GEWIN, Circuit Judge:
This appeal is taken from a district court order denying a preliminary injunction sought by the Securities and Exchange Commission (SEC) against Continental Commodities Corporation (Continental Commodities), Charles Long, and Continental Commodities Trading Company.
According to the verified complaint, Continental Commodities, a Texas corporation incorporated in November of 1972, Charles Long, its President, and Continental Commodities Trading Company, a partnership formed in California by Long in mid-January 1973, offered to sell and sold to public investors interests denominated options on commodities futures contracts.
The complaint filed by the SEC asserted that jurisdiction could be grounded upon one of two bases. The first base was the trading enterprise itself, the second, promissory notes issued as partial reimbursement to customers who held open accounts with Continental Commodities at the time trading was suspended.
The trading enterprise extended the opportunity to invest in commodities futures contracts. Continental Commodities undertook to recommend certain commodities futures contracts to its customers. An interested customer would first be issued an option, guaranteeing him the right to purchase the contract at a stated price, with the option to remain open for a specified period of time. Continental Commodities neither owned the underlying futures contract nor escrowed any portion of the customer payments for the purpose of acquiring such contracts. In addition, Continental Commodities undertook to advise a customer of the most opportune moment either to sell or to exercise the option. Finally, it also offered investment counseling as to the most propitious time to sell a specific futures contract.
The complaint alleged that several fraudulent acts were committed in connection with the discretionary trading accounts and particular options on futures contracts. Among these were that Continental Commodities misrepresented the lucrativeness of trading in commodities futures and the amount of reserve it had on deposit in a bank to cover for the money invested in such futures, and in specific instances of counseling as to when to exercise options, that it misrepresented the then current market price of the underlying commodity futures contract.
The second potential base for finding subject matter jurisdiction was that, upon receiving notification that trading on options was suspended, Continental Commodities issued promissory notes to some of its customers as partial reimbursement. Although the record is somewhat obscure as to the precise number of recipients and the maturity date of the notes, it would appear that the notes were ostensibly non-interest bearing, with a maturity date of less than 9 months, and were issued to more than a nominal number of customers.
The complaint, as amplified by verified affidavits before the district court, alleges that the notes represented 40% of the amount of money owed to a customer, and that before issuing them, Continental Commodities exacted a promise of forbearance from legal action if payments were made as promised. Charles Long is alleged to have informed customers that the SEC had frozen his accounts, valued at $3,000,000 and thereby precluded him from paying off the debts owed by Continental Commodities, and to have indicated that the SEC would permit the company to remain in business if it would return 60% of the investors' original investments immediately and give promissory notes for the balance. Moreover, the record contains a letter written by Charles Long to a customer expressing Long's hope that Continental Commodities would square its accounts, register its options, and resume trading again. This letter tends to belie Long's testimony that there was "no way" Continental Commodities could stay in business, and is buttressed by an affidavit submitted by an SEC attorney to the effect that
Having recounted the facts which spawned this litigation and which were before the district court in its ruling on the SEC's motion for a preliminary injunction, it is critical to take cognizance of the procedural labyrinth traversed by the parties below and on appeal. As we noted earlier, the complaint filed by the SEC posited two theoretical bases for subject matter jurisdiction — that both the scheme for trading on discretionary accounts and the notes issued were securities. The latter argument was somewhat ill-framed, and hence in its April 9, 1973 order denying the motion for a preliminary injunction, the district court merely addressed and rejected the SEC's contention that the scheme of trading on discretionary accounts amounted to an investment contract. Subsequently, the SEC sought a rehearing due to the failure of the court to consider the contention that the notes were securities within the definitions of the Securities Act of 1933 and the Securities Exchange Act of 1934. The district court disposed of this motion on May 3, 1973, ruling that the notes issued by Continental Commodities were not subject to the abuses sought to be curbed by the Acts and hence did not fall within their ambit.
On appeal, the SEC seeks to preserve only its contention that the notes were securities. In its brief, the SEC informs us that assuming a favorable ruling on appeal, it will move for a permanent injunction and may then resurrect the investment contract theory.
