Document ID: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-caDC-96-05018/USCOURTS-caDC-96-05018-0/pdf.json

Parties Involved:
Life Partners, Incorporated
Appellant
Brian D. Pardo
Appellant
Securities and Exchange Commission
Appellee

Document Text:

<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued April 4, 1996 Decided July 5, 1996

No. 95-5364

SECURITIES AND EXCHANGE COMMISSION,

APPELLEE

v.

LIFE PARTNERS, INCORPORATED AND

BRIAN D. PARDO,

APPELLANTS

Consolidated with

96-5018, 96-5090

-

Appeals from the United States District Court

for the District of Columbia

(No. 94cv01861)

Thomas W. Kirby argued the cause for appellants, with whom Ida W. Draim was on the briefs.

Eric Summergrad, Assistant GeneralCounsel, Securities&ExchangeCommission, argued the cause

for appellee, with whom Richard H. Walker, General Counsel, Paul Gonson, Solicitor, and Ross A.

Albert, Special Counsel, were on the brief. Jacob H. Stillman, Associate General Counsel, entered

an appearance.

Before: WALD, GINSBURG and HENDERSON, Circuit Judges.

Opinion for the Court filed by Circuit Judge GINSBURG.

Dissenting Opinion filed by Circuit Judge WALD.

GINSBURG, Circuit Judge: A viatical settlement is an investment contract pursuant to which

an investor acquires an interest in the life insurance policy of a terminally ill persontypically an

AIDS victimat a discount of 20 to 40 percent, depending upon the insured'slife expectancy. When

the insured dies, the investor receives the benefit of the insurance. The investor's profit is the

difference between the discounted purchase price paid to the insured and the death benefit collected

from the insurer, less transaction costs, premiums paid, and other administrative expenses.

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 1 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

Life Partners, Inc., under the direction of its former president and current chairman Brian

Pardo, arrangesthese transactions and performs certain post-transaction administrative services. The

SEC contends that the fractional interests marketed by LPI are securities, and that LPI violated the

Securities Act of 1933 and the Securities Exchange Act of 1934 by selling them without first

complying with the registration and other requirements of those Acts. The district court agreed and

preliminarily enjoined LPI from making further sales.

LPI argues that (1) viaticalsettlements are exempt from the securities laws because they are

insurance contracts within the meaning of the McCarran-Ferguson Act, 15 U.S.C. § 1012(b), and §

3(a)(8) of the 1933 Act, 15 U.S.C. § 77c(a)(8), and (2) the fractional interests sold by LPI are not

in any event securities within the meaning of the 1933 and 1934 Acts. LPI asserts alternatively that

it could modify its program so asto come within a safe harbor exemption for private offerings under

SEC Rule 506, 17 C.F.R. § 230.506.

We agree with the district court that viatical settlements are not exempt from the securities

laws asinsurance contracts. Contraryto the district court, however, we conclude that LPI's contracts

are not securities subject to the federalsecuritieslaws because the profitsfrom their purchase do not

derive predominantly from the efforts of a party or parties other than the investors; therefore, we do

not reach LPI's alternative argument that it might be able to alter its operation in such a way as to be

entitled to a private offering exemption.

I. Background

LPI appeals four orders of the district court. First, in August 1995 the court held that LPI

violated §§ 5(a) and (c) of the Securities Act, 15 U.S.C. § 77e(a) and (c), and § 15(a) of the

Securities Exchange Act, 15 U.S.C. § 78o(a), by selling unregistered securities. The court ordered

LPI to bring its operationsinto compliance with the Acts "forthwith," but did not enjoin the company

from continuing to sell viatical contracts. In the same order the court found that the SEC made out

a prima facie case that LPI had materially misstated and omitted certain facts in selling securities, in

violation of the anti-fraud provisions of § 10(b) of the 1934 Act, 15 U.S.C. § 78j(b), and Rule 10b-5

promulgated thereunder, 17 C.F.R. § 240.10b-5, and preliminarily enjoined LPI from committing

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 2 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

securities fraud.

Second, the following month the court denied LPI's motion for a partial stay of the August

order pending appeal. The district judge directed LPI to file within 20 days a report detailing the

steps the company had undertaken to comply with the securities laws.

Third, in January 1996 the district court, holding that LPI had not adequately complied with

its prior directives, preliminarilyenjoined LPI fromoffering orselling unregistered fractionalinterests

in viatical settlements. With the court's approval, the parties stipulated that the injunction would be

stayed with respect to transactions then in process, and that LPI would not seek any broader stay

pending our resolution of this matter.

Finally, in March 1996 the district court granted an Emergency Motion for Supplemental

Provisional Relief that the SEC filed in reaction to an affidavit in which Pardo asserted that LPI had

complied with the court's prior rulings and advised the court that LPI planned to resume the sale of

viaticalsettlements. LPI interpreted a statement in the court's opinion of January 1996, to the effect

that "pre-purchase activities cannot alone" subject LPI to the Securities Acts, to mean that by

discontinuing its performance of post-purchase services, the company could resume itssales without

violating the injunction. The district court, however, concluded that LPI's "technical changes have

done little to alter the substance ofthe services provided to investors," and preliminarily enjoined LPI

from selling fractional interests in viatical settlements "by any ... means whatsoever," pending this

court's decision on appeal.

At the same time that it wasissuing these three preliminaryinjunctions against LPI, the district

court acknowledged that the company provides "valuable funds [to] AIDS patients in their final

illness" and that after "an apparently exhaustive two-year investigation" the SEC could produce no

evidence or even allegations "that any investor, terminally ill patient, or insurance company has been

defrauded, misled, or is in any way dissatisfied with an LPI viatical settlement." The Commission,

however, points out that the securitieslaws, and in particular the disclosure requirements ofthe 1933

and 1934 Acts, are intended to prevent abuses before they arise. Still, that neither policyholders nor

investors have complained of any abuse may help to explain why the viatical settlements industry is

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 3 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

not more regulated. A number of states have enacted laws protecting the insureds but, according to

the SEC, no state has undertaken specifically to protect investorsin viaticalsettlements. (In all states

investors are still protected by the common law of fraud, of course.)

Although some promoters of viatical settlements do register them as securities under the

federal securities laws, LPI observes that registration means higher costs for investors and

correspondingly lower prices for terminally ill policyholders, and objects that any significant

administrative delayeven if the Commission were, for example, to permit the offeror to use one

master registration and to make only a supplemental filing pertaining to each policy in which it

proposes to sell fractional interestsmight be fatal in this time-sensitive context. The Commission

concedes that some policy-by-policy disclosure of risk factors would be required but ventures that

the burden would not be prohibitive. The Commission also notes that some firms have sought and

obtained an exemption from the federalsecuritieslawsfor their viatical contracts; presumably a firm

might also buy insurance policies for its own account or act as an agent, matching a single investor

with a terminally ill insured, without running afoul of the securities laws.

That is not how LPI does business, however. LPI sells fractional interests in insurance

policies to retail investors, who may pay as little as $650 and buy as little as 3% of the benefits of a

policy. In order to reach its customers, LPI uses some 500 commissioned "licensees," mostly

independent financialplanners. For its efforts, LPI's net compensation is roughly 10% of the purchase

price after payment of referral and other fees. Pardo claims that LPI is by far the largest of about 60

firms serving the rapidly growing market for viatical settlements; in 1994 the company accounted

for more than half of the industry's estimated annual revenues of $300 million. The company is 95%

beneficiallyowned by Pardo through a trust, and 5% owned byDr.Jack Kelly, who performs medical

evaluations of policyholders on LPI's behalf.

LPI was also the first company to develop a plan by which an investor could participate in a

viatical settlement through an Individual Retirement Account. In order to circumvent the Internal

Revenue Code prohibition upon IRAs investing in life insurance contracts, LPI structures the

purchase through a separate trust established for that purpose. The IRA lends money to the trust,

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 4 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

for which it receives a non-recourse note; the trust then uses the loan proceeds to purchase an

interest in a life insurance policy, the death benefits of which collateralize the note. When the insured

dies and the benefits are paid, the proceeds go to pay off the note held by the IRA.

Both LPI's program for individual investors and its IRA program have gone through three

iterations during the course of this litigation. In each, LPI performed or performs a number of

pre-purchase functions: Specifically, even before assembling the investors, LPI evaluates the insured's

medical condition, reviews hisinsurance policy, negotiatesthe purchase price, and preparesthe legal

documents. The difference among the three versions is that LPI performs ever fewer (and ultimately

no) post-purchase functions.

In Version I, the program that was the subject of the district court's August 1995 order, LPI

or Pardo could appear, and continue to appear after the investors had purchased their interests, in an

insurance company's records as the owner of a policy; LPI insists, however, that this practice was

adopted not because LPI had any continuing entrepreneurialrole to play but only at the urging of the

insurance companies for their administrative convenience; the investor was at all times the legal

owner. Also, once an investor acquired an interest in a policy he could avail himself of LPI's

on-going administrative services, which included monitoring the insured's health, assuring that the

policy did not lapse, converting a group policyinto an individualpolicywhere required, and arranging

for resale of the investor's interest when so requested and feasible.

