Opinion ID: 348579
Heading Depth: 1
Heading Rank: 1

Heading: Applicability of Federal Securities Acts

Text: 4 In Count I of his original complaint, Hirk alleged that the discretionary futures trading agreement and the power of attorney which he executed constitute either an investment contract or (a) certificate of interest or participation in (a) profit-sharing agreement, thus qualifying as a security under the Securities Act of 1933 (15 U.S.C. § 77b(1)) and the Securities Act of 1934 (15 U.S.C. § 78c(a)(10)). As securities, defendants were obligated to register them pursuant to Section 5 of the 1933 Act (15 U.S.C. § 77e) and to comply with the anti-fraud provisions of both those Acts (15 U.S.C. §§ 77q, 78j(b), 78o (c) and SEC Rules 10b-5, 15c1-2 and 15c1-7). He claims that their failure to do so makes them liable for his loss of over $28,000 under 15 U.S.C. § 77l. 5 Count I was dismissed on June 24, 1974, on the ground that the arrangement entered into by Hirk was not an investment contract and therefore not a security under 15 U.S.C. § 77b(1) and § 78c(a)(10) because the requisite element of common enterprise was lacking. Applying the Milnarik 3 test for determining an investment contract, the court found that Hirk's allegations of overlapping investment services and the similarity of concomitant transactions in various discretionary trading accounts by the defendants did not transform Hirk's single account, limited to his own investment, into a joint account with other investments. Mem. op. 3-5. Attempting to eliminate this flaw in his pleadings, Hirk filed an amended complaint alleging that the defendants treated all of the discretionary trading accounts in substantially the same manner and consequently that he shared pro-rata with the other accounts as if all the funds had been commingled. He further alleged that his investment monies were employed by the defendants to finance ARCO's operating expenses and the advertising scheme used to attract other investors. The district court dismissed this amended Count I on August 30, 1974, finding that the similar treatment afforded Hirk and other investors was insufficient to establish the requisite commonality, especially in light of plaintiff's claim that such treatment was in direct contravention of defendants' representations and plaintiff's expectations (mem. op. 3-5).
6 On appeal, Hirk challenges the district court's holding that this discretionary trading account is not an investment contract and hence that the anti-fraud provisions of the Federal Securities Acts are not applicable. He realizes that because of the virtual identity of the definitions of security contained in the two federal securities laws, any determination that the arrangement qualifies as a security under one statute will control the disposition of that issue with respect to the companion law. Tcherepnin v. Knight, 389 U.S. 332, 335-336, 88 S.Ct. 548, 19 L.Ed.2d 564. He is also aware that unless this Court overrules its prior decision in Milnarik v. M-S Commodities, Inc., 457 F.2d 274 (7th Cir. 1972), certiorari denied, 409 U.S. 887, 93 S.Ct. 113, 34 L.Ed.2d 144, holding that a discretionary trading account is not a security, or that the alleged facts in this case are distinguishable from those in Milnarik, his attempts to reverse the district court's decision on Count I must fail. For the following reasons, this Court affirms this portion of the district court's decision. 7 The Milnarik court was guided in the construction of the term security by several important principles: first, the purpose of the federal security laws is remedial in nature; second, the legislature has directed that these laws be construed liberally and flexibly to effectuate their purpose (Tcherepnin, supra, 389 U.S. at 336, 88 S.Ct. 548, 553); and third, form should be disregarded for substance and the emphasis should be on economic reality (id. ). Within this tripartite framework, Milnarik applied the well-recognized definition of an investment contract established in SEC v. W. J. Howey, 328 U.S. 293, 301, 66 S.Ct. 1100, 1104, 90 L.Ed. 1244, (t)he test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others, and found that the element of commonality was lacking. Judge Stevens (now Justice Stevens) reached this conclusion because the investors in Milnarik did not expect to obtain profits from the operation of all the discretionary trading accounts managed by their common broker, but rather from their individual trading accounts independently of all others. Indeed, he concluded that all that was created by the discretionary arrangement was an agency-for-hire relationship. 