Amicus Curiae Brief — SEC v. Edwards

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MOTION FILED No. 02-1196 \ 4)

MAR 1 7 2003 IN THE

Supreme Court of the Anited States

SECURITIES AND EXCHANGE COMMISSION,

Petitioner,

Vv.

CHARLES E. EDWARDS,

Respondent.

On Petition for a Writ of Certiorari to the

United States Court of Appeals

for the Eleventh Circuit

MOTION FOR LEAVE TO FILE BRIEF

AMICUS CURIAE AND BRIEF AMICUS CURIAE

OF THE NORTH AMERICAN SECURITIES

ADMINISTRATORS ASSOCIATION, INC.,

IN SUPPORT OF THE PETITION FOR A WRIT

OF CERTIORARI FILED BY THE SOLICITOR

GENERAL OF THE UNITED STATES

ON BEHALF OF THE SECURITIES

AND EXCHANGE COMMISSION

MARK J. DAVIS *

Associate Counsel

ROYCE O. GRIFFIN

General Counsel

JOHN R. VEATOR

Deputy General Counsel

STEPHEN W. HAL!

Associate Counsel

NORTH AMERICAN SECURITIES

ADMINISTRATORS ASSOCIATION, INC.

10 G Street, N.E.. Suite 710

Washington, D.C. 20002

* Counsel of Record (202) 737-0900

March 17, 2003

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MOTION FOR LEAVE TO FILE

BRIEF AMICUS CURIAE

Pursuant to Supreme Court Rules 21 and 37, the North

American Securities Administrators Association, Inc.

(“NASAA”), respectfully moves this Court for leave to file an

amicus curiae brief in support of the Petition for a Writ of

Certiorari (“Petition”) filed by the Solicitor General on behalf

of the Securities and Exchange Commission.

Parties Who Have Withheld Consent

Respondent Charles E. Edwards has withheld his consent

to NASAA’s filing an amicus curiae brief in support of

the Petition.

Nature of the Movant’s Interest

NASAA is the nonprofit association of the state,

provincial, and territorial securities regulators in the United

States and Canada, and of the Mexican national government.

It has 66 members, including the securities regulators in all

50 states, the District of Columbia, and Puerto Rico. Formed

in 1919, it is the oldest international organization devoted to

the protection of investors in securities.

Two of the principal goals of NASAA and its members are

protecting investors from fraud and abuse in the offer and sale

of securities, and promoting uniformity in the interpretation

of the securities laws. The Eleventh Circuit’s decision in this

case, holding that ETS pay phone investments are not

securities, undermines investor protection on several levels:

(1) it strips away the protections of federal securities

regulation from pay phone investment contracts, which are

notorious vehicles for fraud and abuse; (2) it narrows the

definition of “investment contract” under SEC v. W. J. Howey

Co., 328 U.S. 293 (1946), creating significant loopholes for

unscrupulous promoters selling other types of investments;

and (3) it sets a precedent that may adversely affect the

evolution of state securities law to the detriment of investors,

insofar as state courts often look to federal decisions for

guidance on issues common to state and federal securities

law. NASAA has an interest in removing these threats to

investor protection by supporting this Court’s review of the

lower court’s decision.

The Eleventh Circuit’s decision also undermines uni-

formity. It conflicts with decisions from the First, Third, and

Ninth Circuits, as well as decisions from the Supreme Courts

of Utah and Washington. SEC v. SG Ltd., 265 F.3d 42 (Ist

Cir. 2001); SEC v. Infinity Group Co., 212 F.3d 180 (3d Cir.

2000); United States v. Carman, 577 F.2d 556 (9th Cir.

1978); Payable Accounting Corp. v. McKinley, 667 P.2d 15

(Utah 1983); Suave v. K.C. Inc., 591 P.2d 1207 (Wash. 1979).

As a consequence of the Eleventh Circuit’s decision, the

citizens of Alabama, Florida, and Georgia face a heightened

and disproportionate risk of financial exploitation because

they do not receive the deterrent and remedial benefits of

federal securities regulation with respect to pay phone

investments and similarly structured offerings. This predica-

ment increases the likelihood that those citizens will be the

victims of fraud and abuse. NASAA therefore also has an

interest in seeking to restore federal securities regulation of

pay phone programs and similar investment contracts in the

Eleventh Circuit to eliminate this imbalance.

Reasons for Granting the Motion

NASAA’s amicus curiae brief should be accepted because

it will assist the Court by providing it with relevant matter not

likely to be advanced by the other parties to the case. See

Sup. Ct. R. 37.1. NASAA is uniquely situated to address the

deleterious impact of the appellate court’s decision on public

investors. For almost a century, state securities regulators

have been at the forefront of the fight to protect Main Street

investors from illegal and fraudulent securities offerings.

NASAA, informed by its members, is intimately familiar with

the toll that such schemes take on individual investors and the

importance of securities regulation as a deterrent and as a

remedy. Second, NASAA can speak with authority on the

impact that federal decisions have on state securities law.

State courts and administrative agencies often look to federal

case law for guidance with respect to securi.ies issues. The

appellate court’s decision, if left uncorrected, threatens to

weaken state as well as federal securities law and undermine

the cause of investor protection. Finally, NASAA offers legal

analysis that complements the Solicitor General’s arguments

in support of the Petition.

In summary, NASAA and its members have a

demonstrable interest in the outcome of this case and the

amicus curiae brief will assist the Court.

Conclusion

NASAA requests that the Court grant leave to file the

accompanying amicus curiae brief.

Respectfully submitted,

MARK J. DAVIS *

Associate Counsel

ROYCE O. GRIFFIN

General Counsel

JOHN R. VEATOR

Deputy General Counsel

STEPHEN W. HALL

Associate Counsel

NORTH AMERICAN SECURITIES

ADMINISTRATORS ASSOCIATION, INC.

10 G Street, N.E., Suite 710

Washington, D.C. 20002

* Counsel of Record (202) 737-0900

March 17, 2003

QUESTIONS PRESENTED

1. Whether a return on an investment should be excluded

from the meaning of “profits” under the Howey test for

investment contracts merely because the promoter of the

investment offers a fixed rate of return.

