SEC v. EDWARDS
Charles Edwards founded a company that sold pay telephones and then leased them back from the purchasers for a fixed monthly fee. After Edwards filed for bankruptcy, the Securities and Exchange Commission (SEC) sued him for selling securities (considering the telephones to be investments on the part of the purchasers and therefore securities) in violation of the registration and anti-fraud provisions of the federal securities laws.
A federal district court froze Edwards' assets in a preliminary injunction. The 11th Circuit Court of Appeals overruled the district court's injunction for lack of jurisdiction. The SEC, the court reasoned, failed to show that Edwards' selling pay telephones was an "investment contract" under federal securities laws. In defining "investment contract," the court used the Supreme Court's ruling in SEC v. W.J. Howey Co. (1946), that a financial interest is an "investment contract" if it involves (1) an investment of money, (2) in a common enterprise, (3) with the expectation of profits to be derived solely from the efforts of others. The 11th Circuit ruled that the SEC could not meet the test's third part because the purchasers received a fixed fee that was guaranteed by contract and therefore not dependant on Edwards' success.
Does the Securities Exchange Act's (1934) term "investment contract" include an investment scheme in which the promoter promises a fixed return or the investor is entitled to a particular rate of return?
Legal provision: Securities Act of 1933, the Securities and Exchange Act of 1934, or the Williams Act
Yes. In a unanimous opinion delivered by Justice Sandra Day O'Connor, the Court held that an investment scheme promising a fixed rate of return can be an "investment contract" and thus a "security" subject to federal securities laws. The test the Court uses for determining whether a scheme is an "investment contract" is "whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others." Because the test does not distinguish between promises of fixed returns and promises of variable returns, the scheme at issue here can be defined as an "investment contract."
Argument of Gen Theodore B. Olson
Chief Justice Rehnquist: We'll hear argument next in No. 02-1196, the Securities and Exchange Commission v. Charles E. Edwards.
Mr. Olson: Thank you, Mr. Chief Justice, and may it please the Court:
Over 10,000 persons in 38 States invested $300 million in respondent's payphone business on the expectation that their investments would yield a 14 percent return due to respondent's experience, efficiency, and management expertise.
The decision below that these transactions were not investment contracts merely because they specified a fixed return to the investor, rather than an unspecified portion of the enterprise's profits, can not be squared with the language, history, and purpose of the Securities Acts, 70 years of consistent SEC interpretation and enforcement, and this Court's jurisprudence.
The congressional definition of security, as this Court has repeatedly said, is broad and flexible, and intended to be all-inclusive to cover the countless and variable schemes devised by those who would seek money from others on the promise of a return.
Congress intended, in the words of this Court, to encompass virtually any instrument that might be sold as an investment, and the term investment contract, this Court has held, was intended to be a broad catch-all.
Therefore, substance, not form or title, governs.
These terms, investment contract, are to be construed broadly to embrace... again, in the words of this Court... all forms of investment schemes that bear a resemblance to what is commonly understood to be a security.
And this Court has said, because promoters are so creative, these terms must be flexible and inclusive.
A catch-all must catch all.
It is irrational to conclude that Congress would have defined security...
Justice Stevens: Mr. Solicitor General, may I jump ahead for a second?
Is the... is your adversary correct in saying that as far as decided cases are concerned, not the position of the SEC, but there is no judicial decision holding that a... an instrument that provides a fixed return is an investment contract?
Mr. Olson: Well, Justice Stevens, I can answer this by saying that the seminal case, Howey, referred to and cited Blue Sky cases and Federal court of appeals decisions, which did contain those type of instruments, fixed return instruments.
This specific question has not previously been decided by this Court, but the Court has never decided, and the cases that the Court referred to in Howey did not ever say that... that the fixed return instrument was excluded from the term investment contract.
Chief Justice Rehnquist: How about the United Housing case?
Mr. Olson: Well, again, with respect to that case, the... I... the Court has decided consistently that what is critical is the... that the investor expects a return.
The Court has never said...
Chief Justice Rehnquist: But the United Housing case did refer... suggest that the requirement that the income come from profits, did it not?
Mr. Olson: Well, the... the references to the... to the... this... from this... our perspective, Mr. Chief Justice, is that the return must be examined from the standpoint of the investor, the invest... and the Court... I don't think the Court intended to restrict in that case, and the language is not reasonably susceptible in my judgement to the... to the understanding that that was intended to exclude investments or instruments that provided a fixed return.
What the Court has repeatedly referred to is the... from the standpoint of the investor, what the investor is expecting to do is to put his or her money to work for him or her, that is to say, put that money into an enterprise of some sort so the investor can sit back and watch the returns come in.
The investor doesn't care whether that's a fixed return or a speculative return.
In fact, the definition in both the 33 and the 34 Act includes types of investments, such as common stock, that have speculative returns built into their definition, so to speak, fixed returns instruments, such as bonds, preferred stock, indentures, and that sort of thing.
Then the term, as this Court has repeatedly said, those terms are relatively fixed and understood.
But because Congress wanted to embrace, because this is a remedial statute intended to protect the investing public and the integrity of the marketplace so that people will feel secure in investing their resources in other instruments that promoters are offering...
Justice Ginsburg: General Olson, you... you put the stress on investment and that seems right with the statute refers to investment contracts, but there are surely debt instruments that would not be investment contracts.
So what is the dividing line between something that constitutes a plain old debt that is not an investment contract and not a security, and one that is?
I mean, how do we identify something as an investment contract rather... rather than an ordinary debt?
Mr. Olson: Well, I think the answer, Justice Ginsburg, is that many of those instruments that are ordinary debt instruments may be investment contracts as well.
This Court has repeatedly said is that these terms are overlapping...
Justice Ginsburg: And what makes it... what makes something an investment contract?
Mr. Olson: Well, what this Court has said is that when a person puts their money into a common enterprise with the expectation... expectation of a return, that is... through the... as a result of the efforts of others, that is an investment contract.
