Amicus Curiae Brief — SEC v. Edwards

No. 02-1196

—— OF 1

IN THE

Supreme Court of the United States

tile (yy

SECURITIES AND EXCHANGE COMMISSION,

Petitioner.

Vv.

CHARLES E. EDWARDS,

Respondent.

On a Writ of Certiorari to the

United States Court of Appeals

for the Eleventh Circuit

BRIEF OF THE

NORTH AMERICAN SECURITIES

ADMINISTRATORS ASSOCIATION, INC.,

AS AMICUS CURIAE, IN SUPPORT OF THE

SECURITIES AND EXCHANGE COMMISSION

MARK J. DAVIS *

Associate 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

June 26, 2003

eee een ener SY a

WILSON-EPES PRINTING CO., INC. — (202) 789-0096 — WASHINGTON, D.C. 20001

QUESTIONS PRESENTED

|. 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 contrac-

tually promises or guarantees the return.

(i)

TABLE OF CONTENTS

Page

a i

ee V

INTEREST OF THE AMICUS CURIAE....................

SUMMARY OF THE ARGUMENT........................ 3

TT aa ialtiitieetiitiemananeus 4

1. THE APPELLATE COURT’S DECISION

OPENS AN ENORMOUS LOOPHOLE IN

SECURITIES LAW, WHICH EXPOSES

INVESTORS TO A NEIGHTENED RISK OF

ceri cntecenmssnnensesesccenees 4

A. Soap) Of the PODICIW........0000ccccccccessesssecesess 4

B. Benefits of Regulation......................:c000000 7

ee 8

ll. THE APPELLATE COURT’S DECISION

CONFLICTS WITH THE PLAIN MEANING

AND INTENT OF THE SECURITIES

LAWS, THE VAST WEIGHT OF

DECISIONAL AUTHORITY, AND THE

UNDERLYING RATIONALE FOR THE

INVESTMENT CONTRACT DEFINITION ... 13

A. The Appellate Court’s Interpretation of

“Profits” Is Unduly Narrow........................ 14

|. Statutory Language and Legislative

ce 14

2. Federal Court Decisions .................... 15

3. State Court Decisions....... ............... 19

4. Regulatory Interpretation................... 22

(iit)

iV

TABLE OF CONTENTS—Continued

Page

The Appellate Court’s Interpretation of

the “Efforts of Others” Test Is Plainly

SE TTret i cccenncnnennieninniiemounmanenionmneiiinienneain 23

The Appellate Court’s Rulings Have No

Rationale Under the Securities Laws ........ 26

Se tetianiaisicesiiaiiiattiiiiniadeencseneennn 27

f,

¥

meee

Vv

TABLE OF AUTHORITIES

CASES

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

Fo, ee

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

Council, 467 U.S. 837 (1984)... ccccceeeeeeeeee

Dep't of Banking & Fin. v. Mehl,

No. 02-0526, 2002 WL 31452438 (Fla.

Dep't of Banking « Fin. Oct. 17, 2002)

Page

24

Fn 7, 9, 10, 13, 22, 23, 26

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

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

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

Dep't of Banking & Fin. v. Paytel Communic.

Sys., Inc., No. 98-1626, 2000 WL 347485 (Fla.

Div. of Admin. Hr’gs Mar. 16, 2000)................

Garvin v. Sec'y of State, No. 2002 CV 60273

(Ga. Sup. Ct., Fulton County Mar. 17, 2003)

ERE are eevee eee

Garvin v. Sec’y of State, No. OSAH-

SECSTATE-SECUR-023 1234-33-PJ (Ga. Off.

of Admin. Hr’gs Aug. 28, 2002) (Order on

TEARS CAE TEED

Gaudina v. Haberman, 644 P.2d 159 (Wyo.

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

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

In re Alpha Telcom, Inc., No. $-99225 (EX),

1999 WL 1083919 (Wisc. Comm’r of Sec.

ead GUE crnsiuntecneennninasncmnnsetenmmanennmeanee

In re Alpha Telcom, Inc., No. 01-36-S, 2001 WL

1650906 (Ark. Sec. Dep’t Sept. 5, 2001)...........

In re Communics. Mktg. Assocs., Inc., No. DBR

00-114 (R.1. Mar. 28, 2000) 000.0... eeeeeeeeees

vi

TABLE OF AUTHORITIES—C ontinued

Page

In re ETS Payphones, Inc., No. 01-0056CD,

2002 WL 1586379 (Ind. Sec. Div. June 7,

EE ccnnsnaninnnnncnnemannemeniennmneeaennenen 8

In re Fecht, No. 02-12, 2002 WL 927153 (Tx. St.

QU OG“ 5

In re Nat'l Communics. Mktg., Inc., No. A-02-

0037 (Ore. Div. of Fin. & Corp. Sec. Oct.

In re Nat'l Communics. Mktg., Inc., No. 99-06-

0176, 2001 WL 236889 (Wash. Sec. Div. Feb.

I ial nd aheeaset iia aiaaeiiaicicalians 5

In re Nat'l Communics. Mktg., Inc., No. 99E039

OQ Ue 7

In re Phoenix Telecom LLC, No. 2-16-99-038

(Mont. Sec. Dep’t Oct. 29, 1999)... cccccceeeee 5

In re Rahaim, No. E-2000-22 (Mass. Sec. Div.

July 11, 2000) (Memorandum and Order)......... 23

In re Sommer, No. S-03489A-03-0000 (Ariz.