2. Whether a return on an investment, which is in fact

wholly dependent upon the efforts of others, should

nevertheless be viewed as not “derived from the efforts of

others” under Howey merely because the promoter contract-

ually promises or guarantees the return.

(i)

TABLE OF CONTENTS

Page

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SUMMARY OF THE ARGUMENT .......000........0::ecees 3

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1. THE APPELLATE COURT’S DECISION

OPENS AN ENORMOUS LOOPHOLE IN

SECURITIES LAW, WHICH EXPOSES

INVESTORS TO A HEIGHTENED RISK OF

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A. Scope of the Problem.................:cccccceeees 4

B. Benefits of Regulation ............0...........0006 5

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ll. THE APPELLATE COURT’S DECISION

CONFLICTS WITH THE DECISIONS OF

THIS COURT, THREE FEDERAL CIR-

CUIT COURTS, AND NUMEROUS STATE

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A. The Appellate Court’s Narrow Inter-

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1. Conflict with Federal and State Court

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2. Other Considerations.......................... 16

(111)

iv

TABLE OF CONTENTS—Continued

Page _

B. The Appellate Court’s Unique _Inter-

pretation of the “Efforts of Others” ........... 18

1. Conflict with Federal Court

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2. Other Considerations ......................0+ 19

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TABLE OF AUTHORITIES

CASES Page

Albanese v. Florida Nat'l Bank of Orlando, 823

eT 18

Chevron, U.S.A, Inc. v. Natural Res. Def.

Council, 104 S.Ct. 2778 (1984) .o..cccccceeeeeeees 17

Dep't of Banking & Fin. v. Mehl, No. 02-0526,

2002 WL 31452438 (Fla. Dep’t of Banking &

Fin. Oct. 17, 2002) (Final Order)................0000. 7

Dep't of Banking & Fin. v. Mehl, No. 02-0526,

2002 WL 31452438 (Fla. Dep’t of Banking &

Fin. July 16, 2002) (Recommended Order) ....... 5

Garvin v. Secretary of State, No. OSAH-

SECSTATE-SECUR-0231234-33-PJ (Ga. Off.

of Admin. Hgs Aug. 28, 2002) (Order on

EEE eee 8,17

In re Alpha Telcom, No. 99-07-0220, 2002 WL

459704 (Wash. Sec. Div. Mar. 13, 2002).......... 4

In re Rahaim, No. E-2000-22 (Sec’y of the

Commonw. of Mass., Sec. Div. July 11, 2000)

(Memorandum and Order) ................0ccccccceeeeeeees 18

In re Yucatan Resorts, No. 2002-10-33, 2002 WL

31971658 (Pa. Sec. Comm’n Oct. 22, 2002)

(Summary Order to Cease and Desist)............... i)

lowa ex rel. Miller v. Pace, Equity No. LA26445

(lowa D. Ct., Warren County, Sept. 4, 2002),

appeal docketed, No. 02-1726 (lowa Oct. 28,

rie ciceicsieibiniissiiiteansnnnstnteinsniteameinisindbiniasieiianinideeenenecs 8, 15

Joseph v. Geier, No. 01 CV 1151 (Colo. D. Ct.,

Denver County, Jan. 30, 2003) (order on

motions for summary judgment)...............0000 9,15

King v. Pope, 91 §.W.3d 314 (Tenn. 2002)........... 7

LTV Fed. Credit Union v. UMIC Gov't Sec. Inc.,

523 F. Supp. 819 (N.D. Tex. 1981), aff'd, 704

F.2d 199 (Sth Cir. 1983), cert. denied, 464

Se a Ne ncvionitiasininensaiiiensiiiiniatigntntiininipineniemcines 14

vi

TABLE OF AUTHORITIES—Continued

Payable Accounting Corp. v. McKinley, 667 P.2d

BS Ga Fee ccccsescccntcnennenennsnennnen cxenennemnn

People v. White, 12 P.2d 1078 (Cal. Dist. Ct.

Ra. CGIIED cncanserecnmessnrcememaseseesssssannemesnenennanenns

Reves v. Ernst & Young, 494 U.S. 56 (1990).........

SEC v. Alpha Telcom, Inc., No. CV 01-1283 PA,

2002 WL 193093 (D. Or. Feb. 7, 2002).............

SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344

CFG ccccceneccascnscscsceresesssceceussneseesmmesanenneneneusnees 13,

SEC v. ETS Payphones, Inc., 300 F.3d 1281

{Le A Sennen 10, 11,

SEC v. Glenn W. Turner Enterprises, Inc., 474

Pw 8 en

SEC v. Haje, No. 92-510-CIV-J20 (M.D. Fla.),

1993 WL 347148 (SEC Release No. 13772,

TE

SEC v. Infinity Group Co., 212 F.3d 180 (3d Cir.

2000), cert. denied, 532 U.S. 905 (2001)...........

SEC v. Levine, No. 94-6898-CIV-ZLOCH (S.D.

Fla.), 1994 WL 559076 (SEC Release No.

Se GE ee

SEC v. Linktel Communications, Inc., No. 100-

CV-3169-WBH (N.D. Ga.), 2000 WL

1773106 (SEC Release No. 16186, Dec. 4,

SEC v. Phoenix Telecom, No. 100-CV-1970-JTC

(N.D. Ga.), 2001 WL 874314 (SEC Release

Dear, FFG, Aim, SD, Be D cececcenssesonsssescscenencseneee

SEC v. Phoenix Telecom, L.L.C., No. 1:00-CV-

1970-JTC, 2000 WL 33956119 (N.D. Ga.

Ran, By TD eevee

SEC v. Quarter Call, Inc., No. 94Z-1227 (D.

Colo.), 1996 WL 635380 (SEC Release No.

a ee Ok, I eeeeensnidinuiiin

Page

16, 17

12, 18

18

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TABLE OF AUTHORITIES—Continued

SEC v. SG Lid., 265 F.3d 42 (1st Cir. 2001).......... 13

SEC v. Unique Financial Concepts, 196 F.3d

Se ly See cadeiiasiiesisaicidiceialiesiniasisenliatiain 13

SEC v. W. J. Howey Co., 328 U.S. 293 (1946)...... passim

Stevens v. Liberty Packing Corp., 161 A. 193

Sa aUh CUTIE tiichieaeiaieeieciitininciiieiiaiitle at leaeys 11,15

Stigall v. Secretary of State, No. EN-18727 (Ga.