Sterling Trust Company, an independent escrow agent acting for LPI, actually performed

most of these post-purchase administrative functions. When the purchase closed, Sterling collected

its own fee and that of LPI, escrowed funds for expected premium payments, and delivered the

balance to the seller. Thereafter Sterling held the policy, held and disbursed all funds, ensured that

all paperwork was in order, and filed the death claim. If an investor designated Sterling as the

beneficiary, then Sterling also collected and distributed the death benefits. LPI had no continuing

economic interest in the transaction after receipt of its fee upon the sale to the investor.

Between the district court's August 1995 and January 1996 orders, LPI implemented revised

procedures in an unsuccessful effort to meet the objections raised by the SEC and upheld by the

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 5 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

court. In this Version II, neither LPI nor Pardo appeared as the owner of record of the insurance

policy; instead, the investors were at all times the owners of record and thus had a direct contractual

relationship with the insurance company. Indeed, Sterling agreed to report to the SEC any attempt

by LPI to exercise ownership rights over any policies. Second, LPI affirmed that both the purchase

money and the benefit payments would flow through Sterling and not through LPI. Third, LPI

disclosed to prospective investors that Pardo is a 95% beneficial owner of LPI and that he had

previously been involved in (unrelated) disputes with three federalregulatory agencies(the SEC, the

Resolution Trust Corporation, and the Federal Deposit Insurance Corporation). Fourth, investors

were informed that theywere not obligated to useSterling's post-purchase services, whichwere being

offered to them as a convenience to take or to leave. In fact, LPI furnished investors with all of the

information needed to handle post-purchase activities themselves. The district court determined,

however, in its order of January 1996 that these revised procedures still did not comply with the

securities laws.

Finally, in yet a further attempt to allay the concerns of the SEC and of the district court, LPI

in February 1996 unveiled Version III. Pardo would resign as president of LPI in favor of Mike

Posey, the former president of Sterling. More important, LPI declared that it would no longer

provide any post-purchase services to purchasers either directly or indirectly (i.e., through an agent

such as Sterling). All such services would become the sole responsibility of the investor; Sterling

would still be available to provide services as the agent of the investor if the investor elected to

contract with Sterling for that purpose. The district court rejected this proposal in its March 1996

order.

II. Analysis

We take up first LPI's opening argument that viaticalsettlements are insurance contracts and

therefore entitled to an exemption from the 1933 Act. Finding that argument wanting, we proceed

to consider whether the fractional interests promoted by LPI are "securities" within the meaning of

that Act using the three-part test prescribed in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), in

which each investor acquired an individual parcel of citrus fruit acreage together with a portion of

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 6 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

the profits arising from the promoter's management of the citrus grove, id. at 295-96. The Supreme

Court held in Howey that an investment contract is a security if the investors (1) expect profits from

(2) a common enterprise that (3) depends upon the efforts of others. Id. at 298-99. Because LPI's

contracts fail the third element of this test, we hold that they are not securities. Finally, we go on to

address LPI's programfor the sale of viaticalsettlementsto IRAs; the issue there is whether the notes

used to facilitate such purchases are themselves securities even though the underlying viatical

settlements are not. We conclude that because the notes do not change the economic substance of

the transaction they are not securities.

These are all questions of law and we review them all de novo. See Delaware and Hudson

Ry. Co. v. United Transp. Union, 450 F.2d 603, 620 (D.C. Cir. 1971) ("Insofar as the action of the

trial judge on a request for preliminary injunction rests on a premise as to the pertinent rule of law,

that premise is reviewable fully and de novo"). Let us begin.

A. Exemption of Viatical Settlements as Insurance Contracts

If viaticalsettlements are insurance contracts, then they are altogether exempt fromcoverage

under the federal securities laws. See Securities Act of 1933, 15 U.S.C. § 77c(a)(8) ("insurance ...

policy ... issued by a corporation subject to the supervision of the insurance [authority] of any State"

exempt from coverage). In favor of that exemption, LPI argues first that a viatical settlement

redistributes risk in the same manner as does an insurance contract. The purchaser incurs a risk that

the insured will live longer than anticipated, thus diminishing the present value of the death benefit;

the insured is relieved of some of the financial implications of that risk (e.g., the need for funds to

cover extended medical care) by taking a reduced but immediate payment. Second, invoking the

McCarran-Ferguson Act, 15 U.S.C. § 1012(b), which provides that no federal law may "impair or

supersede any law enacted by any State for the purpose of regulating the business of insurance," LPI

maintains that its activities of selling and advertising death benefits are part of the "business of

insurance," see SEC v. National Secs., Inc., 393 U.S. 453, 460 (1969) (statute governing sale and

advertising of policies regulates "business of insurance"), and further refers us to the district court's

finding that a number ofstates expressly regulate viaticalsettlements "in the insurance sections ofthe

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 7 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

state codes."

We are advised by LPI that nine states now regulate viatical settlements and that others are

considering the Model Viatical Settlements Act drafted by the National Association of Insurance

Commissioners. The SEC observes, however, that these regulations protect sellers (insureds), not

buyers(investors). LPI rejoins that the dearth of regulations to protect buyers indicates only that the

states believe that such regulation is unnecessary. Indeed, the McCarran-Ferguson Act exemption

from the federal securities laws is triggered not only when a state prohibits but also when it permits

an insurance activity. See American Mut. Reins. Co. v. Calvert Fire Ins. Co., 367 N.E.2d 104, 109

(Ill. App. Ct. 1977).

We agree with LPI insofar as it implies that the important question is not whether the states

regulate viatical settlements. The scope for federal regulation of viatical settlements does not turn

upon whether the states regulate them; federal regulation is foreclosed or not depending upon

whether viaticalsettlements are insurance contracts within the exemption that the Congress of 1933

expressly provided forsuch instruments, or the marketing offractional interestsis part ofthe business

of insurance within the meaning of the McCarran-Ferguson Act. Accordingly, we focus upon that

question.

The district court concluded that LPI "does not issue insurance policies or underwrite risk or

undertake the normal activities of an insurance company." The SEC adds that LPI does not engage

in the quintessential insurance function of risk-pooling, i.e., transforming what is a highly uncertain

outcome for the individual insured into a highly predictable outcome by insuring a large number of

persons. That an insurance policy underlies the viatical settlement is, the Commission says, irrelevant;

any substantial asset might have served just as well. Moreover, the Commission states that "the

business of insurance" referred to in the McCarran-Ferguson Act encompasses the relationship

between an insurance company and an insured; the relationship that the SEC wants to regulate is that

between a promoter and itsinvestors, and regulation of that relationship "is not insurance regulation,

but securities regulation." See National Secs., 393 U.S. at 460.

The SEC's argument on thisscore is much more persuasive than LPI's. The seller of a viatical

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 8 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

settlement is not foregoing current consumption in order to protect against future risk, as does the

buyer of an insurance policy. Quite the contrary: he is giving up the protection of a policy already

in effect, in favor of current consumption. Nor is there any evidence that the typical investor who

buys an LPI viatical contract poolsthe financialrisk that the seller will live longer than expected. To

do so, the investor would have to acquire enough contracts to reduce the actuarial risk associated

with the life span of each individual seller. The record gives no indication, however, that LPI's

investors systematically engage in the risk-pooling that is the essential characteristic of insurance.

Moreover, there is no reason to expect that state insurance commissioners would regard even the

pooling of viatical contracts as a form of insurance. To the extent that regulation of insurance

companiesis prompted by concern over their ability to pay benefits when due, that concern is simply

not applicable to investors in a viatical settlement because the insured receives payment from the

investors at the outset; thereafter the investor has no further liability to the insured.

To be sure, the investor's pre-payment of the death benefit diminishes the insured's risk that

he will become insolvent before he dies; but as the SEC suggests, that initial risk of insolvency could

have been reduced by the insured's liquidation of any asset that he owned. For example, the buyer

could just as effectively have purchased the seller's home subject to his reservation of a life estate in

the property, or the buyer might have factored the seller's accounts receivablewhich, like death

benefits, will be paid at an uncertain future date and bear some risk of default. These

arrangementsand numerous othersentailroughlythe same investmentrisk-sharing features asthe

acquisition of a fractional interest in death benefits, but they do not involve an insurance contract.

That the underlying asset in this case happens to be an insurance contract is, as the SEC maintains,

simply irrelevant.

In short, a viaticalsettlement is not an insurance policy, and the business ofselling fractional

interests in insurance policies is no part of "the business of insurance." LPI's offering does not,

therefore, qualify for the insurance exemption from the federal securities laws, and is not shielded

from federal regulation by the McCarran-Ferguson Act.

B. The Three-Part Test of Howey

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 9 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

We turn next to the question whether the LPI contracts are properly characterized as

securities within the terms of the 1933 Act. That determination is controlled by the Supreme Court's

decision in Howey which, as stated above, holds that an investment contract is a security subject to

the Act if investors purchase with (1) an expectation of profits arising from (2) a common enterprise

that (3) depends upon the efforts of others. 328 U.S. at 298-99. To the extent practical we examine

each component of the test separately.