Corp. Comm’n Feb. 25, 2003), available at

http://www.ccsd.cc.state.az.us/enforcement/

Actions/2003/feb25-03 pdf ............cccccceeeeeeeeenes 5

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

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

(Summary Order to Cease and Desist)............... 11

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,

SED ccccnensentinntenenenmmnnemenniieimniamerninnins 10, 21-22

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

Denver County Jan. 30, 2003) (Order on

Motions for Summary Judgment)..................00+ 12, 21

King v. Pope, 91 S.W.3d 314 (Tenn. 2002)........... 21

Vii

TABLE OF AUTHORITIES—Continued

Page

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

ee I iccncnnicsinninieniinernenimnineen 21

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

i 9, 20

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

FD: FR ccchentcenssteninentieimninenen 16

Penn. Sec. Comm'n v. Yucatan Resorts S.A., No.

277 M.D. 2003 (Pa. Commw. Ct. June 5,

2003) (Opinion and Order) ...............ccceceeeeeees 11,12

Prohaska v. Hemmer-Miller Devel. Co., 256 Ill.

App. 331 (IIL. Ct. App. 1930)... ce eeeeeeees 16

Reves v. Ernst & Young, 494 U.S. 56 (1990)......... 14

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

2002 WL 193093 (D. Or. Feb. 7, 2002)............. 6

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

en 14-15, 19

SEC v. Crude Oil Corp., 93 F.2d 844 (7th Cir.

en TEEN 16

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

oe) passim

SEC v. G. Weeks Securities, Inc., 678 F.2d 649

A 24, 25

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

a ES IPED cerciemeceienineneneninemnens 24

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

1993 WL 347148 (SEC Release No. 13772,

BI Bis Gere cncsecemnenceninmnenemminnetmmnnninn 6

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

2000), cert. denied, 532 U.S. 905 (2001)........... 18

Vill

TABLE OF AUTHORITIES—Continued

Page

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

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

en 6

SEC v. Linktel Communic., Inc., No. 100-CV-

3169-WBH (N.D. Ga.), 2000 WL 1773106

(SEC Release No. 16186, Dec. 4, 2000)............ 6

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

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

0 a 6

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

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

RIND, Eig ED renee 6

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

Colo.), 1996 WL 635380 (SEC Release

SED eet Sees Ge, TD cecaveseneennsesvenenenen 12

SEC v. SG Lid., 265 F.3d 42 (ist Cir. 2001).......... 18

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

bo ee 19

SEC v. Universal Service Ass'n, 106 F.2d 232

ee 18, 19

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

State v. Gertsch, 49 P.3d 392 (Idaho 2002)....... 10, 19, 20

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

OO 16

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

Comm’r of Sec. Sept. 6, 2002) (Final

en 23, 26

Suave v. K.C., Inc., 591 P.2d 1207 (Wash. 1979).. 21

Tcherepnin v. Knight, 389 U.S. 332 (1967)........... 15, 26

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

Se Ca ccecstentaenisecrnieceneniarnidasiicaameniiaintadiniammniiaal 14, 15,17

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

SUI Ul cccsrtnneniaieeseianiaiicsinnitiininiiiiieleetimameianiie 18, 20, 25

ix

TABLE OF AUTHORITIES—Continued

STATUTUTES AND REGULATIONS

of bil) |

Be Biles Oe OOS cecursneneneseeennresrsernnenesemenmenes

BB CBR 6 Vii nccccescensasneenssccrssesscssnsnennssensseassseens

LEE E ol), See

BS UBB. © 7 Pe cccccenccsscsvcsccecscscescsvveccsvecnessssnssnencese

OL) dl

en

BREET er

| oly il iiiatdeiamiasaiiamatai

BS GREE. © Peli eccccsesessvescusesesecscesesesssessssesenenaspsusscnee

EE ee

een

Unif. Sec. Act of 1956 § 10D .................ccccccccereeeees

Unif. Sec. Act OF 1956 § 201 ....ccescosccrssrcccsccescesesees

Unil. Sec. Act OF 1956 § SOL ....ccccorrccsccccsccsssecceees

Unif. Sec. Act of 1956 § 408 .............cccccccccsesseeeeees

Unif. Sec. Act Of 1956 § 409 ......ccccccsssessrsseesceseees

Unif. Sec. Act Of 1956 § 410 .......scssscscssesssseeceeeseees

RULES OF COURT

OE EES eee

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

60273 (Ga. Super. Ct., Fulton County Dec. 16,

Appellant’s Proof Br., Jowa ex rel. Miller v.

_ Pace, No. 02-1726 (lowa Jan. 21, 2003)...........

Chart showing states adopting Unif. Sec. Act of

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

uniform/vol7 .html#secu6r...............ccccceeeeereeeeeeees

cmon mom mH anuaoaanarnna~

10

X

TABLE OF AUTHORITIES—Continued

Garvin v. Sec’y of State, No. 2002 CV 60273,

Application No. A03D0309 (Ga. Ct. App. Apr.

14, 2003) (Applic. for Discr. App.) .............008

Garvin v. Sec’y of State, No. 2002 CV 60273,

Application No. A03D0309 (Ga. Ct. App. Apr.

29, 2003) (Order Granting Applic. for Discr.

BABI.) acececcscscnncscesesonescsensnesssscensnnsnnnnsensesononononnenes

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

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

inetcbill.nsf/fsbillcont/1777905SCD8404C8 187

256CC50077A764?0pen&file=1311_01.pdf....

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

NASAA, State SecuritiesCops Announce Actions

Against Sellers of Payphone Schemes; Losses

Estimated at $76 Million So Far, March 13,

2001, available at www.nasaa.org, “Archived

Fe eI cecencnesenemseseesesesnsscensssnmemsesmenemenee

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”..............ccscssscssseseees

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 Jan. 13, 2003)...

Page

12

_—

26-9: BEI TOE IS mes

IN THE

Supreme Court of the Anited States

No. 02-1196

SECURITIES AND EXCHANGE COMMISSION,

Petitioner,

Vv.