Comm’r of Sec. Sept. 6, 2002) .............::cccceeeeees 17

Suave v. K.C., Inc., 591 P.2d 1207 (Wash. 1979).. 15

Tcherepnin v. Knight, 389 U.S. 332 (1967)........... 11, 20

United Hous. Found., Inc. v. Forman, 421 U.S.

ee TTI acscnssisiscetessesecidiniiibiialitinantniacipciinanah 10, 11, 12, 16

United States v. Carman, 577 F.2d 556 (9th Cir.

STATUTES AND REGULATIONS

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TABLE OF AUTHORITIES—Continued

Unif. Sec. Act of 1956 § 409 ............ccccccscsscccsssseees

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RULES OF COURT

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MISCELLANEOUS

Aff. of Charles R.T. O’Kelley, attached as Ex. B

to Pet’r Br. in Support of Pet. for Judicial

Review, Garvin v. Sec'y of State, No: 2002 CV

6027 (Ga. Super. Ct., Fulton County, Dec. 16,

Appellant’s Proof Br., /owa ex rel. Miller

v. Pace, No. 02-1726 (lowa) (filed

I doin Se eccccncncsinaniannsiicitinitnsininiianinnnimanneniianiinnie

Chart showing states adopting Unif. Sec. Act of

1956, available at www.law.cormell.edu/

uniform/vol7.html #SeCUT...............cceeeeeeeeeeeeees

House Bill 1311, Ist Sess. (Colo. 2003),

available at http://www.leg.state.co.us/2003a/

inetcbill.nsf/fsbillcont/ 177790SCD8404C8 187

256CC50077A764?Open&file=1311_01.pdf....

12 Joseph C. Long, Blue Sky Law § 2.58 (2002)..

NASAA, State Securities Cops Announce

Actions Against Sellers of Payphone Schemes;

Losses Estimated at $76 Million So Far,

March 13, 2001, available at http://www.

nasaa.org/nasaa/abtnasaa/display_top_story.as

a

NASAA, “Top 10” Investment Scams Listed by

State Securities Regulators” (Aug. 26, 2002;

Apr. 23, 2001), available at www.nasaa.org,

“News and Public Afffairs”.................cccsceeeeeeees

. ix

TABLE OF AUTHORITIES—Continued

Resp’t Req. to Vacate Cease and Desist Order or

in the Alternative, Mot. for Summ. J. and Br.

in Support Thereof, /n re Yucatan Resorts,

No. 2002-10-33 (Pa. Sec. Comm'n) (filed

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Websters New International Dictionary (2d ed.

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Page

INTEREST OF THE AMICUS CURIAE

The North American Securities Administrators Associa-

tion, Inc. (“NASAA”), is the nonprofit association of the

State, provincial, and territorial securities regulators in the

United States and Canada, and of the Mexican national

government. It has 66 members, including the securities

regulators in all 50 states, the District of Columbia, and

Puerto Rico. Formed in 1919, it is the oldest international

organization devoted to the protection of investors in

securities.

Two of the principal goals of NASAA and its members are

enhancing investor protection and increasing uniformity in

the interpretation of the securities laws. The appellate court’s

decision undermines both of these interests.

A. Investor Protection

The Eleventh Circuit’s decision in this case, holding that

ETS pay phone investments are not securities, undermines

investor protection on several levels. First, it removes the

protections of federal securities regulation from pay phone

investment contracts, which are notorious vehicles for fraud

and abuse. Although it is to be expected that state regulation

of these investments will continue unabated, eliminating the

SEC’s jurisdiction over such offerings will at a minimum

increase the burden on state regulators and heighten the risk

that investors will fall victim to these schemes. NASAA

therefore has an interest in seeking the reversal of the

appellate court’s decision and ultimately the restoration of

federal regulation of these products.

' Pursuant to Sup. Ct. R. 37.6, NASAA represents that no counsel for

any party authored this brief in whole or in part, and no person or entity,

other than NASAA, its members, or its counsel, made any monetary

contribution to the preparation or submission of the brief.

2

Second, the appellate court’s decision substantially nar-

rows the definition of “investment contract” under SEC v. W.

J. Howey Co., 328 U.S. 293 (1946). The court held that

investments offering either fixed or contractually guaranteed

returns do not qualify as investment contracts. This

unsupported interpretation of Howey creates loopholes that

unscrupulous promoters will undoubtedly seek to exploit in

the future as they invent new ways to defraud the investing

public. NASAA has an interest in helping to prevent this

potentially far-reaching impact of the appellate court’s

decision.

Finally, the appellate court has set a precedent that may

adversely affect the evolution of state securities law to the

detriment of investors, insofar as state courts often look to

federal decisions for guidance on issues common to state and

federal securities law. NASAA has an interest in helping to

ensure that the appellate court’s decision does not weaken

state securities law in this way.

B. Uniformity

The Eleventh Circuit’s decision also undermines uniform-

ity in securities law. The ruling conflicts with decisions from

three other federal circuit courts, as well as decisions from the

highest courts of two states. As a consequence of the

Eleventh Circuit’s decision, the citizens of Alabama, Florida,

and Georgia face a heightened risk of being victimized by pay

phone promoters. Those citizens do not receive the deterrent

and remedial benefits of federal securities regulation with

respect to pay phone investments and similarly structured

offerings. This lack of uniformity will tend to attract

financial predators who have been turned away from other

jurisdictions where pay phone sale and leaseback agreements

are fully regulated as securities. NASAA has an interest in

seeking the review of the appellate court’s decision to

promote fairness and to prevent any state, or group of states,

from becoming a preferred haven for fraud and abuse.

3

SUMMARY OF THE ARGUMENT

The SEC’s petition for a writ of certiorari (“Petition”)

should be granted, and ultimately the appellate court's

decision should be reversed, for two compelling reasons.

First, the court’s decision, if left intact, will expose thousands

of investors in the Eleventh Circuit to a heightened risk of

fraud and abuse at the hands of pay phone promoters and

those selling a variety of similar sale and leaseback invest-

ments no longer subject to federal regulation as securities.