1. Expectation of Profits

The SECarguesthat the profitstest requires only that "the investor could lose hisinvestment,

or that the value of his return could fluctuate," quoting Guidry v. Bank of LaPlace, 954 F.2d 278,

284 (5th Cir. 1992), and that, although the death benefit that an investor gets from a viatical

settlement is in a fixed dollar amount, the profitability of the investment can vary because of the

uncertain interval of time between the date of investment and the date of the insured's death. The

insured'slife span affects profitability in two ways: First, the annualized rate of return depends upon

the length of the investment. Second, unless there has been a waiver of premiums pursuant to the

terms of the insurance policy, the amount of the investor's outlay for premiums depends upon the

insured's life span.

Arguing against the profits test as set forth in Guidrywhich, by the way, is unclear about

whether possible loss and fluctuating return are sufficient or merely necessary conditionsLPI

maintainsthat under United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 852 (1975), profits

must be derived from "either capital appreciation resulting from the development of the initial

investment ... or a participation in earnings resulting from the use of the investors' funds," neither of

which obtains with respect to viatical contracts. At oral argument the SEC asserted that even under

this formulation viatical settlements satisfy the profits test of Howey because they appreciate in

valuepresumablybecause the insured's death draws nearer with the passage oftime, thusincreasing

the present value of the death benefit. The Commission's reading of Forman, however, starkly omits

the requirement that the capital appreciation result "from the development of the initial investment."

Id. The increased value of a viatical contract requires no "development" at all; it depends entirely

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 10 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

upon the inexorable passage of time and the inevitable death of the insured.

On the other hand, the definition in Forman was apparently intended only to summarize the

cases that had by then come before the Courtnot, as LPI implies, to preempt future development

upon the basis of further experience. In full context, this is what the Court said:

By profits, the Court has meant either capital appreciation resulting from the

development of the initial investment, as in [SEC v. C.M. Joiner Leasing Corp., 320

U.S. 344, 349 (1943) ] (sale of oil leases conditioned on promoters' agreement to drill

exploratory well), or a participation in earnings resulting from the use of investors'

funds, as in Tcherepnin v. Knight, [389 U.S. 332, 339 (1967)] (dividends on the

investment based on savings and loan association's profits). In such cases the investor

is "attracted solely by the prospects of a return" on his investment. Howey, supra, at

300. By contrast, when a purchaser is motivated by a desire to use or consume the

item purchased"to occupy the land or to develop it themselves," as the Howey

Court put it, ibid.the securities laws do not apply.

421 U.S. at 852-53. If the examples of Joiner and Tcherepnin were exhaustive, then the concept of

profits would exclude, for example, the return on an investment in a residential mortgage or in any

formofconsumerloanneither ofwhichordinarilyinvolves capital appreciation or earningsresulting

from the use of the investors' funds. Both activities are undertaken in the expectation of profits,

however, at least as that term is commonly understood.

The Court's general principle we think, is only that the expected profits must, in conformity

with ordinary usage, be in the form of a financial return on the investment, not in the form of

consumption. This principle distinguishes between buying a note secured by a car and buying the car

itself.

The asset acquired by an LPI investor is a claim on future death benefits. The buyer is

obviously purchasing not for consumptionunmatured claims cannot be currently consumedbut

rather for the prospect of a return on his investment. As we read the Forman gloss on Howey, that

is enough to satisfy the requirement that the investment be made in the expectation of profits.

2. Common Enterprise

The second element of the Howey test for a security is that there be a "common enterprise."

So-called horizontal commonalitydefined by the pooling of investment funds, shared profits, and

shared lossesis ordinarily sufficient to satisfy the common enterprise requirement. See, e.g., Revak

v. SEC Realty Corp., 18 F.3d 81, 87 (2d Cir. 1994). Here, LPI brings together multiple investors and

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 11 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

aggregates their funds to purchase the death benefits of an insurance policy. If the insured dies in a

relatively short time, then the investorsrealize profits; if the insured lives a relatively long time, then

the investors may lose money or at best fail to realize the return they had envisioned; i.e., they

experience a loss of the return they could otherwise have realized in some alternative investment of

equivalent risk. Any profits or losses from an LPI contract accrue to all of the investors in that

contract; i.e., it is not possible for one investor to realize a gain or loss without each other investor

gaining or losing proportionately, based upon the amount that he invested. In that sense, the

outcomes are shared among the investors; the sum that each receives is a predetermined portion of

the aggregate death benefit.

LPI claims, however, that there is no pooling and therefore no shared profits or losses because

each investor acquires his own interest in the policy. Moreover, there is no requirement that the

entire policy be purchased. It seems to us that the pooling issue reduces to the question whether

there is a threshold percentage of a policy that must be sold before an investor can be assured that

his purchase of a smaller percentage interest will be consummated. If not, then each investor's

acquisition is independent of all the other investors' acquisitions and LPI is correct in asserting that

there is no pooling. On the other hand, if LPI must have investors ready to buy some minimum

percentage of the policy before the transaction will occur, then the investment is contingent upon a

pooling of capital.

When we raised this point at oral argument, the SEC contended that inter-dependency among

investors was not necessary to a determination that their funds are pooled; the test, according to the

Commission, is whether the funds are "commingled." In this context, however, commingling in itself

is but an administrative detail; it is the inter-dependency of the investors that transforms the

transaction substantively into a pooled investment. (Indeed, if the investments are inter-dependent,

it would not matter if LPI scrupulously avoided commingling the investors' fundsfor example, by

passing their checks directlyto the seller at the closing.) Meanwhile, counsel for LPI volunteered that

the issue ofselling some minimumacceptable percentage of a policy has never arisen because LPI has

always attracted purchasersfor the full interest being offered. He went on to acknowledge, however,

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 12 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

that if the situation were to arise, LPI would allow the insured the option of withdrawing from the

transaction. Such a practice would of course serve LPI's interest as well as that of the policyholder.

Many of the post-purchase administrative functions (e.g., monitoring the insured's health, collecting

the death benefit) involve costs that are seemingly invariant to the number of investors or the

percentage of a policy that has been sold. Neither LPI nor the investors would be anxious to spread

these costs over contracts representing much less than the full value of a policy.

Therefore, we think that pooling isin practice an essentialingredient ofthe LPI program; that

is, any individual investor would find that the profitability if not the completion of his or her purchase

depends upon the completion ofthe larger deal. Because LPI's viatical settlements entail this implicit

formof pooling, and because any profits or losses accrue to all investors(in proportion to the amount

invested), we conclude that all three elements of horizontal commonalitypooling, profit sharing,

and loss sharingattend the purchase of a fractional interest through LPI. (We need not reach,

therefore, the SEC's alternate contention that the LPI program entails "strict vertical

commonality"another formulation ofthe common enterprise test recognized in some circuits. See,

e.g., Brodt v. Bache & Co., Inc., 595 F.2d 459, 461 (9th Cir. 1978).)

Although horizontal commonality is ordinarily enough to make out the common enterprise

required under the Howey test, in this instance LPI argues that commonality is not a sufficient

condition because it is not obvious that there is an "enterprise" in the picture. For this LPI relies

heavily upon Rodriguez v. Banco Central Corp., 990 F.2d 7, 10 (1993), in which the First Circuit

held that "[e]ven if bought for investment, the land itself does not constitute a business enterprise."

In that case the investors purchased lots in Florida; the land had value in itself, and the seller had

created no "enterprise" that would have an effect upon that value. LPI suggests that the investors

in a viatical settlement likewise are buying only their fractional interest in the death benefit, not a

share in a common business enterprise.

The SEC, for its part, would have us distinguish Rodriguez from the present case on the

ground that here the promotermakesspecific commitments effective afterthe investors purchase their

interests. Indeed, the First Circuit did remark that "commitments and promises incident to a land

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 13 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

transfer ... can cross over the line and make the interest acquired one in an ongoing business

enterprise." Id. at 11. As the SEC's response implies, however, LPI's argument that there is no

enterprise in the picture is more properly addressed to the third part of the Howey testwhether

profits are expected to arise fromthe efforts of others. We consider that question in the next section,

where we take up the importance of the promoter's post-purchase commitments.

3. Profits Derived Predominantly from the Efforts of Others

The final requirement of the Howey test for an investment to be deemed a security is that the

profits expected by the investor be derived from the efforts of others. In this connection, the SEC

suggests that investors in LPI's viatical settlements are essentially passive; their profits, the

Commission argues, depend predominantly upon the efforts of LPI, which provides pre-purchase

expertise in identifying existing policyholders and, together with Sterling, provides post-purchase

management of the investment. Meanwhile, LPI argues that its pre-purchase functions are wholly

irrelevant and that the post-purchase functions, by whomever performed, should not count because

they are only ministerial. On this view, once the transaction closes, the investors do not look to the

efforts of others for their profits because the only variable affecting profits is the timing of the

insured's death, which is outside of LPI's and Sterling's control.

By itsterms Howey requiresthat profits be generated "solely" from the efforts of others. 328

U.S. at 298. Although the lower courts have given the Supreme Court's definition of a security

broadersweep by requiring that profits be generated only "predominantly" from the efforts of others,

see, e.g., SEC v. International Loan Network, Inc., 968 F.2d 1304, 1308 (D.C. Cir. 1992); Goodman

v. Epstein, 582 F.2d 388, 408 n.59 (7th Cir. 1978), they have never suggested that purely ministerial

or clerical functions are by themselves sufficient; indeed, quite the opposite is true. See, e.g., SEC

v. Koscot Interplanetary, Inc., 497 F.2d 473, 483 (5th Cir. 1974); SEC v. Glen W. Turner

Enterprises, Inc., 474 F.2d 476, 482 (9thCir. 1973) (efforts of othersmust be "undeniablysignificant

ones, those essential managerial efforts which affect the failure or success of the enterprise").