Now, many notes, or many types of offerings, might be based upon a fixed return and might appear in the... to look like notes or fixed return types of investments and still be investment contracts.
Justice Kennedy: But the... depending on the investment skills of others, that's... is very unhelpful to me.
I... I would think most creditors who extend credit rely on the investment skill or the financial responsibility of... of the lender.
That's how they're going to get their money back.
So, I... I find that test hard to work with as a limitation.
I know it comes from Howey.
Mr. Olson: It does... it does come from Howey, and I think that the best way to look at that, Justice Kennedy, is to look at that the investor, as opposed to using his own resources, his own efforts, his own energy, his own creativity, is counting on other people to make the... the instrument...
Justice Kennedy: Well, but my point is all creditors do that just on straight loans...
Mr. Olson: Well... well...
Justice Kennedy: so that doesn't advance us very far.
Mr. Olson: Well, that's right.
And there are some overlap, but this Court has said, and it repeated it and analyzed it from that context in the Reves case, that there are some commercial contexts and some consumer contexts in which the Securities Acts were never intended to cover.
Justice Kennedy: Well, the Reves case had language that doesn't help you because it seems to exclude a fixed return, but...
Mr. Olson: Well...
Justice Kennedy: so I... I don't...
Mr. Olson: We...
Justice Kennedy: know how great the Reves case is for you.
Mr. Olson: What the Reves case says, and I think Your Honor is referring to footnote 4 in the case, in which the Court, in construing what was meant by the... the term note, looked at the definition of... in... in the Forman case, which included the earlier Howey case, as to define an investment contract.
But in that footnote, the Court very carefully went on to say the definition that we're examining here with respect to investment contract is irrelevant with respect to notes.
That is dicta piled upon dicta in a sense, because the Court... we... I... we respectfully submit... mischaracterized Forman, the case that the... where the Court was concentrating on the difference between someone investing their resources to get something to use, in that case...
Chief Justice Rehnquist: Well, if... if you... if you don't like dicta that's against you, a lot of the things you've been quoting are dicta that weren't really necessary to deciding the case.
Mr. Olson: Well, what we... Mr. Chief Justice, I don't think that what we're quoting with respect to what we're relying on is dicta.
What the... the Court is... has defined the term investment contract, first of all, in the Joiner case, and then in the Howey case in very broad terms.
Chief Justice Rehnquist: Supposing I... I loaned someone $10,000, they've just hung out their shingle to practice law, and I'm... I want obviously the money back, but whether I get the money back or not is very much going to depend on his skill.
Is that an investment contract?
Mr. Olson: That's... that is... that is probably not an investment contract because it is a personal transaction between individuals.
What this... could the factors that this Court used in the Reves...
Chief Justice Rehnquist: Well, but all these are transactions between individuals.
That doesn't distinguish anything.
Mr. Olson: Well, what the... one of the... one of the things that the Court said in Reves is that, to the extent that there are any ambiguities at the edge and those particular factors were considered in Reves, it... the... the scheme of distribution, the nature of the relationships between the individuals, is this... the... is someone seeking to acquire money to use as capital in the... in the operation of an enterprise...
Chief Justice Rehnquist: Well, is... are you saying then that a one-on-one transaction can never be an investment contract?
Mr. Olson: No, we're not saying that.
In fact, the Court held to the contrary in the Wharf Holdings case that there may be... and in another case in this Court's jurisprudence... that simply because there are one individual or one entity dealing with another entity doesn't exclude the... the operation of the term investment contract.
Justice Kennedy: But the problem is, as... as you well know, Justice Ginsburg begins it, and the Chief Justice is asking the same question, if we're going to write this opinion, it seems to me we have to have some limiting principles, some limiting language.
Now, we could just talk about these facts and it'd be a case good for this ride only, but we're... we're wondering about whether or not these facts yield certain insights as to what might be definitional principles for an investment contract.
Mr. Olson: Well, with respect to the cases at the margin, the Court articulated the same kind of analysis that the Securities and Exchange Commission does.
Where there are cases at the margin, the Court will consider the motivation of the person raising the money, the person investing in the... in the operation, the nature and type of promotion that's taking place, and... and the motivations of the seller and things of that nature.
What... what the question presented here is considerably more narrow, the question presented here is it... is... is it disqualified as an investment contract simply because the return is fixed or specified?
Now, if the Court were to adopt that definition, imagine the size of the super highway loophole that would be created in the Securities Act.
Instead of promising the sky or... or a speculative return, the investors that develop these types of schemes will simply say 50 percent or 25 percent...
Justice Kennedy: Yes, but... but... but you don't... well, maybe you do... we just say an investment contract can include a fixed return and then remand it to the Eleventh Circuit for it to figure out the puzzle?
Mr. Olson: Well, it's not... the... the only reason that the Eleventh Circuit decided that this case couldn't go forward... they couched it in terms of jurisdiction, but it's really failure to state a claim... was that this instrument had a fixed 14 percent return and said investment contracts can't not include that...
Justice O'Connor: So your point is that's all we have to decide, whether the fact that it's a fixed return excludes it from the definition of a security?
Mr. Olson: Precisely.
Justice O'Connor: But it would be desirable to have some clearer understanding of what's covered, and if you had to take your best shot at constructing a definition, what would it be?
Mr. Olson: Well, I would adopt, and the Government would propose, that the Court do no more than rearticulate what the Court has repeatedly stated... and it's stated it as well in Howey as it could possibly state it... a transaction in which a person invests money in an enterprise with the expectation of a return, gain, profit.
Now, in the Forman case that we submit was not characterized correctly in the Reves footnote, the Court used all of those terms, the expectation of a profit, the expectation of a return.
In Howey itself the Court...
Justice Scalia: We... we've gone... gone around that.
I mean, the problem is the ordinary loan, the ordinary loan from one individual to another.
I loan you $10,000 and you will pay it back over so many years and give me so much interest a year, meets that qualification, meets that description, and you acknowledge that that is not an investment contract.
