Opinion ID: 498197
Heading Depth: 2
Heading Rank: 2

Heading: Arkansas Securities Claim

Text: 22 First Financial next alleges that the defendant's failure to disclose material facts violated the antifraud provisions of the Arkansas Securities Act. Ark.Stat.Ann. Sec. 67-1235 et seq. (1980). The threshold and dispositive issue is thus whether the mortgages constitute securities within the meaning of the Arkansas Securities Act. Security is defined as follows: 23 Security means any note; stock; treasury stock; bond; debenture; evidence of indebtedness; certificate of interest or participation in any profit-sharing agreement; collateral-trust certificate; preorganization certificate or subscription; transferable share; investment contract; variable annuity contract; voting-trust certificate; certificate of deposit for a security; certificate of interest or participation in an oil, gas, or mining title or lease or in payments out of production under such a title or lease; or, in general, any interest or instrument commonly known as a security or any certificate of interest or participation in, temporary or interim certificate for, guarantee of, or warrant or right to subscribe to or purchase any of the foregoing. 24 Ark.Stat.Ann. Sec. 67-1247(l )(1) (1985 Cum.Supp.). 25 First Financial argues that the terms investor and investment used in the purchase agreement indicate the parties intent that the transaction was not an ordinary commercial loan transaction. However, it is fundamental that this court must look beyond the labels used by the parties when determining whether a particular arrangement involves a security as that term was intended by the Arkansas legislature. Schultz v. Rector-Phillips-Morse, Inc., 261 Ark. 769, 552 S.W.2d 4, 11 (1977) (It is not the label that determines whether these units are securities, but the economic substance of the financing of the venture.). 26 It is not clear from Arkansas case law whether the test used to determine if a transaction involves a security under Arkansas law is, in substance, the same test used under federal law. However, after concluding that the tests are essentially the same, the district court analyzed this transaction using the four part test set forth in S.E.C. v. W.J. Howey Co., 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946). The Howey test defines a security as (1) an investment (2) in a common venture (3) with a reasonable expectation of profits (4) to be derived from the entrepreneurial or managerial efforts of others. Union Nat. Bank of Little Rock v. Farmers Bank, 786 F.2d 881, 884 (8th Cir.1986). 27 In Smith v. State, 266 Ark. 861, 587 S.W.2d 50, 52 (App.1979), cert. denied, 445 U.S. 905, 100 S.Ct. 1082, 63 L.Ed.2d 321 (1980), the Arkansas Court of Appeals identified five significant common characteristics of a security: (1) the investment of money or money's worth; (2) investment in a venture; (3) the expectation of some benefit to the investor as a result of the investment; (4) contribution towards the risk capital of the venture; and (5) the absence of direct control over the investment or policy decisions concerning the venture. 28 It is not necessary for the purposes of this appeal to resolve the question whether these tests are in essence the same. Under either approach the mortgages purchased by First Financial lack the essential characteristics of a security, under the Arkansas Securities Act. 29 In the Arkansas Supreme Court's most recent pronouncement on this question the court stated, the underlying economic substance of a security is an arrangement where the investor is a mere passive contributor of risk capital to a venture in which he has no direct or managerial control. Casali v. Schultz, 292 Ark. 602, 732 S.W.2d 836, 837 (1987). 30 It is clear from the record before the court that First Financial was not an investor as that term is used in a securities analysis. The record shows that First Financial purchased more than 2.2 million dollars worth of mortgages. The transaction was nothing more than an ordinary commercial transaction and not an investment. In addition, the 2.2 million dollars cannot be fairly characterized as risk capital. Risk capital, in this context, refers to money or property invested in a business venture. Surely, First Financial cannot argue that the 2.2 million was an investment in Hutton Mortgage's business, nor can it be argued that First Financial expected to profit from Hutton Mortgage's business. This money is more accurately characterized as the purchase price of the mortgages and not as an investment in a business venture. 31 In addition, First Financial possesses the critical element of control that is lacking in a security. The owner of a security lacks the ability to control the venture in which he is investing. This concept of control, or lack of control, is the basis for the requirement that a security derives its value from the managerial or entrepreneurial efforts of others. In contrast to a security, First Financial had complete control over the mortgages that it purchased. 32 First Financial argues that because the mortgages were serviced by a third-party servicing company the requirement that a security derive its value from the efforts of others is met. This argument misses the point. The activities performed under the mortgage servicing agreement were merely administrative and ministerial in nature. These activities do not constitute the managerial or entrepreneurial efforts of others. Further, First Financial was able to terminate the mortgage servicing agreement and administer the mortgages itself, thus the servicing company was merely an agent of First Financial. First Financial's ability to take control over the administration of the mortgages demonstrates that it was not relying on the efforts of others to generate a return on the mortgages. 33 The purchase of mortgages serviced by a third-party is no different than the purchase of an apartment complex managed by a third-party. This court has held that a transaction involving the purchase of an apartment complex in conjunction with a servicing contract does not involve a security under the federal securities laws. See Schultz v. Dain Corp., 568 F.2d 612, 615 (8th Cir.1978); Fargo Partners v. Dain Corp., 540 F.2d 912, 915 (8th Cir.1976). A critical factor in the court's holding in these cases and the case at bar is that the purchaser has retained ultimate control over his purchase. 34 Finally, First Financial did not have an expectation of benefit or profit as those terms are used in the Smith v. State and Howie tests. First Financial had the right to payment of fixed amounts of principal, plus a fixed rate of interest, payable by the mortgagors at fixed times. First Financial did not have an opportunity for either capital appreciation or participation in the earnings of Hutton Mortgage or the individual mortgagors. This court has held that a fixed rate of return is not a profit as that term is used in the Howey test. Kansas State Bank v. Citizens Bank, 737 F.2d 1490, 1495 (8th Cir.1984). Similarly, we do not believe that a fixed rate of return is an expectation of benefit to the investor as contemplated by the Arkansas Court of Appeals in Smith v. State.