Fed. Sec. L. Rep. P 94,710 Securities and Exchange Commission v. Koscot Interplanetary, Inc.

This appeal emanates from a district court order denying an injunction sought by the Securities & Exchange Commission (SEC) against Koscot Interplanetary, Inc., (Koscot) for allegedly violating the federal securities laws. Specifically, the SEC maintained that the pyramid promotion enterprise operated by Koscot was within the ambit of the term security, as employed by the Securities Act of 1933 and the Securities Exchange Act of 1934, 1 that as such it had to be registered with the SEC pursuant to the ’33 Act, 2 and that the manner in which Koscot purveyed its enterprise to potential investors contravened the anti-fraud provisions of the *475 ’34 Act. 3 In a comprehensive opinion, reported at 365 F.Supp. 588 (N.D.Ga.1973), the district court denied the injunction holding that the Koscot Scheme did not involve the sale of a security. Because of our disagreement with the district court’s reasoning, we reverse.

I

A. The Koscot Scheme

The procedure followed by Koscot in the promotion of its enterprise can be synoptically chronicled. 4 A subsidiary of Glen W. Turner Enterprises, Koscot thrives by enticing prospective investors to participate in its enterprise, holding out as a lure the expectation of galactic profits. All too often, the beguiled investors are disappointed by paltry returns.

The vehicle for the lure is a multi-level network of independent distributors, purportedly engaged in the business of selling a line of cosmetics. At the lowest level is a “beauty advisor” whose income is derived solely from retail sales of Koscot products made available at a discount, customarily of 45%. Those desirous of ascending the ladder of the Koscot enterprise may also participate on a second level, that of supervisor or retail manager. For an investment of $1,000, a supervisor receives cosmetics at a greater discount from retail price, typically 55%, to be sold either directly to the public or to be held for wholesale distribution to the beauty advisors. In addition, a supervisor who introduces a prospect to the Koscot program with whom a sale is ultimately consummated receives $600 of the $1,000 paid to Koscot. The loftiest position in the multilevel scheme is that of distributor. An investment of $5,000 with Koscot entitles a distributor to purchase cosmetics at an even greater discount, typically 65%, for distribution to supervisors and retailers. Moreover, fruitful sponsorship of either a supervisor or distributor brings $600 or $3,000 respectively to the sponsor.

The SEC does not contend that the distribution of cosmetics is amenable to regulation under the federal securities laws. ■ Rather, it maintains that the marketing of cosmetics and the recruitment aspects of Koscot’s enterprise are separable and that only the latter are within the definition of a security. That the district court acknowledged the *476 fragmentation discerned by the SEC is witnessed by the following observation:

“Many if not all of the persons, seeking to become Koscot distributors are attracted by the lure of money to be earned by high-pressure recruiting of other persons into the Koscot program, rather than the sale of the cosmetics themselves.”

365 F.Supp. at 590. And since case-law countenances the fragmented approach which the SEC presses upon us, see SEC v. United Benefit Life Insur. Co., 387 U.S. 202, 207, 87 S.Ct. 1557, 1559, 18 L.Ed. 2d 673, 677 (1967); SEC v. Glen W. Turner Enterprises, Inc., 474 F.2d 476 (9th Cir.), cert. denied 414 U.S. 821, 94 S.Ct. 117, 38 L.Ed.2d 53 (1973), it is upon the promotional aspects that we focus in determining whether Koscot did offer a security.

The modus operandi of Koscot and its investors is as follows. Investors solicit prospects to attend Opportunity Meetings at which the latter are introduced to the Koscot scheme. Significantly, the investor is admonished not to mention the details of the business before bringing the prospect to the meeting, a technique euphemistically denominated the “curiosity approach.” The Koscot manual describes the reasoning behind the approach and its operation in the following manner:

“DON’T GO INTO DETAILS. Never explain the program to a prospect before bringing him to an Opportunity Meeting. Do not mention Kosmetics or give any particulars, as many people will prejudge the program and decide it is not for them before they see the presentation.