The decision is an unfortunate blueprint for unscrupulous

promoters who will easily devise new schemes that fall

outside the appellate court’s narrow definition of an invest-

ment contract. Because state courts often look to federal

decisions in the area of securities regulation, the appellate

court’s ruling can be expected to weaken state securities law

over the long term if it is not reversed.

Second, the appellate court’s decision is an erroneous

interpretation of federal law. It conflicts with the majority of

cases from federal and state courts. The decision also

conflicts with the policies underlying securities law, the plain

meaning and intent of the statutory provisions at issue, and

the interpretation of the law by the regulatory agencies

entrusted with administering it.

ARGUMENT

1. THE APPELLATE COURT'S DECISION OPENS

AN ENORMOUS LOOPHOLE IN SECURITIES

LAW, WHICH EXPOSES INVESTORS TO A

HEIGHTENED RISK OF FRAUD AND ABUSE

By holding that the ETS pay phone investments are not

securities, the court has placed investors at risk. Over the

past decade, there have been widespread abuses in the

marketing of pay phone schemes, and as a consequence,

thousands of investors have lost money. Continued

4

regulation of these and similar products under both federal

and state securities law is essential to limit the financial harm

they cause.

A. Scope of the Problem

The pattern of abuses in the marketing of pay phone sale

and leaseback programs is well documented. In March 2001,

NASAA announced the results of a crackdown by securities

regulators in 25 states and the District of Columbia against

individuals and companies that sold illegal pay phone sale

and leaseback investments.? Nearly 4,500 people, most of

them elderly, were reported to have lost $76 million investing

in these schemes. Over the years, state securities regulators

across the country have initiated scores of administrative and

civil injunctive actions against pay phone sale and leaseback

companies and their agents, including ETS, Alpha Telcom,

Phoenix Telecom, QCI, and others.’ See, e.g., cease and

desist orders issued by Kansas, North Carolina, and Rhode

Island against ETS, Exs. 9, 10, 11; see also cases discussed

infra at Part IL. A.

The SEC also has vigorously pursued enforcement actions

against these illegal enterprises. Examples include this case

against ETS as well as four injunctive actions in federal

district court in Florida and Georgia in which the SEC sought

millions of dollars in disgorgement and other relief against

four pay phone companies and their agents. SEC v. Phoenix

> NASAA, State Securities Cops Announce Actions Against Sellers

of Payphone Schemes; Losses Estimated at $76 Million So Far.

March 13, 2001, available at http://www.nasaa.org/nasaa/abtnasaa’

display top story.asp?stid=108.

* The investments offered by these companies are essentially the same.

Alpha Telcom offered investors 30% of adjusted gross revenues, but

with a guaranteed minimum that equated to a 14% return. See, eg /n re

Alpha Telcom, No. 99-07-0220, 2002 WL 459704, *3 (Wash. Sec. Div.

Mar. 13, 2002).

5

Telecom, No. 100-CV-1970-JTC (N.D. Ga.), 2001 WL

874314 (SEC Release No. 17089, Aug. 3, 2001); SEC v.

Linktel Communications, Inc., No. |\00-CV-3169-WBH (N.D.

Ga.), 2000 WL 1773106 (SEC Release No. 16816, Dec. 4,

2000); SEC v. Levine, No. 94-6898-CIV-ZLOCH (S.D. Fla.),

1994 WL 559076 (SEC Release No. 14279, Sept. 30, 1994);

SEC v. Haje, No. 92-510-CIV-J20 (M.D. Fia.), 1993 WL

347148 (SEC Release No. 13772, Sept. 3, 1993).

The violations common to these operations include the sale

of unregistered securities by unlicensed agents and fraudulent

misrepresentations and omissions concerning the risks of loss,

the financial condition of the enterprise, and prior disciplinary

actions against the company or its principals. See generally

SEC v. Alpha Telcom, Inc., No. CV 01-1283 PA, 2002 WL

193093 (D. Or. Feb. 7, 2002); SEC v. Phoenix Telecom,

L.L.C., No. 1:00-CV-1970-JTC, 2000 WL 33956119 (N.D.

Ga. Aug. 2, 2000). In short, pay phone sale and leaseback

programs pose a serious risk to investors. See Dep't of

Banking & Fin. v. Mehl, No. 02-0526, 2002 WL 31452438, at

*24-25 (Fla. Div. Admin. Hgs. July 16, 2002) (Recom-

mended Order) (multi-million dollar fine imposed against the

seller of ETS pay phone investments because many investors

were left in “irreversibie financial ruin for the remaining

years of their lives”).

B. Benefits of Regulation

The SEC and state securities regulators have long viewed

pay phone sale and leaseback schemes as securities and have

regulated them as such. Accordingly, investors have been

receiving important protections. First, those who sell securi-

ties must be tested and licensed to help ensure they have the

character and fitness to accept investor funds and render

investment advice. See 15 U.S.C. § 780; Unif. Sec. Act of

1956 § 201 (licensing of industry participants). Second, the

securities themselves must be registered so that material

information about the offerings and the issuers is made

6

available to investors. See 15 U.S.C. §§ 77f, 77g, 77); Unif.

Sec. Act of 1956 § 301 (registration of securities). Third, the

securities laws impose stiff civil and criminal penalties as a

deterrent against violations of the licensing, registration, and

anti-fraud provisions. See 15 U.S.C. §§ 77q, 77t, 77x, 78f,

78j, 78u; Unif. Sec. Act of 1956 §§ 101, 408-410 (civil and

criminal penalties). Finally, the securities laws give regula-

tors the authority to seek important remedial measures,

including injunctions, disgorgement, and restitution, to help

redress violations after they occur. See id. (injunctive relief

and civil liabilities).

With these tools at their disposal, regulators can deter

violations in the first instance, halt violations in progress, and

attempt to recover ill-gotten gains from those who have

profited at the expense of investors. All of these provisions

have played an important role in limiting the harm that illegal

pay phone investment schemes and other investment

contracts have inflicted on the investing public.