CHARLES E. EDWARDS,

Respondent.

On a Writ of Certiorari to the

United States Court of Appeals

for the Eleventh Circuit

BRIEF OF THE

NORTH AMERICAN SECURITIES

ADMINISTRATORS ASSOCIATION, INC.,

AS AMICUS CURIAE, IN SUPPORT OF THE

SECURITIES AND EXCHANGE COMMISSION

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, Canada, and Mexico. 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.

' 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,

2

The members of NASAA are responsible for administering

state securities laws and regulations. Their principal activities

include licensing, registration, enforcement, and investor

education. State securities regulators also strive to increase

uniformity in the securities laws, as enacted and as inter-

preted. NASAA supports the work of its members in all of

these endeavors, for the ultimate purpose of protecting inves-

tors from fraud and abuse.

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, 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 the restoration of federal regulation of

these products.

Second, the appellate court’s decision substantially

narrows the federal definition of “investment contract” under

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

Circuit 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 undoubtedly will seek

to exploit in the future as they invent new ways to defraud the

investing public. NASAA has an interest in helping to

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

contribution to the preparation or submission of the brief. Pursuant to

Sup. Ct. R. 37.3, NASAA further represents that both parties to this

appeal consented to the filing of this amicus brief. Copies of their written

consents are being filed with this brief.

_—_

3

prevent this potentially far-reaching impact of the appellate

court’s decision.

Finally, the appellate court has set a precedent that, if

affirmed by this Court, will profoundly and adversely affect

the evolution of state securities law to the detriment of

investors. State courts and administrative agencies 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.

SUMMARY OF THE ARGUMENT

The appellate court’s decision should be reversed for two

reasons. First, the narrow interpretation of Howey adopted by

the Eleventh Circuit will harm investors. If affirmed, the

ruling will expose thousands of everyday citizens throughout

the country to a heightened risk of fraud and abuse at the

hands of pay phone promoters and others selling a variety of

sale and leaseback investments no longer subject to federal

regulation as securities. More broadly, the decision provides

an unfortunate blueprint to unscrupulous promoters who

easily will devise new schemes that fall outside the appellate

court’s narrow definition of an investment contract. In its

most far-reaching impact, the decision will have a corrosive

effect not only on federal securities law, but on state securi-

ties law as well. Federal courts in general exert an important

influence over state courts and administrative tribunals in the

area of securities regulation, and the decisions of this Court

have by far the greatest impact. It is therefore essential that

this Court reject the appellate court’s decision so that state

securities law is not undermined.

Second, the appellate court’s decision should be reversed

because it is legally untenable. The ruling conflicts with the

plain meaning and intent of the securities laws, the vast

weight of federal and state court decisions, and long-standing

4

administrative agency interpretation. There is no persuasive

rationale for the Eleventh Circuit’s narrow construction of the

term “investment contract,” nor is there any reason for

excusing Edwards or any similar promoter from complying

with the licensing, registration, and disclosure requirements

imposed under the securities laws. Unless the pay phone

investments at issue in this case continue to be fully regulated

as securities at both the federal and state level, investors will

suffer. Accordingly, the Eleventh Circuit’s decision should

be reversed.

ARGUMENT

I. THE APPELLATE COURT’S DECISION GPENS

AN ENORMOUS LOOPHOLE IN SECURITIES

LAW, WHICH EXPOSES INVESTORS TO A

HEIGHTENED RISK OF FRAUD AND ABUSE

By holding that the ETS pay phone investment is not a

security, the appellate 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 regula-

tion of these and similar products under both federal and state

securities law is essential to limit the financial harm they

inflict upon investors.

A. Scope of the Problem

The pattern of abuses in the marketing of pay phone sale

and leaseback programs is well documented. Over the years,

state securities regulators across the country have initiated

scores of administrative and civil actions against pay phone

sale and leaseback companies and their agents, including

ETS, Alpha Telcom, Phoenix Telecom, QCI, and others.

> The investments sold 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, e.g,. In re

wee aq AE LIE TEPER

5

The record in this case, for example, includes three cease and

desist orders issued against ETS by state securities regulators

in Kansas, North Carolina, and Rhode Island, all arising from

the sale of unregistered securities and, in the action by North

Carolina, fraudulent sales practices as well. ° . Exs. 9, 10,

11. Other cases abound.’

The scope of the problem was highlighted in March 2001,

when NASAA announced the results of a crackdown by

securities regulators in 25 states and the District of Columbia

against individuals and companies selling pay phone sale and

leaseback investments in violation of state securities law. See

NASAA, State Securities Cops Announce Actions Against

Sellers of Payphone Schemes; Losses Estimated at $76

Million So Far, March 13, 2001, available at www.nasaa.org,

“Archived Top Stories.” Nearly 4,500 people, most of them

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

these schemes, which were described as “the tip of a very

large iceberg.” /d. As a further part of its continuing effort to

warn the investing public about illegal and fraudulent

investments, NASAA repeatedly has included sale and

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

Mar. 13, 2002).

* A sampling of enforcement actions against pay phone programs

includes the following cases, in addition to the actions discussed else-

where in the brief: /n re Sommer, No. S-03489A-03-0000 (Ariz. Corp.

Comm'n Feb. 25, 2003), available at http://www.ccsd.cc.state.az.us/

enforcement/Actions/2003/feb25-03.pdf; Jn re Nat'l Communics. Mktg.,

Inc., No. A-02-0037 (Ore. Div. of Fin. & Corp. Secs. Oct. 2002); /n re

Fecht, No. 02-12, 2002 WL 927153 (Tx. St. Sec. Bd. Apr. 24, 2002); /n re

Alpha Telcom, Inc., No. 01-36-S, 2001 WL 1650906 (Ark. Sec. Dep’t

Sept. 5, 2001); /n re Nat'l Communics. Mktg., Inc., No. 99-06-0176, 2001

WL 236889 (Wash. Sec. Div. Feb. 26, 2001); Dep't of Banking & Fin. v.