USE THE CURIOSITY APPROACH. When you invite a prospect to an Opportunity Meeting, arouse his curiosity. Tell him you have discovered a wonderful financial opportunity that will fit him like a glove! Or, tell him you have seen a money tree and would like for him to take a look at it.”

Thus, in the initial stage, an investor’s sole task is to attract individuals to the meeting.

Once a prospect’s attendance at a meeting is secured, Koscot employees, frequently in conjunction with investors, undertake to apprise prospects of the “virtues” of enlisting in the Koscot plan. The meeting is conducted in conformity with scripts prepared by Koscot. Indeed, Koscot distributes a bulletin which states: “. . . this program is to be presented by the script. It is strongly recommended that you consider replacing any individual who does not present the program verbatim.” The principal design of the meetings is to foster an illusion of affluence. Investors and Koscot employees are instructed to drive to meetings in expensive cars, preferably Cadillacs, to dress expensively, and to flaunt large amounts of money. It is intended that prospects will be galvanized into signing a contract by these ostentations displayed in the evangelical atmosphere of the meetings. Go-Tours, characterized by similar histrionics, are designed to achieve the same goal.

The final stage in the promotional scheme is the consummation of the sale. If a prospect capitulates at either an Opportunity Meeting or a Go-Tour, an investor will not be required to expend any additional effort. Less fortuitous investors whose prospects are not as quickly enticed to invest do have to devote additional effort to consummate a sale, the amount of which is contingent upon the degree of reluctance of the prospect.

B. The District Court

The district court rebuffed the SEC’s effort to subject Koscot’s promotional scheme to the federal securities laws. The SEC argued that the scheme qualified as a profit-sharing arrangement, an interest commonly known as a security, and an investment contract. The profit-sharing theory was rejected because in the district court’s view, a successful recruiting distributor receives not a *477 share of Koscot’s profit but rather a fixed fee. 365 F.Supp. 590-591. 5 The court refused to endorse the SEC’s position that the pyramid arrangement constituted an interest “commonly known as a security” for two reasons. First, even under a traditional approach, under which the essential inquiry is how the interest is viewed in legal and financial circles, the question of whether a pyramid arrangement fell within the definition was still a polemical one; 6 and second, the risk capital theory, which allegedly would encompass the Koscot arrangement, was of such recent vintage and had such a mixed reception with the courts that it should not be applied in lieu of the traditional definition. 7

Of more immediate concern is the reasoning employed by the district court in rejecting the SEC’s contention that Koscot sold “investment contracts,” for it is our disagreement with this conclusion that prompts us to reverse. The district court correctly cited the following language from SEC v. W. J. Howey Co., 328 U.S. 293, 298-299, 66 S.Ct. 1100, 1103, 90 L.Ed. 1244, 1249 (1946), as the standard controlling its disposition of the case.

“[A]n investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party. .” (emphasis added)

This test subsumes within it three elements: first, that there is an investment of money; second, that the scheme in which an investment is made functions as a common enterprise; and third, that under the scheme, profits are derived solely from the efforts of individuals other than the investors. See, e. g., SEC v. Glen W. Turner Enterprises, 474 F.2d 476 (9th Cir.), cert. denied, 414 U.S. 821, 94 S.Ct. 117, 38 L.Ed.2d 53 (1973); 1050 Tenants v. Jakobson, 365 F.Supp. 1171, 1176 (S.D.N.Y.1973). The district court pretermitted a consideration of the first two elements in finding that the third component of the test was not satisfied because Koscot investors expended effort in soliciting re *478 cruits to meetings, in participating in the conduct of meetings, and in attempting to consummate the sale of distributorships and subdistributorships. Moreover, it specifically rejected the less idolatrous adherence to the Howey language manifest in SEC v. Glen W. Turner Enterprises, Inc., supra, reasoning that the Ninth Circuit’s interpretation was antagonistic to the literal approach of both this Circuit and the Supreme Court.