Mr. Olson: The... what the Court has said is that in... in those kind of cases, where it does not look as typical as the typical investment scheme...
Justice Scalia: What makes it look like a typical investment... I mean, that's what we're trying to get...
Mr. Olson: What makes it look like a...
Justice Scalia: What makes it look like the typical investment...
Mr. Olson: Well, the characteristics are...
Justice Scalia: You say it is not the mere fact that it's not a fixed return.
That isn't it.
What is it then?
Mr. Olson: Well, the things that make it look like an investment contract in this context is that the individual is putting himself, his money, into an enterprise that is being, in this case, widely promoted... as I said, 10... over 10,000 investors put their money into this enterprise hoping to get some return as a result of the... the efficiency or effectiveness...
Justice O'Connor: So at least where it's marketed to the public you would say it's covered, at least that, even though you don't know backing up where to cut it off?
Mr. Olson: Well, the... the precise lines here, Justice O'Connor, may be difficult in a particular one-on-one investment case.
The Court acknowledged that in the Reves case, said that there... there are... there are situations that look more like consumer transactions or they may look... more look like...
Justice Stevens: So isn't the question about the individual transaction really related to the conflict on this horizontal and vertical distinction that Judge Lay relied on in his concurring opinion?
And as I understand it, that's not before us as to the validity of his vote in the case.
Mr. Olson: That's... that's correct, Justice...
Justice Stevens: Because I don't understand either party to have addressed the... this alleged conflict over horizontal or vertical.
Mr. Olson: That was not what... yes, that's correct.
Judge Lay discussed that in his concurring opinion, but the court did not rely upon that, the parties have not briefed that, and that question is not before this Court.
Justice Stevens: So it's entirely possible that you could win here and the case would be remanded for the court of appeals to decide whether or not Judge Lay was right?
Mr. Olson: I guess that's... I guess that's... that's possible.
Justice Kennedy: Your... your opening argument says there are agreements for investment contracts...
Mr. Olson: Yes, we did.
Justice Kennedy: that's what you asked us...
Mr. Olson: Yes, we do.
And... and... I think that there is... this is not a difficult case from that standpoint, because all of the indicia that the SEC has been using for years, and what the SEC has articulated this standard in formal adjudications, to which this Court defers under Chevron, it did 2 years ago in the Zandford case, with respect to the SEC, there is here in this case 70 years of consistent enforcement of this principle by the Securities and Exchange Commission...
Justice Breyer: So to be clear about your... what you're saying is, there are a lot of criteria that rule out loans, ordinary loans, because after all, they would otherwise come in the words evidence of indebtedness.
There are a lot of words in this contract that could pick up ordinary loans, but then there are a lot of criteria that rule them out, of all those words, not just investment contract.
And this case is about one word.
What you would like is a decision that says, the word profit in Howey meant profit in the sense of ordinary return, return being broad enough to encompass fixed or variable returns of various kinds, period, end of the matter, reversed or remanded.
That's... that's your... that's your point, not get into these other criteria for other things.
Mr. Olson: Precisely, and the Court has not done that in the past, does not need to do so here.
There are situations like the Reves case where the Court said, well, some notes are securities, some notes are not securities, and then goes through... what the Court in that case was looking at, a Second Circuit decision that said, well, some notes are not securities, some are securities, and then laid out a methodology, which, by the way, is the same methodology that the SEC understand... well... widely understood to employ with respect to those cases at the margin.
But, Justice Breyer, I agree completely.
This is a paradigmatic investment contract.
It's like the cases involving chinchillas or rabbits, one of these cases involving rabbits, it... there's two of the... two of the...
Chief Justice Rehnquist: Except it's different in that here there's a fixed return.
In those, there was not.
Mr. Olson: That's not correct, respectfully, Mr. Chief Justice.
Two of the... two of the cases cited in Howey, People v. White and Stevens v. Liberty Packing, were...
Chief Justice Rehnquist: Well, I thought you meant cases in this Court.
Mr. Olson: No.
I'm talking about cases that this Court accepted when it decided the Howey case, but this Court has never...
Justice Scalia: Well, that's a pretty, you know, that's a pretty tentative attribution to... to this Court, that... that it was paying that close attention that it understood in all of those cases whether it was a fixed return or not.
Mr. Olson: Well, it certainly wasn't ruling it out, Justice Scalia.
What this Court... what the... this Court specifically said in Howey, because it had nothing to go on.
Congress, first of all, decided to make the definition as wide as possible to use again this Court's language to cover everything that might commonly be understood to be a security, and because promoters are so ingenious, to cover all types of investments that might carry some of those characteristics.
So the Court said, we're going to look at the cases that involve the Blue Sky statutes that... that had been in existence and had been interpreted prior to the adoption of the 33 Act.
There's not one of those statutes that limited investment contract to a variable return and excluded fixed return, was not one of those cases under the Blue Sky statutes that excluded fixed return investment contracts from the definition of investment contract.
Chief Justice Rehnquist: Well, were... were they all fixed return cases then?
You say there was not one of them that excluded fixed returns.
Mr. Olson: They were not... they were not... some of them were variable returns, Mr. Chief Justice, but some of them were fixed return.
The two cases I cited, the one was People v. White, where, if the Court looks at that case, the Court will find that the... the... the language of it is... the party of the first part will pay $5,000 and the party of the second part after 5 years will pay $7,500 back.
That was a fixed return investment.
But not only did the Court in Howey cite those two Blue Sky cases that involved fixed returns, but the Court cited then four... and we mention these, I'll not go through the names again here, we mention them in our briefs... four court of appeals decisions that had involved no pooling of interest and there... there have been two SEC formal adjudications, which again, as I said, this Court gives deference to.
And the first time the SEC sought to enforce an investment contract in this kind of context is SEC v. Universal Services, which goes back to 1936.
Very seldom does this Court have that kind of 70-year history of consistent enforcement by the agency vested with responsibility, and again, these have matured themselves into not only court decisions but, in addition, formal adjudications.
