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Securities and Exchange Commission v. Charles Edwards

Summary of the Facts

The pithy facts of the case are that Charles Edwards owned and operated a corporation that sold payphones on a sale-and-leaseback business arrangement.  The company would sell the pay telephones for $7000 and, thereafter, lease them back from buyers for fixed $84 monthly payments, which assured the buyers of a 14% yearly return. In addition, the buyers were also not required to operate any part of the payphones collect its coin revenues on a daily basis or maintain the same. Also, the agreement relating to the sale of payphone contained another clause of buyback where the company had promised to the buyers to repay the full purchase price when the lease had expired. ETS Payphones, however, did not attract sufficient sums of money to satisfy its promise to pay under the leasehold agreements and it was highly dependent on the funds from new investors. Later, Edwards declared a bankruptcy. The Securities and Exchange Commission (SEC) initiated an administrative proceeding against Edwards, claiming that the company was trading unregistered securities, thereby violating the registration and antifraud provisions of federal securities laws.

Parties and their Stands

     The petitioner in this regard is the SEC. According to the petitioner, the sale-and-leaseback arrangements equaled investment contracts and it also operated as a Ponzi Scheme since the used investors' money in order to make the fixed leaseback payments. Therefore, the petitioner argued that Edwards violated the registration and antifraud provisions of the Securities Act, Exchange Act, and Rule 10b-5.

The respondent was Charles Edward the president of ETS Payphones Inc.

He argued out that the position taken by the SEC was incorrect since the purchaser had no part in owning the enterprise's income

Instead, the purchaser acquired a right to a periodic payment with an obligation attached under a lease rather than bought with the enterprise by the third party individual. Therefore, the investment contracts themselves were not securities and, therefore, the company need not have been subject to federal securities law. Procedural History The District Court below adjudged that the leaseback agreement was an investment contract which defined a security, and therefore should have been subject to the federal securities law.

The lower court based its rationale upon the reasoning developed in SEC v. W.J.

It was further held in  SEC v. Howey Co, 328 U.S. 293 (1946) that any arrangement or contract that involves an individual putting their funds in a common enterprise and earns a return from a promoter's or third party's effort is an investment contract.     Using Howey's definition of an investment contract will involve implying that: Since the purchasers depended on the operation of the pay telephones by ETS and that it makes efforts to earn the 14% annual return as well as the buyback price at the expiry of the price. Besides, the purchasers earned profits from the efforts of ETS, not the buyers, as it was ETS's responsibility to day-to-day manage and maintenance the payphones. Accordingly, the District Court found that Edwards flouted the registration requirements when he offers and sells investment contract in interstate commerce without registration as called for the federal securities laws. As if that was not enough, he was involved in a business fraud when he deceived investors that the payphone business was a money-spinner while; he depended on the money on new investors to meet his obligations under the lease agreements. The Court of Appeals overturned the judgment. The Eleventh Circuit concluded this leaseback arrangement in fact did not contain the essential elements of the definition of an investment contract as defined in Howey, such as capital appreciation and sharing in the enterprise earnings because the payment to the investors was a fixed monthly payment which did not vary with the business profit or loss.

The returns were also not fully rested relied on efforts of the promoter or the third parties as Edwards rather they were a product of contract bargaining which gave Edward a contractual obligation to pay the purchaser. Legal Issue Was a sale-and-leaseback arrangement that provided a fixed instead of a variable rate of return an investment contract, and therefore, a security that is subject to the federal securities laws? Case Summary Court's Ruling

Yes. An investment plan that furnished a fixed rather than a variable interest in the total sum of dividends, was an investment contract and hence securities within the ambit of the Federal Securities Laws.

Court's Reasoning

The points the Supreme Court judged most relevant to the determination were: (1) the fact that the respondent was in a business in which investors/purchasers were principally "lured by the prospect of a return" from the investment, and, 2) that the respondent was responsible for managing, monitoring, and also performing routine maintenance of payphones.

The court relied on test set forth in Howey which described an investment contract as one which the schemes entails investing money "in a common enterprise" where the return comes the efforts of a third party [promoter].

The Court insisted that this description was adjustable to fit the different and several arrangements devised by businesses that use the funds promised as a return on their investments.

The Court held that the returns earned "from the efforts of others" encompass, inter alia, dividends, periodic payments, and appreciation of invested value. The Supreme Court declined to exempt contracts that promise a fixed rate of return from the definition of security. It proffered a rationale that there is no justification for circumscribing the promises; the investors were tempted in both the promises entailing a guarantee of making a return from their investments. Edwards' payphone business had also given a promise of precisely the same thing—a fixed monthly return.

It went on to state that all the cases that Howey relied on to deduce the security of investment contract made no differentiation between a fixed return and a variable return.     Instead of fixed or variable nature of returns, the following are the fundamental elements when determining an investment contract: (1) investment in a common enterprise, (2) reasonable profit from the effort of the promoter [third party]. When they said mortgage notes are sold with a package of management services and a promise to repurchase the notes in case of default they will be equivalent to securities. This question was elaborated upon in In Re Abbett, Sommer & Co., 44 S. E. C. 104 (1969).

Together with it, the package of mortgage notes, in the case at hand, will be strictly adhering to the Howey's description of the investment contracts, that is – "the investment of funds with the anticipation of receiving a return from the efforts of others". Conclusion I wholeheartedly agree with the decision of the Court in the case. The decision made helped in making the decision more flexible to fit the different types of schemes where businesses tend persuade investing public contribute funds to the business with the promise of getting a return. Consequently, as the financial markets expand, the businesses will be more creativity and create more complex investments to escape being subject to federal securities laws. It is important for the Court's to have an elastic definition of investment contract that will accommodate several securities to protect investors.

The Court in this case never mincing its words held that irrespective of the nature of expected returns whether they are several or fixed, then a scheme would be an investment contract if there is expected profit from the efforts of someone else.

However, as noted by Albert (2011), the is still a lack of absolute parameters that investors and businesses can use to identify investment contracts. The issue is characterized by uneven applications as evident in the instance whereby the District Court and the Court of Appeals held completely on the interpretation of sale and leaseback arrangement. The greater protection of the investor and the increased confidence in capital markets will have better results with a definition of the elements of an investment contract that is more fine-tuned. 

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