Opinion ID: 720633
Heading Depth: 2
Heading Rank: 2

Heading: The Three-Part Test of Howey

Text: 28 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, 66 S.Ct. at 1102-03. To the extent practical we examine each component of the test separately.
29 The SEC argues that the profits test requires only that the investor could lose his investment, 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's life 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. 30 Arguing against the profits test as set forth in Guidry--which, by the way, is unclear about whether possible loss and fluctuating return are sufficient or merely necessary conditions--LPI maintains that under United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 852, 95 S.Ct. 2051, 2060, 44 L.Ed.2d 621 (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' [318 U.S.App.D.C. 309] 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 value--presumably because the insured's death draws nearer with the passage of time, thus increasing 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 upon the inexorable passage of time and the inevitable death of the insured. 31 On the other hand, the definition in Forman was apparently intended only to summarize the cases that had by then come before the Court--not, as LPI implies, to preempt future development upon the basis of further experience. In full context, this is what the Court said: 32 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, 64 S.Ct. 120, 122, 88 L.Ed. 88 (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, 88 S.Ct. 548, 554-55, 19 L.Ed.2d 564 (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, [328 U.S.] at 300 [66 S.Ct. at 1103-04]. 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. 33 421 U.S. at 852-53, 95 S.Ct. at 2060-61. 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 form of consumer loan--neither of which ordinarily involves capital appreciation or earnings resulting 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. 34 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. 35 The asset acquired by an LPI investor is a claim on future death benefits. The buyer is obviously purchasing not for consumption--unmatured claims cannot be currently consumed--but 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.
36 The second element of the Howey test for a security is that there be a common enterprise. So-called horizontal commonality--defined by the pooling of investment funds, shared profits, and shared losses--is 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 aggregates their funds to purchase the death benefits of an insurance policy. If the insured dies in a relatively short time, then the investors realize 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. 37 [318 U.S.App.D.C. 310] 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. 38 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' funds--for example, by passing their checks directly to the seller at the closing.) Meanwhile, counsel for LPI volunteered that the issue of selling some minimum acceptable percentage of a policy has never arisen because LPI has always attracted purchasers for the full interest being offered. He went on to acknowledge, however, 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. 39 Therefore, we think that pooling is in practice an essential ingredient of the 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 of the larger deal. Because LPI's viatical settlements entail this implicit form of 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 commonality--pooling, profit sharing, and loss sharing--attend 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 of the common enterprise test recognized in some circuits. See, e.g., Brodt v. Bache & Co., Inc., 595 F.2d 459, 461 (9th Cir.1978).) 40 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. 41 The SEC, for its part, would have us distinguish Rodriguez from the present case on the ground that here the promoter makes specific commitments effective after the investors purchase their interests. Indeed, the First Circuit did remark that commitments and promises incident to a land 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 [318 U.S.App.D.C. 311] addressed to the third part of the Howey test--whether profits are expected to arise from the efforts of others. We consider that question in the next section, where we take up the importance of the promoter's post-purchase commitments. 42
43 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. 44 By its terms Howey requires that profits be generated solely from the efforts of others. 328 U.S. at 298, 66 S.Ct. at 1102-03. Although the lower courts have given the Supreme Court's definition of a security broader sweep 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. Glenn W. Turner Enterprises, Inc., 474 F.2d 476, 482 (9th Cir.1973) (efforts of others must be undeniably significant 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 those post-purchase functions that are entrepreneurial and those that are ministerial; thereafter, we consider the relevance of pre-purchase entrepreneurial services. 45 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. 46 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 of the 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. 47 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 [318 U.S.App.D.C. 312] 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. 48 The Commission disputes the district court's characterization of post-purchase services as 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 viatical settlements. Third, LPI is quite specific in warning its clients that 49 viatical transactions are not liquid assets. There is no established market for the resale of such 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. 50 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 less that their profits derive predominantly from those efforts. 51 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. 52 In sum, the SEC has not identified any significant non-ministerial service that LPI or Sterling performs for investors once they have purchased their fractional interests in a viatical settlement. Nor do we find that any of the ministerial functions have a material impact upon the profits of the investors. Therefore, we turn to the question whether LPI's pre-purchase services count as the efforts of others under the Howey test. 53 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. 54 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 investors [318 U.S.App.D.C. 313] the promoters had promised to make future improvements to 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. 55 In both Noa and McCown, the courts of appeals regarded the promoter's pre-purchase efforts as insignificant to the question whether the investments--in silver bars and parcels of land, respectively--were securities. The different outcomes trace wholly to the promoters' commitment to perform meaningful post-purchase functions in McCown but not in Noa. 56 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 pre-purchase activities cannot alone support a finding that investors' profits derive from the activities of LPI. Instead, the court relied upon the pre-closing activities in addition to the post-closing activities that LPI continues to perform. 57 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 its investors 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 overall success 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. 58 The SEC urges us to go even further than did the district court, however, in appraising the significance of LPI's pre-purchase activities insofar as they 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 notes that LPI may continue to perform some functions, such as preparing the preliminary agreement and evaluating the insured's policy and medical file, 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. 59 Absent compelling legal support for the Commission's theory--and the Commission actually furnishes no support at all--we 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 federal securities laws. 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 anyone else is expected to make further efforts that will affect the outcome of the investment, then the need for federal securities regulation is greatly diminished. While, to be sure, coverage under the 1933 Act might increase the quantity (and perhaps the quality) of information available to the investor prior to the closing, the securities laws [are not] a broad federal remedy for all fraud. Marine Bank v. Weaver, 455 U.S. 551, 556, 102 S.Ct. 1220, 1223, 71 L.Ed.2d 409 (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 [318 U.S.App.D.C. 314] common venture with profits derived from the entrepreneurial or managerial efforts of others. Forman, 421 U.S. at 852, 95 S.Ct. at 2060. 60 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 insured--just 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.  61 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 vehicle was deemed a security subject to the federal securities laws although the investor did not look to the promoter (or another party) to provide significant post-purchase efforts. 62 In this case it is the length of the insured's life 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. 63