Opinion ID: 199659
Heading Depth: 1
Heading Rank: 3

Heading: administering the tripartite test

Text: 27 What remains is to analyze whether purchases of the privileged company's shares constitute investment contracts. We turn to that task, taking the three Howey criteria in sequence. 28
29 The first component of the Howey test focuses on the investment of money. The determining factor is whether an investor chose to give up a specific consideration in return for a separable financial interest with the characteristics of a security. Daniel, 439 U.S. at 559. We conclude that the SEC's complaint sufficiently alleges the existence of this factor. 30 To be sure, SG disputes the point. It argues that the individuals who purchased shares in the privileged company were not so much investing money in return for rights in the virtual shares as paying for an entertainment commodity (the opportunity to play the StockGeneration game). This argument suggests that an interesting factual issue may await resolution -- whether participants were motivated primarily by a perceived investment opportunity or by the visceral excitement of playing a game. Nevertheless, this case comes to us following a dismissal under Rule 12(b)(6), and the SEC's complaint memorializes, inter alia, SG's representation that participants could firmly expect a 10% profit monthly on purchases of the privileged company's shares. That representation plainly supports the SEC's legal claim that participants who invested substantial amounts of money in exchange for virtual shares in the privileged company likely did so in anticipation of investment gains. Given the procedural posture of the case, no more is exigible to fulfill the first part of the Howey test. 31
32 The second component of the Howey test involves the existence of a common enterprise. Before diving headlong into the sea of facts, we must dispel the miasma that surrounds the appropriate legal standard. 33 1. The Legal Standard. Courts are in some disarray as to the legal rules associated with the ascertainment of a common enterprise. See generally II Louis Loss & Joel Seligman, Securities Regulation 989-97 (3d ed. rev. 1999). Many courts require a showing of horizontal commonality -- a type of commonality that involves the pooling of assets from multiple investors so that all share in the profits and risks of the enterprise. See SEC v. Infinity Group Co., 212 F.3d 180, 187-88 (3d Cir. 2000), cert. denied, 121 S. Ct. 1228 (2001); SEC v. Life Partners, Inc., 87 F.3d 536, 543 (D.C. Cir. 1996); Wals v. Fox Hills Dev. Corp., 24 F.3d 1016, 1018 (7th Cir. 1994); Revak v. SEC Realty Co., 18 F.3d 81, 87 (2d Cir. 1994); Curran v. Merrill Lynch, Pierce, Fenner & Smith, 622 F.2d 216, 222, 224 (6th Cir. 1980), aff'd on other grounds, 456 U.S. 353 (1982). Other courts have modeled the concept of common enterprise around fact patterns in which an investor's fortunes are tied to the promoter's success rather than to the fortunes of his or her fellow investors. This doctrine, known as vertical commonality, has two variants. Broad vertical commonality requires that the well-being of all investors be dependent upon the promoter's expertise. See Villeneuve v. Advanced Bus. Concepts Corp., 698 F.2d 1121, 1124 (11th Cir. 1983), aff'd en banc, 730 F.2d 1403 (11th Cir. 1984); SEC v. Koscot Interplanetary, Inc., 497 F.2d 473, 478-79 (5th Cir. 1974). In contrast, narrow vertical commonality requires that the investors' fortunes be interwoven with and dependent upon the efforts and success of those seeking the investment or of third parties. SEC v. Glenn W. Turner Enters., 474 F.2d 476, 482 n.7 (9th Cir. 1973). 34 Courts also differ in the steadfastness of their allegiance to a single standard of commonality. Two courts of appeals recognize only horizontal commonality. See Wals, 24 F.3d at 1018; Curran, 622 F.2d at 222, 224. Two others adhere exclusively to broad vertical commonality. 1 See Villeneuve, 698 F.2d at 1124; Koscot, 497 F.2d at 478-79. The Ninth Circuit recognizes both horizontal commonality and narrow vertical commonality. See Hocking v. Dubois, 885 F.2d 1449, 1459 (9th Cir. 1989) (en banc). To complicate matters further, four courts of appeals have accepted horizontal commonality, but have not yet ruled on whether they also will accept some form of vertical commonality. See Infinity Group, 212 F.3d at 187 n.8; Life Partners, 87 F.3d at 544; Teague, 35 F.3d at 986 n.8; Revak, 18 F.3d at 88. At least one of these courts, however, has explicitly rejected broad vertical commonality. See Revak, 18 F.3d at 88. 35 Thus far, neither the Supreme Court nor this court has authoritatively determined what type of commonality must be present to satisfy the common enterprise element. We came close in Rodriguez, in which we hinted at a preference for horizontal commonality. There, promoters selling parcels of land made strong and repeated suggestions that the surrounding area would develop into a thriving residential community. 