As we noted earlier, the district court rejected the SEC's contention that the trading in discretionary commodities accounts engaged in by Continental Commodities fell within the ambit of the term security,
As was noted in SEC v. Koscot Interplanetary, Inc., 497 F.2d 473, p. 477 (5th Cir. 1974) [No. 73-2339], this test subsumes within it three elements: first the existence of an investment of money; second, that the scheme functions as a common enterprise; and third, that profits of the enterprise are derived solely from the efforts of others. It was the asserted absence of the second element that prompted the district court to hold that an investment contract did not exist.
Following the Seventh Circuit's reasoning in Milnarik v. M-S Commodities, 457 F.2d 274 (7th Cir.), cert. denied, 409 U.S. 887, 93 S.Ct. 113, 34 L. Ed.2d 144 (1972), and that contained in Wasnowic v. Chicago Bd. of Trade, 352 F.Supp. 1066 (M.D.Pa.1972), aff'd without opinion, 491 F.2d 752 (3d Cir.), cert. denied, ___ U.S. ___, 94 S.Ct. 2407, 40 L.Ed.2d 773 (1974),
457 F.2d at 276-277. Were this view compatible with pronouncements of the Supreme Court and this Circuit, then the district court's reasoning would be compelling. However, we cannot accept the Milnarik view.
In SEC v. Koscot Interplanetary, Inc., supra, this court decried a litmus application of the Howey test and expressed its preference for a resilient standard which would comport with the uniformly acclaimed remedial purposes of the Securities Act of 1933 and the Securities Exchange Act of 1934. While primarily concerned with explicating the contours of the "solely from the efforts of others" element, we had occasion to consider the parameters of the common enterprise element as well. There, we endorsed the Ninth Circuit's formulation
Accordingly, although in the Koscot scheme of multi-level distributorships, wherein each investor's profit materialized only when the prospects he attracted to Opportunity Meetings and Go-Tours enlisted as distributors or sub-distributors with Koscot, this court nevertheless deemed the requisite commonality to be present:
SEC v. Koscot Interplanetary, Inc., supra at 479. This language expressly rejects the proposition that the pro-rata sharing of profits is critical to a finding of commonality, accord, Blackwell v. Bentsen, 203 F.2d 690, 691-692 (5th Cir. 1953), cert. dismissed, 347 U.S. 925, 74 S.Ct. 528, 98 L.Ed. 1078 (1954); SEC v. Glen W. Turner, Inc., supra at 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.1967),
Rather, as in SEC v. Koscot Interplanetary, Inc., supra, the critical inquiry is confined to whether the fortuity of the investments collectively is essentially dependent upon promoter expertise. Continental Commodities renders investment counseling concerning which option on commodities futures to invest in, when to sell or exercise the option, and if the option is exercised, when to sell the specific futures contract. Lacking the business acumen possessed by promoters, investors inexorably rely on Continental Commodities' guidance for the success of their investment. This guidance, like the efficacy of Koscot meetings and guidelines on recruiting prospects and consummating a sale, is uniformly extended to all its investors. That it may bear more productive fruits in the case of some options than it does in cases of others should not vitiate the essential fact that the success of the trading enterprise as a whole and customer
The second question for consideration is whether the notes issued by Continental Commodities in partial reimbursement to its customers upon the suspension of trading in unregistered commodities futures options are embraced by the Securities Act of 1933 and the Securities Exchange Act of 1934 and hence constitute an alternative basis of subject matter jurisdiction. Section 77b(1) of the '33 Act stipulates that unless the context otherwise requires, "the term `security' means any note. . . ." Section 77c(a) exempts from the '33 Act's registration provisions, at issue in the charges under 15 U.S.C. § 77e(a) & (c):
The definitional section of the term security in the 1934 Act, 15 U.S.C. § 78c(a) states that unless the context otherwise requires,
The record indicates that some of the notes issued by Continental Commodities were to mature in less than nine months. Hence we must determine initially whether the reimbursement notes issued by Continental Commodities are the type of notes sought to be regulated by the Acts and whether their maturity dates bring them within the registration exemption in the '33 Act and within the definitional exemption of the '34 Act.
We must also consider whether the transactions in which these notes were issued satisfy the additional jurisdictional prerequisites of the Acts.