Because post-purchase entrepreneurial activities are the "efforts of others" most obviously relevant

to the question whether a promoter is selling a "security," we turn first to the distinction between

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 14 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

those post-purchase functions that are entrepreneurial and those that are ministerial; thereafter, we

consider the relevance of pre-purchase entrepreneurial services.

Ministerial versus entrepreneurial functions, post-purchase. In Version I of its program, LPI

and not the investor could appear as the owner of record of the insurance policy. LPI's ownership

gave it the ability, post-purchase, to change the party designated as the beneficiary of the policy,

indeed to substitute itself as beneficiary. That ability tied the fortunes of the investors more closely

to those of LPI in the sense that it made the investors dependent upon LPI's continuing to deal

honestly with them, at least to the extent of not wrongfully dropping them as beneficiaries.

This does not, however, establish an association between the profits of the investors and the

"efforts" of LPI. Nothing that LPI could do by virtue of its record ownership had any effect

whatsoever upon the near-exclusive determinant ofthe investors' rate of return, namely how long the

insured survives. Only if LPI misappropriated the investors' funds, or failed to perform its

post-purchase ministerial functions, would it affect the investors' profits. Such a possibility provides

no basis upon which to distinguish securities from non-securities. The promoter's "efforts" not to

engage in criminal or tortious behavior, or not to breach its contract are not the sort of

entrepreneurial exertions that the Howey Court had in mind when it referred to profits arising from

"the efforts of others."

In Version II LPI no longer appeared as the record owner of a policy, but LPI and Sterling

continued to offer the following post-purchase services: holding the policy, monitoring the insured's

health, paying premiums, converting a group policy into an individual policy where required, filing

the death claim, collecting and distributing the death benefit (if requested), and assisting an investor

who might wish to resell his interest. LPI characterizes these functions as clerical and routine in

nature, not managerial or entrepreneurial, and therefore unimportant to the source of investor

expectations; in sum, anyone including the investor himself could supply these services. The district

court seemed to agree with LPI about the character if not the significance of most post-purchase

services, for it described them as "often ministerial in nature."

The Commission disputes the district court's characterization of post-purchase services as

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 15 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

ministerial, but attempts to portray only one service in particular as entrepreneurial: we refer to the

secondary market that LPI purportedly makes. By establishing a resale market, according to the

SEC, LPI links the profitability of the investments it sells to the success of its own efforts. We find

this argument unconvincing for several reasons. First, there is no evidence in the record before us

that investors actually seek to liquidate their investments prior to the receipt of death benefits.

Second, there is no evidence that LPI's potential assistance adds value to the investment contract;

an investor could, for all that appears, get the same help with resale (if any is needed) through any

one of the many firms that sell viaticalsettlements. Third, LPI is quite specific in warning its clients

that

viatical transactions are not liquid assets. There is no established market for the resale

ofsuch policies. They should be purchased only by persons who are willing and able

to hold the policy until it matures.... Life Partners' present practice is to assist in the

resale of policies purchased by its clients [but] ... [t]here is no guarantee that any

policy can be resold, or that resale, if it occurs, will be at any given price.

LPI's promise of help in arranging for the resale of a policy is not an adequate basis upon which to

conclude that the fortunes of the investors are tied to the efforts of the company, much lessthat their

profits derive "predominantly" from those efforts.

In Version III LPI provides no post-purchase services. All such services are the sole

responsibility of the investors, who may purchase them from Sterling or not, as they choose. The

district court minimized the significance of this choice, stating that "it is neither realistic nor feasible

for multiple investors, who are strangers to each other, to perform post-purchase tasks without

relying on the knowledge and expertise of a third party [and] the third party in this case will almost

certainly be Sterling." Even if we accept this assessment, it does not alter our analysis. As we have

seen, none of Sterling's post-purchase services can meaningfully affect the profitability of the

investment. It is therefore of no moment whether Sterling performs those services usually or always,

or whether it does so as the agent of LPI or as the agent of the investor.

In sum, the SEC has not identified any significant non-ministerialservice that LPI or Sterling

performsfor investors once theyhave purchased their fractional interestsin a viaticalsettlement. Nor

do we find that any of the ministerial functions have a material impact upon the profits of the

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 16 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

investors. Therefore, we turn to the question whether LPI's pre-purchase services count as "the

efforts of others" under the Howey test.

Entrepreneurial functions, pre-purchase. LPI's assertion that its pre-purchase efforts are

irrelevant receives strong, albeit implicit, support from the Ninth Circuit decision in Noa v. Key

Futures, Inc., 638 F.2d 77 (1980) (per curiam). In that case, which involved investments in silver

bars, the court observed that the promoter made pre-purchase efforts to identify the investment and

to locate prospective investors; offered to store the silver bars at no charge for a year after purchase

and to repurchase them at the published spot price at any time without charging a brokerage fee. The

court concluded, however, that these services were only minimally related to the profitability of the

investment: "Once the purchase ... was made, the profits to the investor depended upon the

fluctuations of the silver market, not the managerial efforts of [the promoter]." Id. at 79-80.

The Tenth Circuit applied the same principle (to reach a different result) with respect to an

investment in undeveloped land. McCown v. Heidler, 527 F.2d 204 (1975). In that case, the

plaintiffs claimed that the parcels they had purchased were securities. In marketing the parcels to

potential investorsthe promoters had promised to make future improvementsto the lots. "[W]ithout

the substantial improvements pledged by [the promoters] the lots would not have a value consistent

with the price which purchasers paid.... The utilization of purchase money accumulated from lot sales

to build the promised improvements" could bring the scheme within the purview of the securities

laws. Id. at 211.

In bothNoa and McCown, the courts of appealsregarded the promoter's pre-purchase efforts

as insignificant to the question whether the investmentsin silver bars and parcels of land,

respectivelywere securities. The different outcomes trace wholly to the promoters' commitment

to perform meaningful post-purchase functions in McCown but not in Noa.

In the present case, the district court distinguished Noa on the ground that, because silver is

a fungible commodity, the promoter's pre-purchase efforts were inconsequential; LPI, in contrast,

performed highly specialized functions in identifying and evaluating individual policies suitable for

purchase by investors. Still, the district court declared (in its January 1996 opinion) that

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 17 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

"pre-purchase activities cannot alone support a finding that investors' profits derive fromthe activities

of LPI." Instead, the court relied upon the "pre-closing activities in addition to the post-closing

activities that LPI continues to perform."

The Commission at oral argument tried to distance itself from Noa on roughly the same

ground, arguing that an investor could, without great effort, independently evaluate the silver bars

in that case, whereas an LPI investor would have considerably greater difficulty, especially in those

instances where the terminally ill insured insists upon anonymity until the closing of the sale. LPI

counters that itsinvestors also play an active pre-purchase role in setting their own purchase criteria

(such as the insured's life expectancy and the minimum acceptable risk rating of the insurer) and

reviewing the insured's health profile and his insurance policy. Even if true, the district court

appropriately characterized LPI's pre-purchase efforts as "undeniably essential to the overallsuccess

of the investment." The investors rely heavily, if not exclusively, upon LPI to locate insureds and to

evaluate them and their policies, as well as to negotiate an attractive purchase price.

The SEC urges us to go even further than did the district court, however, in appraising the

significance of LPI's pre-purchase activitiesinsofar asthey count toward "the efforts of others." The

Commission reminds us that the Supreme Court did not draw a bright line distinction in Howey

between pre- and post-purchase efforts, and notesthat LPI may continue to performsome functions,

such as preparing the preliminary agreement and evaluating the insured's policy and medicalfile, right

up to the closing of the transaction. Therefore it would be hypertechnical, according to the

Commission, to discount the importance of LPI's pre-purchase entrepreneurial functions simply

because they occur before the moment of closing.

Absent compelling legalsupport for the Commission'stheoryand the Commission actually

furnishes no support at allwe cannot agree that the time of sale is an artificial dividing line. It is

a legal construct but a significant one. If the investor's profits depend thereafter predominantly upon

the promoter's efforts, then the investor may benefit from the disclosure and other requirements of

the federalsecuritieslaws. But if the value of the promoter's efforts has already been impounded into

the promoter's fees or into the purchase price of the investment, and if neither the promoter nor

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 18 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

*Our dissenting colleague suggests that pre-purchase managerial activities are alone sufficient

if they are the predominant factor in determining whether profits are eventually realized. Dissent

at 5. In support of this proposition she can find only a dictum in a district court case, SEC v.

