address the issue whether the lease assignments offered and sold to investors by the defendant brokers are securities under the federal securities laws.
INTEREST OF THE COMMISSION AND SUMMARY OF ITS POSITION
The Securities and Exchange Commission, the agency principally responsible for the administration and enforcement of the federal securities laws, submits this brief as amicus curiae to address the question whether the lease assignments sold to plaintiffs in this case are within the definition of "security" under the Securities Act of 1933, 15 U.S.C. 77a et seq., and the Securities Exchange Act of 1934, 15 U.S.C. 78a et seq. This issue is of considerable importance to the Commission since it recurs with some frequency in private and Commission litigation and also is presented in a Commission enforcement action against the promoters of the lease assignments which is pending before this Court. In re The Bennett Funding Group, Inc., 96-Civ-2237 (JES).
The lease assignments offered and sold by the defendants are securities under two different tests under the federal securities laws, either of which suffices to demonstrate a security. First, the assignments are "notes," in that they are fixed obligations to pay money over a period of time. Under the applicable Supreme Court test, these notes are securities. They were sold by the issuer to raise money for its ongoing business, and were bought by investors because of the return they offered. The assignments were mass marketed to thousands of investors, and were represented in terms that would lead a reasonable investor to believe they were securities. Finally, there is no alternative scheme of regulation that would render the application of the federal securities laws unnecessary.
Alternatively, the lease assignments were "investment contracts," which are securities under the federal securities laws. An investment contract is an investment of money in a common enterprise with the expectation of profits from the efforts of the promoter or a third party. The plaintiffs here were, on the facts alleged, investing in a common enterprise — their money was pooled with that of other investors, they shared risks and the opportunity for a return with those investors, and their ability to reap a return was dependent on the success of the enterprise as a whole. They were expecting profits in the form of a return on their money. And they were dependent for those returns on the efforts of the promoters or others — both in the selection of the leases and in the post-purchase servicing of the asset. 1/
STATEMENT OF THE CASE
A. Facts
According to the complaint, plaintiffs are a class of over 20,000 investors who purchased various investments offered by The Bennett Funding Group, Inc. and related entities (collectively "BFG") through the defendant brokers (C. 74, 75). 2/ BFG held itself out as a full-service business equipment leasing and finance company (C. 15(a)). Through the trade name Aloha Leasing, BFG purchased full pay-out direct financing leases and installment sales contracts generated by office equipment dealers (id.).
Among the instruments that BFG offered to the public were so-called "lease assignments" (C. 84, 127-143). BFG purported to acquire leases on items of office equipment, mostly "small ticket" items such as photocopiers and facsimile machines (more than 95% of the purported leases involved items worth less than $15,000) (C. 15(a)). The supposed lessees or end-users were municipalities, which agreed to make monthly payments on the equipment for terms between two and five years (C. 130). In its synopsis for investors in the municipal leasing program, BFG emphasized that because the lessees were municipalities, the lease assignments were tax-exempt and safe (C.128). Hundreds of million of dollars worth of these instruments were sold to thousands of investors (C. 127).
BFG purported to assign these leases to individual investors (C. 127). When investors were given lease assignment documents, it looked as if they owned an interest in an underlying lease (C. 134-35, 189-90). A BFG synopsis for investors stated that the assignment represented a municipality's promise to pay under installment purchase contracts (C. 130). Assignment documents purported to convey all of BFG's right, title and interest to the investor and identified the purported lessee, the investor's purchase price, the monthly payment due to the investor (broken down by interest and principal), and the total amount of future payments owed under the lease (C. 134-35).
BFG promised to service the leases (C. 132). It serviced all leases, member contracts and dealer inventory notes (C. 15(a)), including billing the end-users, collecting monthly installments, following up on defaults, and performing the administrative tasks necessary to maintain the contracts (C. 106). BFG had a staff of 180 employees, organized into credit, billing, collection and legal departments, to manage approximately 60,000 transactions (C 107). Investors had no part to play in these efforts, and were led to expect that their profits would derive solely from the efforts of others (C. 205(e)).
BFG sold the investments in order to raise money for general use in its leasing business, and plaintiffs purchased them primarily for the profit they were expected to generate (C. 205(a)). Plaintiffs were seeking relatively secure income from the investments (C. 3).