The securities laws have prophylactic purposes.
They are designed to protect people that put their money in the hands of other people who are running business... businesses... and from whom they expect to make a return.
I invite the Court's attention to exhibit 17 and particularly pages 116 through 119 of the joint appendix, and this is the type of note that the... the respondent will say, well, this was not our document, this was one of our distributor's documents, but it's alleged in the... in the complaint and there is evidence to support that this is... this was out there available for investors to see.
There are millions to be made from pay... owning payphones, watch the profits add up.
And then on page 119, this document goes on to say, for the payphone owner, the need to do individual things to make money is taken care of through these management contracts, because the payphone owner can benefit from the experience, operating efficiencies, and management expertise provided by ETS Payphones.
Chief Justice Rehnquist: What sort of management expertise is required to manage payphones?
Mr. Olson: Well, there's... there are many of things, at least, A, there was a promise that it was done, and secondly, Mr. Chief Justice, where that payphone is put, how it is managed, the appearance of the payphone, is it... is it mechanically functioning properly.
This was the promise that was held out... give your money to us, we have thousands and thousands of these payphones...
Chief Justice Rehnquist: This isn't exactly Warren Buffett, though, running around replacing payphones.
Mr. Olson: Well, that's correct, Mr. Chief Justice, and maybe that's the point, that... that the thousands of investors who invested in this type of scheme are the same type of thousands of investors that invest in other types of schemes.
What the Securities Exchange Acts require is that for people who are marketing opportunities to invest widely to the public... and I use the word widely carefully because it doesn't have to be that widely, but it was here... to expect people to provide their money and then to provide a return to put their money to work, that's what the securities laws are all about, to provide that remedial prophylactic purpose of requiring registration so honest transactions will take place in the marketplace.
If the investor could do to... to... to comply with the Eleventh Circuit and say, well, I'm not going to say 14 percent anymore, I'm going to say you're going to double your money every 5 years, or it's going to be a good return, it's going to... it's going to be pie in the sky, you're going to go home and retire, that would all of a sudden make it not an investment contract.
And the very people...
Justice Scalia: But you're... you're saying that it... it somehow remains... does it remain or not remain an investment contract is... if all that you alter is that it was not offered to the public, it's one individual who loans money to this company and the business of this company is with... with payphones, okay, and the deal with him is you will get 14 percent a year back on your...
Mr. Olson: If it's... if...
Justice Ginsburg: on your loan.
Mr. Olson: Mr.... Justice Scalia, if it's the same kind of transaction where I... I'm going to buy this payphone, lease it back to me, I'm going to have a management contract, and you're going to make a lot of money, the fact that it's one person, this Court's jurisprudence says does not make it not that... does not make it not an investment contract.
Justice Scalia: What... what makes it different just from a straight loan?
What makes it different?
Mr. Olson: Because it is a... it is...
Justice Scalia: the buying of the phone first or what?
Mr. Olson: It is a... it is a package in which it... in the... in the first place is, I think, Justice Breyer's question suggests it might... that might be a note and that might be a security under certain circumstances.
But is it a... it is the type of scheme transaction in which people invest their money on... for those types of purposes, and... and in... where... where there are difficulties at the margin, this Court and the SEC have provided a formula by which these various different factors can be examined as in the Reves case.
What I was about to say is that to the extent that you change the requirement and allow it to be speculative, the more speculative you can be, the less likely you're required to comply with the securities laws.
That seems like tilting the securities laws completely on their head.
The people that are the least... that are the most risk-averse are looking for guarantees of returns and fixed returns.
The people that depend... that aren't the Warren Buffetts, that depend upon the integrity of the system, are the ones that are going to be most vulnerable if the Eleventh Circuit decision is upheld.
Mr. Chief Justice, I'd like to reserve the balance of my time.
Argument of Michael K. Wolensky
Chief Justice Rehnquist: Very well, General Olson.
Mr. Wolensky, we'll hear from you.
Mr. Wolensky: Mr. Chief Justice, and may it please the Court:
We start with the language of the statute, and that tells us two things.
First of all, commercial leases is not a term included in the statute, and second of all, the term investment contract is undefined.
But over a course of 10 decisions during the past 60 years, this Court has identified the essential attributes of investment contracts.
It has identified those, defined those, and explained those.
One of the essential attributes of investment contracts is a return of profits.
The Court's restrictive definition of profits in the... in the Forman case and then reiterated in the Reves case, captures very effectively the investment risk and investment reward characteristics...
Justice Stevens: Is it your position that no debt security could ever be an investment contract?
Mr. Wolensky: As long as it was a fixed return, that is correct.
Justice Stevens: Well, why it distinguished between a fixed return and an other kind of debt security?
Mr. Wolensky: Well, under the SEC's explanation in its briefs, it refers to a lot of things as fixed returns, which are really just sham, boastful promises by promoters, and I believe that's what takes this situation completely out of what the SEC is proposing.
Both parties here agree that the correct test the Court should apply is the Howey test.
There... we don't disagree on that.
Justice Stevens: And you contend that test would never cover a debt security?
That's my question.
Mr. Wolensky: That is correct.
That test would never cover a debt securities because this Court has defined profits for Howey test purposes to mean an expectation of profits from earning...
Justice Stevens: What would be the underlying reason for excluding debt securities and limiting the coverage of the Act to equity securities?
Mr. Wolensky: Investment risk, Your Honor.
That is the key.
Justice Stevens: Well, there was an investment risk here.
Mr. Wolensky: Well, there really wasn't, because what you have is a commercial lease arrangement, a telephone acts as the collateral, so to speak, to use this Court's words from the Reves case, but you have a commercial lease arrangement like commercial lease arrangements done throughout the country...
Justice Stevens: Well, but this is a leasing arrangement that's really a financing arrangement.
The use of leasing for financing purposes really developed after the Act was passed...
Mr. Wolensky: It did...