Brigadoon Scotch Distribs., Ltd., 388 F. Supp. 1288, 1293 (S.D.N.Y. 1975), in whichas the

dissent concedesthe promoter's managerial efforts continued post-purchase through its

agreement to repurchase the coins it was selling. Indeed, the district court's holding was

controlled by Glen-Arden Commodities, Inc. v. Costantino, 493 F.2d 1027 (1974), in which the

Second Circuit had held that even though the "very investment to be made was in [Scotch

whiskey] to be specifically selected " by the promoters, the promise by the promoters to "find

buyers for the Scotch or buy it back themselves" was the primary reason for characterizing the

investment as a security. Id. at 1035 (original emphasis). 

anyone else is expected to make further efforts that will affect the outcome of the investment, then

the need for federalsecuritiesregulation is greatly diminished. While, to be sure, coverage under the

1933 Act might increase the quantity(and perhapsthe quality) ofinformation available to the investor

prior to the closing, "the securitieslaws[are not] a broad federalremedy for allfraud." Marine Bank

v. Weaver, 455 U.S. 551, 556 (1982). They are concerned only with securities fraud, and the

question before us is the threshold question whether a fractional interest in a viatical settlement is a

security. To answer that question we look for "an investment in a common venture" with profits

"derived from the entrepreneurial or managerial efforts of others." Forman, 421 U.S. at 852.

We see here no "venture" associated with the ownership of an insurance contract from which

one's profit depends entirely upon the mortality of the insuredjust as the First Circuit saw no

"enterprise" associated with holding land for investment in Rodriguez, 990 F.2d at 10. Nor is the

combination of LPI's pre-purchase services as a finder-promoter and its largely ministerial

post-purchase services enough to establish that the investors' profits flow predominantly from the

efforts of others.*

While we doubt that pre-purchase services should ever count for much, for present purposes

we need only agree with the district court that pre-purchase services cannot by themselves suffice to

make the profits of an investment arise predominantly from the efforts of others, and that ministerial

functions should receive a good deal less weight than entrepreneurial activities. The SEC (like the

district court) has identified no post-purchase service provided by LPI or Sterling that could fairly

be characterized as entrepreneurial and combined with LPI's pre-purchase services to affect the

outcome of the Howey test. Nor has the Commission pointed to a single case in which an investment

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 19 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

vehicle was deemed a security subject to the federalsecuritieslaws although the investor did not look

to the promoter (or another party) to provide significant post-purchase efforts.

In this case it isthe length of the insured'slife that is of overwhelming importance to the value

of the viatical settlements marketed by LPI. As a result, the SEC is unable to show that the

promoter's efforts have a predominant influence upon investors' profits; and because all three

elements of the Howey test must be satisfied before an investment is characterized as a security,

Revak, 18 F.3d at 87, we must conclude that the viatical settlements marketed by LPI are not

securities.

C. The LPI Program for IRA Investments in Viatical Settlements

Finally, we must resolve the question, which the district court did not reach, whether the notes

issued under the company's IRA program might be securities even though the underlying fractional

interestsin viaticalsettlements are not. In brief, the program is structured as follows: LPI establishes

a separate trust for each investor's IRA; the trust borrows money from the IRA and issues a

non-recourse note in exchange. The trust uses the loan proceeds to invest in a viatical contract, the

death benefits of which collateralize the note. When the death benefits are ultimately paid, the trust

distributes them to the IRA in satisfaction of the note.

The SEC urges that we decide whether the notes are securities by application of the "family

resemblance test" of Reves v. Ernst & Young, 494 U.S. 56, 65 (1990), pursuant to which a note is

deemed to be a security unless it resembles one of a list of instruments that are not securities.

Because we have already determined, however, that the underlying viatical contracts are not

securities, and because the essential characteristics of the investment are no different whether the

purchaser is an IRA or an individual investor, the status of the notes under the 1933 Act does not

require extended analysis.

The note is used in these transactions, as the SEC itself affirms in its brief, merely in order to

navigate around certain restrictionsin the tax code that preclude IRAsfrominvesting in life insurance

contracts. If the individual who owns the IRA wants to invest the IRA's capital in a viatical

settlement, then the note is nothing more than a device by which to make that investment in a form

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 20 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

that complies with the tax code; use of the note does not alter the substance of the transaction in any

manner that would suggest a role for the securitieslawsthat is not otherwise indicated by law. In this

we follow directly the teaching of the Supreme Court: "[I]n searching for the meaning and scope of

the word "security' in the Act, form should be disregarded for substance and the emphasis should be

on economic reality." Tcherepnin, 389 U.S. at 336. Applying this precept, we hold that the

noteslike the viatical contracts for which they standare not securities.

III. Summary and Conclusion

LPI advancestwo argumentsin support ofthe proposition that its viaticalsettlements are not

subject to the federal securities laws. First, the company contends that its contracts are exempt as

insurance contracts under the Securities Act of 1933 and the McCarran-Ferguson Act. For the

reasons set forth in Part II.A, however, we conclude that a viatical settlement is not an insurance

policy, and that the business of selling fractional interests in insurance policies is not part of "the

business of insurance." We therefore reject LPI's exemption argument.

Second, LPI maintainsthat the fractional interests which it sellsto investors are not securities

within the meaning of the 1933 Act, as controlled by the Supreme Court's decision in Howey. In

PartsII.B(1) and II.B(2), respectively, we conclude that LPI's contracts meet two parts ofthe Howey

test: investors purchase the contracts with an expectation of profits; and they pool their funds, then

share any profits or losses that arise. In Part II.B(3), however, we hold that fractional interests in

viaticalsettlements, in any of the three versions marketed or proposed byLPI, are not securities. The

combination of LPI's pre-purchase services as a finder-promoter and its largely ministerial

post-purchase servicesis not enough to satisfy the third requirement in Howey: the investors' profits

do not flow predominantly from the efforts of others. Finally, we hold that the notes issued to IRAs

by LPI-sponsored trusts are not securities either. Looking to the substance of such transactions, we

see that the notes are used solely for tax purposes, not as a means of raising capital.

Accordingly, this case is remanded to the district court with instructions to vacate the three

injunctions entered against LPI in August 1995, January 1996, and March 1996.

So ordered.

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 21 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

WALD, Circuit Judge, dissenting. I agree with the majority that viatical settlements are not

exempt from the securities laws as insurance contracts, that notes issued under Life Partners, Inc.'s

("LPI") IRA program are not securities, and also that LPI's viatical settlements meet the first two

requirements of the three-part test for an investment contract set out in SEC v. W.J. Howey Co., 328

U.S. 293, 298-99 (1946). These two requirements are that investors in viatical settlements (1) expect

profitsfrom (2) a common enterprise. I part company with the majority, however, because I believe

that the third requirement of the Howey test, that (3) the expected profits be generated solely from

the efforts of others, is also met here.

Several background principles should guide our analysis of whether or not the fractional

interests in viatical settlements marketed by LPI satisfy Howey's third prong and therefore are

securities. One such principle is that we should avoid imposing overly formal restrictions on what

qualifies as a security and instead apply securities laws flexibly so as to achieve their remedial

purposes. Pinter v. Dahl, 486 U.S. 622, 653 (1988); SEC v. Capital Gains Research Bureau, Inc.,

375 U.S. 180, 195 (1963); Baurer v. Planning Group, Inc., 669 F.2d 770, 772 (D.C. Cir. 1981).

In Howey the Court stated that the definition of security "embodies a flexible rather than a static

principle, one that is capable of adaptation to meet the countless and variable schemes devised by

those who seek the use of the money of others on the promise of profits." Howey, 328 U.S. at 299.

It has repeated this mantra of flexibility in subsequent cases applying the Howey test, and has

consistently underscored that "form should be disregarded for substance and the emphasisshould be

on economic reality." Tcherepnin v. Knight, 389 U.S. 332, 336 (1967); United Housing Found.,

Inc. v. Forman, 421 U.S. 837, 848-49 (1975).

A second principle, however, is that the securities laws do not grant federal protection to all

investments, but only to that subcategory ofinvestmentsthat are securities. Marine Bank v. Weaver,

455 U.S. 551, 556 (1982) ("Congress, in enacting the securities laws, did not intend to provide a

broad federal remedy for all fraud"); Northland Capital Corp. v. Silver, 735 F.2d 1421, 1431 (D.C.

Cir. 1984). Hence, although the securities laws are to be interpreted flexibly and cover many

arrangements that do not superficially resemble securities, they cannot be interpreted so flexibly as

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 22 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

to cover every type of investment. The paradigmatic instance of an investment that is not a security

is the mere purchase of land with the hope that its value will naturally increase. See, e.g., Rodriguez

v. Banco Cent. Corp., 990 F.2d 7, 10 (1st Cir. 1993) ("[a]simple sale ofland, whether for investment

or use, is not a "security' ").

The third and final principle is that the securities laws, and in particular the Securities Act of

1933 and the Securities Exchange Act of 1934 which are the statutes at issue here, embody the belief

that information isthe most important formofinvestor protection. The Court has remarked that "the

design ofthe[se]statute[s] isto protect investors by promoting full disclosure ofinformation thought

necessary to informed investment decisions," and it has used this concern for ensuring adequate

accessto information to guide its application of the Acts. SEC v. Ralston Purina Co., 346 U.S. 119,

124-26 (1953); see also Capital Gains Research Bureau, 375 U.S. at 186 ("[a] fundamental

purpose, common to [the securities laws], was to substitute a philosophy of full disclosure for the

philosophy of caveat emptor"); LOUIS LOSS & JOEL SELIGMAN, 1 SECURITIESREGULATION 171-94,

391-94 (3d ed. 1989) (describing the disclosure philosophy of the securities laws). A new security

must be registered before it can be publicly offered, which means simply that information on the

security, issuer and underwriter must be submitted to the Securities and Exchange Commission

("SEC"). If there has been adequate and complete disclosure, the SEC has no power to prevent a

security frombeing marketed because it believesthe security to be too risky. LOSS,supra, at 227-29.