II

Thus, we are called upon to address that which the court below did not consider — whether the Koscot scheme satisfies the first two elements of the Howey test — and that which the district court did consider — whether the scheme satisfies the third component of the test. The latter inquiry entails, in the first instance, a determination of whether the “solely from the efforts of others” standard is to be literally or functionally applied. We address these issues seriatim.

A. The First Two Elements

Since it cannot be disputed that purchasers of supervisorships and distributorships made an investment of money, cf. SEC v. Glen W. Turner Enterprises, Inc., supra, at 481, our initial concern is whether the Koscot scheme functions as a common enterprise. As defined by the Ninth Circuit, “[a] common enterprise is one in which the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment or of third parties.” SEC v. Glen W. Turner Enterprises, Inc., supra at 482 n. 7. The critical factor is not the similitude or coincidence of investor input, but rather the uniformity of impact of the promoter’s efforts.

That this definition comports with the standard applied by the Supreme Court and this Circuit is witnessed by an examination of the reasoning employed in Howey, supra, and in Blackwell v. Bentsen, 203 F.2d 690 (5th Cir. 1953), cert. dismissed, 347 U.S. 925, 74 S.Ct. 528, 98 L.Ed. 1078 (1954). In Howey, the Court of Appeals had concluded that an investment contract did not exist where the management and cultivation of citrus acreage was entrusted to the promoter, with the rate of the investor’s return to be measured by the produce of the acreage he owned. The Court of Appeals explained that:

“Here it is quite clear that each purchaser looked for the income from his investment to the fruitage of his own grove and not to the fruitage of the groves as a whole. It is quite clear, too, that each purchaser’s income was in no sense dependent upon the purchase or development of other tracts than his own except in the sense that as grove owners generally prospered, each owner of a grove would.” (emphasis added)

151 F.2d 714, 717 (5th Cir. 1945). In reversing, the Supreme Court emphasized not whether profits were pooled, but rather the fact that the feasibility and success of the enterprise, in attracting individuals to invest, and in cultivating, harvesting and marketing the citrus products, rested on the availability of the Howey Company’s management:

“Such persons [investors] have no desire to occupy the land or to develop it themselves; they are attracted solely by the prospects of a return on their investment. Indeed, individual development of the plots of land that are offered and sold would seldom be economically feasible due to their small size. Such tracts gain utility as citrus groves only when cultivated and developed as component parts of a larger area. A common enterprise managed by respondents or third parties with adequate personnel and equipment is therefore essential if the investors are to achieve their paramount aim of a return on their investments.” (emphasis added)

328 U.S. at 300, 66 S.Ct. at 1103, 90 L.Ed. at 1250. Moreover, in Blackwell v. Bentsen, supra, involving investments in a tract which was part of an 800 acre *479 unit to be developed and marketed as a citrus grove, this Court implicitly rejected any requirement of coterminality of investor input. For there, investors were permitted to sell the produce of their own acreage if they elected to do so.

Similarly, here, the fact that an investor’s return is independent of that of other investors in the scheme is not decisive. Rather, the requisite commonality is evidenced by the fact that the fortunes of all investors are inextricably tied to the efficacy of the Koseot meetings and guidelines on recruiting prospects and consummating a sale. See SEC v. Glen W. Turner Enterprises, Inc., supra at 482; United States v. Herr, 338 F.2d 607 (7th Cir. 1964), cert. denied, 382 U.S. 999, 86 S.Ct. 563, 15 L.Ed.2d 487, rehearing denied, 383 U.S. 922, 86 S.Ct. 898, 15 L.Ed.2d 679 (1966); cf. Marshall v. Lamson Bros, and Co., 368 F.Supp. 486, 488 (S.D.Iowa 1974); Mitzner v. Cardet International, Inc. et al., 358 F.Supp. 1262, 1265 (N.D.Ill.1973). 8

B. The Third Element — Solely from the Efforts of Others

As was noted earlier, the critical issue in this case is whether a literal or functional approach to the “solely from the efforts of others’’ test should be adopted, i. e., whether the exertion of some effort by an investor is inimical to the holding that a promotional scheme falls within the definition of an investment contract. We measure the viability of the SEC’s advocacy of a functional approach by its compatibility with the remedial purposes of the federal securities acts, the language employed and the derivation of the test utilized in Howey, and the decisions in this circuit and other federal courts.

