Opinion ID: 2608924
Heading Depth: 4
Heading Rank: 2

Heading: Did the Hearing Officer's Decision Have a Reasonable Basis in the Law?

Text: The primary purpose [of Alaska's Blue Sky law] is to protect the unwary and unsophisticated members of the general public from deceit and fraud in securities transactions. Pratt v. Kirkpatrick, 718 P.2d 962, 969 (Alaska 1986). In both Hentzner and American Gold & Diamond, we applied federal cases interpreting the Securities Act of 1933, reasoning that, given the analogous definitions of securities under state and federal statutes, federal case law provides a reasonable basis to conclude that an offering is a security within AS 45.55.130(12). Hentzner, 613 P.2d at 823 & n. 4; American Gold & Diamond, 678 P.2d at 1345-47 & n. 5; 15 U.S.C. § 77b(1) (1981). Thus, if these notes would be securities under federal law, then the hearing officer had a reasonable basis for finding them to be securities under state law. In the recently decided case of Reves v. Ernst & Young, ___ U.S. ___, 110 S.Ct. 945, 108 L.Ed.2d 47 (1990), the Supreme Court resolved a long standing debate among the circuits as to how the Federal Securities Act should be applied to notes. All nine justices agreed that the literal or family resemblance test of the Second Circuit was the most apt. See id. at ___ & ___, 110 S.Ct. at 950 & 956 (Rehnquist, C.J., concurring in part and dissenting in part). See generally Exchange Nat'l Bank of Chicago v. Touche Ross & Co., 544 F.2d 1126, 1137 (2nd Cir.1976) (Friendly, J.), modified, 726 F.2d 930 (2nd Cir.1984). The Court in Reves limited the application of the investment contract test of SEC v. W.J. Howey, 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946) to investment contracts. The Court reasoned that just because a note is not also an investment contract does not necessarily take it out of the statute, which on its face applies to notes. Reves, ___ U.S. at ___, 110 S.Ct. at 950 (To hold that a `note' is not a `security' unless it meets a test designed for an entirely different variety of instrument `would make the Acts' enumeration of many types of instruments superfluous, `... and would be inconsistent with Congress' intent to regulate the entire body of instruments sold as investments.) (citations omitted). In American Gold & Diamond, we adopted the Howey investment contract test to analyze the investment contract at issue. American Gold & Diamond, 678 P.2d at 1345-46. American Gold & Diamond did not involve a note. Id. at 1345. Howey is still good law after Reves as to investment contracts; some, but not all, notes also meet the Howey test for investment contracts. Reves, ___ U.S. at ___, 110 S.Ct. at 950. Nevertheless, both notes and investment contracts fall within the statutory definition of security. [4] The Reves test for notes begins with the plain language of the statute, which on its face applies to notes, unless the context otherwise requires. Id. The burden is on the defendant to prove that a note is not a security because the context otherwise requires. Id. Not all notes are securities. The purpose of the federal securities acts is to regulate the field of investment; the definition of security should be interpreted sufficiently broadly to encompass any instrument that might be sold as an investment. Id. at ___, 110 S.Ct. at 948. In an effort to give substance to the investment/non-investment dividing line, the Reves Court, drawing on Touche Ross, 544 F.2d at 1138, set forth a broad, non-exclusive laundry list of contexts in which notes are not securities: ... the note delivered in consumer financing, the note secured by a mortgage on a home, the short-term note secured by a lien on a small business or some of its assets, the note evidencing a character loan to a bank customer, short-term notes secured by an assignment of accounts receivable, or a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized). Reves, ___ U.S. at ___, 110 S.Ct. at 950, quoting Touche Ross, 544 F.2d at 1138. See also Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930, 939 (2nd Cir.), cert. denied, 469 U.S. 884, 105 S.Ct. 253, 83 L.Ed.2d 190 (1984) (adding to the laundry list a commercial bank loan to finance current operations of a borrower's business); Equitable Life Assur. Soc'y of the United States v. Arthur Andersen & Co., 655 F. Supp. 1225, 1235-44 (S.D.N.Y. 1987) (unsubordinated loan from insurance company made in the regular course of its business, limiting the borrower's ability to incur further debt); Boeck v. Logan 480 Dairy Farm, 606 F. Supp. 868, 871 (S.D.Iowa 1985) (purchase money security note on a dairy farm). If a note is not on the list, or does not bear a strong family resemblance to something on this list, then it is a security under federal law. Reves, ___ U.S. at ___, 110 S.Ct. at 950; Touche Ross, 544 F.2d at 1138. The Reves Court then announced four factors shared by the items on the list, to help guide future additions to it: First, we examine the transaction to assess the motivations that would prompt a reasonable seller and buyer to enter into it. If the seller's purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a security. If the note is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller's cash-flow difficulties, or to advance some other commercial or consumer purpose, on the other hand, the note is less sensibly described as a security. Second, we examine the plan of distribution of the instrument, to determine whether it is an instrument in which there is common trading for speculation or investment. Third, we examine the reasonable expectations of the investing public: The Court will consider instruments to be securities on the basis of such public