As the majority indicates, prior cases have established that in order for the third prong of the

Howey test to be met the activities of the promoter must be of a managerial or entrepreneurial

character, and not merely ministerial or clerical. Majority opinion ("Maj. op.") at 17. In the words

of the Ninth Circuit, the third prong of Howey is satisfied when "the efforts by those other than the

investor are the undeniably significant ones, those essentialmanagerial efforts which affect the failure

or success of the enterprise." SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476, 482 (9th Cir.),

cert. denied, 414 U.S. 821 (1973); see also Forman, 421 U.S. at 852 ("touchstone of [the Howey

test] is the presence of an investment in a common venture premised on a reasonable expectation of

profitsto be derived fromthe entrepreneurial or managerial efforts of others"). Prior cases have also

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 23 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

1

I agree with the majority's characterization of LPI's post-purchase activitiesholding the

policy, monitoring the insured's health, paying premiums, converting a group policy into an

individual policy if required, and collecting and distributing the death benefitas ministerial, but

with two caveats. First, unlike the majority, I consider LPI's promise to assist in the resale of

policies combined with its emphasis on the availability of resale opportunities to constitute a

managerial post-purchase activity. Lifetime Funding Newsgram (January 1994), reprinted in

Joint Appendix ("JA") IIIB 3182-83; Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce,

Fenner & Smith, Inc., 756 F.2d 230, 240-41 (2d Cir. 1985) (stressing Merrill Lynch's promise to

maintain a secondary market for resale of certificates of deposit ("CD") in finding Howey test

satisfied). I agree with the majority, however, that LPI does not in general highlight the resale

option but on the contrary warns investors that "[l]ife insurance policies purchased through

viatical transactions are not liquid assets." LPI, Report of Compliance Efforts, reprinted in JA-S

4123; Maj. op. at 19-20. Although LPI did emphasize the possibility of resale in regard to

policies with longer terms (24-36 months and 36-48 months), LPI indicated in its reply brief that

it has stopped doing so and now includes the same warning about the lack of liquidity in this

context as well. Reply Br. at 13 n.8.

Second, I attach greater significance than the majority does to the fact that in Version I

LPI often appeared as the owner of record of the policy and not the investors. As the district

court noted, this meant that creditors of LPI might be able to reach the policies were LPI to

encounter financial difficulties. Consequently, the investors' profits were dependent on LPI's

efforts to remain a financially viable company and not simply, as the majority claims, on LPI's "

"efforts' not to engage in criminal or tortious behavior." Maj. op. at 18. But LPI no longer

appears as the record owners of the policies, and therefore my disagreement with the majority on

this point is not material. 

held that Howey's third prong should be interpreted broadly to allow an investment contract to exist

where the profits come "predominantly," but not solely, from the efforts of others. See, e.g., SEC

v. International Loan Network, Inc., 968 F.2d 1304, 1308 (D.C. Cir. 1992).

The key question for us is whether the third prong of the Howey test is met when the

managerial activities of the promoter occur only before the investment is purchased.1 The district

court took the position there is no need for post-purchase activities to be managerial activities,

provided that there are some post-purchase activities and at some point the promoter has performed

managerial activities. I agree with the majority that this approach fails. Insisting that some activity

must occur after purchase but allowing any activity, no matter how trivial, to satisfy thisrequirement

violates the principle that form should not be elevated over substance and economic reality.

The majority instead takes the position that in order for Howey's third prong to be satisfied,

the promoter must perform managerial and entrepreneurial activities after the investment is

purchased. Maj. op. at 21-22. The net effect of the majority's position is to incorporate a bright-line

rule into Howey's third prong: whatever the surrounding circumstances, an investment is not a

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 24 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

security unlesssignificant managerial activities by the promoter occur post-purchase. The advantage

of this approach is that it offers a clear method for distinguishing between investment contracts that

are securities and investment contracts that are simply investments. In that regard, it accords with

the principle that the securitieslaws cannot be so broadlyinterpreted asto encompass all investments.

But it does so at a substantial cost. Like the district court's approach, it elevates a formal element,

timing, over the economic realityofthe investors' dependence on the promoter. Even more troubling,

the majority's approach undercuts the flexibility and ability to adapt to "the countless and variable

schemes" that are the hallmarks of the Howey test. Howey, 328 U.S. at 299.

I agree that the requirement of Howey's third prong is most clearly met where the promoter

engages in post-purchase activities. But I do not believe that investments based on pre-purchase

managerial activities only should be categorically excluded from the coverage of the acts. Rather,

I would distinguish between investments that satisfy the Howey third prong and those which do not

by focusing on the kind and degree of dependence between the investors' profits and the promoter's

activities. I believe that the third prong of the Howey test can be met by pre-purchase managerial

activities of a promoter when it isthe success ofthese activities, either entirely or predominantly, that

determines whether profits are eventually realized. These pre-purchase activities must be directed

at the sale of the investment opportunity; for example, efforts to build up a business are directed at

making a business successful and therefore would not qualify, even if the ultimate aim is to sell the

business to an investor. Cf. Emisco Indus. Inc. v. Pro's Inc., 543 F.2d 38, 40-41 (7th Cir. 1976).

In practice, this requirement may impose a time element, as activities that do not occur around the

time of sale are unlikely to be found to be directed at the sale of an investment opportunity. But

provided the promoter's activities are so directed, the fact that the activities occurred prior to

purchase would not bar the investment from qualifying as an investment contract under Howey.

On the other hand, if the realization of profits depends significantly on the post-investment

operation of market forces, pre-investment activities by a promoter would not satisfy Howey's third

prong. In such a situation, the realization of investor profits is fundamentally outside of the

promoter's control and the investor's dependence on the promoter is more circumscribed. By the

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 25 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

same logic, Howey'sthird prong would not be satisfied whenever the promoter's managerial activities

occurred prior to purchase and the realization of profits depended significantlyonoutside forces,such

as a lottery. See, e.g., SEC. v. Energy Group of America, Inc., 459 F. Supp. 1234, 1240 (S.D.N.Y.

1978). However, occasions where profits are determined by the operation of market forces will likely

be the most common version of this situation.

The reason I focus on the degree of dependence between the investors' profits and the

promoter's activities is twofold. First, I believe that this focus is more in keeping with the tenor of

the Supreme Court's opinions applying Howey and its concern that regulation be tied to underlying

economic reality instead of form. Second, I believe that distinguishing between profits realized from

the promoter's activities and profits realized from the operation of market forces coheres with the

beliefthat investors are protected by accessto information. When profits depend on the intervention

of market forces, there will be public information available to an investor by which the investor could

assess the likelihood of the investment's success. Thus, for example, a purchaser of silver bars has

access to information on the trends in silver prices, an investor in paintings can get a sense, at least

generally, of how the market for artwork is faring, and a purchaser of an undeveloped lot has access

to information on growth trends in the area. Obviously, the degree to which this information is

actually available to an investor depends on the sophistication and education of an investor, but that

is true about investments generally. Moreover, where profits depend on the operation of market

forces "registration ... could provide no data about the seller which would be relevant to those market

risks." SEC v. G. Weeks Securities, Inc., 678 F.2d 649, 652 (6th Cir. 1982).

Where profits depend on the success ofthe promoter's activities, however, there isless access

to protective information and the type of information that is needed is more specific to the promoter.

Given the pivotal role of the promoter's activities, what the investor needs to know is not generally

how this type of activity has fared but what the specific risk factors attached to the investment are

and whether there is any reason why the investor should be leery of the promoter's promises. This

need for information holds true in regard to investors prior to purchase as much as to investors who

have committed their fundsindeed, more so, if they are to avoid over-risky investments. The

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 26 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

majority argues that we need not be concerned about protecting investors where the profitability of

an investment hinges on pre-purchase activities. Maj. op. at 22. Presumably this is because investors

already have a potent weaponthey can refuse to invest in the policy. But the claim that investors

need not be protected prior to committing funds has been rejected byCongress, which made the goal

of ensuring that investors have adequate information before they commit their money or enter

contracts the central concern of the Securities Acts. Capital Gains Research Bureau, 375 U.S. at

186; Ralston Purina, 346 U.S. at 124-26.