Justice Stevens: and this is really a financing transaction.
Mr. Wolensky: It can be characterized that way, Your Honor.
Justice Stevens: Well, certainly the person's return, it didn't depend on what happened in his own phone booth, the one he happened to own.
His... his risk was what the overall enterprise would produce, as I understand it.
Mr. Wolensky: That's absolutely correct, Your Honor, and that is a credit risk, not an investment risk.
Justice Breyer: What's preferred stock?
Mr. Wolensky: Preferred stock is an... has both investment risk, because it can have fluctuating values, some do.
Justice Breyer: So can debt.
Mr. Wolensky: Debt can if there's a market for the debt.
Justice Kennedy: There is.
Mr. Wolensky: But the investor... that's correct... but the characterization of the return to the investor in debt is generally viewed as... as a return, the interest rate, and as far as the market... market...
Justice Breyer: That is preferred stock.
Mr. Wolensky: Preferred stock, but it's a capital appreciation issue and that's not an issue here.
Justice Breyer: So can debt appreciate.
Mr. Wolensky: Well, that's right, but that's capital appreciation and we don't have capital appreciation in this case.
Justice Scalia: What about bonds?
The definition also includes bonds.
The term security means any note, stock, bond.
Mr. Wolensky: That's correct, and a bond is a fixed return instrument.
Justice Souter: It is indeed.
Mr. Wolensky: It's a specifically designated type of security by Congress.
It is not... it does not fall under the investment contract rubric.
It may vary in its value and have capital appreciation...
Justice Scalia: Yes, but... but when some of the things that are specifically listed are fixed return items, it seems hard to credit your contention that somehow the reason investment contracts cannot cover this particular arrangement is because this arrangement has a fixed return.
But... but Congress intended the term security to cover some things that have fixed return.
Why not investment contracts?
Mr. Wolensky: Without question, it did, but Congress and... and this Court has stated very clearly, certainly in the Reves case...
Justice Souter: Yeah, but the Reves case was dictum, and the question here is, are we going to turn that dictum into a holding?
And before we get to a holding I think you've got to answer Justice Scalia's question.
When we have specific examples of... of... of fixed returns, why should the general proposition investment contract somehow be held not to include as a generality a fixed return contract?
Mr. Wolensky: Our position is that investment contract is an equity-type security, and we think that is founded on all of the history and when Congress used the term investment contract...
Justice Souter: Let... let me... I... I don't want to be... be short with you, but I don't think you're getting at what he and I want.
We... we have examples in which the fixed returns securities are specifically listed.
Why... let's be specific... why would Congress have wanted to exclude this kind of a scheme?
Mr. Wolensky: Because...
Justice Souter: It's being marketed as a classic investment scheme.
Why would it have wanted to exclude this one?
Mr. Wolensky: Because this is a... this is a commercial lease.
Justice Souter: Well, it's not a... a normal commercial lease.
It's a... it's a commercial lease of an essentially trivial piece of property, which is replicated thousands and thousands and thousands and thousands of times.
It is marketed on... on the theory that you're going to get an extraordinarily generous rate of interest.
These are... these are not classic sale and lease-back contracts.
Mr. Wolensky: Well, I... I disagree with Your Honor.
I believe it is a legitimate lease.
There's never been a question that it's not an enforceable lease.
There's never been a question that the telephone didn't have the value ascribed to it.
It was fairly valued.
Justice Souter: But it's being marketed not to people who want to go into the lease business, but people who want to invest their money and sit back at home and get at return.
Mr. Wolensky: That may be true, but it cannot be denied that in fact there was a lease agreement.
Every witness who testified or provided a declaration in connection with the case acknowledged that it was a lease.
Justice Souter: Let's assume it is not denied.
Why would Congress have wanted to exclude this kind of fixed return transaction when it is classically being marketed as an investment?
Mr. Wolensky: There were leases that were being used for commercial purposes in 1933.
Lease financing was being used on very significant items then in the railroad area and other areas, but leases are not new, novel, or unusual.
Investment contract was designed, as this Court has said...
Justice O'Connor: No, but as a public policy issue, I have the same question Justice Souter has.
From a standpoint of public policy, why in the world would Congress want to exclude a broadly marketed scheme like this from the definition of investment contract?
Why would it?
It's marketed like other schemes that might have a variable return.
They put all these little phone booths together and it required the management of others to know how to place them and service them and make it work.
It's not something that the... a person acquiring the lease is going to do individually.
I mean, why isn't... why would Congress have wanted to exclude this?
Mr. Wolensky: Justice O'Connor, the... the only answer I can give is because it does not have investment risk.
It's... it is excluded from the term investment contract because it doesn't have investment risk.
All of the pre-33 Act cases...
Justice O'Connor: Well, I suppose it does from the standpoint of the management required to make this scheme work.
Mr. Wolensky: Well, that's a credit risk...
Justice Scalia: Anybody who was investing in... in payphones in the era of the... the satellite was taking an investment risk, I would think.
Mr. Wolensky: Well, when the...
Justice Scalia: Like the buggy went just before the horse... just before the automobile.
Mr. Wolensky: Justice Scalia...
Justice Breyer: Must mean something special by investment risk.
You must not mean what we ordinarily mean because I think your investors don't feel that way.
So what do you mean by it?
When you say no investment risk, you know, we're all reacting this way because it seems so obvious to us, anybody who invested money in this has now lost all his money, so it must have been pretty risky.
So... so I... you must mean something special by it.
If you do, I want you to explain it.
Mr. Wolensky: Well, the... the money that was lost was lost as a result of a bankruptcy and what occurred in the bankruptcy, but when the bankruptcy was filed, these phone owners still owned their telephones and they were still entitled to their lease payments.
That was dealt with in the bankruptcy and the details of that are not involved in the record here but in... there's a... a significant difference between investment risk, which this Court characterized in Forman and recognized from the VALIC case, is a matter of fluctuating value generally.
When you look at credit risk you're...