Paytel Communic. Sys., Inc., No. 98-1626, 2000 WL 347485 (Fla. Div. of

Admin. Hr’gs Mar. 16, 2000); In re Alpha Telcom, Inc., No. S-99225

(EX), 1999 WL 1083919 (Wisc. Comm’r of Sec. Nov. 24, 1999); Jn re

Phoenix Telecom LLC, No. 2-16-99-038 (Mont. Sec. Dep’t Oct. 29,

1999).

6

leaseback schemes in its annual review of the “Top 10” scams

to be avoided. See NASAA, “Top 10” Investment Scams

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

Apr. 23, 2001), available at www.nasaa.org, “News and,

Public Affairs.”

The U.S. Securities and Exchange Commission (SEC) also

has taken aggressive enforcement action 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 Telecom, No.

100-CV-1970-JTC (N.D. Ga.), 2001 WL 874314 (SEC

Release No. 17089, Aug. 3, 2001); SEC v. Linktel Commu-

nics., Inc., No. 100-CV-3169-WBH (N.D. Ga.), 2000 WL

1773106 (SEC Release No. 16816, Dec. 4, 2000); SEC vy.

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. Fla.), 1993 WL 347148

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

The violations common to these operations include the sale

of unregistered securities in the form of investment contracts

by unlicensed agents making fraudulent misrepresentations

and omissions concerning the risk of loss, the likelihood of

profits, the financial condition of the enterprise, and the

promoter’s disciplinary history. 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).

These violations of the securities laws have caused enor-

mous financial injury to public investors. An enforcement

action brought by the state securities regulator in Florida

against two individuals who sold the ETS program illustrates

the point. See Dep’t of Banking & Fin. v. Mehl, No. 02-0526,

2002 WL 31452438, at *24-25 (Fla. Div. Admin. Hr’gs

7

July 16, 2002) (Recommended Order), aff'd, Dep't of

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

(Fla. Dep’t of Banking & Fin. Oct. 17, 2002) (Final Order).

The administrative law judge in Meh/ concluded that the ETS

pay phone program was an investment contract, bearing “all

the indicia of a Ponzi scheme,” which the respondents had

sold, along with other illegal offerings, in violation of the

licensing and registrations provisions of the Florida securities

act. /d. at *16, 22-24. The ALJ imposed multi-million dollar

fines against each of the respondents, with this observation:

“These fines are fair for the enormity of the harm caused by

Respondents in this case. Even if acting only negligently,

Respondents have left many persons in irreversible financial

ruin for the remaining years of their lives.” /d. at *24.

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 as intended by Congress and

the state legislatures. First, the securities themselves must be

registered so that material information about the offering is

made available to prospective investors before they part with

their money. See 15 U.S.C. §§ 77f, 77g, 77j; Unif. Sec. Act

of 1956 § 301 (registration of securities); see also In re Nat'l

Communics. Mktg., Inc., No. 99E039 (Ka. Sept. 25, 1998)

(Cease and Desist Order), Ex. 10, at 5 (due to lack of

registration, Kansas residents are not provided with the

investment information required by the Kansas Securities

Act).* Second, those who sell securities must be tested and

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

states 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.html#secur. Even

those states that have passed their own securities laws have similar

regulatory requirements and remedies.

licensed to help ensure they have the knowledge 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); see also In re Communics. Mktg.

Assocs., Inc, NO. DBR 00-114 (R.I. Mar. 28, 2000) (Cease

and Desist Order), Ex. 11 at 3 (respondent’s failure to be

licensed exacerbates likelihood that untrained, inexperienced

salespersons will defraud or take advantage of investors).

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, 78), 78u; Unif. Sec. Act of 1956 §§ 101, 408-

410 (civil and criminal penalties). Finally, the securities laws

give regulators the authority to seek important remedial

measures, including injunctions, disgorgement, and restitu-

tion. See id. (injunctive relief and civil liabilities); see also

In re ETS Payphones, Inc., No. 01-0056CD, 2002 WL

1586379, at *1 (Ind. Sec. Div. June 7, 2002) (ETS salesman

ordered to disgorge commissions to injured investor pursuant

to consent agreement).

With these requirements and remedies at their disposal,

regulators can deter violations in the first instance, enjoin

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 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. If allowed to stand, the decision’s most immedi-

ate impact will be to tie the SEC’s hands with respect to pay

phone sale and leaseback programs, as well as all other

investment contracts that have been structured to provide

9

fixed or guaranteed returns.’ While indications are that state

securities regulators will continue to enforce their laws

against promoters of these products, sidelining the SEC will

increase the burden on these state regulators and inevitably

expose investors to a heightened risk of fraud and abuse.

The appellate court’s decision also threatens a much

broader harm by fundamentally narrowing the application of

the Howey investment contract test. “Guaranteed” and “fixed

returns” often are meaningless labels that promoters attach to

their investment contracts to attract investors. See Dep't of

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

(Fla. Dep’t of Banking & Fin. Oct. 17, 2002) (Final Order)

(observing that the guarantee accompanying ETS contracts

was “nothing more than the promoter’s means of lulling the

investor into a feeling of security and thereby parting him

from his money”). Under the court’s decision, these same

terms—easily inserted into a contract—will serve as a

convenient shield against regulation of investment contracts

as securities. Regulators can now expect to see the

emergence of a wide variety of new and fraudulent

investment schemes specifically designed to benefit from the

loophole created by the appellate court.

