Securities Law - Recent Developments Concerning SEC v. Howey, 328 U.S. 293 (1946)

SEC v. Howey, 328 U.S. 293 (1946) is one of the most important cases interpreting the securities laws.

The Defendants offered "units of a citrus grove development coupled with a contract for cultivating, marketing and remitting the net proceeds to the investor."

The SEC sued and alleged that the Defendants had failed to register the unit offering. The Defendants responded that they were not offering securities - rather they were offering the right to engage in citrus farming.

The Supreme Court held that the units were "investment contracts" under the Securities Law. 15 U.S.C. Section 77b(a)(1). The Court defined the investment contract as "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 third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise." Id at 299.

The Supreme Court held that the interests in the citrus farm were investment contracts because the contracts were "an opportunity to contribute money and to share in the profits of a large citrus fruit enterprise managed and partly owned by respondents." Moreover, the purchasers were not seeking to own land. They hoped to obtain a return on their investment. As the Court noted, "all the elements of a profit-seeking business venture are present here. The investors provide capital and share in the earnings and profits; the promoters manager, control and operate the enterprise."

The holding of Howey is crucial to the operation of the Securities Laws. Without this holding, promoters could design investment contracts that would be exempted from regulation under the Act.

Recent Developments:

Two recent decisions have reaffirmed the long-standing principles set forth in Howey.

In Warfield v. Alaniz, 569 F.3d 1015 (9th Cir. 2009), the Ninth Circuit held that certain charitable gift annuities were investment contracts under the federal securities laws.

The promoter, Robert Dillie, sold charitable annuities that promised an investment return to investors during their lifetimes and gifts to charities when the passed away. The Foundation raised $55 million from investors. Unfortunately it was a Ponzi scheme and had no investments. Ultimately, the Foundation collapsed. A receiver was appointed to recover assets for the victims. The receiver filed a lawsuit seeking the return of commissions paid to agents who sold the charitable annuities. After a trial the District Court entered judgment in favor of the receiver and against the agents.

The agents appealed on the ground that the charitable annuities were not investment contract and, thus, not securities.

The Ninth Circuit rejected their arguments and affirmed the judgment. The Court held that the annuities were investment contracts because there was "(1) an investment of money (2) in a common enterprise (3) with an expectation of profits produced by the efforts of others."

The annuities were investments because the promoter promised a substantial return on the investment to the participants.

The second decision we will review is Liberty Property Trust v. Republic Properties Corporation, 577 F.3d 335 (D.C. Cir. 2009).

The Plaintiffs brought claims under the securities laws against the Defendant Republic that marketed certain limited partnership units.

The two main defendants controlled the defendant and, in exchange for limited partnership units, transferred a valuable contract to the limited partnership. Later, as a result of a scandal, that contract was terminated by city of West Palm beach. The limited partnership interests became worthless.

The Defendants argued that the limited partnership interests were not investment contracts because they were on both sides of the transaction (they owned the Defendant and some of the limited partnership interests.) The court held that the limited partnership interests were securities because two of the defendants "expected to profit from the efforts of [others]." The two defendants lacked sufficient control over the limited partnership, so they were clearly trying to profit from the work of other people.

In sum, the Howey decision remains good law and is as relevant today as it was in 1946.

Edward X. Clinton, Jr.

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Does Illinois Permit Lawsuits By Those Who Merely "Hold" Securities?

The United States Supreme Court in Blue Chip Stamps v. Manor Drugstores, 421 U.S. 723 (1975) held that investors injured by fraud may recover under the Federal Securities Law only if the deceit caused them to purchase or sell securities. In the Blue Chips case, the Supreme Court stated that states may supply the remedy when Federal Law does not. California has done so. It authorizes “holder actions” which are suits by investors who contend that the fraud caused them to hold their shares when they would have sold them had they known the truth. See, Small v. Fritz Companies, Inc., 30 Cal. 4th 167 (2003).

Plaintiff, Anderson, the holder of about 95,000 shares of Aon Corporation claimed in a U.S. District Court case that he would have sold his stock in Aon if he known earlier of fraud by the Company. When the financial information was discovered the stock dropped from about $69.00 a share to about $14 a share. Anderson’s claim was under the Illinois Securities Law and the District Judge held that the Illinois law supplies the rule of decision. Securities law in Illinois tracks federal law when the statutes use the same language, see Tirapelli v. Advanced Equities, Inc., 351 Ill.App. 3d 450, 455, 813 N.E. 2d 1138, 1142 (2004), which means that Illinois may follow the purchaser-seller rule of Blue Chip Stamps. The District Court concluded that the Plaintiff does not have a claim under Illinois law.