expectations, even where an economic analysis of the circumstances of the particular transaction might suggest that the instruments are not securities as used in that transaction. Finally, we examine whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary. Reves, ___ U.S. at ___-___, 110 S.Ct. at 951-52 (citations omitted). The hearing officer below applied the Second Circuit test adopted in Reves, and concluded that the notes at issue were securities, because they bore no family resemblance at all to the commercial transactions of the Touche Ross list: The promissory notes issued to Messrs. Drew and Thompson are not of the type described by the Second Circuit and bear not even the faintest resemblance to them. These notes were not delivered in consumer financing or secured in any way, do not formalize an institutional loan to a home buyer, and do not resemble cash-flow financing by a business or anything similar. Messrs. Drew and Thompson apparently regarded the loans as profit-making investments. Furthermore, this is the kind of transaction in which the additional protection available under the securities laws is needed. [Messrs.] Drew and Thompson were relatively unsophisticated investors who incurred significant risk without the practical ability to obtain and evaluate necessary information before taking that risk. In fact, there was a very high risk of non-repayment, but not only was this fact not made clear, it was not mentioned. Moreover, this transaction was part of a broader pattern of similar transactions, nationwide in scope, involving large numbers of transactions, large amounts of money and focusing on vulnerable people. The offer and sale of notes to Messrs. Drew and Thompson thus did not take place in a context that requires the notes to be treated as other than securities. Far from finding no compelling reasons for disregarding the plain language of the statute, I find compelling reasons for adhering to it. Application of the Second Circuit's literal test to this case thus dictates the conclusion that the notes are securities within the meaning of AS 45.55.130. We agree. The notes in this case bear no resemblance at all to any of the routine commercial financing arrangements excluded from coverage by Reves and Touche Ross nor has Caucus shown any reason to exclude these notes from coverage. The notes were sold in order to finance Caucus' fund-raising activity, and Drew and Thompson were both led to believe that they would be repaid. This cuts in favor of finding the notes to be securities. Reves, ___ U.S. at ___, 110 S.Ct. at 950. Emphasized in Reves was that the notes there, like the notes here, were specifically offered at an interest rate higher than Drew and Thompson were earning on their investments. Id. at ___, 110 S.Ct. at 952. Moreover, as in Reves, the plan of distribution here was coordinated and national in scope. Id. Drew and Thompson were not the only targets of Caucus: ten others have made similar loans in Alaska, and similar cease and desist orders have been issued in Minnesota, Indiana, and Washington, with similar proceedings having begun in Maryland and Illinois. Drew and Thompson were led to believe and did believe that they would earn a profit; the public's reasonable perceptions of notes as investments militate in favor of a finding of security. See id. Finally, the notes here were not collateralized or insured; thus, just as in Reves, there was no risk-reducing factor cutting against a finding of security. Id. Given the foregoing, and that this scheme was found to be fraudulent and thus squarely within the purpose of the Blue Sky Act, the Division had at least a reasonable basis in law for finding the notes to be securities. We affirm this determination. Caucus argues that a note cannot be a security because securities entail profits and fixed rates of return are not profits. We reject this proposition. Defendants maintain that a stated rate of interest cannot be a profit... . [I]f interest is not a profit within the meaning of securities, then no note, bond, or debenture can ever be regulated by such statutes. This would mean that the greater part of all investment capital would be exempt from any kind of regulation because promoters would label the benefits from their activities as interest. It would be odd indeed that a promoter would be liable for making double your money pie-in-the-sky promises of profits and dividends, but could entirely escape accountability for equally outrageous claims that savers can earn 100% interest on their accounts. Each promise is illusory; each scheme is identical save for labels; each solicitation is equally fraught with peril for the unwary investor. If it be objected to that the court is indulging in reductio ad absurdum argument, and that no one has ever offered such rates for notes, it bears reminding that on August 9, 1920 when federal authorities closed the Ponzi operation for mail fraud, a rival concern called the Old Colony Foreign Exchange Co. promised disappointed Ponzi investors 100% interest on six month notes. N.Y. Times, Aug. 10, 1920, at 8. Two days previously, the Massachusetts Attorney General lamented that the Commonwealth had no state law authorizing him to suspend or control Ponzi's affairs. N.Y. Times, Aug. 8, 1920, at 23. Massachusetts passed its Blue Sky law shortly after, on May 27, 1921. Acts 1921, chap. 499. Its definition of security included any note. Robertson v. White, 635 F. Supp. 851, 859-60 & n. 2 (W.D.Ark. 1986), rev'd sub nom. Arthur Young & Co. v. Reves, 856 F.2d 52 (8th Cir.1988), rev'd sub nom. Reves v. Ernst & Young, ___ U.S. ___, 110 S.Ct. 945, 108 L.Ed.2d 47 (1990); see also Reves, ___ U.S. at ___ n. 4, 110 S.Ct. at 952 n. 4.