990 F.2d at 11. Although we held that the financial arrangement did not constitute a security, we implied that an actual commitment by the promoters to develop the community themselves, coupled with the buyers' joint financing of the enterprise, could constitute a common enterprise. See id. 36 The case at bar requires us to take a position on the common enterprise component of the Howey test. We hold that a showing of horizontal commonality -- the pooling of assets from multiple investors in such a manner that all share in the profits and risks of the enterprise -- satisfies the test. This holding flows naturally from the facts of Howey, in which the promoter commingled fruit from the investors' groves and allocated net profits based upon the production from each tract. See Howey, 328 U.S. at 296. Adopting this rule also aligns us with the majority view and confirms the intimation of Rodriguez. Last, but surely not least, the horizontal commonality standard places easily ascertainable and predictable limits on the types of financial instruments that will qualify as securities. 2 37 2. Applying the Standard. Here, the pooling element of horizontal commonality jumps off the screen. The defendants' website stated that: The players' money is accumulated on the SG current account and is not invested anywhere, because no investment, not even the most profitable one, could possibly fully compensate for the lack of sufficiency in settling accounts with players, which lack would otherwise be more likely. Thus, as the SEC's complaint suggests, SG unambiguously represented to its clientele that participants' funds were pooled in a single account used to settle participants' on-line transactions. Therefore, pooling is established. 38 Of course, horizontal commonality requires more than pooling alone; it also requires that investors share in the profits and risks of the enterprise. The SEC maintains that two separate elements of SG's operations embody the necessary sharing. First, it asserts that SG was running a Ponzi or pyramid scheme dependent upon a continuous influx of new money to remain in operation, 3 and argues that such arrangements inherently involve the sharing of profit and risk among investors. Second, the SEC construes SG's promise to divert a portion of its profits from website operations to support the privileged company's shares as a bond that ties together the collective fortunes of those who have purchased the shares. While we analyze each of these theories, we note that any one of them suffices to support a finding of commonality. 39 We endorse the SEC's suggestion that Ponzi schemes typically satisfy the horizontal commonality standard. In Infinity Group, investors contributed substantial sums of money to a trust established by the defendants and received in exchange a property transfer agreement guaranteeing stupendous annual rates of return. 212 F.3d at 184-85. The economic guarantees were based upon the trust's purported performance experience, financial connections, and ability to pool large amounts of money. Id. at 185. Participants were promised that investing in the trust was a risk-free proposition, and that their cash infusions would be repaid in full upon demand. Id. at 184-85. Expected profits were a function of the number of capital units held pursuant to the contract with the trust; in turn, the number of capital units allocated to each investor was directly proportional to the size of his or her investment. Id. at 188-89. On these facts, the Third Circuit held that horizontal commonality existed, emphasizing that under the plan's terms each investor was entitled to receive returns directly proportionate to his or her investment stake. Id. at 188. 40 SG's virtual shares bear striking factual similarities to the financial instruments classified as investment contracts in Infinity Group. SG's flat 10% guaranteed return applied to all privileged company shares, expected returns were dependent upon the number of shares held, the economic assurances were based on the promoter's ability to keep the ball rolling, the investment was proclaimed to be free from risk, and participants were promised that their principal would be repaid in full upon demand. Like the Third Circuit, we think that these facts suffice to make out horizontal commonality. 41 In all events, SG's promise to pay referral fees to existing participants who induced others to patronize the virtual exchange provides an alternative basis for finding horizontal commonality. The SEC argues convincingly that this shows the existence of a pyramid scheme sufficient to satisfy the horizontal commonality standard. The most instructive comparison is to SEC v. Int'l Loan Network, 968 F.2d 1304 (D.C. Cir. 1992). A key element of the defendants' elaborate, multifaceted, financial distribution network in that case was a pyramid sales program in which participants stood to receive 50% commissions on membership fees paid by individuals whom they recruited, plus lesser commissions on sales by those recruited by their recruits. Id. at 1306. The court of appeals ruled that this structure satisfied the requirements of horizontal commonality. Id. at 1308. In the process, it relied heavily upon the fact that the network generated income only through constant expansion of membership, which depended on individual recruiting and the appeal of the promoter's larger marketing campaign. Id. 42 Like the investors in Int'l Loan Network, StockGeneration participants who recruited new participants were promised bonuses worth 20%-30% of the recruit's payments. Taking as true the SEC's plausible allegation that the sine qua non of SG's operations was the continued net inflow of funds, the investment pool supporting the referral bonus payments was entirely dependent upon the infusion of fresh capital. Since all participants shared in the profits and risks under this pyramidal structure, it furnishes the sharing necessary to warrant a finding of horizontal commonality. 