By far, most casesfinding the Howey test to be met involve situationsin which post-purchase

managerial activities either occur or are promised. In Howey, for example, the promoter not onlysold

orchard lots but also contracted to manage the lots as an orchard after theywere purchased. Howey,

328 U.S. at 299-300. But there is precedent supporting an approach that focuses on the degree and

kind of dependence between the investors' profits and the promoter, rather than on the timing of the

promoter's efforts. Contrary to the majority's suggestion that pre-purchase activities may be

altogether irrelevant, see Maj. op. at 22, courts frequently refer to pre-purchase as well as

post-purchase activities of the promoter in finding Howey's third prong met. In Glen-Arden

Commodities, Inc. v. Costantino, 493 F.2d 1027 (2d Cir. 1974), for example, the Second Circuit

noted that investors' profits depended on the promoter's expertise in selecting whiskey for investors

to purchase as well as on the promoter's promise to buy back the whiskey in the future. Id. at 1035;

see also Gary Plastic, 756 F.2d at 240-41 (finding an investment contract where promoter both

promised to maintain a secondary market for CDsa post-purchase managerial activityand used

its market power to negotiate favorable CD rates with participating banksa pre-purchase activity);

Gordon v. Terry, 684 F.2d 736, 740 n.4, 742-43 (11thCir. 1982), cert. denied, 459 U.S. 1203 (1983)

(emphasizing promoter's claimed expertise in locating bargain-priced Florida properties for investor

to purchase, as well as promoter's post-purchase activities of structuring leverage scheme and

utilizing personal contacts to ease resale, in denying summary judgment on question of whether

investment contract existed).

Indeed, there are occasions, albeit rare, when most of the promoter's significant managerial

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 27 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

activities occur before purchase and a court has found Howey's third prong satisfied. One such

instance is SEC v. Brigadoon Scotch Distribs., Ltd., 388 F. Supp. 1288 (S.D.N.Y. 1975), in which

a promoter both selected coins for purchase and offered post-purchase buy-back and accounting

services. While it is true that the promoter's post-purchase activities in this case qualify as

managerial, the court specifically stated that the promoter's selection activities alone were sufficient

to satisfy Howey's third prong because "[c]oins do not appreciate in value at the same rate and

accordingly their selection is the most crucial factor in determining how much profit an investor in

coins will make." See id. at 1293. Another is Bailey v. J.W.K. Properties, Inc., 904 F.2d 918 (4th

Cir. 1990), where the promoter selected specially bred cow embryos for investors to purchase and

then raised and marketed the cows. Although the promoter's activities in raising and marketing the

cows occurred post-purchase, the Fourth Circuit emphasized the promoter's pre-purchase activity of

selecting and crossbreeding embryos in finding that Howey's third prong was met:

If the investment scheme had been merely to raise cattle for slaughter, the interests

purchased by the plaintiffs may not have constituted investment contracts....

However, the Albemarle Farms program also involved the selection of

embryos and crossbreeding. The plaintiffs had no expertise in making such selections

and had an extremely limited range of alternative sources of such information.

Id. at 924-25; see also Energy Group, 459 F. Supp. at 1241 (purchase of property in expectation

that it will appreciate due to promoter's expertise in selecting the property is one category of

investment contract); 5B ARNOLD S. JACOBS, LITIGATION UNDER RULE 10B-5, § 38.03[b][I] at 2-

212, § 38.03[b][v], at 2-258 (1996) (quoting Energy Group and arguing that promoter activities

taking place concurrent with or after sale of security satisfy Howey's third prong).

Notably, I have found no case which holds, as the majority here does, that pre-purchase

activities alone cannot satisfy Howey's third prong. Even the cases cited by the majority in support

of its position do not argue that the pre-purchase/post-purchase line has determinative significance.

Rather, the decisions in these cases appear to turn on the role that market forces as opposed to the

promoter's activities play in the realization of profits. For example, Noa v. Key Futures, Inc., 638

F.2d 77 (9th Cir. 1980), held that the purchase ofsilver bars, even with the promoter's offer to store

and repurchase the silver, was not an investment contract. In reaching this decision the Ninth Circuit

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 28 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

emphasized that "the profits to the investor depended upon the fluctuations of the silver market, not

the managerial efforts of [the promoter]." Id. at 79. On the other hand, in McCown v. Heidler, 527

F.2d 204 (10th Cir. 1975), the Tenth Circuit held that sales of real estate parcels constituted

investment contracts because the price of the parcels reflected the value of the promoter's

development activities. Id. at 211; see also SEC v. Belmont Reid & Co., Inc., 794 F.2d 1388, 1391

(9th Cir. 1986) (Howey's third prong not met where primary purpose of prepayment plan involving

purchase of gold coins was "to profit from the anticipated increase in the world price of gold");

Jenson v. Continental Financial Corp., 404 F. Supp. 792, 803 (D. Minn. 1975) (Howey third prong

is not met by commodity futures contracts because "[t]he profitability of the investment is solely

dependent on the operation of the commodities market and the investors [sic] own investment

decisions"). Although in Rodriguezthe First Circuit focused on Howey'ssecond prong, the existence

of a common enterprise, it found the question of whether the value of the investment derives from

the operation of the market or the actions of the promoters to be of critical importance. The First

Circuit maintained that the sale of real estate could not constitute an investment contract where the

promoter did not promise to develop the land and instead it was expected to appreciate by "natural

forces," specificallyeconomic growth spurred bythe presence ofDisneyWorld. Rodriguez, 990 F.2d

at 11-12.

The approach I advocateallowing Howey's third prong to be met by pre-purchase

managerial activities of a promoter when the eventual realization of profits depends predominantly

on these activities and not on the marketis also supported by the line of cases applying Howey's

third prong to generalpartnerships. The investment in these cases is a contribution of capital in return

for an interest in an ongoing partnership, and thus they do not address the specific question of

whether pre-purchase activities alone can create an investment contract. But these cases are relevant

because theydemonstrate that other courts have been concerned to applyHowey'sthird prong flexibly

and with an eye to protecting passive investors who are at an informational disadvantage in regard

to a promoter or who must rely on a promoter for some unique expertise. Since the terms of general

partnership agreements usually grant all partners authority to participate in decisionmaking,

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 29 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

investments in general partnerships would appear to fail the requirement of Howey'sthird prong that

profits must come predominantly from the efforts of others. Instead, several courts have adopted an

approach that focuses not on the terms of the partnership agreement but on the relationship between

the investor and the promoter. Under this approach, a general partnership can constitute an

investment contract if the agreement grants the partner little control, "the partner ... is so

inexperienced and unknowledgeable in business affairs that he isincapable of intelligently exercising

his partnership ... powers," or "the partner ... is so dependent on some unique entrepreneurial or

managerial ability of the promoter or manager that he cannot replace the manager." Williamson v.

Tucker, 645 F.2d 404, 424 (5th Cir.), cert. denied, 454 U.S. 897 (1981); see also Koch v. Hankins,

928 F.2d 1471, 1476-78 (9th Cir. 1991)(adopting Williamson test); Matek v. Murat, 862 F.2d 720,

728 (9th Cir. 1988)("access to information about the investment, and not managerial control, is the

most significant factor" in applying the securities acts).

It is true that there is no clear line distinguishing when a promoter's pre-purchase activities

predominate in the realization of profits and when market forces play a significant role. But I expect

that in practice this distinction would not be a difficult one to make, and that the background

principles of federal securities regulation would help decide close cases. I also expect that the

occasions where investment profits depend predominantlyon an investor's pre-purchase activities are

extremely rare. As the cases above illustrate, the most common pre-purchase managerial activity is

the use ofsome special expertise to select items for purchase. Usually, however, the purpose of this

selection is to identify items "within a particular class of items which will appreciate at a faster rate

than will the particular class in general." Bailey, 904 F.2d at 924 (quoting J. LONG, BLUE SKY LAW

§ 2.03[2][d][iii], at 2-45 to 2-46 (1986)). Since in these cases the realization of profits depends

significantly on what happensin the market for that type ofitem, the investment would not constitute

a security.

Given the paucity of cases where pre-purchase managerial activities ofthe promoter alone are

likely to create a security, my fear that the majority's approach will unduly restrict the flexibility of

the Howey test might appear exaggerated. On the other hand, the difficulty with illustrating the

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 30 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

restrictive effects of the majority's bright-line approach could be seen as a very good reason to

preserve flexibility, for flexibility is what allows us to adapt our existing securities laws to address

"novel schemes," schemes that we cannot easily anticipate ahead of time. At the very least, surely

we should heed the concerns of the SEC, which bears primary responsibility for administering the

securities laws. In its brief the SEC has urged us not to draw "a sharp line between those efforts

occurring at or around the time of the investment of money, and those occurring thereafter" for fear

that such a line would create a loophole in the securitieslawsthat promoters could exploit. Appellee

Br. at 41; see also Forman, 421 U.S. at 858 n.25 (noting that the views of the SEC would have been

given considerable weight had the agency's position been consistent); SEC v. R.G. Reynolds Enters.,

Inc., 952 F.2d 1125, 1132 n.7 (9th Cir. 1991)("[w]hile the SEC's view is not conclusive, it is entitled

to substantial weight").

LPI's viatical settlements represent one of the rare instances where investor profits depend

predominantly on the pre-purchase managerial activities of a promoter. As the district court found,

whether investorsrealize the profitsthey expect depends on whether LPI's estimation ofthe insured's

life span is accurate. The longer the insured remains alive, the lower the investors' profits, particularly

if premiums must continue to be paid. Moreover, the record clearly supports the district court's

finding that investors rely on LPI's evaluation of the insured's life expectancy. LPI emphasizes the

detailed assessment of the insured's medical condition that it performs in its promotional materials.