BFG investments were offered and sold to a broad segment of the public by more than 100 seller entities located throughout the United States (C. 205(b)). BFG characterized the instruments as investments, similar to municipal bonds and mutual funds, and compared them favorably to "more conventional municipal bonds" (C. 131), leading investors to expect that the investments were securities (C. 205(c)).
Although BFG purported to be passing through payments from a particular lease to a corresponding investor, it did not do so (C 132). In fact, BFG sold numerous interests in purported leases that did not exist. BFG sold $55 million worth of purported photocopier leases with NYC Transit that were non-existent (C. 137). It also assigned leases to more than one investor at a time (C 138-40).
Rather than paying investors by passing through payments on the leases, BFG pooled the payments it received from investors, from lessees, and from other sources in one account, from which it made payments to investors (C. 132). BFG's payments to investors had no relationship to payments made on the purportedly assigned contracts; BFG generally paid investors regardless of whether the end-user was delinquent in payments (C. 194). BFG used some funds that came from new investors to make payments to earlier purchasers of the lease assignments (id., C. 190). Plaintiffs claim, and the Commission in a separate law suit also alleges, that in this respect BFG operated as a fraudulent "Ponzi" scheme (C. 4-7, 132, 141). 3/
Eventually, BFG reached a point where new investments were outstripped by obligations to earlier investors (C. 9). In January, 1996, all BFG investors were notified that the rate of interest they had been receiving would be temporarily reduced due to a short term problem with the income BFG was receiving on certain leases (C. 10). In March 1996, BFG filed for bankruptcy (C. 9-10).
B. Proceedings in this Court
Plaintiffs filed the consolidated class action complaint in this action on September 16, 1996, on behalf of themselves and a class of similarly situated purchasers of BFG investments (C. 16). The defendants include individual members of the Bennett family, executives and officers of BFG, BFG's auditor, law firms, the purported insurers of certain of the instruments, and the brokers and financial advisors who sold BFG products (C. 17-38). BFG and related entities in bankruptcy were not named as defendants because of the automatic stay provided in Section 362 of the Bankruptcy Code, 11 U.S.C. 362 (C. 15).
Plaintiffs allege, inter alia, violations by various defendants of certain provisions of the federal securities laws, specifically, Sections 12(1) and (2) of the Securities Act, 15 U.S.C. 77l(1) and (2), and the antifraud provisions of Section 10(b) of the Securities Exchange Act, 15 U.S.C. 78j(b), and Rule 10b-5 thereunder, 17 C.F.R. 240.10b-5. 4/
Defendants have moved to dismiss the complaint, asserting among other things that plaintiffs have failed to state a claim because the lease assignments are not securities (D. Mem. 1-12). 5/
ARGUMENT
UNDER THE FACTS ALLEGED IN THE COMPLAINT, THE LEASE ASSIGNMENTS OFFERED AND SOLD BY THE DEFENDANTS ARE SECURITIES WITHIN THE COVERAGE OF THE FEDERAL SECURITIES LAWS.
In considering whether to grant the defendants' motion to dismiss, the Court must of course take the facts alleged in the complaint as true, with all reasonable inferences in the favor of the non-moving party. Under the facts alleged in the complaint, the investment instruments offered and sold by the defendants satisfy two tests — the "note" test and the "investment contract" test — either of which independently suffices to demonstrate the existence of a security under the federal securities laws.
A. The Lease Assignments Meet the Definition of Securities in the Form of Notes.
Section 2(1) of the Securities Act of 1933, 15 U.S.C. 77(b)(1), defines "security" to include any "note" or "evidence of indebtedness." Section 3(a)(10) of the Securities Exchange Act, 15 U.S.C. 78 (a)(10), similarly includes any "note." A note is "[a]n instrument containing an express and absolute promise to pay to a specified person, or bearer, a definite sum of money at a specified time." Black's Law Dictionary 1060 (6th ed. 1990). The lease assignments are notes because they require the lessees to make fixed monthly payments over a specified amount of time (C. 134-35). Investors were promised a sum certain, to be paid in monthly installments, including interest (id.).
Although the securities acts by their terms include all notes within the definition of security, the courts have recognized that notes often are used in contexts, such as commercial or consumer financing by lending institutions, where it would not be appropriate to find that they are securities. In Reves v. Ernst & Young, 494 U.S. 56, 64 (1990), the Supreme Court held that a note will be presumed to be a security, but that the presumption is rebuttable if it is shown that a note bears a "strong family resemblance" to any instrument on a list of notes which have previously been deemed not to be securities, 6/ or if it is determined — looking to four factors identified in Reves — that the note should be on the list. 7/ Id. at 66-68. The four factors are:
(1) an "examin[ation of] the transaction to assess the motivations that would prompt a reasonable seller and buyer to enter into it," that is, whether it was motivated by investment or commercial purposes;
(2) whether the note "is an instrument in which there is 'common trading for speculation or investment'" (quoting SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 351 (1943));
(3) "the reasonable expectations of the investing public"; and
(4) "whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary."