A. Notes as Securities
As the foregoing discussion indicates, the treatment extended to notes under the two Acts, while not precisely the same, is virtually identical. See Bellah v. First National Bank of Hereford, 495 F.2d 1109, 1112 (5th Cir. 1974); Zeller v. Bogue Electric Manufacturing Corp., 476 F.2d 795, 799-800 (2d Cir. 1973); Anderson v. Francis I. duPont &
Taking their cue from the Supreme Court's pronouncement that "`[i]nstruments may be included within any of [The Acts'] definitions, as a matter of law, if on their face they answer to the name or description,'" Tcherepnin v. Knight, 389 U.S. 332, 339, 88 S.Ct. 548, 555, 19 L.Ed.2d 564, 571 (1967), quoting SEC v. C. M. Joiner Leasing Corp., 320 U.S. 344, 351, 64 S.Ct. 120, 123, 88 L.Ed. 88, 93 (1943), most courts have countenanced a literal reading of the definition of security to the extent that almost all notes are held to be securities. See Rekant v. Desser, 425 F.2d 872, 878 (5th Cir. 1970); Lehigh Valley Trust Co. v. Central National Bank of Jacksonville, 409 F.2d 989, 991-992 (5th Cir. 1969); Joseph v. Norman's Health Club, 336 F.Supp. 307, 313 (E.D.Mo.1971). Such a literal reading is compatible with the acknowledged policy of strictly construing exemptions from the coverage of the Acts. See SEC v. Ralston Purina Co., 346 U.S. 119, 126, 73 S.Ct. 981, 985, 97 L.Ed. 1494, 1499 (1953); Hill York Corp. v. American International Franchises, Inc., 448 F.2d 680, 689 (5th Cir. 1971). However, it should not be employed to frustrate the spirit or intention of Congress in promulgating the Acts.
That the notes issued by Continental Commodities possess a maturity date of less than nine months is not dispositive. This court intimated as much in United States v. Rachal, 473 F.2d 1338 (5th Cir. 1973), where in a case involving the exemption from registration for short-term notes, we approved the following instruction given by the trial court:
473 F.2d at 1343. Underlying our approval was the premise that the Acts' exemptions for notes extend only to commercial paper, not investment paper. This premise has received increasing acceptance, as indicated by the number of cases rejecting the proposition that notes of less than 9 months maturity are per se exempt from the registration provisions of the '33 Act and the definitional section of security appearing in the '34 Act. See Zeller v. Bogue Electric Manufacturing Corp., supra at 800; Sanders v. John Nuveen and Co., Inc., 463 F.2d 1075, 1080 (7th Cir.), cert. denied, 409 U.S. 1009, 93 S.Ct. 443, 34 L. Ed.2d 302 (1972); SEC v. Vanco, Inc., 283 F.2d 304 (3d Cir. 1960), aff'g, 166 F.Supp. 422, 423 (D.N.J.1958); United States v. Hill, 298 F.Supp. 1221, 1226-1227 (D.Conn.1969); Anderson v. Francis I. duPont & Co., supra at 708-709. Additional testimony to its approval is supplied by courts which deem the commercial-investment dichotomy as implicit within the "unless the context otherwise requires" prefatory language of 15 U.S.C. §§ 77b(1) and 78c(a)(10), see Lino v. City Investing Co., 487 F.2d 689, 694-695 (3d Cir. 1973); Joseph v. Norman's Health Club, Inc., supra at 313, and those courts which read the dichotomy into the definitional sections without positing a precise derivational source. See Davis v. Avco Corp., 371 F.Supp. 782, 787 (N.D.Ohio 1974); SEC v. Thunderbird Valley, Inc., 356 F.Supp. 184, 188 (D.S.D.1973); McClure v. First National Bank of Lubbock, Texas, 352 F.Supp. 454, 457-458 (N.D.Tex. 1973). And it was this impressive line of cases which led this court to hold that the exemption for short-term notes under the Securities Exchange Act of 1934 applied only to commercial and not investment paper in Bellah v. First National Bank of Hereford, supra. Accordingly,
The above quoted instruction approved in United States v. Rachal, supra, largely reflects the SEC's position concerning the exemption from the '33 Act's registration provisions. Securities Act.Rel. No.4412, 26 Fed.Reg. at 9159.