C. Future Impact

The appellate court’s decision in this case threatens harm

to investors on multiple levels by stripping away these

protections. Its most immediate impact is to tie the SEC’s

hands in the Eleventh Circuit as to pay phone sale and

leaseback programs, as well as all other investment contracts

that have been structured to provide fixed or guaranteed

* The Uniform Securities Act of 1956 is the predominant model for

state securities laws. It has been adopted by 34 states, with some

individual variations. See Chart showing states adopting Unif. Sec. Act of

1956, available at www.law.cornell.edu/uniform/vol7 .htmi#secur. Even

those state that have passed their own securities laws have similar

EEE Ee

-

returns.” While indications are that state securities regulators

in Alabama, Florida, and Georgia will continue to enforce

their laws vigorously against promoters of these products,

sidelining the SEC will increase the burden on these state

regulators and expose investors to heightened risk.

The court’s decision also threatens a much broader harm

by fundamentally narrowing the application of the Howey

investment contract test. “Guaranteed” and “fixed returns”

are often meaningless labels that promoters attach to their

investment contracts to attract investors. Under the court’s

decision, these same terms—easily inserted into a contract—

will also serve as a convenient shield against regulation under

the securities laws. Regulators can now expect to see the

emergence of a wide variety of new and bogus investment

contracts specifically designed to benefit from the loophole

created by the appellate court.

Finally, the court’s decision will undermine state, as well

as federal, securities regulation. State courts and state

administrative agencies often consult federal decisions for

guidance on securities issues. See, e.g., Payable Account-ing

Corp. v. McKinley, 667 P.2d 15, 17 (Utah 1983) (states

frequently rely on federal case law in interpreting state

security acts); Dep't of Banking & Fin. v. Mehl, No. 02-0526,

2002 WL 31452438, at *2 (Fla. Dep’t of Banking & Fin. Oct.

17, 2002) (Final Order) (“In some instances, state and federal

securities laws appear as mirror images. Both, for example,

have the same definition for the term ‘security.’ For these

reasons, in the absence of state decisional law, state courts

will look to federal court decisions for guidance”); Cf. King v.

Pope, 91 S.W.3d 314 (Tenn. 2002) (reversing Tennessee

ATM machines and Internet kiosks are examples of other products

that have been the subject of illegal investment schemes similar to the pay

phone sale and leaseback programs. See NASAA,“Top /0” Investment

Scams Listed by State Securities Regulators” (Aug. 26, 2002; Apr. 23,

2001), available at www.nasaa.org, “News and Public Affairs.”

8

Court of Appeals, which had adopted federal rather than State

commonality standard to hold pay phone contracts were not

securities).

The appellate court’s decision already has emboldened pay

phone promoters and others to challenge prior rulings against

them in state enforcement actions. These arguments are

surfacing in states within the Eleventh Circuit and elsewhere.

In Jowa ex rel. Miller v. Pace, Equity No. LA26445 (lowa D.

Ct., Warren County, Sept. 4, 2002), appeal docketed, No. 02-

1726 (lowa, Oct. 28, 2002), the lowa District Court found

that ETS pay phone investments were investment contracts

under Howey, and ordered the defendant to make restitution

of over $300,000 for fraud in the sale of unregistered secur-

ities. /d. at 16, 23-24, 27-28. The defendant has appealed the

state district court’s order to the lowa Supreme Court, and is

relying heavily on the Eleventh Circuit’s opinion in this case

for the proposition that the ETS offerings are not investment

contracts, as a matter of law. See Appellant’s Proof Br. at 28-

32, lowa ex rel. Miller v. Pace, No. 02-1726 (lowa) (filed

Jan. 21, 2003). The appeal is pending.

In Garvin v. Secretary of State, No. OSAH-SECSTATE-

SECUR-0231234-33-PJ, at | (Ga. Off. of Admin. Hgs Aug.

28, 2002) (Order on Reconsideration), an administrative law

judge with the Georgia Office of Administrative Hearings

ruled that the ETS pay phone investment was a security,

issued a cease and desist order against further offerings of the

investment, and imposed a fine against the respondent for

selling unregistered securities. The respondent has filed a

petition for review in state court, relying in part on the

Eleventh Circuit’s opinion in this case. See Aff. of Charlies

R.T. O’Kelley, attached as Ex. B to Pet’r Br. in Support of

Pet. for Judicial Review, at 7-8, Garvin v. Sec’y of State, No.

2002 CV 6027 (Ga. Super. Ct., Fulton County, Dec. 16,

2002). The petition for review is pending.

The appellate court’s decision is also being cited in defense

of investments other than pay phone sale and leaseback

programs. In /n re Yucatan Resorts, No. 2002-10-33, 2002

WL 31971658, at *1-2 (Pa. Sec. Comm’n Oct. 22, 2002)

(Summary Order to Cease and Desist), the respondents were

named in a cease and desist order for selling unregistered

securities in the form of a vacation resort leasing program.

The program offered an annual return of 9%-11%, and

featured the services of a third-party agent to handle leasing

of the resort units for investors. /d. at *1. On January 22,

2003, the respondents filed a request to vacate the order, and

a motion for summary judgment in the alternative, relying in

part on the appellate court’s ruling. See Resp’t Req. to

Vacate Cease and Desist Order or in the Alternative, Mot. for

Summ. J. and Br. in Support Thereof, at 11-14, /n re Yucatan

Resorts, No. 2002-10-33 (Pa. Sec. Comm'n) (filed Jan. 13,

2003). That request is pending.

The influence of the Eleventh Circuit’s decision is not

confined to courts and administrative agencies. Evidently as

a direct result of the court’s ruling, a bill has appeared in the

Colorado legislature that would amend the definition of a

security in that state to exclude leaseback arrangements “in

exchange for a contractually fixed and guaranteed rate of

return.” See House Bill 1311; Ist Sess. (Colo. 2003).

Colorado is among the states where both state and federal

regulators have taken aggressive enforcement action against

pay phone promoters. See Joseph v. Geier, No. 01 CV 1151

(Colo. D. Ct., Denver County, Jan. 30, 2003) (order om

motions for summary judgment) (Phoenix Telecom pay

phone program held to be illegal investment contract); SEC v.