1. The Legal Standard

We begin our analysis by noting that the 1933 and 1934 Acts are remedial in nature, 9 Affiliated Ute Citizens v. United States, 406 U.S. 128, 151, 92 S.Ct. 1456, 1471, 31 L.Ed.2d 741, 760 (1972); SEC v. W. J. Howey Co., supra, 328 U.S. at 299, 66 S.Ct. at 1103, 90 L.Ed. at 1250; Tcherepnin v. Knight, 389 U.S. 332, 336, 88 S.Ct. 548, 553, 19 L.Ed.2d 564, 569 (1967), and hence are to be broadly construed. Tcherepnin v. Knight, supra at 336, 88 S.Ct. at 553, 19 L.Ed.2d at 569; Ayers v. Wolfinbarger, 491 F.2d 8, 16 (5th Cir. 1974); SEC v. Glen W. Turner Enterprises, Inc., 474 F.2d at 480-481; Nor-Tex Agencies, Inc. v. Jones, 482 F.2d 1093, 1098 (5th Cir. 1973), cert. denied, 415 U.S. 977, 94 S.Ct. 1563, 39 L.Ed.2d 873 (1974); SEC v. MacElvain, 417 F.2d 1134, 1137 (5th Cir. 1969). This court recently reaffirmed these principles, noting in Small- *480 wood v. Pearl Brewing Co., 489 F.2d 579, 592 (5th Cir. 1974), that “[t]he securities laws are intended to protect investors not merely to test the ingenuity of sophisticated corporate counsel.”

A literal application of the Howey test would frustrate the remedial purposes of the Act. As the Ninth Circuit noted in SEC v. Turner Enterprises, Inc., supra at 482, “[i]t would be easy to evade [the Howey test] by adding a requirement that the buyer contribute a modicum of effort.” See also Lino v. City Investing Co., 487 F.2d 689, 692-693 (3d Cir. 1973). The Supreme Court admonished against such a rigid and quixotic application, noting in Tcherepnin v. Knight, supra, 389 U.S. at 336, 88 S.Ct. at 553, 19 L.Ed.2d at 569, that in searching for the meaning and scope of the word security, form should be disregarded for substance, and proclaiming in SEC v. W. J. Howey Co., 328 U.S. at 301, 66 S.Ct. at 1104, 90 L.Ed. at 1251, that “[t]he statutory policy of affording broad protection to investors is not to be thwarted by unrealistic and irrelevant formulae.” It would be anomalous to maintain that the Court in Howey intended to formulate the type of intractable rule which it had decried. The admitted salutary purposes of the Acts can only be safeguarded by a functional approach to the Howey test.

Moreover, a close reading of the language employed in Howey and the authority upon which the Court relied suggests that, contrary to the view of the district court, we need not feel compelled to follow the “solely from the efforts of others” test literally. Nowhere in the opinion does the Supreme Court characterize the nature of the “efforts” that would render a promotional scheme beyond the pale of the definition of an investment contract. Clearly the facts presented no issue of how to assess a scheme in which an investor performed mere perfunctory tasks. Indeed, just prior to concluding that the sales of units of citrus grove development, coupled with contracts for cultivating, marketing and remitting the net proceeds to investors constituted sales of investment contracts, the Court observed that “the promoters manage, control and operate the enterprise.” 328 U.S. at 300, 66 S.Ct. at 1104, 90 L.Ed. at 1250 (emphasis added). One commentator has seized upon the italicized words in concluding that only schemes in which investors exercise managerial control are excluded from the definition of investment contracts. See Long, An Attempt to Return “Investment Contracts” to the Mainstream of Securities Regulation, 24 Okla.L.Rev. 135, 176 (1971).

