SEC Prevails in Tenth Circuit

The SEC prevailed in a recent Tenth Circuit Court of Appeals ruling which upheld a grant of summary judgment in favor of the agency by the district court. The critical question before the Court was whether notes sold to investors were securities. In sustaining the Commission’s position, the Circuit Court held that the question is one of law which could be resolved on summary judgment, rejecting defense claims that the issue had to be considered by the jury. SEC v. Thompson, Case No. 11-4182 (10th Cir. Oct. 4, 2013).

The case centers on an alleged Ponzi scheme conducted by defendant Ralph Thompson through his company, Novus Technologies, LLC. That entity was founded in 2000 by Mr. Thompson as a vehicle for his investments. To implement his plans Mr. Thompson needed to raise $12 million.

Over time Mr. Thompson became involved with two investment programs which were supposed to generate huge returns. One was a proprietary algorithm for trading on the S&P 500 that was claimed to give investors monthly returns of 5% to as much as 40%. The second was a real estate investment program that its investors claimed would guarantee investors returns of 10% per month. Later a third real estate program was added.

To raise money unsecured promissory notes were sold. Those notes provided for repayment after a term of six months plus monthly interest of 3% to 5%, depending on certain options selected by the investor. The notes also stipulated that the borrower could extend the term for a period of six months as long as the interest was paid. The instrument stated on its face that it was not a security.

Mr. Thompson marketed the notes, claiming that they represented a more conservative investment than a 401(k) or a mortgage. Investors were told about the reserve of cash and assets held by Novus to cover any money borrowed. Sales continued until April 2007 when the SEC filed suit and obtained a freeze order. Subsequently, the district court granted summary judgment in favor of the SEC on its fraud claims.

The critical question on appeal was if the notes were securities within the meaning of the Supreme Court’s decision in Reves v. Earnst & Young, 494 U.S. 56 (1990). While the securities laws define what constitutes a security in broad terms which include a “note,” Reves made it clear that not every note is covered. Rather, that term must be viewed in the context of what Congress sought to accomplish under the securities laws. To assess this point the Supreme Court adopted a version of the Second Circuit’s “family resemblance test. Under this approach a note is presumed to be a security, although it left the question open for those instruments which have a term of less than six months. The presumption can only be rebutted if the instrument resembles those which are in fact not securities. Those include notes delivered in consumer financing, with a home mortgage, those which are short term or which are associated with an open account debt incurred in the ordinary course of business.

The application of the resemblance test is governed by four factors under Reves. First, the court must consider the motivations of the purchaser and seller to the transaction. Second, the “plan of distribution” of the instrument must be evaluated with a view to whether there is common trading for speculation or investment. Third, the reasonable expectations of the investing public must be considered. Fourth, the question of whether some factor such as the existence of another regulatory scheme which significantly reduces the risk of the instrument and makes protection under the securities laws unnecessary must be evaluated. If the application of this test suggests that the instrument is not sufficiently analogous to one on the list, then consideration must be given to if another category should be added which would again require analysis using the four factor test.

Critical to Appellant’s claims here is his contention that a jury must make the ultimate determination on the family resemblance test. This claim is contrary to established Tenth Circuit and other authority which holds that the question is one of law, not fact, and that submitting it to a jury is error, at least in a civil case. While there may be factual issues involving the application of the family resemblance test, the Court held “that in the context of a civil case where the ‘security’ status of a ‘note’ is disputed, the ultimate determination of whether the note is a security is one of law; thus, resolution of factual disputes will be necessary only in those rare instances where the reviewing court is unable to make a proper balancing of the family-resemblance factors without resolving those factual disputes.” And, in view of the presumption that the note is a security, once a moving party demonstrates that there is no dispute of a material fact, the opposing party has the burden to demonstrate that it is not.

Here Appellant failed to rebut the presumption. The first question is the reasonable motivations of a buyer and seller of the instruments. Where, as here, the purpose is to raise money for the use of the enterprise or to finance investments, it instrument is likely a security.

Similarly, consideration of the second and third factors also fails to support Mr. Thompson. In evaluating the “plan of distribution” it is not necessary that the notes be traded on an exchange. Rather, it is sufficient that they are sold to a broad segment of the public as here. While the issue regarding the “reasonable perceptions of the investing public” is a closer call, it also does not support Appellant. The instruments were characterized as “investments.” While the notes did state that they were not securities, in view of the perceptions of the public this one factor will not, according to Reves, outweighs the others if, as here, they suggest the notes are securities.

Finally, the last factor, which considers whether there is an alternate regulatory scheme, also cuts against Appellant. In this regard the Court held that “If the instrument ‘would escape federal regulation entirely if the Acts were held not to apply,’ the fourth factor cuts toward characterizing the instrument as a security.” Here this is precisely the case. Accordingly, the Court affirmed the decision of the district court.

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