The Seventh Circuit in Anderson v. Aon Corporation, No. 09-1144 decided July 26, 2010, after sorting out various procedural maneuvers by plaintiff, in effect held that it was not clear if Illinois will permit holder actions, but it reversed the District Court that had dismissed Plaintiff’s complaint and remanded so that Plaintiff could pursue his claim.

Does Plaintiff have a holder claim under Illinois law? The final determination of this issue will await a trial.

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Contract Law - Illinois Court Rejects Impossibility of Performance Defense

The case captioned, YPI 180 N. LaSalle Owner, LLC, v. 180 N. LaSalle II, LLC, 1-09-1797, provides an interesting discussion of the impossibility of performance doctrine.

The Plaintiff was an assignee of a contract to purchase real estate. It argued that the 2008 financial crisis following the failure of Lehman Brothers made it impossible to obtain financing and therefore it was excused from performance.

The Court, like the trial court, rejected the rescission claim. The court noted that "Rescission is an equitable remedy that seeks to restore the contracting parties to their precontract positions." Opinion at 5.

The Court noted that "impossibility of performance as a ground for rescission of a contract refers to those factual situations where the purposes for which the contract was made have, on the one side, become impossible to perform." See 30 R. Lord, Williston on Contracts, Section 77:95 (2004). The court noted that the impossibility defense is limited "to the destruction of the means of performance by an Act of God, vis major, or by law" and that performance should only be excused in extreme circumstances. Seaboard Lumber Co. v. United States, 308 F.3d 1283, 1294 (Fed. Cir. 2002); Kel Kim Corp. v. Central Markets, Inc., 70 N.Y.2d 900, 902, 519 N.E. 2d 295, 296 (1987). More importantly, "where a contingency that causes the impossibility might have been anticipated or guarded against in the contract, it must be provided for by the terms of the contract or else impossibility does not excuse performance.

Here, Plaintiff's claim was rejected because it was foreseeable that a commercial lender might not provide the required financing to complete the real estate purchase.

Comment: this is a novel and creative attempt by the plaintiff's lawyer to rescind a real estate contract, but it did not convince the trial court or the Illinois Appellate Court. As the court noted, if the inability to obtain commercial financing, standing alone, were sufficient to excuse performance...., then the law binding contractual parties to their agreements would be of no consequence." The Court is correct, the Plaintiff could have negotiated for a financing contingency in the contract, but apparently failed to do so. Opinion at 10.

Edward X. Clinton, Jr.

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Contract Law - Seventh Circuit Blocks An Attempt to Hold Shareholders Liable For Corporate Debts

On August 2, 2010, the Seventh Circuit issued an opinion (written by Judge Easterbrook) in the case captioned Fusion Capital Fund II, LLC v. Richard Ham and Carla Aufdenamp, 09-3723, reversing a decision by Judge Shadur, holding that corporate shareholders could be liable for the corporation's debts.

The Plaintiff sought to collect a debt incurred by a corporation directly from the corporation's shareholders. The debt arose as a result of an ill-fated merger transaction.

Millenium Holding corporation was insolvent. However, it had previously gone public and its stock was tradeable. Another company, Sutura, Inc., sought to go public by merging into Millenium. As the Court noted, "Sutura wanted to go public without all the fuss and bother (and expense) of a registration statement and the release of audited financials." As a part of the merger agreement, Millenium agreed to raise $15 million in new capital. Later, Plaintiff Fusion and Millenium signed a contract and agreed to provide the $15 million.

When the merger with Sutura failed to close, Fusion "wrote to Millenium that the money would not be forthcoming." Sutura then terminated the merger agreement.
Fusion prevailed in contract litigation and later sued in the Northern District of Illinois to collect its legal fees incurred.

Fusion brought its claim against Ham and Aufdenkamp, Millenium's controlling shareholders. The District Court held that the Ham and Aufdenkamp were personally liable for the debt under Nevada law. The District Court ruled that Ham and Aufdenkamp became the "alter ego" of the corporation because (a) they influenced and governed it; (b) there was a "unity of interest" between the shareholders and the corporation; and (c) "adherence to the corporate fiction of a separate entity would sanction fraud or promote manifest injustice." Opinion at 4.

The Seventh Circuit agreed with the analysis with respect to the first two elements of the alter ego test. However, there was no fraud because Fusion was well aware - when it entered into the contract - that Millenium had no assets and was insolvent.

The Court reasoned that Fusion should have been aware that it could never enforce its contract (for the payment of legal fees) because Millenium was broke.