Id.
The burden is on those seeking to exclude a note from the definition of security. Id. at 63-64, 67. An analysis of the four factors demonstrate that the defendants cannot meet that burden, and that the BFG lease assignments are securities.
Under the first factor, the court examines the transaction to determine the motivations that would prompt a reasonable buyer and seller to enter into it. See Id. at 66. An instrument is likely to be a security if "the seller's purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate." Id. "The inquiry is whether the motivations are investment (suggesting a security) or commercial or consumer (suggesting a non-security)." Pollack v. Laidlaw Holdings, Inc., 27 F.3d 808 (2d Cir.), cert. denied,115 S. Ct. 425 (1994) (finding investment motivation for loan participation transactions because buyers clearly sought to invest and seller was "raising funds for its general business activities of making and servicing mortgages" (id. at 812-13)).
Both BFG and the investors were motivated to enter into the lease assignments by investment, rather than commercial motivations. BFG's purpose in selling the lease assignments was to raise money for general use in its leasing business (C. 205(a)), and the investors' purpose in buying them was to earn a profit (C 3, 205(a)). 8/
With regard to the second factor, the plan of distribution, plaintiffs need show only that the instrument is "offered and sold to a broad segment of the public." 494 U.S. at 59. BFG obtained thousands of investors in the lease assignments nationwide through a network of registered broker-dealers (C. 205). The broad solicitation of, and sales to, the investing public plainly satisfied this factor. See Pollack, 27 F. 3d at 813 ("broad-based unrestricted sales to the investing public" support a finding under second Reves factor that loan participations are securities).
The third factor, the reasonable expectations of the investing public, also leads to the conclusion that the lease assignments are securities. There is no question that investors who purchased lease assignments from the defendant brokers were looking to earn a "valuable return on investment." 494 U.S. at 68 n.4. They were seeking a relatively secure return, associated with a municipal obligation that was represented to be tax-free and safe (C. 3, 128). Moreover, BFG's own synopsis of the lease assignment program compares these instruments favorably with "more conventional municipal bonds" (C. 130). This characterization of the lease assignments as investments, in the absence of countervailing factors that would lead one to question the characterization, is enough to support a reasonable prospective purchaser's expectation that they are securities. Reves, 494 U.S. at 69; Diaz Vicente v. Obenauer, 736 F. Supp. 679, 693 (E.D. Va. 1990). See also Pollack, 27 F.3d at 813; SEC v. Cross Financial Services, 908 F. Supp. 718, 729 (C.D. Cal. 1995) (promoters' "representations, particularly in their brochure, stressing the security and attractiveness of the investment, satisfy the third element").
As to the fourth factor, there is no alternative scheme of regulation, indeed no risk-reducing factors, that might render the need for protection under the federal securities laws unecessary. If the federal securities laws are not applicable, the lease assignments will escape regulation altogether.
In applying the Reves test it is important to stress what is being analyzed. We do not suggest that the underlying equipment leases were securities, or that the ordinary commercial or consumer relationship between a lessor and lessee involves securities. What is at issue here is not the underlying lease relationship, but rather the transaction in which assignments in the leases were sold to the plaintiffs. As the Second Circuit has emphasized, even if an underlying asset is not a security, the sale of interests in the asset may, depending on how and to whom the interests are marketed and sold, be a security. For example, in Pollack v. Laidlaw Holdings, Inc., supra, the court held that participations in commercial loans were securities, although commercial loans are on the Reves list of non-securities. In evaluating whether participations in such loans are securities, the Pollack court looked to the motivations of the participator and participants, the manner of distribution of the participations, and how the participations were marketed. Here too, one must look to the motivations of BFG and the lease assignees, the manner or distribution of the assignments, and how the assignments were marketed.