The derivation of the “solely from the efforts of others” test also tends to belie a talismanic approach to its application. The Court reasoned in Howey that Congress intended that this test be applied because it had been crystallized by prior state court interpretations. 328 U.S. at 298 n. 4, 66 S.Ct. at 1103 n. 4, 90 L.Ed. at 1249 n. 4. In the only state case cited in the body of the opinion, State v. Gopher Tire & Rubber Co., 146 Minn. 52, 177 N.W. 937 (1920), the agreement signed by investors in the scheme contemplated that such investors would act as “booster agents” for the sale of Gopher Tire & Rubber Company’s goods. 146 Minn, at 56, 177 N.W. at 938. And in one of the cases cited in footnote 4 of Howey, supra, 328 U.S. at 298 n. 4, 66 S.Ct. at 1103, 90 L.Ed. at 1249, Stevens v. Liberty Packing Corp., 111 N.J.Eq. 61, 161 A. 193 (1932), the scheme envisioned even more substantial participation by an investor. Under the second of two plans devised for raising rabbits, an investor would raise rabbits sold to him by the company which would in turn then purchase the offspring for a fixed price per head. Despite the efforts that an investor with Liberty Packing Corp. might expend, the New Jersey court deemed the rabbit breeding scheme to involve an investment contract. 10 Thus, it is apparent that *481 neither Congress, in fashioning a definition of an investment contract nor the Court in interpolating this definition, could have relied upon crystallized authority endorsing a litmus formula. 11 This observation militates against the conclusion that the test was intended to exclude from the definition of investment contract, any scheme where an investor contributed a nominal menial effort.

Subsequent case-law also supports the conclusion that the Howey test is not possessed of the talismanic quality ascribed to it by the court below. In SEC v. United Benefit Life Insurance Co., 387 U.S. 202, 87 S.Ct. 1557, 18 L.Ed.2d 673 (1967), the Supreme Court held that the accumulation provisions of an annuity contract constituted an investment contract. Significantly, Justice Harlan failed to cite Howey, but rather announced the test as being “ ‘what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.’ ” 387 U.S. at 211, 87 S.Ct. at 1562, 18 L.Ed.2d at 680, quoting SEC v. C. M. Joiner Leasing Corp., 320 U.S. 344, 352, 353, 64 S.Ct. 120, 124, 125, 88 L.Ed. 88, 93, 94. Were the Howey definition to occupy the exalted position in investment contract adjudication attributed to it by Koscot, Justice Harlan inexorably would have relied upon it. We would note too that the Court of Appeals in both this Circuit and the Tenth and Second Circuits have on occasion deemed schemes to be investment contracts in reliance upon the aforementioned language from Joiner and not that from Howey. Compare Buie v. United States, 420 F.2d 1207, 1210 (5th Cir. 1969), cert. denied, 398 U.S. 932, 90 S.Ct. 1830, 26 L.Ed.2d 97 (1970) (sale of oil and gas leases to be operated by sellers), with Continental Marketing Corp. v. SEC, 387 F.2d 466 (10th Cir. 1967), cert. denied, 391 U.S. 905, 88 S.Ct. 1655, 20 L.Ed.2d 419 (1968) (sale of live beavers with purchasers exhorted to contract with a professional rancher to raise them), and Glen-Arden Commodities, Inc. v. Costantino, 493 F.2d 1027, 1034 (2d Cir. 1974) (sale of Scotch whiskey warehouse receipts).