43 We will not paint the lily. We conclude, without serious question, that the arrangement described in the SEC's complaint fairly can be characterized as either a Ponzi or pyramid scheme, and that it provides the requisite profit-and-risk sharing to support a finding of horizontal commonality. Taking as true the SEC's allegation that SG's ability to fulfill its pecuniary guarantees was fully predicated upon the net inflow of new money, the fortunes of the participants were inextricably intertwined. As long as the privileged company continued to receive net capital infusions, existing shareholders could dip into the well of funds to draw out their profits or collect their commissions. But all of them shared the risk that new participants would not emerge, cash flow would dry up, and the underlying pool would empty. 44 SG's most perfervid argument against a finding of horizontal commonality consists of a denial that its operations comprise a Ponzi or pyramid scheme. It says that any such scheme requires a material misrepresentation of fact and some element of fraud or deception, and adds that those additional features are lacking here; to the contrary, the rules of StockGeneration were fully and accurately disclosed to all participants. We do not gainsay that considerable disclosure occurred. SG emphasized that new participants constituted the sole source of all financial income for its StockGeneration website. 4 Indeed, in describing the structure and mechanism of its virtual stock exchange, SG drew a colorful analogy between the privileged company's shares and an enormous card table with a mountain of money. According to SG, thousands of participants continuously threw money onto the table by purchasing shares in the privileged company, while other participants simultaneously sold their shares back to the exchange to retrieve their winnings from the table. SG remarked that the system would remain stable so long as the size of the mountain either remained constant or continued to grow. 45 Despite the fact that SG was relatively candid in pointing out the fragile structure of the venture, its argument lacks force. Even if we assume, for argument's sake, that misrepresentations of fact and badges of fraud are necessary for the existence of a Ponzi or pyramid scheme, the SEC's complaint contains allegations sufficient, as a matter of pleading, to establish both elements. First, the complaint alleges that SG materially misrepresented the nature of the enterprise by concealing the fact that the supply of new participants inevitably would be exhausted, causing the scheme to implode and all existing participants to lose their money. 5 Second, the SEC's complaint plausibly characterized SG's flat guarantee of a 10% monthly return on the privileged company's shares and its assurances that it would support those shares as material misrepresentations of fact. Third, the SEC alleged that SG deceived participants by failing to disclose its intent to keep investor money for itself. 46 Of course, given its this was only a game defense, SG may well have colorable arguments anent materiality (i.e., that, based upon its explicit disclosures, no reasonable investor should have been deceived or misled). But it is not this court's place to resolve such fact-sensitive questions in the context of a Rule 12(b)(6) motion for dismissal. See Cruz v. Melecio, 204 F.3d 14, 21-22 (1st Cir. 2000). For present purposes, it is enough that the SEC's allegations, taken as true, satisfy the common enterprise component of the Howey test. 6 47
48 The final component of the Howey test -- the expectation of profits solely from the efforts of others -- is itself divisible. We address each sub-element separately. 49 1. Expectation of Profits. The Supreme Court has recognized an expectation of profits in two situations, namely, (1) capital appreciation from the original investment, and (2) participation in earnings resulting from the use of investors' funds. Forman, 421 U.S. at 852. These situations are to be contrasted with transactions in which an individual purchases a commodity for personal use or consumption. Id. at 858. The SEC posits that SG's guarantees created a reasonable expectancy of profit from investments in the privileged company, whereas SG maintains that participants paid money not to make money, but, rather, to acquire an entertainment commodity for personal consumption. Relying heavily on Forman, the district court accepted SG's thesis. SEC v. SG Ltd., 142 F. Supp. 2d at 130-31. We do not agree. 50 In Forman, apartment dwellers who desired to reside in a New York City cooperative were required to buy shares of stock in the nonprofit cooperative housing corporation that owned and operated the complex. Based on its determination that investors were attracted solely by the prospect of acquiring a place to live, and not by financial returns on their investments, the Forman Court held that the cooperative housing arrangement did not qualify as a security under either the stock or investment contract rubrics. Id. at 853. The Court's conclusion rested in large part upon an Information Bulletin distributed to prospective residents which stressed the nonprofit nature of the cooperative housing endeavor. Id. at 854 (emphasizing that [n]owhere does the Bulletin seek to attract investors by the prospectof profits resulting from the efforts of the promoters or third parties). 