B. The Lease Assignments Are Securities Under the Test for Investment Contracts.
If the Court determines that the lease assignments are notes, the inquiry into whether they are securities comes to an end, but if the instruments in this case are not securities under the notes test, they are "investment contracts," which are among the items expressly defined as securities under the federal securities laws. See Section 2(1) of the Securities Act, 15 U.S.C. 77b(1), & Section 3(a)(10) of the Exchange Act, 15 U.S.C. 78c(a)(10). In SEC v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946), the Supreme Court defined an "investment contract" as a contract, transaction or scheme in which there is (i) an investment of money (ii) in a common enterprise (iii) with the expectation of profits solely from the efforts of the promoter or a third party. The Howey Court said the term "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." Id. at 299.
The defendants do not dispute that the first Howey element is satisfied — the plaintiffs made an investment of money (C. 144; see D. Mem. 5 n.4). They claim, however, that there was no common enterprise, that investors were not expecting profits, and that they were not expecting profits from the efforts of the promoters or others. In fact, all of the Howey elements are met here.
1. Common enterprise
A common enterprise requires a showing of "commonality" in some form — either horizontal or vertical. Defendants argue (D. Mem. 4-7) that neither form of commonality existed.
(a) Horizontal Commonality
A common enterprise can be demonstrated by showing horizontal commonality, which can be shown through "the tying of each individual investor's fortunes to the fortunes of the other investors by the pooling of assets, usually combined with the pro rata distribution of profits." Revak v. SEC Realty Corp., 18 F.3d 81, 87 (2d Cir. 1994). "In a common enterprise marked by horizontal commonality, the fortunes of each investor depend upon the profitability of the enterprise as a whole" (id.). That is exactly what resulted when BFG pooled investors' funds and made payments to them, not by passing through the actual payment on an individual lease, but by allocating payments from the pooled account in which all funds were commingled. Investors received their pro rata payments without regard to whether payment on the purported underlying lease had been made. Investors' fortunes thus were linked when payments were made from the common pool.
Defendants do not counter these allegations. Instead they incorrectly claim (D. Mem. 6-7) that plaintiffs' own complaint describes a program in which individual leases are assigned to individual investors, which they argue is inconsistent with pooling. They do this by attributing to plaintiffs a description of the program (C. 130) that is not the plaintiffs' allegation at all, but rather is identified in the complaint as a quotation from BFG's Municipal Lease Program synopsis. They likewise assert that plaintiffs' description of the program (C.130-37) depicts individual, not pooled, leases, but leave out the words in those paragraphs of the complaint — "purported" or "purports" — which make it clear that plaintiffs were only skeptically recounting what BFG claimed the program was. In fact, in describing how the program actually operated, the plaintiffs make frequent allegations that investor money was pooled (C 132, 141, 146, 148, 190).
(b) Narrow Vertical Commonality
Narrow vertical commonality occurs where the fortunes of the investors are tied to the fortunes of the promoter and not necessarily to those of other investors. Revak, 18 F.3d at 87. The Second Circuit has not decided whether narrow vertical commonality satisfies the common enterprise element of the Howey test, but many other courts have held that it does. See 2 Louis Loss & Joel Seligman, Securities Regulation, 927-35 (3d ed. 1989). 9/
Narrow vertical commonality exists here because BFG made periodic payments to the investors without regard to whether BFG had received payment on the purportedly underlying lease. The ability of investors to receive returns on their investments was closely linked to the ability of BFG to generate money, including by raising money from new members, from which to make the payments. See SEC v. Pinckney, 923 F. Supp. 76, 81-82 (E.D.N.C. 1996); Connors v. Lexington Insurance Co., 666 F.Supp. 434, 440 (E.D.N.Y. 1987).
2. Expectation of Profit
The defendants claim that because investors were expecting a fixed return, they were not expecting "profits" under the Howey test. That argument is based on a misreading of United Housing Foundation, Inc. v. Forman, 428 U.S. 837 (1975), to require that the anticipated profits be (D. Mem. 7, quoting id. at 852) "either capital appreciation resulting from the development of the initial investment * * * or a participation in earnings resulting from the use of investors' funds." See also Reves, 494 U.S. at 68 n.4.
The discussion of profit in Forman describes only the types of profit involved in two of the Court's prior cases, and was not intended to be exhaustive. Forman itself did not turn on the distinction between fixed and other returns. In Forman investors bought shares of "stock" carrying with them the right to occupy units in a cooperative apartment development, not with a view to a profit but with a view to acquiring housing. The Court held that an investment of money which is made not for the purpose of realizing a profit, but rather for the acquisition of an item for consumption, is not a security. Immediately following the portion of Forman quoted by the defendants, the Court stated that where a person invests money
"attracted solely by prospects of a return" on his investment, the securities laws apply. By contrast, when a purchaser is motivated by a desire to use or consume the item purchased — "to occupy the land or to develop it themselves," as the Howey Court put it, * * * — the securities laws do not apply.