Moreover, a significant number of federal courts invoking the Howey test, have either given it a broader more salutary application or endorsed such an application in principle. Thus, in several cases where the scheme required or envisioned the possibility of participation by an investor in the enterprise, courts nevertheless found an investment contract *482 to exist. See Miller v. Central Chinchilla Group, Inc., 494 F.2d 414 (8th Cir. 1974) (investors purchased and raised Chinchillas which were then repurchased by promoters and sold by latter to new prospects); SEC v. Glen W. Turner, supra (promotion of self improvement courses by investors to new prospects); United States v. Herr, supra (investors in records and success manuals sold by American Sales Training Research Associates, Inc. (ASTRA), in addition to receiving higher returns for self distribution as opposed to distribution by ASTRA sales force, received additional money from bringing in other inactive distributors); Blackwell v. Bentsen, supra (deeds for citrus acreage and management contracts, with provision that purchasers are permitted to give directions as to the marketing of crops on their tract); 1050 Tenants v. Jakobson, 365 F.Supp. 1171 (S.D.N.Y.1973) (offering of shares of stock, entitling purchasers to proprietary leases in apartment at 1050 Park Avenue, which after closing date, was to be managed by tenants); Mitzner v. Cardet International, Inc. et al., 358 F.Supp. 1262 (N.D.Ill.1973) (scheme wherein area managers recruited area distributors who in turn found people to deliver Cardet brochures and pick up orders and deliver Cardet products to purchasers); SEC v. Addison, 194 F.Supp. 709 (N.D.Tex.1961) (in lieu of investing capital in potential profits of a mining company, workers were entitled to invest by participating in mining and other operations on a non-salaried basis). 12 Two Circuits, while finding conventional franchise agreements beyond the reach of the securities laws, have explicitly endorsed the broader definition of investment contract. Compare Lino v. City Investing Co., 487 F.2d 689, 692 (3d Cir. 1973) with Nash & Associates, Inc. v. Lum’s of Ohio, 484 F.2d 392, 395 (6th Cir. 1973). See also L. M. H. Inc. v. Lewis, 371 F.Supp. 395, 397 (D.N.J.1974). 13 The prevailing seholar *483 ly commentary comports with this view. E. g., Long, An Attempt to Return “Investment Contracts” to the Mainstream of Securities Regulation, 24 Okla.L.Rev. 135, 144 (1971); Coffey, The Economic Realities of a “Security”: Is There a More Meaningful Formula?, 18 W.Res.L.Rev. 367, 377 (1967); Comment, Pyramid Marketing Plans and Consumer Protection: State and Federal Regulation, 21 J. of Public Law 445, 460 (1972); Note, Securities Regulation of Pyramid Schemes, 51 Texas L.Rev. 788, 794 (1973); Note, Pyramid Schemes: Dare to be Regulated, 61 Geo.L.J. 1257, 1280 (1973).

In view of these developments and our analysis of the import of the language in and the derivation of the Howey test, we hold that the proper standard in determining whether a scheme constitutes an investment contract is that explicated by the Ninth Circuit in SEC v. Glen W. Turner Enterprises, Inc., supra. In that case, the court announced that the critical inquiry is “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” Id. at 482. 14

Contrary to the view of the district court, our adoption of this test represents no fundamental departure from the standard we have previously applied. Indeed, our canvass of the cases presenting an investment contract issue to this court, see Nor-Tex Agencies, Inc. v. Jones, supra; SEC v. MacElvain, supra; Buie v. United States, supra; Lynn v. Caraway, 379 F.2d 943 (5th Cir. 1967), cert. denied, 393 U.S. 951, 89 S.Ct. 373, 21 L.Ed.2d 362 (1968); Moses v. Michael, 292 F.2d 614 (5th Cir. 1961); Roe v. United States, 287 F.2d 435 (5th Cir.), cert. denied, 368 U.S. 824, 82 S.Ct. 43, 7 L.Ed.2d 29 (1961), second appeal, 316 F.2d 617 (5th Cir. 1963); Blackwell v. Bentsen, supra; SEC v. W. J. Howey Co.,