Justice Stevens: I'm sure you don't think a person who buys a bond doesn't take an investment risk.
Mr. Wolensky: A person who buys a bond takes a credit risk, not an investment risk.
There is a difference, and I believe...
Justice Breyer: There's a significant...
Justice Stevens: You think buying a... a whole portfolio of bonds is not an investment?
Mr. Wolensky: Well, it... it is an investment, but it... it is not the type of investment risk that you see in fluctuating values securities or equity securities.
Justice Souter: Have you ever held a bond when interest rates were going up?
Mr. Wolensky: I... I agree...
Justice Souter: You would have learned what an investment risk was.
Mr. Wolensky: Justice Souter, I agree that bonds can fluctuate in value and that deals with a capital appreciation...
Justice Souter: Which means that it is more than a mere credit risk.
Mr. Wolensky: To the extent you were looking to the bond to return a value and... and hold it for purposes of changing value, it theoretically could.
Justice Souter: And anyone who buys a bond with the possible expectation of selling before maturity assumes exactly that.
Mr. Wolensky: They are going to face that risk and that... that is, in fact, an investment risk.
But the key here, it seems to me, is the fact that you do have a lease agreement, that is what it is involved here.
It is a legitimate lease agreement.
It is like any other equipment lease agreement and it is going to be dealt with under State law.
There is also a significant issue here with respect to the coverage of other regulatory agencies.
We have in fact Federal Trade Commission coverage here.
There's no question about that.
It is involved...
Justice Ginsburg: Mr. Wolensky, you don't challenge, do you, that under State Blue Sky Laws, this distinction between variable and fixed return is not made, that State Blue Sky Laws treat as investment contracts... do not draw the line between fixed and variable returns?
Mr. Wolensky: The... the challenge I make is that before 1933 the State Blue Sky Laws that were... cases that were incorporated and mentioned in Joiner and in Howey were variable return cases.
I disagree with the SEC on the two cases.
Justice Ginsburg: Do you agree that there are a body of cases under State Blue Sky Laws that involve... maybe some of them even involve these payphone schemes... but that have fixed and not variable returns?
Mr. Wolensky: As of today, that is correct.
That is what I see in the amici brief and I have no reason to question that.
The way the law has developed under State law, it would include fixed returns, that's correct.
Justice Ginsburg: So why, if this notion of an investment contracts comes out of State Blue Sky laws and we are told that the one thing in this area, because schemes are invented every day, is that... that the interpretation should be flexible, not static, to meet the countless and variable schemes devised by those who seek the use of money of others?
Mr. Wolensky: Justice Ginsburg, this Court has... has repeated that over and over.
I will agree with that, but the Court has talked about new, novel, and unusual schemes.
There is nothing new, novel, or unusual about lease agreements and commercial leases, and what you have to focus on here is what the Court has said.
It has given guidance.
It has said that unanimously... it may have a been a footnote in Reves, but certainly...
Justice Ginsburg: But when the issue isn't in the case, what a court says in a casual footnote, when the case had nothing to do with fixed versus variable returns.
I mean, yes, the Court made it used in cautious languages, but we... but in none of the cases that came here was the question, do you draw the line between fixed and variable returns?
In the case that... that you featured... you call it Forman or United Housing... there it was a question of investment versus consumption.
Did you buy this thing to sit back and get money from it or did you buy it so you could live in the house?
That was the distinction that was before the Court in this case.
I don't know any of our cases that... that drew the line between... that where the issue was before the Court.
Mr. Wolensky: Justice Ginsburg, in Forman, the Court had to address the issue of whether there was an investment contract involved, and it stated what I would call the Forman formulation of profits in connection with doing that analysis on the three types of profits that allegedly... or that had been found and allegedly were present in the Second Circuit decision, and it applied that formulation to each one of those.
So it was...
Justice Ginsburg: But it did... but the case was not about equity versus debt classification.
It was about whether you were attracted... whether you were attracted to purchasing the shares by a desire to get a financial return or were you attracted because you wanted a place to live.
That's what... that's the two questions... that was the dividing line that the Court was dealing with there.
It wasn't dealing with equity versus debt.
Mr. Wolensky: That is correct, Justice Ginsburg.
And then in Reves, it was dealing with the distinction between equity and debt.
Justice Kennedy: Well, but in... in Forman there was no distinction between fixed and variable income.
Mr. Wolensky: It was not, but when you read the... Justice Kennedy, when you read what the Court said in Forman, it's talking about an expectation of profits or capital appreciation, and those are two variable forms.
They're not... they're not fixed.
They necessarily vary with the marketplace.
If I can finish answering your question, Justice Ginsburg, with respect to Reves, there was a distinction, a very specific distinction there, between fixed and... and variable.
That's what that case was about, investment contract versus note.
And the Eighth Circuit had decided that the investment contract case of... that the investment contract test of Howey would apply to notes.
There were a series of tests and this Court used the Reves opinion to... to go through those and decide, and it came up with a family resemblance test that had been used by the Second Circuit.
In the footnote in Reves, it is very clear that what the Court is doing is distinguishing and explaining why Howey does not apply to notes, which are fixed instruments.
I think it is not just a passing reference and it... it was unanimously stated that...
Justice Ginsburg: But I thought that... I thought that the meaning of investment contract was not at issue in Reves.
Mr. Wolensky: The meaning of investment contract was not at issue, but distinguishing investment contract was at issue in Reves, and explaining why it was not applicable in that case.
The parties briefed the issue, the SEC briefed the issue as amicus took the same position it... it has taken here, and the Court in Reves said that is not the position we accept.
Justice Scalia: And it's... it's taken that position for a long time, Mr. Wolensky.
It's not just the case law that you have to contend with, it's also... this is after all an administrative law case.
The meaning of investment contract, you must admit, is at least ambiguous, and the SEC has taken the position it's taken here for a very long time.
Mr. Wolensky: Well, if I can address...
Justice Scalia: Why shouldn't we defer to the F... SEC's judgement about the matter?