"When Millenium signed a contract promising to reimburse Fusion's legal expenses if litigation ensued, Fusion knew beyond a doubt that Millenium would be unable to keep that promise - unless the merger closed. Someone who wants to protect himself against the possibility that a thinly capitalized corporation will be unable to pay its debts asks the investors for a guaranty. It is feckless to do business with a corporation such as Millenium without one. Yet Fusion did not get a guaranty but also did not even ask for one....A business such as Fusion that neglects to arrange for payment if the worst comes to pass is not well positioned to seek judicial aid....Fusion wants to be protected from this asymemetry [the risk that Millenium would not be able to pay], but to get this protection Fusion should have negotiated for a guaranty and refused to deal if the Hams would not give one."

The Court distinguished the situation where the debtor is solvent when the contract is signed, but later siphons off its assets to avoid payment.

Comment: This is a thoughtful opinion that takes the polar opposite view of the District Court. It is a reminder to lawyers that anything can happen on appeal and that the underlying economics of a transaction are often far more persuasive than case citations and three-factor tests.

Edward X. Clinton, Jr.

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Securities Law - A Rare Loss For the SEC

A District Court case (Southern District Of New York) involves allegations of insider trading in violation of Section of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10(b)-(5). The case is captioned SEC v. Nelson J. Obus, et. al., 06 Civ 3150, United States District Court for the Southern District of New York. The opinion was written by George B. Daniels, District Judge. The opinion can be found in the Pacer Systems. It is Document 77 and is dated September 20, 2010.

Following a SEC investigation, the SEC filed a Complaint alleging insider trading in violation of Section 10(b) and Rule 10(b)-5 against Tom Strickland, an employee of GE Capital Corp. The SEC alleged that Strickland tipped a friend, Peter Black, an analyst at Wynnefield Capital, about the potential acquisition of SunSource by a financial buyer. Black then, according to the SEC Complaint, passed the information to his superior, Opus, who purchased the stock of SunSource. The Court referred to the “Classical” and “Misappropriation” theories of insider trading.

Under each theory the SEC must prove five elements: (1) the tipper possessed material non-public information concerning a publicly traded company; (2) the tipper disclosed this information to the tippee; (3) the tippee traded in the company’s securities while in possession of the insider information; (4) the tippee knew or should have known that he tipper had violated a relationship of trust by providing the non-public material information and (5) the tippee benefited from the disclosure of the information. S.E.C. v. Warde, 151 F.3s 42, 47 (2d Cir. 1998). All of the Defendants filed a motion to dismiss the Complaint for failure to state a cause of action.

GE Capital sought to do business with SunSource. GE submitted a best effort proposal to provide 95 million dollars of financing in support of a potential buyer’s buyout of SunSource. Strickland was the front person for the GE underwriting team. Strickland learned that Wynnefield was an owner of SunSource stock and that his college classmate, Black, worked at Wynnefield. Following Strickland’s call to Black, Wynnefield purchased a block of SunSource Stock.

GE was subpoenaed by the SEC to testify pursuant to Federal Rule Of Civil Procedure 30(b)(6) about Strickland’s employment history. The GE employee testified that Strickland was trying to do some underwriting when he talked to his friend, Black.
The SEC based its insider trading allegations on the premise that by tipping Black about the impending SunSource merger, Strickland breached the fiduciary duty he owed to SunSource as a “temporary insider.” The District Court noted that neither Strickland nor his employer GE was a corporate insider of SunSource and that accordingly the classical theory of insider trading was not violated.

The Court said that the SEC cannot prove that GE or Strickland owed a duty of confidentiality to SunSource on the date of Strickland’s call to his friend Black and that summary judgment was rendered in favor or the Defendants in regard to the “classical” theory of insider trading.

The Court then considered whether the misappropriation theory applies when a person commits fraud in connection with the securities transaction. The Court concluded that Strickland engaged in no active deception. Such being the case the misappropriation theory did not apply.

Accordingly, the Court dismissed the SEC Complaint against all Defendants.

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Securities Law - Verdict Upheld by Seventh Circuit

RK Company sued Jackie R. See for violations of the Federal and State Securities Laws. The case is entitled RK Company v. Jackie R. See, No. 07-3984 decided September 22, 2010 by the Court Of Appeals for the Seventh Circuit.

The Seventh Circuit summarized the basis for the case as follows:

"Harvard Scientific Corporation and its founder Jackie R. See claimed to be developing a new product to treat male and female sexual dysfunction. Dr. See touted HSC's soon-to-be success in creating this product in a series of press releases and securities filings. This attracted an investment by RK Company..."

Plaintiffs invested $500,00 in Defendant’s LLC.

