Split Decisions for the SEC on What Constitutes a Security

In recent rulings the SEC obtained mixed results on the question of what constitutes an investment contract. In one case the agency obtained a summary judgment ruling in its favor. In a second the Commission lost a motion to dismiss centered on the same question.

The win. In SEC v. Radical Bunny LLC, No. 11-16275 (9th Cir. Opinion issued July 10, 2013) the Commission prevailed, securing an order affirming summary judgment granted in its favor by the district court. Here the complaint claimed that beginning in late 2005, and continuing through June 2008, the company and four individual defendants raised over $189 million from at least 900 investors through a nationwide offer of unregistered securities in the form of promissory notes or investment contracts. The notes were sold using a series of misrepresentation, according to the SEC.

Each defendant settled, consenting to the entry of permanent injunctions prohibiting future violations of the antifraud and registration provisions. The individuals also agreed to pay disgorgement, prejudgment interest and a penalty. The individuals, however, reserved the right to appeal the summary judgment ruling.

On appeal defendants argued that there was a triable issue of fact as to whether the investments were a security under the test set forth in the Supreme Court’s seminal decision in SEC v. W.J. Howey Co., 328 U.S. 293 1946). The Court concluded that the facts proffered by the Commission met the test.

The undisputed facts demonstrated that Appellants sent each investor a document entitled “Direction to Purchase.” Investments made following the Direction were in a “common enterprise. All the profits were to come from the efforts of the Appellants who promised an 11% return annually. That profit was paid by Radical Bunny. Investors did not have or exercise any control over the underlying loans to be acquired by Radical Bunny with investor funds. Under these circumstances the Court had little difficulty affirming the district court’s conclusion that the Howey test had been met.

The loss. The Howey test was also the critical question in SEC v. Graham, Case No. 13-10011 (S.D. Fla. Ruling issued July 10, 2013). In this case the court concluded that the Commission’s amended complaint failed to adequately plead facts demonstrating that the key elements of the test were met. The case was dismissed without prejudice, leaving the SEC to perhaps try again.

Graham is an action against five individuals who are alleged to have raised about $300 million from 1,400 investors over a four year period beginning in 2004. The defendants “directly and through Cay Club Resorts and Marinas . . . [raised the money] through the offer and sale of units in purported five-star luxury resorts at 17 locations nationwide.” Cays Clubs, according to the complaint, were formed by two of the individual defendants in 2004 as a purported real estate development company. It was composed of about 100 entities controlled by three of the individual defendants. The organization, which was not incorporated in any state, collapsed in July 2008.

The critical issue on the motion to dismiss was the nature of the investment solicited by defendants. In this regard the complaint states that the defendants “offered investors the opportunity to purchase undervalued condominium units and obtain an immediate 15 percent return through a two-year leaseback agreement with Cay Clubs.” Investors were also told that their units would appreciate after being renovated by Cay Clubs.

The “leaseback was the key feature of the Cay Clubs investment,” the SEC stated. While some of the marketing materials described it as voluntary, the complaint states that it was a “critical selling point and a critical factor for investors” because the 15% was to be paid at the closing table which provided investors with an immediate return. To facilitate the process the defendants furnished investors with a list of preferred lenders who “provided 100 percent financing and typically issued 30-year fixed term mortgages to those who executed leaseback agreements.”

Judge James King turned to the Howey test as interpreted by the Eleventh Circuit to assess the adequacy of the Commission’s allegations. Under the Circuit’s precedent the court held that “Plaintiff must show that there was an investment, that it was a common enterprise, and that the buyer lacked control over the profitability of the investment,” citing Alunni v. Development Resources Group, LLC, 445 Fed. Appx. 288 (11th Cir. 2011). At the core of this test is an analysis of the purchase agreement. Here, however, “Plaintiff has neither filed a copy of the purchase agreement on the record, nor included adequate factual allegations in the Amended Complaint concerning the contents of the purchase agreement. Therefore, the Court finds that the Amended Complaint presents insufficient facts to support Plaintiff’s claims.” The motion to dismiss was granted, without prejudice to file a Second Amended Complaint.

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