Opinion ID: 2439704
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Heading: Investment Contract

Text: The term investment contract was construed by the United States Supreme Court in S. E. C. v. W. J. Howey Co., 328 U.S. 293, 301, 66 S.Ct. 1100, 1104, 90 L.Ed. 1244, 1251 (1946) as follows: The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others. The definition has been widely accepted in state and federal cases. Texas courts have also accepted and used it. Clayton Brokerage Co. of St. Louis v. Mouer, 520 S.W.2d 802 (Tex.Civ.App.Austin, writ ref'd n. r. e.), dism'd as moot on rehearing per curiam, 531 S.W.2d 805 (Tex.1975); King Commodity Co. of Texas v. State, 508 S.W.2d 439 (Tex.Civ.App.Dallas 1974, no writ). The Howey test embodies four requirements: (1) investment of money; (2) a common enterprise; (3) expectation of profits; (4) solely from the efforts of others. The Howey case involved a promoter who sold small plots of land which were to be used as citrus groves. Along with the land sale contract, the Howey-in-the-Hills Service Company offered a service contract for the development and cultivation of the land as well as the marketing of fruit raised thereon. Almost all of the investors purchased the service contract with the plots of land. The Supreme Court held that under the above quoted definition the contracts were investment contracts and therefore securities. The Howey test has been applied in many cases to hold various forms of money-making schemes to constitute investment contracts. There is little dispute as to the first and third elements of the Howey test in this case. The purchase of commodity options was obviously an investment of money with the expectation of profits. The controversy is whether the sale of commodity options by CTC to investors constituted a common enterprise, with investors' profits to come solely from the efforts of others. CTC argues that the common enterprise or commonality element is lacking because the profits of each customer depended on the fluctuations of the commodity market and the customer's own investment decisions. Furthermore, they contend that there was no direct relationship between options sold to different customers. We agree that there was no horizontal commonality in this case. Horizontal commonality is between investors and means that the success of one investor is concomitant with the success of other investors. Obviously, different customers of CTC had varying investment results because different commodity options were bought and exercised at different times. The more recent weight of authority, however, permits a showing of vertical commonalitycommon enterprise between investor and promoter, so that the success of the investor is dependent upon the efforts and success of the promoter. S. E. C. v. Koscot Interplanetary, Inc., 497 F.2d 473 (5th Cir. 1974); S. E. C. v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476 (9th Cir.), cert. denied, 414 U.S. 821, 94 S.Ct. 117, 38 L.Ed.2d 53 (1973). Here, the ability of CTC to perform its contractual obligation was solely dependent on the success of the hedging program conducted by STC. Approximately seventy per cent of customers' premiums went to STC to invest and cover the market position of CTC. The fact that each investor's activity is unitary and unrelated to other investors does not destroy the common enterprise requirement. The situation was quite similar in King Commodity Co. of Texas v. State, 508 S.W.2d 439, 443 (Tex.Civ.App.Dallas 1974, no writ), in which the court stated: [T]he money necessary to hedge each option could only come from pooling of the premiums paid by other customers and that if King's use of this money in its trading operations was not profitable, no funds would be available to pay the customers their profits. Thus ... the evidence establishes a common enterprise within the Howey test. We find that the requisite common enterprise existed in this case. The final element of the Howey test which is in dispute is whether the profits anticipated by investors would result solely from the efforts of others. The court of civil appeals found that this requirement of an investment contract was not satisfied, and reversed on that basis. It is this finding with which we disagree. Early cases construing the Howey test gave literal effect to the phrase solely from the efforts of others. The investor was required to have exerted no effort with regard to the investment. The more recent trend, however, and in our view the more reasonable approach, is to use a more realistic test which inquires whether the investor made any significant efforts. The solely from the efforts of others requirement could be easily evaded by requiring the investor to exert some modicum of effort, such as picking one orange in the Howey citrus groves. This would be a blind and mechanical view of what constitutes an investment contract. We agree that the more realistic test is whether the efforts made by those other than the investor are undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise. S. E. C. v. Glenn W. Turner Enterprises, Inc., supra at 482; King Commodity Co. of Texas v. State, supra ; State Commissioner of Securities v. Hawaii Market Center, Inc., 52 Haw. 642, 485 P.2d 105 (1971). In this case, CTC actively sought investors inexperienced in the commodities market. The salesmen provided these unsophisticated investors with market reports and buy and sell recommendations, but the investor decided on his own whether to exercise his option. It is the defendants' contention that the exercise of the option is the effort of investors sufficient to prevent the options from being securities. We believe that the speculative nature of the investment necessarily contemplated that the investor would be heavily dependent upon CTC personnel and the advice which they gave. CTC personnel frankly testified that customers were not supposed to understand the CTC business operation. CTC salesmen used a WATS line to call customers when the market moved to a point of being profitable, and advised the customer what to do. Although the final decision was left to the customer, he rarely had any choice but to follow the advice given him by CTC. Upon a very similar set of facts, the Austin Court of Civil Appeals stated our view of this case: Once a customer has parted with his money, he is dependent upon the financial responsibility, business ability, integrity, expertise and market advice of appellant and, unknown to him, third parties who participate in appellant's commodity trading. It is the essential managerial efforts of those other than the investor which affect the failure or success of the enterprise. Investors are not required to, and they do not, exert any significant efforts in order to make a profit on their investment. For all practical purposes the critical managerial decisions affecting the investor's funds are solely within the control of appellant. And finally, an investor cannot without the actual assistance of appellant, exercise his option and receive his profit. Clayton Brokerage Co. of St. Louis v. Mouer, 520 S.W.2d 802, 809 (Tex.Civ.App. Austin, writ ref'd n. r. e.), dism'd as moot on rehearing per curiam, 531 S.W.2d 805 (Tex.1975). We recognize that discretionary accounts were involved in Clayton Brokerage, by which the seller had de facto control of the customer's account with authority to buy or sell. We do not, however, view that as a distinguishing factor from this case since CTC was relied upon so heavily by its customers. Although the customers in this case as well as in Clayton Brokerage had the legal right to participate in the commodity options trading, the substance of the transaction was that the seller would exert the significant investment efforts. The investor was not required to actively participate and seldom did. We conclude, therefore, that the commodity options sold by CTC in this case meet the requirements of an investment contract, as set forth in the Howey test.