421 U.S. at 852-53; see also id. at 858 ("What distinguishes a security transaction * * * is an investment where one parts with his money in hope of receiving profits from the efforts of others, and not where he purchases a commodity for personal consumption or living quarters for personal use."). Those who invested in the lease arrangements here did so in the hope of ultimately receiving profits, and not with any intent to "use or consume" the instruments. See SEC v. Life Partners, Inc., 87 F.3d 536, 543, reh'g denied, 102 F.3d 587 (D.C. Cir. 1996) (discussing Forman, and holding that "The [Supreme] Court's general principle we think, is only that the expected profits must, in conformity with ordinary usage, be in the form of a financial return on the investment * * *.).
A fixed return does not prevent an instrument from being a security under the investment contract test. In Howey itself, the Court cited as an example of an investment contract that fell within the securities laws an agreement which involved a promise to return $7500 to a person who invested $5000. Howey, 328 U.S. at 298 n.4, citing People v. White, 124 Cal. App. 548, 550-51, 12 P.2d 1078, 1079 (Dist. Ct. App. 1932). See also Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner, & Smith, Inc., 756 F.2d 230, 240-41 (2d Cir. 1985)(interests in certificates of deposit); El Khadem v. Equity Securities Corp., 494 F.2d 1224, 1229 (9th Cir.), cert. denied, 419 U.S. 900 (1974). Connors, 666 F. Supp. at 440. But see, e.g., RTC v. Stone, 998 F.2d 1534 (10th Cir. 1993).
3. Dependence on the Efforts of Others
Finally, the defendants claim that the investors were not dependent for their profits on the efforts of the promoters or others. In Forman, the Supreme Court stated that this prong of the investment contract test requires "a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others." 421 U.S. at 852. 10/
All of the purported entrepreneurial and managerial efforts necessary to realize profits on these investments were undertaken by BFG and its related entities. BFG located and acquired equipment leases with municipalities and arranged for marketing them to investors. It agreed to service the leases (including billing the municipalities, processing their payments, paying investors, and dealing with defaults). Investors were not expected to do any of these tasks, for which they were, in any event, neither trained nor well-situated. They were "typical passive investors." Aqua-Sonic, 687 F.2d at 584. 11/
The fact that BFG in fact ran its business as a Ponzi scheme rendered investors even more dependent on the promoter. Investors were entirely dependent for their payments on BFG successfully bringing in new investors and new funds.
The recent decision of the D.C. Circuit in SEC v. Life Partners, Inc., 87 F.3d 536, reh'g denied, 102 F.3d 587 (D.C. Cir. 1996), is not to the contrary, as defendants argue (D. Mem. 10-11). In that case investors purchased and held interests in the life insurance policies of terminally ill persons, which they had purchased at a discount in a so-called viatical settlement. The D.C. Circuit held that the interests were not investment contracts because investors were not dependent on the efforts of others. While the court agreed that investors were dependent on the promoters to locate and evaluate the life insurance policies, those efforts came before the investors purchased their interests. The Life Partners court held that it would only consider pre-purchase efforts in conjunction with post-purchase efforts, and that it could find no such post-purchase efforts in that case.
Whatever the merits of the Life Partners decision, there clearly were "entrepreneurial or managerial" post-purchase efforts by the promoters in the case before this Court. In its statement denying rehearing in Life Partners, for example, the D.C. Circuit identified a number of post-purchase services in the mortgage backed securities market "that should easily meet the 'efforts of others' test as we have interpreted it." 102 F.3d at 589. Among these were collecting late mortgage payments, initiating foreclosures, structuring and monitoring work-outs, and negotiating concessions in order to avoid refinancing. Id.
Similar services are obviously required with respect to equipment leases; for example, the complaint alleges that BFG held itself out as providing on-going services in dealing with defaults. The investors also are dependent on the ongoing efforts of others to oversee the lease arrangement: to service, repair or replace equipment, and otherwise deal with problems that may typically arise in the leasing of office equipment. 12/ In short, recovering on an investment in a lease arrangement generally is far different from the way in which the D.C. Circuit believed investors would recover on the insurance contracts at issue in Life Partners, by simply waiting for the insured person to die.