Finally, the court’s decision wil! 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 Accounting

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

frequently rely on federal case law in interpreting state

securities acts). As observed by the Florida Department of

* 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.”

10

Banking and Finance, “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.” Dep't of

Banking & Fin. v. Mehl, 2002 WL 31452438, at *2. Some

state securities laws expressly provide that their interpretation

should be coordinated with the interpretation and administra-

tion of federal securities law. See State v. Gertsch, 49 P.3d

392, 396 (Idaho 2002).

The appellate court’s decision has prompted numerous pay

phone promoters to challenge prior rulings against them in

state enforcement actions. These arguments have surfaced in

states within the Eleventh Circuit and elsewhere. In /owa 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 transactions were investment contracts under

Howey, and ordered the defendant to make restitution of ayer

$300,000 for fraud in the sale of unregistered securities. /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 Jan. 21,

2003). The appeal is pending.

In Garvin v. Sec’y of State, No. OSAH-SECSTATE-

SECUR-0231234-33-PJ, at | (Ga. Off. of Admin. Hr’gs 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 filed a peti-

tion for review in state court, relying in part on the Eleventh

Circuit’s opinion in this case. See Aff. of Charles 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 60273 (Ga. Super. Ct., Fulton County Dec. 16, 2002). On

March 17, 2003, the Georgia Superior Court ruled against the

respondent, expressly rejecting the Eleventh Circuit’s analy-

sis and affirming that the ETS program is an investment

contract. See Garvin v. Sec'y of State, No. 2002 CV 60273

(Ga. Sup. Ct., Fulton County Mar. 17, 2003) (Final Order).

However, on April 14, 2003, the respondent filed an

application in the Georgia Court of Appeals for a discre-

tionary appeal, relying again on the Eleventh Circuit’s

decision in this case. See Garvin v. Sec'y of State, No. 2002

CV 60273, Application No. A03D0309, at 17, 20 (Ga. Ct.

App. Apr. 14, 2003). That application was granted on April

29, 2003, and the appeal is pending. See id. (Order Granting

Applic. for Discr. App.).

The Eleventh Circuit’s decision also has been 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 Penn-

sylvania Securities Commission named the respondents in a

summary 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 Eleventh Circuit’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

12

Resorts, No. 2002-10-33 (Pa. Sec. Comm’n Jan. 22, 2003).

That request is pending.°

The influence of the Eleventh Circuit’s decision has not

been confined to courts and administrative agencies.

Evidently as a direct result of the court’s ruling, a bill was

introduced in the Colorado legislature that would have

amended the definition of a security in that state to

exclude \easeback arrangements involving “a contractually

fixed and guaranteed rate of return.” See House Bill 1311,

Ist Sess. (Colo. 2003).’ This bill is particularly significant

because Colorado is among the states where both state and

federal regu'ators 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 on — iotions for Summary Judgment) (Phoenix

Telecom pay phone program held to be 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 defendants obtained over $9 million from 520

investors in fraudulent sales of pay phone investments).

Although the bill did not become law, it nevertheless was a

* On May 2, 2003, the Pennsylvania Securities Commission was forced

to seek a preliminary injunction against Yucatan in the Commonwealth

Court of Pennsylvania, to address violations of the summary cease and

desist order and to enforce a lawfully issued subpoena. See Penn. Sec.

Comm'n v. Yucatan Resorts S.A., No. 277 M.D. 2003 (Pa. Commw. Ct.

June 5, 2003) (Opinion and Order). On June 5, 2003, the court

granted the requested relief but left the core legal issue—whether the

Yucatan offering is a security—to be resolved in the administrative

proceeding. /d.

” Available at http://www. leg.state.co.us/2003a/inetcbill.nsf/fsbcont/

1777905CD8404C8 | 87256CC50077A764?0pen&file=1311 O1.pdf.

13

troubling attempt to curtail state securities regulation using

the Eleventh Circuit’s decision as a justification.*

These examples illustrate the potentially far-reaching

impact that this case may have on state securities regulation

and ultimately on public investors. Although the state courts

and administrative tribunals that have had occasion to address

the Eleventh Circuit’s decision thus far have consistently

rejected it,” the decision of this Court undoubtedly will have a

more profound influence on the .tates’ interpretation of the

Howey test in pending and future cases. To prevent the

erosion of state securities regulation, and to restore the SEC’s

regulatory jurisdiction to full strength, this Court should

reverse the decision of the appellate court.

il. THE APPELLATE COURT’S' DECISION

CONFLICTS WITH THE PLAIN MEAN-

ING AND INTENT OF THE SECURITIES

LAWS, THE VAST WEIGHT OF DECI-

SIONAL AUTHORITY, AND THE UNDER-

LYING RATIONALE FOR THE INVESTMENT

CONTRACT DEFINITION

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

* information about the progress of the bill is available at the follow-

ing website: http://www. leg. state.co.us/2003a/inetcbill.nsf/Frameset?Read

Form& viewname=3&.

* Even where repudiated, the Eleventh Circuit's decision has been

watched with interest at the state level. As observed by the Florida

Department of Banking and Finance in Mehl, “even if the states were

bound by the Eleventh Circuit’s decision, this decision, as a matter of law,

is not final. The SEC has petitioned the [Eleventh Circuit] for rehearing

en banc.” Dep't of Banking & Fin. v. Mehl, No. 02-0526, 2002 WL

31452438, at *4 (Fla. Dep’t of Banking & Fin. Oct. 17, 2002)

(Final Order).

14

considered profits for purposes of defining an “investment

contract” under Howey and United Hous. Found., Inc. v.