Quarter Call, Inc., No. 94Z-1227 (D.Colo.), 1996 WL

635380 (SEC Release No. 15145, Nov. 4, 1996) (action

against now bankrupt pay phone company QCI, finding that

° Available at http://www.leg.state.co.us/2003a/inetcbill nsf/fsbillcont/

1777905CD8404C8 | 87256CC50077A764?Open&file=1311 O1.pdf

10

defendants obtained over $9 million from 520 investors in

fraudulent sales of pay phone investments). The bill

introduced in the state legislature is an apparent attempt to

curtail securities regulation in Colorado, using the appellate

court’s decision as a justification.

These examples illustrate the potentially far-reaching

impact that the appellate court’s decision may have on

securities regulation and ultimately, on public investors. To

stem this tide and restore the SEC’s regulatory jurisdiction to

full strength, this Court should grant the SEC’s Petition, and

upon a review on the merits, reverse the decision of the

appellate court.

Il. THE APPELLATE COURT’S DECISION CON-

FLICTS WITH THE DECISIONS OF THIS

COURT, THREE FEDERAL CIRCUIT COURTS,

AND NUMEROUS STATE COURTS

The appellate court held that because the returns promised

by ETS were at a fixed rate, they could not be classified as a

participation in earnings, and therefore could not be

considered profits for purposes of defining an “investment

contract” under Howey and Forman. See SEC v. ETS

Payphones, Inc., 300 F.3d at 1284-85. As an alternative basis

for its decision, the court also held that because investors’

returns were contractually guaranteed, those returns were not

derived from the efforts of others. /d. at 1285. The appellate

court’s decision conflicts with the precedents of this Court,

three federal circuit courts, and numerous state courts. The

appellate court’s decision also conflicts with traditional

statutory analysis, the policies underlying the securities laws,

and the interpretations of the federal and state administrative

agencies responsible for securities regulation.

1]

A. The Appellate Court’s Narrow Interpretation

of Profits

I. Conflict with Federal and State Court

Decisions

Under Howey and a venerable line of Supreme Court cases,

courts are to interpret the definition of “investment contract”

broadly and must seek to effectuate the remedial purpose

of federal securities law, which is investor protection. See

Howey, 328 U.S. at 299, 301; see also Tcherepnin v. Knight,

389 U.S. 332, 336 (1967). The appellate court’s decision

conflicts with these fundamental principles. The court seized

upon a restrictive interpretation of Forman and adopted

a “limited meaning” of the word “profits.” See 300 F.3d

at 1284. The court furthermore dismissed an enforcement

action against an illegal enterprise that defrauded thousands

of investors, a result at odds with the remedial purpose of the

federal securities laws.

The appellate court’s decision also conflicts with this

Court’s specific formulations of the “profits” test. In Howey,

the Court chose a variety of terms to describe an investor’s

expectations under an investment contract, including

“income,” “profit,” and “financial returns.” See Howey, 328

U.S. at 298, 300. All of these words encompass fixed as well

as variable returns. The Court confirmed the broad meaning

of these terms by relying on state cases involving investment

contracts with fixed returns. See People v. White, 12 P.2d

1078, 1079, 1081 (Cal. Dist. Ct. App. 1932) (investment

contract found where promoter offered a $7500 return on

$5000 invested in enterprise trading trust deeds, bankrupt

stocks, and foreclosure instruments); Stevens v. Liberty

Packing Corp., 161 A. 193, 194, 195 (N.J. Ch. 1932)

(investment contract found where promoter offered $1 per

offspring in breeding scheme involving sale and leaseback of

rabbits). Removing any doubt on this issue, the Court in

Howey declared: “It is immaterial whether the enterprise is

12

speculative or non-speculative .... The statutory policy of

affording broad protection to investors is not to be thwarted

by unrealistic and irrelevant formulae.” See Howey, 328 U.S.

at 301.

The Forman case is not to the contrary. Once again, the

Court’s choice of words belies the appellate court’s narrow

interpretation. In Forman, the Court repeatedly used termi-

nology that is consistent with fixed as well as variable

returns: “income,” “profits,” and “financial returns.” See

United Hous. Found., Inc. v. Forman, 421 U.S. 837, 851-53

(1975). The Court’s reference to “participation in earnings”

was not an attempt to graft technical distinctions—such as

fixed versus variable rates—onto investment contract

analysis, but to differentiate the expectations of an investor

from those of someone seeking to use or consume a

commodity. See Forman, 421 U.S. at 852-53. The holding in

Forman rested squarely on this point, not on notions of fixed

or variable returns: “What distinguishes a security trans-

action—and what is absent here—is an investment where one

parts with his money in the 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.” /d.

at 858. On this basis, the Court held that stock in a non-profit

housing cooperative was not an investment contract. /d. at

853. By contrast, of course, investors in the ETS program

were motivated by the lure of profits, not by a desire to

acquire telephones.’

” Even if “participation in earnings” were the litmus test for investment

contracts, the appellate court’s decision would still be incorrect because

receiving fixed returns does not preclude one from participating in

earnings. To the extent ETS investors actually received fixed monthly

yields from pay phone operations, they would have been participating in

earnings because their returns would have been paid from earnings. The

appellate court conceded as much: “Of course, the funds generated by the

pay phones helped ETS meet its obligations.” 300 F.3d at 1285.

13

The court’s decision also conflicts with Supreme Court

cases holding that the nature of an investment offering may

be determined by the representations that promoters have

used to sell it to the public. See SEC v. C.M. Joiner Leasing

Corp., 320 U.S. 344, 352-53 (1943) (oil leases combined with

test drilling services). Until the appellate court issued its

decision in this case, the Eleventh Circuit followed this

approach. See SEC v. Unique Financial Concepts, 196 F.3d

1195 (11th Cir. 1999) (sham investment in foreign currency

options evaluated under Howey in terms of the promoter’s

representations). Respondent Edwards quite clearly used the

lure of “profits” to sell his pay phone investments. See Ex.

14, at 1, 2; Ex. 15. at 5, 7, 8, 9; Ex. 17, at 4, 5, 8, 9, 10, 11;

Ex. 22, at 1, 5.

The appellate court’s interpretation of profits also conflicts

with decisions issued in at least three other federal circuits.