Mr. Wolensky: If I can address that for just a moment, Justice Scalia...
Justice Scalia: That's why I asked the question.
Justice Breyer: I hoped you would.
Mr. Wolensky: [Laughter]
Mr. Wolensky: Thank you, sir.
With respect to the very long time, if you go back to the case the SEC has pointed to a number of times, the Universal Service case from 1939 in the Seventh Circuit, when you... and the SEC talks about its position in that case... its position in that case was stated in its brief in that case, and when you look at its brief in that case, it recognizes that it is not dealing with a fixed return as we would talk about it.
In fact, in the brief, the SEC says the amount ultimately credited to the contributor's account, the amount itself being dependent upon the degree of success attending the venture... and I'm reading from pages 39 and 40 and footnote 10... with respect to the Abbett, Sommer case, which is a 19... I believe 62 decision... by the SEC, the SEC admitted in Abbett, Sommer that it wasn't looking at traditional profits analysis.
That was a mortgage loan servicing case and they said that what was being offered there was not just the repayment on the notes but also the services, and they found that the reduction of risk in that case was the... basically the profit.
So they departed from what is a normal profit analysis and that's freely admitted.
In the interpretative release they've issued, the multi-level release under the 33 Act, number 5211, in there the SEC admits that Howey is an equity-type test.
They specifically say that.
So I think that when you look at the history of what this Court has done and what the SEC has done, when you get to... when you get to Reves and when you get to Forman, it is... there's no ambiguity left as to what is meant by profits at that point.
So I think a position...
Justice Ginsburg: I think there is.
I think that in United Housing itself they spoke about profit may be derived from income yielded by an investment, income yielded by investment.
That doesn't say income from earnings.
Mr. Wolensky: That is correct, but in the very same area of the opinion is where the Court says by profits in the Howey analysis, we have meant a participation in earnings or capital appreciation, citing the earlier cases.
Justice Ginsburg: They said that in one place.
They said financial returns in another place.
They said income in another place.
Maybe they were so incautious about the precise use of those terms because they were focusing on an investment purpose versus a... a utilitarian purpose.
Mr. Wolensky: I would agree with that, but the fact that Reves concluded what it did about Forman's requirements would tend to show that that's really what Forman required.
The... the court of appeals, of course, was not free to disregard what was a unanimous statement by this Court.
This Court obviously can change its opinion or change its view, but there is no compelling reason to depart from what has been accepted for 25 years.
Other courts of appeals...
Justice Ginsburg: Well, why isn't there, when the SEC... let's assume that you're right about that the SEC was never crystal clear about its position.
But now it says, we've looked at these schemes, payphones is a good one, a lot of elderly people are investing in these schemes because they promise a fixed return and that sounds secure to them, better than variable out of earnings and profits, so this is exactly what we should be protecting the public against.
If the SEC takes that position clearly now and you're dealing with a statutory term that's in a line, some of the things are equity, some are debt, and in the middle is this term investment contract.
Why should we tie it to variable versus fixed?
Mr. Wolensky: Justice Ginsburg, because this Court has said more than once, every fraud is not a securities fraud.
There are other avenues of protection.
There are several risk-reducing factors involved in these leases.
The leases themselves are covered by State law in the Uniform Commercial Code.
There's other regulatory coverage, other agencies.
In fact, some of the State agencies that filed amici briefs here have indicated that they believe they have coverage of those.
So the fact that the Federal securities laws might not cover this doesn't mean that there's not going to be protection of the public.
The consequence, and I think it's an important consequence that the Court has to be aware of here if it agrees with the SEC's position, is that every equipment lease can be brought under the rubric of Howey if...
Chief Justice Rehnquist: Why, why, why?
Justice Breyer: That's not...
I mean, there are all kinds of other criteria, you know.
I mean, you have to be putting up money, it has to be... if it is a big market... scheme marketed to the... to the public like this, yes.
But if it isn't, if GM happens to buy some... a railroad car from one of its suppliers, I would think the answer's no.
But there are a lot of other criteria, so why everyone?
Mr. Wolensky: Well, the... it is not in the record but it is public knowledge and information that is available that some $200 billion of equipment leasing occurs every year, and it... equipment leasing involves everything from telephone systems to computers, office equipment.
It is a very, very large industry.
If that applies to this large industry...
Justice Breyer: You'd have to be passive, you'd have to... you'd have to treat it as an investment.
I doubt that most of that leasing is really that, but I mean, my point is, aren't there dozens of other criteria that you have to satisfy, not just this fixed variable one?
And that's a serious question.
Mr. Wolensky: Well, on... Justice Breyer, there are... there essentially are four criteria that the... that the SEC would say you have to apply: an investment of money... and this Court said in Daniel that investment of money doesn't just mean money, it can mean services, it can mean assets
That's why we say in analyzing this it doesn't matter whether you bring your phone to the agreement or money to the agreement, but if you put equipment into a lease arrangement, you have an investment...
Justice Breyer: Invest money may itself refer to the thousands of public people who simply want to give money to an enterprise in contrast to General Motors that rents a railroad car as part of its business.
Mr. Wolensky: I can contrast that and agree with you that in General Motors, renting a railroad car is part of its business.
It is not going to be probably found to run afoul of the securities laws.
Justice Breyer: So what is the example of the bad thing that happens when we agree with the SG?
Mr. Wolensky: General, broad, small item equipment leases will be covered by the Howey test.
Justice Breyer: The people who are not themselves in business, by people who are not themselves in business or by people who are themselves in business?
Mr. Wolensky: Well, whether they're in business or not in business the securities laws would still cover them and I don't believe there's an exemption that would be available for the ordinary business.
Justice Souter: Why... why isn't your argument equally applicable to notes?
We've been through that in Reves.
I mean, you could have argued in Reves, my God, are you going to cover every note.
You're making the same argument here with investment... investment contract, aren't you?
Mr. Wolensky: Well, not necessarily.