7 51 We think it noteworthy that the Forman Court contrasted the case before it with Joiner. In that case, economic inducements made by promoters in conjunction with the assignment of oil well leases transformed the financial instrument under consideration from a naked leasehold right to an investment contract. 320 U.S. at 348. The Joiner Court found dispositive advertising literature circulated by the promoters which emphasized the benefits to be reaped from the exploratory drilling of a test well. Id. (Had the offer mailed by defendants omitted the economic inducements of the proposed and promised exploration well, it would have been a quite different proposition.). 52 The way in which these cases fit together is instructive. In Forman, the apartment was the principal attraction for prospective buyers, the purchase of shares was merely incidental, and the combination of the two did not add up to an investment contract. 421 U.S. at 853. In Joiner, the prospect of exploratory drilling gave the investments most of their value and all of their lure, the leasehold interests themselves were no more than an incidental consideration in the transaction, and the combination of the two added up to an investment contract. 320 U.S. at 349. This distinction is crucial, see Forman, 421 U.S. at 853 n.18, and it furnishes the beacon by which we must steer. 53 Seen in this light, SG's persistent representations of substantial pecuniary gains for privileged company shareholders distinguish its StockGeneration website from the Information Bulletin circulated to prospective purchasers in Forman. While SG's use of gaming language is roughly analogous to the cooperative's emphasis on the nonprofit nature of the housing endeavor, SG made additional representations on its website that played upon greed and fueled expectations of profit. For example, SG flatly guaranteed that investments in the shares of the privileged company would be profitable, yielding monthly returns of 10% and annual returns of 215%. In our view, these profit-related guarantees constitute a not-very-subtle form of economic inducement, closely analogous to the advertising representations in Joiner. In the same way that the prospect of profitable discoveries induced investors to buy oil well leases, the prospect of a sure-fire return lured participants to buy shares in the privileged company (or so it can be argued). 54 This is not to say that SG's gaming language and repeated disclaimers are irrelevant. SG has a plausible argument, forcefully advanced by able counsel, that no participant in his or her right mind should have expected guaranteed profits from purchases of privileged company shares. But this argument, though plausible, is not inevitable. In the end, it merely gives rise to an issue of fact (or, perhaps, multiple issues of fact) regarding whether SG's representations satisfy Howey's expectation-of-profit requirement. 55 2. Solely from the Efforts of Others. We turn now to the question of whether the expected profits can be said to result solely from the efforts of others. The courts of appeals have been unanimous in declining to give literal meaning to the word solely in this context, instead holding the requirement satisfied as long as the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise. Turner Enters., 474 F.2d at 482; accord Rivanna Trawlers Unlimited v. Thompson Trawlers, Inc., 840 F.2d 236, 240 n.4 (4th Cir. 1988) (adopting this holding and listing eight other circuits which have held to like effect). This liberal interpretation of the requirement seemingly comports with the Supreme Court's restatement of the Howey test. See Forman, 421 U.S. at 852 (explaining that the touchstone is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others). 8 56 We need not reach the issue of whether a lesser degree of control by a promoter or third party suffices to give rise to an investment contract because SG's alleged scheme meets the literal definition of solely. According to the SEC's allegations, SG represented to its customers the lack of investor effort required to make guaranteed profits on purchases of the privileged company's shares, noting, for example, that playing with [the] privileged shares practically requires no time at all. SG was responsible for all the important efforts that undergirded the 10% guaranteed monthly return. As the sole proprietor of the StockGeneration website, SG enjoyed direct operational control over all aspects of the virtual stock exchange. And SG's marketing efforts generated direct capital investment and commissions on the transactions (which it pledged to earmark to support the privileged company's shares). 57 SG's payment of referral bonuses to participants who introduced new users to the website does not require a different result. Even if a participant chose not to refer others to the StockGeneration website, he or she still could expect, based on SG's profit-related guarantees, to reap monthly profits from mere ownership of the privileged company's shares. Accordingly, the SEC's complaint makes out a triable issue on whether participants expected to receive profits derived solely from the efforts of others.