Forman, 421 U.S. 837, 851-53 (1975). 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. Each of these

rulings conflicts with the plain meaning and legislative intent

of the securities laws, federal and state court precedents, and

administrative interpretations that federal and state regulators

have been applying for years. The court’s rulings further-

more lack a persuasive rationale under the securities laws.

A. The Appellate Court’s Interpretation of

“Profits” Is Unduly Narrow

1. Statutory Language and Legislative Intent

The appellate court’s holding that fixed returns do not

satisfy the “profits” test for investment contracts is incon-

sistent with a statutory analysis. As argued by the SEC in its

Petition for a Writ of Certiorari, the words “investment

contract,” “income,” and “profit” all encompass fixed as well

as variable rates of return. See Petition for a Writ of Certio-

rari, at 10-11. The appellate court’s restrictive interpretation

of the term “investment contract” is inconsistent with the

plain meaning of the statutory language chosen by Congress.

Legislative intent supports this reading of the statute.

Congress intended to define the term “security” broadly in

order to eliminate serious abuses in the securities markets.

See, e.g., Reves v. Ernst & Young, 494 U.S. 56, 60 (1990);

United Hous. Found., Inc. v. Forman, 421 U.S. at 847-48.

The term “investment contract” was added 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 invest-

ment.” See Reves, 494 U.S. at 61; SEC v. C. M. Joiner

15

Leasing Corp., 320 U.S. 344, 351 (1943). Of course, many of

the instruments enumerated in the definition of a security

involve fixed returns, promises, and even guarantees. See 15

U.S.C. §§ 77b(a)(1), 78c(a)(10). As a catchall term, the refer-

ence 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”).

In accordance with this legislative intent, this Court has

repeatedly declared that the definition of “investment

contract” must be construed broadly to effectuate the

remedial purposes of the federal securities laws and to protect

investors. See Howey, 328 U.S. at 299, 301; see also

Tcherepnin v. Knight, 389 U.S 332, 336 (1967). The appel-

late court ignored these principles. It seized upon a restrictive

interpretation of Forman and adopted a “limited meaning” of

the word “profits.” See 300 F.3d at 1284. The resulting

dismissal of the SEC’s enforcement action against an

enterprise that defrauded thousands of investors was at odds

with the remedial purposes of the federal securities laws.

2. Federal Court Decisions

The appellate court’s decision also conflicts with this

Court’s original formulation of the investment contract

definition, as well as subsequent judicial interpretations of the

term. In Howey, the Court expressly adopted state court

decisions as a guide for defining the term “investment

contract,” because state courts had developed a definition for

that phrase under blue sky laws enacted prior to the federal

securities laws. See Howey, 328 U.S. at 298. Borrowing

directly from state case law, the Court formulated the

16

definition in terms of “a contract, transaction, or scheme

whereby a person invests his money in a common enterprise

and is led to expect profits solely from the efforts of the

promoter or a third party... .” Jd. at 298-99. As the

foundation for this definition, the Court cited seven state

cases, three of which involved investment contracts offering

fixed returns. /d at n.4. See People v. White, 12 P.2d 1078,

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

found where promoter offered a $7500 return on $5000

invested in enterprise trading trust deeds, stocks of bankrupt

companies, and foreclosure instruments); Stevens v. Liberty

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

(investment contract found where promoter offered fixed

amount per offspring in breeding scheme involving sale and

leaseback of rabbits); Prohaska v. Hemmer-Miller Devel. Co..,

256 Ill. App. 331 (Ill. Ct. App. 1930) (investment contract

found where investor stood to receive up to two-thirds of the

price of a land parcel, but not more). Since its early days,

then, the concept of an investment contract under federal law

has included offerings with fixed returns.'°

Elsewhere in the . ‘owey opinion, the Court used a variety

of terms interchangeably to describe an investor’s expecta-

tions 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. Removing any doubt on the issue, the Court in

Howey declared: “It is immaterial whether the enterprise is

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

’ In Howey, the Court observed that the term investment contract had

been broadly construed by the states “so as to afford the investing public a

full measure of protection” 328 U.S. at 298. The federal securities laws

were intended to be even more broadly applied, in light of the “ingenuity

and fertility of resources of those dealers in securities who deliberately

attempted to avoid” application of blue sky laws. See SEC v. Crude Oil

Corp., 93 F.2d 844 (7th Cir. 1937).

a PTE Se pk REEL a

17

affording broad protection to investors is not to be thwarted

by unrealistic and irrelevant formulae.” See Howey, 328 US.

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 re-

turns: “income,” “profits,” and “financial return.” See United

Hous. Found., Inc. v. Forman, 421 U.S. at 851-53. 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 transaction—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 853.

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

housing cooperative was not an investment contract. In

contrast with the Forman case, investors in the ETS program

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

acquire telephones. The ETS offerings were investment

contracts."

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

investment contracts, the appellate court’s decision would still be incor-

rect 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.

18

_ The appellate court’s interpretation of profits is incon-

sistent with decisions issued in at least four 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 ar

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 Ltd., 265 F.3d 42 (Ist Cir.

2001), the First Circuit had no difficulty finding an

“expectation of profits” where a promoter of “virtual com-

panies” on the internet “flatly guaranteed that investments in

the shares of the privileged company would be profitable,

yielding monthly returns of 10% ....” /d. at 54.

The Seventh and Ninth Circuit Courts of Appeals also have

found offerings to be investment contracts notwithstanding

fixed returns. In United States v. Carman, 577 F.2d 556 (9th

Cir. 1978), the court held that fixed interest on student loans

guaranteed by the federal government was nevertheless profit

to be derived from the efforts of others. The court focused on

the investors’ passive role and continuing dependence upon

the promoter’s sound management and solvency to avoid

certain risks of loss. /d. at 563. Those risks were deemed

“sufficient to bring the transaction within the meaning of a

security, even where the anticipated financial gain is fixed.”