I think the Court did set forth some very specific criteria in Reves.
The family resemblance test exempts out commercial notes that have credit risk and not investment risk.
Justice Souter: Justice Breyer has just been applying a family resemblance test to exclude General Motors' boxcar.
Why isn't that sort of thing just as feasible under investment contract as it is under note?
Mr. Wolensky: It is, and if you... if you look at the criteria the Court looked to, I think you will see that several of the criteria that this Court has talked about indicate that this would not be covered.
I believe it is... it's not specifically related, but the Court noted four criteria, and if you apply those criteria, I think you find that they in fact...
Justice Breyer: You've come to this quite late, but I mean, it seems to me that there are other words besides working with the nature of the fixed or variable return that will draw the kind of line that you think... and I guess I would think... you should draw between an ordinary business, sale and lease-back so they can carry on their business, and some kind of general marketing to the public.
And I'm actually quite interested in that.
You've written about it, though, and I'll get it out of the briefs.
Mr. Wolensky: We have and... and I was... have been trying to address the question that was presented although we felt a different question was involved.
This Court for 60 years has set a jurisprudential standard for investment contracts and while the courts work on the habits of people, people work on the habits of courts.
There are lines that have...
Justice Stevens: In those 60 years we've never said that a fixed return can never be an investment contract.
Mr. Wolensky: That is correct.
You've never explicitly said that, but by never explicitly saying that, that doesn't mean that it necessarily is covered.
The decision of the court of appeals followed this Court's precedents.
It was correct and it should be affirmed.
Rebuttal of Gen Theodore B. Olson
Chief Justice Rehnquist: Thank you, Mr. Wolensky.
General Olson, you have 4 minutes remaining.
Mr. Olson: Thank you, Mr. Chief Justice.
I will try to make just three points.
One, this is about securities.
The statute, which is extraordinarily broad, says note, stock, treasury stock, fractional undivided interest in oil, gas, mineral rights, straddle, option.
It's... there... it would be difficult to draft the statute that was intended to be more all-inclusive than the words used in these two provisions of the 33 and 34 Act.
It is manifestly clear that Congress wanted to cover the waterfront, as this Court has said, everything that looks like a security, and wanted to cover the whole range from pure equity, if there is such a thing, to pure debt, if there is such a thing.
It would be... and then they put catch-all provisions.
If the... if the words didn't cover it, there were catch-all provisions, investment contract is one.
It would be irrational for Congress to say, well, we've got a catch-all for those... from A to Z... that go from A to H that look more... look like equities, but not S to Z that look more like debt, and then we're don't... not sure about the ones in the middle.
The purpose for the catch-all provision is to catch all.
That is what this investment contract was.
Secondly, just two of the cases that were attempted to be distinguished by my colleague, People v. White, he said that did not involve a fixed return.
Well, the language of the case... this is in 12 P. 2d at 1081... the individual promised to spay... pay... a specified sum on a specified date as principal and earnings for the stated period of time upon the investment.
That's pretty much identical to what we have involved in this case.
And in the Securities and Exchange Commission v. Universal Services, another one that my colleague referred to, page 234 of 106 F. 2d, at the end of 5 years there would be returned to each member an amount equal to total contributions plus 30 percent per annum.
Now, this case is 14 percent.
The argument's that being made by the respondent here is an argument that the Blue Sky... a distinction that the Blue Sky Laws don't make.
Congress did not make this distinction.
The Court has never made this distinction.
It conflicts with 70 years of consistent SEC enforcement.
It is squarely inconsistent with the notion of a broad, flexible, remedial purpose of the securities statutes.
It would make no sense, would create a gigantic loophole where individuals, by changing the terms of... from pie in the sky to 14 percent, and they would do that immediately, and Congress would have to deal with it in a way the Congress has already dealt with, and there is no reason to change what they... what the law has been, and the Eleventh Circuit decision should be reversed.
Chief Justice Rehnquist: Thank you, General Olson.
The case is submitted.
Justice O'Connor: The honorable court is now adjourned until tomorrow at 10 o'clock.
Argument of Speaker
Mr. Wolensky: The opinion of the Court in No. 02-1196 Securities and Exchange Commission versus Edwards will be announced by Justice O’Connor.
Argument of Justice O’connor
Mr. O’connor: This case is here on writ of certiorari to the Eleventh Circuit.
The respondent, Charles Edwards, was the chief executive officer and sole shareholder of a company called ETS Payphones.
ETS sold payphones to the public packaged with an agreement under which the purchaser would lease the payphone back to the ETS for a fixed monthly payment.
These payments amounted to approximately a 14% annual return on the purchaser’s investment.
ETS was unable to meet its obligations under the leaseback agreements and filed for bankruptcy.
The Securities and Exchange Commission then initiated this civil enforcement action claiming that the sale and leaseback arrangements were subject to the registration requirements and anti-fraud provisions of the federal securities law.
The District Court concluded that the arrangements were investment contracts, one of the investment instruments included in the definition of security in the Securities Act in 1933 and the Securities Exchange Act of 1934.
The Eleventh Circuit disagreed.
It read our prior cases to require that an investment contract offer either capital appreciation or participation in earnings and thus, to exclude schemes such as this one that offered a fixed rate of return.
In our opinion filed today, we conclude that an investment scheme promising a fixed rate of return can be an investment contract and thus a security subject to the federal securities law.
In our 1946 decision in SEC versus Howey, we established that the test for determining whether a scheme is an investment contract is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.
When we spoke of profits, we were referring simply to the income or return that investors seek on their investment.
Thus, there is no reason to distinguish between promises of fixed returns and promises of variable returns for purposes of this test.
Moreover, excluding fix return schemes from the securities laws would open up and easily exploit a loophole and would leave unregulated a set of schemes particularly attractive to those most vulnerable to investment fraud.
In light of these factors, it is not surprising that the SEC has consistently rejected the limited reading of investment contract that respondent advances, and we do the same.
The decision of the Court is unanimous.