457 F.2d at 276-278. Accord, Wasnowic v. Chicago Board of Trade, 352 F.Supp. 1066, 1069 (M.D.Pa.1972), affirmed without opinion,491 F.2d 752 (3rd Cir. 1974), certiorari denied, 416 U.S. 994, 94 S.Ct. 2407, 40 L.Ed.2d 2407; Stuckey v. duPont Glore Forgan, Inc., 59 F.R.D. 129, 131 (N.D.Cal.1973); contra, SEC v. Continental Commodities Corp., 497 F.2d 516 (5th Cir. 1974); Marshall v. Lamson Bros. & Co., 368 F.Supp. 486, 487 (S.D.Iowa 1974); Berman v. Orimex Trading, Inc., 291 F.Supp. 701, 702 (S.D.N.Y.1968); Maheu v. Reynolds & Co., 282 F.Supp. 423 (S.D.N.Y.1968). 8 Hirk argues that the Milnarik definition of common enterprise as requiring both multiple investors and a pooling of their funds erodes the remedial potential of the securities acts and accordingly should be reexamined. He recommends that this Circuit adopt the contrary position of the Fifth Circuit in SEC v. Continental Commodities Corp., 497 F.2d 516 (5th Cir. 1974). This we decline to do for the following reasons: 9 In Continental Commodities, the Fifth Circuit restated its endorsement of the Ninth Circuit's formulation of a common enterprise as one in which the fortunes of the investor are interwoven with and dependent upon the effort and success of those seeking the investment or of third parties. 497 F.2d at 522 (quoting SEC v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476, 482 n.7 (9th Cir. 1973), certiorari denied, 414 U.S. 821, 94 S.Ct. 117, 38 L.Ed.2d 53). Although this formulation superficially appears co-terminous with the Milnarik definition of common enterprise as joint participants in the same investment enterprise (457 F.2d at 277), the Fifth Circuit's interpretation differs from this Circuit's. In the Fifth Circuit's analysis, the critical factor is whether or not the fortunes of all investors are inextricably tied to the success of the trading enterprise. 497 F.2d at 522 (quoting SEC v. Koscot Interplanetary, Inc., 497 F.2d 473, 479 (5th Cir. 1974)). By stating so, it acknowledged that it was expressly rejecting the necessity of a pooling of investments or investor remuneration on a pro-rata showing of profits, citing the following cases to substantiate its position: Blackwell v. Bentsen, 203 F.2d 690, 691-692 (5th Cir. 1953), certiorari dismissed, 347 U.S. 925, 74 S.Ct. 528, 98 L.Ed. 1078; SEC v. Glenn W. Turner Enterprises, Inc., supra, 474 F.2d 476, 482; Marshall v. Lamson Bros. & Co., 368 F.Supp. 486, 489 (S.D.Iowa 1974); Maheu v. Reynolds & Co., 282 F.Supp. 423, 429 (S.D.N.Y.1968). See also Loss, Securities Regulation 489 (2d ed. 1961). 10 Because Milnarik was decided prior to Continental Commodities and did not directly address the pooling issue, 4 this Court must determine whether the Milnarik conclusion subsumes the existence of a pooling of funds or a pro-rata distribution of profits. 5 Aside from the general tenor of the case, a reading of footnote 7 indicates that Judge Stevens interpreted Howey as requiring just such a pooling. He noted that the Supreme Court had stated there that the individual investor had no right to specific fruit. The Company is accountable only for an allocation of the net profits based upon a check made at the time of picking. All the produce is pooled by the responding companies which do business under their own names (emphasis added). 457 F.2d at 279 n. 7 quoting 328 U.S. at 296, 66 S.Ct. at 1102. Later, in another passage from Howey, which Judge Stevens felt was indicative of its estimation of the relative importance of separate as opposed to common elements of the enterprise, he stated The investors provide the capital and share in the earnings and profits; the promoters manage, control and operate the enterprise (id. quoting 328 U.S. at 300, 66 S.Ct. at 1104 (emphasis added)). 11 It is apparent then that this Court's decision in Milnarik was based on the assumption that a sharing or pooling of funds is required by Howey, and we are unwilling to overrule that determination. The appellate cases cited in Continental Commodities for the contrary proposition tend to support this Circuit's analysis. Thus in Blackwell v. Bentsen, supra, the facts were essentially the same as those in Howey. The investors purchased a deed for a tract of land which was part of a citrus grove managed by the defendant corporation. As in Howey, the deed served as a convenient method of determining the investors' allocable shares of the profits. In Glenn W. Turner, supra, the court was concerned with Howey's meaning of solely in the context of solely from the efforts of others. Although the Ninth Circuit never addressed the issue of pooling of funds there, it did note that the investors would profit if, and only if, the company prospered. Profit paid to the investor was based on how well he sold the company's self-improvement courses to others and was directly proportional to the amount of money the new customer invested in the company. Under such an arrangement a pooling of funds must have occurred. Since these cases offer little or no substantiation for the Fifth Circuit's position, this Court's position in Milnarik will remain the controlling precedent in this Circuit. 