"Unfortunately, HSC's claims of success were not true, and following a bench trial, the court found Dr. See violated federal and state securities laws, state deceptive practices law, and committed common law fraud." The Seventh Circuit noted that the evidence showed that HSC's press releases included false statements and material omissions, "such as HSC's claims that the FDA had authorized clinical studies when it had actually suspended them..."

At trial, Plaintiffs sought damages equal to its investment of $500,000, prejudgment interest and attorneys’ fees. At trial, the plaintiff RK Company was successful. The opinion makes virtually no direct mention of the Securities Laws but rather discusses and rejects various claims of error by
Magistrate Judge Keys who presided.

Jackie See claimed to have a new product to treat sexual dysfunction of men and women. However, his company never received Federal Drug Administration approval and eventually went bankrupt. Defendant’s claim of FDA approval was false. The $500,000 investment by plaintiff was lost.

Following a bench trial, judgment was entered for plaintiff for the amount of the investment, prejudgment interest and attorneys’ fees.

The Seventh Circuit in an opinion by Judge Williams affirmed the ruling of the District Court. The Defendant claimed that the attorneys’ fees were excessive and that it had insufficient time to review the invoices. The invoices of the plaintiff’s attorney had been paid by his client which according to the Seventh Circuit was evidence of reasonableness. The Seventh Circuit noted that the Defendant received copies of plaintiff’s paid invoices on April 9, 2007 and had until August 2, 2010 to review and object to the invoices. The period of review was far in excess of the 15 days provided by the Local Rule.

A full victory for the Plaintiff.

Edward X. Clinton, Sr.

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Securities Law - Mark Cuban Fouls Out!

The SEC sued Mark Cuban, owner of the Dallas Mavericks and other businesses claiming that he wrongfully traded insider information in violation of § 17(a) of the Securities Act of 1933 and § 10 of the Securities Exchange Act by trading in the stock of Mamma.com in breach of his duty to the CEO of Mamma.com and Mamma.com amounting to insider trading under the misappropriation theory of liability. Cuban was a large minority stockholder of Mamma.com. In a telephone call from the CEO of Mamma.com, Cuban learned that Mamma.com was going to trade a public equity offering (PIPE). Cuban agreed in that call to keep the information confidential. Cuban then sold his stake in the Mamma.com to avoid losses from the inevitable fall in share price when the offering was announced. Cuban moved to dismiss.

The District Court found that the SEC Complaint alleged an agreement to keep information confidential, but did not include an agreement not to trade. The SEC appealed arguing that a confidential agreement creates a duty to disclose or abstain and that regardless the confidentiality agreement alleged in the Complaint contained an agreement not to trade on the information. (If interested, see our prior posts on this topic below).

The SEC alleges that Cuban’s trading constituted insider trading and violated Section 10(b) of the Securities Exchange Act. Section 10(b) makes it
unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange . . . [t]o use or employ, in connection with the purchase or sale of any security … any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

Pursuant to this section, the SEC promulgated Rule 10b-5, which makes it unlawful to
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

The Supreme Court has interpreted Section 10(b) to prohibit insider trading under two complementary theories, the “classical theory” and the “misappropriation theory.” The Cuban case involved the misappropriation theory.

The misappropriation theory rests on the principle that if a person violates Section 10(b) when he misappropriates confidential information for securities trading purposes, in a breach of a duty owed to the source of information. This theory was adopted by the United States Supreme Court in United States v. O’Hagan, 521 U.S. 642 (1997). In O’Hagan, the Supreme Court held that a lawyer who traded on confidential information misappropriated that information breaching a duty of trust and confidence he owed to his law firm and the law firm’s client.

The CEO of the Mamma.com was instructed to contact Cuban and to preface the conversation by informing Cuban that he had confidential information to convey to him in order to make sure that Cuban understood before the information was conveyed that he would have to keep the information confidential. Cuban agreed to keep the information concerning the PIPE offering confidential. At the end of the call, after learning about the offer, Cuban said “Well, now I’m screwed. I can’t sell.” Cuban then had a call with a sales representative of the proposed offering to get details of the offering. Following that call he immediately sold his entire stake in the company consisting of over six percent (6%).

The District Court found that the Complaint asserted no facts that reasonably suggest that the CEO intended to obtain from Cuban an agreement to refrain from trading on the information as opposed to an agreement merely to keep it confidential.

The Fifth Circuit held that it was entirely plausible that the CEO understood that in addition to keeping the information confidential, Cuban would not sell. Accordingly, the Fifth Circuit without taking a stand on whether the disclosure by the CEO was intended to restrict Cuban from trading would only be determined following further proceedings in the District Court. Accordingly, the motion dismissing the case was vacated and the parties can proceed with discovery, a summary judgment motion and a trial, if necessary.

Edward X. Clinton, Sr.
Copyright 2010

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