In SEC v. Infinity Group Co., 212 F.3d 180 (3d Cir. 2000),

cert. denied, 532 U.S. 905 (2001), the promoters of an

investment trust argued that shares in their program were not

investment contracts because they featured a fixed rate of

return rather than a rate dependent upon the success of the

investments. The Third Circuit flatly rejected this defense,

holding that “the definition of a security does not turn on

whether the investor receives a variable or fixed rate of

return.” /d. at 189.

In SEC v. SG Lid., 265 F.3d 42 (1st Cir. 2001), the First

Circuit had no difficulty finding an “expectation of profits”

where a promoter of “virtual companies” on the internet

“flatly guaranteed that investments in the shares of the

privileged company would be profitable, yielding monthly

returns of 10% ....” Id. at 54; see also United States v.

Carman, 577 F.2d 556, 563 (9th Cir. 1978) (fixed interest

guaranteed by federal government was nevertheless derived

14

from efforts of others due to investors’ passive role and

continuing dependence upon promoter’s sound management

and solvency).

The appellate court’s decision also conflicts with decisions

issued by two state supreme courts.* In Payable Accounting

Corp. v. McKinley, 667 P.2d 15 (Utah 1983), investors

contributed cash and other assets to fund a_ payroll

management business, for which the company promised to

pay fixed monthly interest. /d. at 16-17. The Supreme Court

of Utah held that the arrangement was an investment contract

under Howey notwithstanding the fixed rate of return: ©

The crucial factor is not whether the rate of return is

fixed, but whether the “investment transaction is so

structured that the money to pay off the investor

eventually will be generated by the venture or

viterprise”.... That the investors receive a fixed rate of

return does not make this scheme any less an investment

contract. The money to pay off the investors is still

generated by PAC, and the risk of loss still depends on

PAC’s managerial skills.

Id. at 19, 21 (quoting LTV Fed. Credit Union v. UMIC Gov't

Sec., Inc., 523 F. Supp. 819, 829 n.5 (N.D. Tex. 1981),

aff'd, 704 F.2d 199 (Sth Cir. 1983), cert. denied, 464 U.S.

852 (1983)).

* As a threshold matter, state court decisions are relevant in this case

for two reasons. The term “investment contract” originated in state blue

sky laws during the early 1900’s, and it was interpreted extensively by

state courts before Congress enacted the federal securities laws. See

Howey, 328 U.S. at 298. For this reason, the Court in Howey expressly

adopted state judicial interpretations of the term “investment contract” as

a guide to its meaning under federal law. /d. Today, virtually every state

securities law in the country includes a definition of the term “security”

that closely parallels the federal definition and that specifically includes

“investment contracts.” Therefore, modern state court decisions, as well

as the early state cases that helped establish the investment contract

definition, continue to serve as a guide to the meaning of the term.

a

: 15

In Suave v. K.C. Inc., 591 P.2d 1207 (Wash. 1979), the

plaintiff invested in a retail appliance leasing business in

return for 12% fixed interest payable monthly. /d. at 1208.

The Supreme Court of Washington held that the arrangement

was an investment contract under Howey, because even

though the investor’s profit may have been constant, she

was still subject to the risk of loss of her entire investment

if the management failed to keep the company profitable. /d.

at 1210.

The appellate court’s opinion conflicts with other state

cases. Two of the state precedents that the Court relied upon

in Howey for defining investment contracts involved fixed

returns. See People v. White, 12 P.2d 1078; Stevens v. Liberty

Packing Corp., 161 A. 193, cited supra. More recently, trial

courts in Colorado and lowa have held that pay phone sale

and leaseback investments, including the ETS contract and a

similar version offered by Phoenix Telecom, were investment

contracts. See Joseph v. Geier, No. 01 CV 1151, at 2 (Colo.

D. Ct., Denver County, Jan. 30, 2003) (order on motions for

summary judgment) (a fixed rate of return does not take an

investment contract out of the definition of a security); Jowa

ex rel. Miller v. Pace, Equity No. LA26445, at 17 (lowa D.

Ct., Warren County, Sept. 4, 2002), appeal docketed, No. 02-

1726 (lowa Oct. 28, 2002) (irrelevant that inducements

leading an investor to risk his initial investment are founded

on promises of fixed returns rather than a share of profits.)”

* Since 1939, a minority line of cases has emerged holding that

payment of a fixed fee such as interest does not meet the profits test. See

12 Joseph C. Long, Blue Sky Law § 2.58 (2002) and cases cited therein.

However, these decisions have been viewed as “defective” for two

reasons. First, the distinction between dividends and interest is often

arbitrary and subject to the control of the promoter. Second, the real focus

of the Howey profits test is on the motivation of the investor, not the

specific nature of the profits or losses of the enterprise. /d.

16

These conflicts between the Eleventh Circuit’s decision

and the decisions of this Court, the federal circuits, and the

state courts provide a compelling basis, within the meaning of

Rule 10, Sup. Ct. R. 10, for granting the Petition.

2. Other Considerations

A plain meaning analysis of the term “investment contract”

provides further evidence that the appellate court’s opinion is

incorrect and should be reviewed by this Court. The words

“investment contract” actually encompass, rather than ex-

clude, fixed rate investments. The dictionary definition of the

term “investment”—in 1934 as well as today—includes the

core concept of investing money for “income or profit.” See

Websters New International Dictionary 1306 (1934);

Websters Third New International Dictionary 1190 (1993).

“Income,” in turn, refers to a gain or recurrent benefit usually

measured in terms of money, and it clearly encompasses

regular and fixed payments, as well as variable amounts. See

Websters New International Dictionary, supra, at 1258;

Websters Third New International Dictionary, supra, at 1143.

The appellate court’s restrictive interpretation of the term

“profits” is inconsistent with the plain meaning of the

terminology chosen by Congress.

Legislative intent supports the point. This Court has re-

peatedly observed that Congress intended to define the term

“security” broadly in order to eliminate serious abuses in the

securities market. See, e.g. Reves v. Ernst & Young, 494 U.S.

56, 60 (1990); United Hous. Found., Inc. v. Forman, 421 U.S.

837, 847-48 (1975). Congress added the term “investment

contract” as a catchall provision to ensure that the statute

would cover not just the items specifically listed, such as

stocks and bonds, but “virtually any instrument that might be

sold as an investment.” See Reves, 494 U.S. at 61; SEC v.