6 12 Aware of the overwhelming impact of Milnarik on the facts of this case, Hirk attempted to circumvent it in the district court by alleging in his amended complaint that his monies and those of other investors were treated as if commingled (par. 9(c)). It is obvious that the amended complaint is insufficient on its face to satisfy the pooling requirements. As if commingled is not the same as commingled. Furthermore, each discretionary trading account is unitary in nature; each account has a success or failure rate without regard to the others. Hirk's effort to sidestep this fact by stressing in paragraph 6 that substantially similar transactions were made in all accounts and that profits or losses ebbed or flowed uniformly also fails because the necessary pooling remains unshown. 13 Hirk suggests that if we are unwilling to adopt the Fifth Circuit's position on the pooling of funds requirement, we instead re-examine Milnarik in terms of the remedial purpose of the Acts, the legislative directives of flexibility, and the emphasis on substance over form. Tcherepnin, supra, 389 U.S. at 332, 336, 88 S.Ct. 548. This we decline to do for the reason that the Milnarik court reached its decision within this framework and quoted with approval the following portion of the district court's decision: 14 Although this Court recognizes that the registration requirements of Section 5 are for the protection of the public and that any exemption therefrom must be strictly construed against one claiming it,    the unitary nature of the contract here involved is not overcome even when the transaction is viewed most strongly against the defendants. 457 F.2d at 277. (Citations omitted; emphasis added.) 15 In conclusion, we reiterate the position taken in Milnarik that (W)e do not believe every conceivable arrangement that would fit a dictionary definition of an investment contract was intended to be included within the statutory definition of a security. Id. at 275-276. 16
17 The contract creating the arrangement between Hirk and ARCO contained a clause which required that 25% of the profits accrued during a one-month period in Hirk's account would be paid to ARCO as compensation for its advisory services. Hirk maintains that this arrangement constitutes a certificate of interest or participation in a profit-sharing agreement, and therefore a security under 15 U.S.C. § 77b(1) and § 78c(a)(10). He argues that with its 75%-25% profit-sharing clause, the contract must be deemed to fall within the literal definition in the Acts, as well as what Professor Lewis Loss has termed (t)he classic example of (such an agreement) is a contract whereby the buyer furnishes the funds and the seller the skill for speculating in the stock or commodity markets under an arrangement to split any profits. Loss, Securities Regulation 489 (2d ed. 1961). 18 In order to be covered by the federal securities laws, a certificate of interest or participation in a profit-sharing agreement must contain the same element of commonality as required by Milnarik for an investment contract. The cases cited by Professor Loss demonstrate that courts have made no real distinction between investment contracts and profit-sharing plans. Furthermore, in all these cases wide-spread public participation in profits was a common characteristic of the securities involved. See, e. g., SEC v. Latta, 250 F.Supp. 170 (N.D.Cal.), affirmed per curiam, 356 F.2d 103 (9th Cir. 1965), certiorari denied, 384 U.S. 940, 86 S.Ct. 1459, 16 L.Ed.2d 539 (contracts to assign undivided distributive shares in a decedent's estate in event of recovery); SEC v. Bill Willoughby Coin Exchange. Fed.Sec.L.Rep. (CCH) P 91,355 (1961-1964 Decisions) (coin investment program where funds of investors are pooled and used in purchase and sale of coins); SEC v. Addison, 194 F.Supp. 709 (N.D.Tex.1961) (loan notes entitling the lenders to interests in mining and other operations); SEC v. Tung Corp., 32 F.Supp. 371 (N.D.Ill.1940) (contracts selling forested lands with lease back agreement requiring seller to care for trees at fixed annual charges). 19 Hirk argues, however, that SEC v. Wickham, 12 F.Supp. 245 (D.Minn.1935), a case cited by the district court on this point, is, contrariwise, supportive of his position. 7 In that case, the court found a discretionary trading account with a 60%-40% profit split to be a security. What Hirk fails to note and what this Court deems to be the essential difference between that case and the instant case is that in Wickham the funds obtained from the various investors were all deposited and commingled in one or more bank accounts. Id. at 248. 20 Because the element of commonality is also absent here, the profit-sharing agreement between the parties cannot be deemed a security within the meaning of the security laws.