LPI, Commonly Asked Questions (January, 1993), reprinted in JA-II 1342-43. While the T-cell

count of a person with AIDS is an important indicator of life expectancy, LPI's reviewing physician

testified that he bases hislife expectancy estimates on several other factors as well, such asincidence

of opportunistic infection, platelet count, pulmonary studies, etc. Testimony of Dr. John Kelly,

reprinted in JA-II 1361. Potential advances in the treatment of AIDS must also be taken into

account. Id., reprinted in JA-II 1360-61. Although investors can ask for a copy of the report on the

insured's medical condition filed by LPI's reviewing physician, they can only review the medical

information supplied by the insured and the insured's physician in LPI's offices. Testimony of Brian

Pardo, reprinted in JA-IIIB 3088-89 ("Pardo Testimony"). Nor do they have any access to medical

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 31 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

information on the insured beyond that obtained byLPI. Under a recently adopted Texas regulation,

which governs LPI's viatical settlements, only a viatical settlement company or broker can contact

an insured about the insured's health status. TEX. ADMIN. CODE tit. 28, § 3.10012 (1996); see also

21 Tex. Reg. 1124 (1996)(noting adoption of new regulations on viaticalsettlements). In any event,

given the technical and complicated nature of this medical information, few investors are likely to be

able to assess the reliability of LPI's life expectancy estimate.

Two other key variables affecting investor profits are the price that LPI negotiatesfor the sale

ofthe policy and whether the policy isfreelyassignable. LPI's former president, Brian Pardo, testified

that investors do not participate in price negotiations because the policy is not offered to investors

for purchase until the seller and LPI have agreed on a price. Pardo Testimony, reprinted in JA-IIIB

3079. Investors thus rely on LPI, with its familiarity with going rates and prominence as a major

viatical company, to obtain a favorable purchase price. Any delay in obtaining benefits after the

insured dies, for example if a former beneficiary or the insurance company challengesthe assignment,

cutsinto profits. Hence, LPI's services of investigating policies, drafting valid assignment contracts,

and arranging if necessary for former beneficiariesto agree to the assignment, is also very important.

Commonly Asked Questions, reprinted in JA-II, 1343-44; Report of Compliance Efforts, reprinted

in JA-S 4124. In addition, policy sellers in some states may have enhanced protections and

revocation rights, and some states may not recognize the purchase of policies by persons without an

insurable interest. LPI, Draft Private Placement Memorandum for Life Partners Ltd, reprinted in JAIIIB 3019. As a result, investors must rely on LPI's knowledge of insurance laws in the different

states and LPI's tracking of proposed legislation affecting viatical settlements.

Market forces, however, do not play a significant role in determining whether profits are

realized. Their only effect is indirect, in that market forces determine whether investment in policies

is profitable compared to other investments. An investment in a life insurance policy might yield a

lessfavorable rate ofreturn than an alternative investment keyed to interest ratesifinterest rates were

to rise dramatically. But this effect on profits is insignificant compared with the effect that LPI's life

expectancy evaluation and other services have, and it is also in no way unique to viaticalsettlements.

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 32 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

Every investment is subject to becoming less profitable because of background economic

developments. In addition, while the course of the insured's illness determines when the insured dies,

the realization of expected investor profits depends not on the timing of the insured's death perse but

rather on whether the death occurs within the period estimated by LPI.

All of the activities performed by LPI occur pre-purchase, and as a result the majority holds

that LPI's viatical settlements do not create an investment contract. Under my approach, since the

investors' profits depend entirely on managerial activities of the promoter, the Howey test is met and

LPI's viatical settlements should be subject to the securities laws. The fact that no investor appears

to have been "defrauded, misled, or is in any way dissatisfied with an LPI viatical settlement," Maj.

op. at 4, does not make thisresult unreasonable. The securities laws are intended to be prophylactic

and prevent abuses before they arise. Even if LPI's practices are legitimate there is no guarantee that

those of other viatical settlement brokers will be similarly aboveboard. Moreover, there are

indicationsthat the viaticalsettlement industry will grow substantially in coming years, as companies

begin to purchase policies from individuals terminally ill from cancer as well as AIDS. See Pamela

Sherrid, Enriching the Final Days, U.S.NEWS & WORLD REP., Aug. 21, 1995 at 56,reprinted in JAIB 483; Keith Stone, Brokers, Terminally Ill Turning Death Into Cash, L.A. DAILY NEWS, Oct. 25,

1992 at N1, reprinted in JA-II 1287-91. A significant jump in viatical sales is also expected to occur

if Congress enacts legislation to clarify that the income from the sale of a life insurance policy is not

taxable to the insured, as it is currently considering doing. See Albert B. Crenshaw, Tackling an

Issue of Agony, WASH. POST, Sept. 1, 1995, at C1, C3, reprinted in JA-4145. The securities laws

are the only currently existing regulatory scheme by which investors in viatical settlements can be

protected. Although several states have enacted laws dealing with viatical settlements, these laws

only protect the insured who isselling the policy and not the investor who is purchasing it. See, e.g.,

N.Y. INS. LAW §§ 7801-7810 (McKinney's Supp. 1996); see generally VIATICAL SETTLEMENTS

MODEL ACT, reprinted in JA-II 1073-88.

It is also important to bear in mind that the majority's bright-line rule will apply to all

investments, not just viatical settlements. An illustration of the restrictive effect that this rule could

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 33 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

2An example of a derivative contract is when two parties enter into an interest-rate swap: one

party agrees to pay the other a fixed rate of interest applied to some dollar amount while the other

agrees to pay a variable interest rate on the same amount. Depending on whether interest rates

rise or fall, one party will pay the other the difference between the two measures when payments

are due, but there is no exchange of the underlying dollar amount. See John C. Hull, OPTIONS,

FUTURES, AND OTHER DERIVATIVE SECURITIES 111-16 (1993). 

have in other contexts can be drawn from the recent problems associated with derivatives. A

derivative is a financial contract, arranged through a dealer, that derives its value by reference to an

underlying asset, interest rate, exchange rate or index.2See Geoffrey B. Goldman, Crafting a

Suitability Requirement for the Sale of Over-the-Counter Derivatives: Should Regulators "Punish

the Wall Street Hounds of Greed"?, 95 COLUM. L. REV. 1112, 1116-19 (1995). Some derivatives

are traded on the organized exchanges, such asthe stock and commodities exchanges, but a growing

portion are not; the total outstanding amount of these non-exchange derivatives, denominated

"over-the-counter" derivatives, was $43.2 trillion at the end of 1995, up 17% from the $36.9 trillion

outstanding at the end of 1994. See Samer Iskandar, SurveyInternational Capital Markets '96:

A Blip in the Growth Trend, FIN. TIMES, June 10, 1996, at 7. The growing prominence of

over-the-counter derivatives and the spectacular losses suffered by some investors, such as Orange

County, have sparked concern that derivatives may be insufficiently regulated. See Goldman, supra,

at 1119-25; J. Christopher Kojima, Product-Based Solutionsto Financial Innovation: The Promise

and Danger of Applying the Federal Securities Lawsto OTC Derivatives, 33AM.BUS.L.J. 259, 261-

63 (1995). What regulatory options are currently available in regard to derivatives is a source of

debate, and commentators disagree in particular as to whether derivatives meet the common

enterprise and expectation of profits from the efforts of others requirements of the Howey test so as

to qualify asinvestment contracts. Compare Procter & Gamble Co. v. Bankers Trust Co., No. C-1-

94-735, 1996 WL 249435 at *6 (S.D. Ohio May 9, 1996) with Kojima, supra, at 298-304. But it is

at least possible to imagine a type of derivative arrangement that would meet the Howey requirements

as they have existed up to now. For example, a dealer could organize a complex set of derivative

transactionsfor a group ofinvestors with the aimof adopting offsetting positionsin different markets

that would generate a certain percentage ofreturn. The realization of profits in this situation depends

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 34 of 35
<<The pagination in this PDF may not match the actual pagination in the printed slip opinion>>

predominatelyon the dealer's expertise in balancing positionsin different markets against one another

rather than onwhat happensin a particular market. Consequently, this type of derivative arrangement

could qualify as an investment contract under the approach I have outlined, but it could not so qualify

under the majority's. Since the significant managerial activity of the derivative dealer---the selection

and structuring of the derivative instrument and the investigation of the parties' financial

statususually occurs before the parties enter into the transaction, the majority's approach would

prevent most derivative transactions from ever constituting investment contracts. As a result, the

majority's approach could seriouslyhamperregulators astheyseek to determine how best to treat this

burgeoning class of financial instruments.

I believe that the majority's position, precluding pre-purchase managerial activities of a

promoter from ever satisfying the third prong of the Howey test, is unwarranted and will serve to

undercut the necessary flexibility of our securities laws. An approach that allows pre-purchase

activities of the promoter to satisfy the third prong when the realization of investors' profits depends

predominantly on these activities offers a means of distinguishing between ordinary investments and

securities that both better conforms to precedent and has a less restrictive effect on the securities

laws. Therefore, I respectfully dissent.

USCA Case #96-5018 Document #209573 Filed: 07/05/1996 Page 35 of 35