C. M. Joiner Leasing Corp., 320 U.S. 344, 351 (1943). Of

course, many of the instruments enumerated in the definition

17

of a security involve fixed returns, promises, and even

guarantees. See 15 U.S.C. §§ 77b(a)(l), 78c(ay(l0). As a

catchall term, the reference to “investment contract” deserves

an interpretation broad enough to include these traditional

characteristics of securities, along with features outside the

mainstream. See C. M. Joiner Leasing, 320 U.S. at 351 (“We

cannot read out of the statute these general descriptive

designations merely because more specific ones have been

used to reach some kinds of documents. Instruments may be

included in any of these definitions, as a matter of law, if on

their face they answer to the name or description”).

The appellate court’s decision also conflicts with the

interpretation of securities law that both federal and state

securities regulators have applied for years. Under the

principle of deference to adininistrative interpretation,

“considerable weight should be accorded to an executive

department’s construction of a statutory scheme it is entrusted

to administer.” See Chevron, U.S.A, Inc. v. Natural Res. Def.

Council, 104 S. Ct. 2778, 2782 (1984). The SEC’s position

that investment contracts include fixed and guaranteed returns

is reflected in the enforcement actions described above, supra

at Part |.A, and in the authorities cited by the Solicitor

General, see Petition at 23-26.

State securities regulators also have brought innumerable

enforcement actions against ETS, their sales agents, and other

companies offering similar sale and leaseback programs. See

actions discussed supra at Part LA. So far, state

administrative law judges and commissions have rejected

arguments that fixed or guaranteed returns put an investment

beyond the reach of Howey. See, e.g., Stigall v. Sec'y of

State, No. EN-18727, at 7-8 (Ga. Comm’r of Sec. Sept. 6,

2002); Garvin v. Sec’y of State, No. OSAH-SECSTATE-

SECUR-0231234-33-PJ, at | (Ga. Off. of Admin. Hgs Aug.

28, 2002) (Order on Reconsideration) (“An offeror may not

avoid registration of a security in Georgia merely by

18

establishing a fixed rate of return on the investment”). But cf.

In re Rahaim, No. E-2000-22, at 5 (Sec’y of the Commonw.

of Mass., Sec. Div., July 11, 2000) (Memorandum and

Order).'° These interpretations of the securities laws by the

regulatory authorities tasked with administering them support

review of the appellate court’s decision.

B. The Appellate Court’s Unique Interpretation of

the Efforts of Others

As an alternative basis for its decision, the appellate court

ruled that because investors’ returns were contractually

guaranteed, those returns were not derived from the efforts of

others. See 300 F.3d at 1285. This decision cannot be

reconciled with decisions from the federal circuit courts or

the policies underlying the securities laws.

1. Conflict With Federal Court Decisions

Decisions from other federal circuits have established that

the appropriate focus of the third Howey element is not on

whether returns are contractually guaranteed, but on “whether

the efforts made by those other than the investor are the

undeniably significant ones, those essential managerial efforts

which affect the failure or success of the enterprise.” See,

e.g., SEC v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476,

482 (9th Cir. 1973).

Prior to this case, the Eleventh Circuit followed this

approach. In Albanese v. Florida National Bank of Orlando,

823 F.2d 408 (Ith Cir. 1987), a case involving an ice

machine sale and leaseback scheme, the court found that the

promoters retained managerial control over the ice machines

and on this basis held that the “efforts of others” test was

' The Rahaim decision held that the ETS pay phone contract was not

an investment contract, on commonality grounds. The case did not rest

on the “profits” or “efforts of others” elements of Howey. See Rahaim,

at 4,9.

19

satisfied. /d. at 410-412. With respect to the third prong of

Howey, the court stated that “Under the precedent of this

circuit, the crucial inquiry is the amount of control that the

investors retain under their written agreements.” /d. at 410.

The appellate court’s decision also conflicts directly with

the Ninth Circuit’s decision in United States v. Carman, 577

F.2d 556, 563 (9th Cir. 1978). There the defendants sold

fixed rate, federally guaranteed packages of student loans,

along with service contracts. /d. at 560, 563-64. Against

charges of securities fraud, the defendants argued that their

offerings were not securities because returns were in the form

of guaranteed fixed interest, which did not depend upon the

promoters’ efforts. /d. at 563. The Ninth Circuit rejected this

argument, observing that the investors had a passive role and

were in fact dependent upon the “sound management and

continued solvency” of the promoter to maintain the

guarantee in place and absorb potential refund liability under

the notes. /d. Similarly in this case, ETS investors were

passive, and they relied upon ETS’s continuing efforts to

manage the pay phones—or entice additional investors—to

provide the returns.

2. Other Considerations

The rationale underlying these cases is clear. The securi-

ties laws were intended to provide investors with certain

safeguards because they put their funds at risk. The

economic reality is that promises and guarantees of returns—

even from a legitimate business enterprise—do not eliminate

investor risk. Promises can be broken and companies can go

bankrupt, as ETS did in this case. Very often, in fact,

assurances of guaranteed returns are part of a promoter’s

sales pitch, not a genuine risk-reducing feature of the

investment. Accordingly, investors need the protections of

the securities laws whether or not their investments are

nominally “guaranteed” or promised to them as the benefit of

their bargain, just as they require those same protections

20

whether or not their returns are fixed. Cf Tcherepnin v.

Knight, 389 U.S. 332, 336 (1967) (in the analysis of invest-

ment contracts, “form is to be disregarded over substance”

and the emphasis should be on “economic reality”).

CONCLUSION

For the reasons set forth above, the SEC’s petition for a

writ of certiorari should be granted.

* Counsel of Record

March 17, 2003

Respectfully submitted,

MARK J. DAVIS *

Associate Counsel

ROYCE O. GRIFFIN

General Counsel

JOHN R. VEATOR

Deputy General Counsel

STEPHEN W. HALL

Associate Counsel

NORTH AMERICAN SECURITIES

ADMINISTRATORS ASSOCIATION, INC.

10 G Street, N.E., Suite 710

Washington, D.C. 20002

(202) 737-0900