Id. As early as 1939, the Seventh Circuit held that an

investment in a supposedly novel agricultural operation,

promising 30% annual returns, was a security under the

early investment contract standard. See SEC v. Universal

Service Ass'n, 106 F.2d 232, 237-38 (7th Cir. 1939). The

court adhered to this result, even though the defendant was

on —— a ae yes

a. 4 oy rs 3 3

ee met eae ar Se J

19

actually insolvent and the promised returns of 30% would

have been “paid not from any profit, but from new

contributions.” /d. at 239."

3. State Court Decisions

The appellate court’s decision conflicts with the decisions

of several state supreme courts.'? In State v. Gertsch, 49 P.3d

392 (Idaho 2002), the defendant sold investments in a

vaguely described business enterprise that was, in reality, a

classic Ponzi scheme. /d. at 394, 397-98. The investors

'2 Another line of Supreme Court and circuit court cases provides

an independent basis for reversing the appellate court's decision at issue

here. The Supreme Court has held 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 offer and sell his pay phone investments, and under this line

of cases, he cannot now disavow the status of those offerings as

investment contracts. See Ex. 15, at 5, 7, 8, 9; Ex. 17, at 4, 5, 8,9, 10, 11;

Ex. 22, at 1,5.

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

for two reasons. First, as discussed in the text above, the term

“investment contract” originated in state securities laws enacted during

the early 1900’s, and 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. Second, virtually every state securities law in the

country includes a definition of the term “security” that parallels the

federal definition by expressly including “investment contracts.”

Therefore, more recent state court decisions, as well as the early state

cases that helped establish the investment contract definition, continue to

serve as a useful guide to the meaning of the term.

20

expected to receive a very high, fixed return of 25%

quarterly. /d. at 394. The defendant asserted that the trans-

actions resembled bank loans more than capital investments

and that the unconditional promise to pay coupled with the

fixed return precluded a finding that the investors sought

profits. /d. at 398. The Idaho Supreme Court, citing princi-

pally to the Ninth Circuit’s decision in United States v.

Carman, 577 F.2d 556 (9th Cir. 1978), rejected this defense

and held that the transactions were investment contracts.

State v. Gertsch, 49 P.3d at 399. The court observed that the

investors did not perceive the transactions as loans, that they

were in fact dependent upon the efforts of the defendant to

cultivate new investors, and that despite the promise of a

fixed return, they faced substantial risk. /d. at 398-99. In

light of these facts, the court upheld the jury’s finding that

“investors sought the return of profits to be made from the

entrepreneurial efforts of others.” /d. The court furthermore

noted that the high rate of return could be viewed as a “cap”

on the profits expected from the venture.” /d. at 399.

Similarly, while the fixed rate of return promised by ETS

may have represented an upper limit on investors’ profits, it

in no way altered the fundamental character of those profits

as derived from the efforts of others.

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

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

return does not make this scheme any less an investment

21

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)).

In Gaudina v. Haberman, 644 P.2d 159 (Wyo. 1982), the

defendant offered interests in a trust account that was

established to acquire supposedly “top quality” investments

such as loans secured by real estate mortgages. The promised

rate of return was 14%. The Supreme Court of Wyoming

held that this investment offering fit the Howey definition of

investment contract “like a glove.” /d. at 164, 166. In Suave

v. KC. 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 return may have been constant, she was still

subject to the risk of loss of her entire investment if the

management failed to sustain the company’s profitability. /d.

at 1210; cf King v. Pope, 91 S.W.3d 314 (Tenn. 2002) (hold-

ing ETS contracts are securities based upon the Hawaii

Markets analysis).

More recently, trial courts in Colorado and lowa have held

that pay phoue 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; to hold otherwise would gut the

effectiveness of the Colorado Securities Act in protecting

investors against a broad range of investment schemes), /owa

22

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).'*

4. Regulatorv Interpretation

The appellate cour! decision also conflicts with

interpretations of the securities laws that federal and state

securities regulators have applied for years. Under the

principle of deference to administrative interpretation, “con-

siderable weight should be accorded to an executive depart-

ment’s construction of a statutory scheme it is entrusted to

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

Council, Inc., 467 U.S. 837, 844 (1984).

The SEC’s position that investment contracts include fixed

and guaranteed returns is reflected in the enforcement actions

described above, supra at Part 1.A., and in the authorities

discussed in the SEC’s Petition for a Writ of Certiorari, 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,

e.g., actions discussed supra at Part LA. Thus far, state

administrative law judges and commissions have rejected

arguments that fixed or guaranteed returns place an

investment beyond the reach of Howey. For example, in

Dep't of Banking & Fin. v. Mehl, No. 02-0526, 2002 WL

‘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

vy

23

31452438 (Fla. Dep’t of Banking & Fin. Oct. 17, 2002) (Final

Order), the Florida Department of Banking and Finance

rejected the Eleventh Circuit's narrow interpretation of

“profits,” observing that the Department had characterized the

ETS pay phone contracts and similar offerings as securities

for ten years. See id. at *3; see also Stigall v. Sec'y of State,

No. EN-18727, at 7-8 (Ga. Comm’r of Sec. Sept. 6, 2002)

(Final Decision) (definition of profits is broader than

Eleventh Circuit test and includes interest); Garvin v. Sec 'y of

State, No. OSAH-SEC STATE-SECUR-0231234-33-PJ, at |

(Ga. Off. of Admin. Hgs Aug. 28, 2002) (Order on Recon-

sideration) (“An offeror may not avoid registration of a

security in Georgia merely by establishing a fixed rate of

return on the investment”). But cf. In re Rahaim, No. E-

2000-22, at 5 (Mass. Sec. Div. July 11, 2000) (Memorandum

and Order).'* These interpretations of the securities laws

by the regulatory agencies tasked with administering them

support reversal of the appellate court’s decision.

