Opinion ID: 720633
Heading Depth: 3
Heading Rank: 3

Heading: Profits Derived Predominantly from the Efforts of Others

Text: 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