Given these post-purchase services, the Court may, even under Life Partners, also take into account the considerable efforts which the promoters purported to undertake pre-purchase in locating and evaluating appropriate lease arrangements for purchase and assignment. See 102 F.3d at 588. Investors were of course wholly dependent on the promoters to conduct these important efforts.
Finally, the Commission believes that Life Partners was incorrect in holding that pre-purchase efforts may not (except in conjunction with post-purchase efforts) be considered under the investment contract test. The Supreme Court has cautioned that "in searching for the meaning and scope of the word `security' in the Act[s], form should be disregarded for substance and the emphasis should be on economic reality." Tcherepnin v. Knight, 389 U.S. 332, 336 (1967). Accord Howey, 328 U.S. at 298 & 301 ("[t]he statutory policy of affording broad protection to investors is not to be thwarted by unrealistic and irrelevant formulae"). But the economic reality is that even where efforts occur just before an investment, investors rely on the efforts of the promoter to realize a profit. 13/ The Life Partners decision, as Judge Wald stated in her dissenting opinion in the case, "elevates a formal element, timing, over the economic reality of the investors' dependence on the promoter." 87 F.3d at 551.
A number of courts have, in finding investment contracts, looked to pre-purchase efforts that included the exercise of expertise by promoters in selecting, or negotiating the price of, an asset in which investors then acquired interests. Most notably, the Second Circuit has found an investment contract to exist where investors purchased interests in certificates of deposit, and relied on, among other things, the pre-purchase efforts of the promoter in "cultivating a large group of banks that desire to borrow money," and "negotiat[ing] with the issuing banks to obtain a favorable rate of interest." Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230, 240 (2d Cir. 1985). See Glen-Arden Commodities, Inc. v. Costantino, 493 F.2d 1027 (2d Cir. 1974) (investors in warehouse receipts for whiskey looked to promoter's expertise in the selection of whiskey and casks); SEC v. Brigadoon Scotch Distributors, Ltd., 388 F. Supp. 1288 (S.D.N.Y. 1975) (promoters' efforts in selecting rare coin portfolios for sale to investors); SEC v. Energy Group, 459 F. Supp. 1234, 1241 (S.D.N.Y. 1978) (purchase of property in expectation that it will appreciate due to promoter's expertise in selecting it is one category of investment contract).14/ Although all of these cases also involved some post-purchase efforts, none suggest that the pre-purchase efforts in locating and evaluating the assets are irrelevant for Howey purposes unless joined with post-purchase efforts.
Indeed, it is commonplace for promoters to "securitize" assets by locating and acquiring assets and then selling investors interests in the assets. Such investments date back more than a century and have involved a wide variety of assets, including not only mortgages but also credit card and other types of receivables and various types of loans. See, e.g., Joseph C. Shenker & Anthony J. Colletta, Asset Securitization: Evolution, Current Issues and New Frontiers, 69 Tex. L. Rev. 1369, 1380 (1991). These well recognized asset-backed securities account for a vast amount of investment capital, as much as hundreds of billions of dollars a year.
In its decision, the Life Partners court suggested an economic rationale for disregarding pre-purchase efforts (87 F.3d at 547):
if the value of the promoter's efforts has already been impounded into the promoter's fees or into the purchase price of the investment, and if neither the promoter nor anyone else is expected to make further efforts that will affect the outcome of the investment, then the need for federal securities regulation is greatly diminished.
But pre-purchase efforts will only be "impounded" into a securities price if the promoter has made full and fair disclosure of its efforts to the market. If such forthrightness and honesty could simply be assumed, there would be no need at all for the securities laws. 15/ As Judge Wald observed (87 F.3d at 552), "the claim that investors need not be protected prior to committing funds has been rejected by Congress, which made the goal of ensuring that investors have adequate information before they commit their money * * * the central concern of the Securities Acts." 16/
We do not believe this Court need reach the issue whether Life Partners is correct, since there are clear post-purchase efforts here. Should this Court reach the issue, however, it should decline to follow Life Partners.
CONCLUSION
For the foregoing reasons, the Securities and Exchange Commission urges the Court to hold that the plaintiffs' investments in lease assignments were securities under the federal securities laws.
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Local Counsel
________________________________ Dated: February 14, 1997 |
Respectfully submitted,
RICHARD A. WALKER
PAUL GONSON
________________________________
________________________________
Securities and Exchange Commission |
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