B. The Appellate Court’s Interpretation of the

“Efforts of Others” Test Is Plainly Misguided

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 aspect of the appellate

court’s ruling is illogical and—like the court’s principal basis

for decision discussed above— irreconcilable with statutory

analysis, case law, and regulatory interpretation.

The court’s ruling is conceptually flawed because the

efforts giving rise to the profits of an enterprise bear no

logical relationship to whether or not those profits are

guaranteed to an investor. An analysis of the court’s decision

'S The Rahaim decision did not rest on the “profits” or “efforts of

others” elements of Howey, but rather on the ALJ's view that a common

enterprise was absent. See /n re Rahaim, No. E-2000-22, at 4, 9.

24

reflects this logical defect at every turn. With respect to the

Statutory language, nothing in the phrase “investment

contract” suggests the exclusion of contractually guaranteed

returns. Quite the opposite: use of the word “contract”

indicates that this category of investment was intended to

encompass contractual promises of many varieties, including

guarantees. The appellate court offers no authority to support

its contrary reading of the statute.

With respect to the case law, courts generally do not focus

on guarantees in connection with the “efforts of others”

analysis. Decisions from the federal circuit courts have

established that the appropriate inquiry under the third

element of Howey is not whether returns are contractually

guaranteed, but “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 Nat'l Bank of Orlando, 823

F.2d 408 (11th Cir. 1987), 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 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.

Courts specifically addressing the guarantee issue have

rejected the notion that a guarantee negates the “efforts of

others” element. In SEC v. G. Weeks Securities, Inc., 678

F.2d 649 (6th Cir. 1982), the Sixth Circuit actually held that a

guarantee provision was what made the offering an

investment contract. The appellant in Weeks offered “standby

pair-offs” on GNMA certificates, which essentially involved

25

buying and selling combinations of GNMA forward

contracts. /d. at 650. Investors were guaranteed a positive

rate of return. /d. at 652-53. The court found that the

guarantee distinguished the offerings from conventional

forward contracts and brought them within the ambit of

Howey:

Appellant’s scheme, the standby with pair-off, offered

an inducement available under neither form of the

traditional forward contract, a guaranteed return... .

G. Weeks Securities could accept the risk of adverse

price fluctuations and guarantee a positive return only if

they successfully invested the commitment fees

deposited by investors. Thus, the standby pair-off would

appear to fit precisely the Supreme Court’s definition of

a security.

Id. at 652-53. Under this reasoning, the ETS guarantee

heightened rather than diminished the importance of the

promoters’ efforts. The investors’ entitlement to a fixed and

positive return presumably required the company to work

ever more strenuously either to manage the pay phones

successfully or recruit additional investors in the tradition of a

Ponzi scheme.

The Ninth Circuit, in United States v. Carman, 577 F.2d

556, 563 (9th Cir. 1978), has expressly rejected the argument

that a guaranteed return vitiates the “efforts of others

element.” 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. Jd. 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

26

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 pay the promised

returns.

State administrative rulings have reached the same result.

See Dep't of Banking & Fin. v. Mehl, No. 02-0526, 2002 WL

31452438, at *3 (Fla. Dep’t of Banking & Fin. Oct. 17, 2002)

(Final Order) (ETS guarantee served only to lull the investor

into a feeling of security); Stigall v. Sec’y of State, No. EN-

18727, at 7-8 (Ga. Comm’r of Sec. Sept. 6, 2002) (Final

Decision) (contractual guarantee of payment that might be

satisfied from capital deemed irrelevant).

C. The Appellate Court’s Rulings Have No

Rationale Under the Securities Laws

Neither of the appellate court’s rulings can be reconciled

with the underlying rationale of the securities laws or the

cases interpreting them. There is no reason to distinguish

investment contracts with fixed or guaranteed returns from

those lacking these features. The securities laws were intend-

ed to provide investors with certain safeguards because they

place their funds at risk. The economic reality is that neither

fixed nor guaranteed returns—even from a legitimate

business enterprise—can eliminate such risk. Promises may

be broken and companies may go bankrupt, as ETS did in this

case, from either mismanagement or outright fraud. Very

often, in fact, promises of fixed returns and assurances of

guaranteed profits are merely sales pitches, not genuine risk-

reducing features of an investment. Accordingly, investors

require the protections of the securities laws whether or not

their returns are fixed or nominally “guaranteed.” Cf.

Tcherepnin v. Knight, 389 U.S. 332, 336 (1967) (in the

analysis of investment contracts, “form is to be disregarded

over substance” and the emphasis should be on “economic

reality”). In terms of the underlying rationale of investor

27

protection, there is no principled basis for distinguishing

investment contracts offering fixed or guaranteed returns

from those that do not.

Nor do the facts of this case suggest any basis for treating

pay phone promoters differently than other issuers under an

investment contract analysis. Nothing about the nature of the

ETS contracts and their inherent risks, the investors to whom

they were marketed, or the promoters themselves can justify

the distinctions drawn by the appellate court. In fact, pay

phone sale and leaseback programs represent precisely the

type of investment that the securities laws were intended to

reach. These products must be subject to continued

regulation at the federal and state level for the protection of

investors.

CONCLUSION

For the reasons set forth above, the Eleventh Circuit’s

decision should be reversed.

Respectfully submitted,

MARK J. DAVIS *

Associate Counsel

JOUN 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

June 26, 2003