Although the SEC release is entitled to great weight, it is not dispositive, see SEC v. Koscot Interplanetary, supra at 483 n. 14; Zeller v. Bogue Electric Manufacturing Corp., supra at 800, and hence the conclusion that the term "security" embraces the Continental Commodities notes need not rest on an application of the factors contained in the SEC release alone. Rather, it is appropriate and preferable to consider and apply the judicially assessed characteristics ascribed to commercial and investment paper.
The paramount concern in this inquiry is upon the nature of the transaction in which the note is issued. In Lino v. City Investing Co., supra, the Third Circuit dismissed on jurisdictional grounds a suit brought under various registration and anti-fraud provisions of
487 F.2d at 695. Thus, the Third Circuit concluded that City Investing Company accepted the note, not to invest in Lino's franchise, but to enable the franchise to be financed.
Illustrative of the transactions in which a note is deemed to be investment paper is Zeller v. Bogue Electric Manufacturing Corp., supra. Zeller, a shareholder in Belco Pollution Control Corp. (Belco), brought a derivative action against Bogue Electric Manufacturing Corp. (Bogue) its parent corporation, alleging as grounds therefor that Bogue had caused Belco to loan money to Bogue on terms that were purportedly unfair. The individual protagonists, directors and accountants of both parent and subsidiary, had caused Belco to make a series of open account loans to Bogue for which no interest was required to be paid. Over a year later, the open account indebtedness was supplanted by a demand interest bearing note, collateralized by shares of Belco stock owned by Bogue. While the opinion of the Second Circuit does not reveal the reason why the note was issued at this time, it does indicate that the initial loan was prompted by operating losses suffered by Bogue. Thus, the loan constituted an attempt to return Bogue to a position of financial viability. And to the extent that this restoration of Bogue would rebound to Belco's benefit, Belco's supplying of money on open account constituted
The analogies between Zeller and the instant case compel us to conclude that the notes issued by Continental Commodities were investment and not commercial in nature. Despite unrelenting arguments by Continental Commodities to the contrary, it is apparent from a review of the record that the notes were issued to rejuvenate and not to liquidate the enterprise. Affiants Thomas M. Cain, Jr. and Bob Doss claimed that they had been apprised by Charles Long that upon reimbursement of its customers in part with cash and in part with the notes, Continental Commodities would be permitted to remain in business by the SEC. Similarly, the record contains a letter written to customer Milton Young in which Long states: "We hope that in a short period of time we are able to register our options as securities and begin selling options again." Finally, affiant Wayne M. Whitaker, a staff attorney with the Fort Worth Regional Office of the SEC, related the substance of Long's explanation for the payment scheme in an interview as follows: "Long stated that he does have funds to pay in full the customer's original investments, but that he is only offering a 60% immediate refund and a note for the remaining 40% to certain large customers in order to leave him with enough cash to sue the West Coast Commodity Exchange and possibly register the options should it become necessary." To the extent that the district court's disposition may have rested on the finding that the notes issued by Continental Commodities were designed to liquidate the enterprise, the aforementioned evidence establishes and we conclude that this finding was clearly erroneous.
Once the resuscitative nature of the notes is established, the conclusion is ineluctable that the notes were investment and not commercial paper. Since revival would inure to their benefit, recipients accepted the notes with the hope of realizing a greater return on their investments. To this extent the recipients here were in a position akin to that of the Belco shareholders in Zeller v. Bogue Electric Manufacturing Corp., supra.
B. Additional Jurisdictional Prerequisites
The final question for review is whether for purposes of the '33 Act, Continental Commodities' issuance of the notes constituted a sale or disposition of a security for value and whether for purposes of the '34 Act, the notes were sold and whether there was any fraud in connection with the sale of such notes. We address the sale aspect under both the Acts, and then turn to the "in connection with" requirement under section 10b alone.
We begin by noting that the meaning of the terms "sale" and "purchase and sale" under different sections of the Acts may vary. See SEC v. National Securities, Inc., 393 U.S. 453, 466, 89 S.Ct. 564, 571, 21 L.Ed.2d 668, 679-680 (1968); International Controls Corp. v. Vesco, 490 F.2d 1334, 1343 n.8 (2d Cir.), cert. denied, ___ U.S. ___, 94 S.Ct. 2644, 40 L.Ed.2d ___ (1974). Amenability of particular securities to these terms is determined by whether the transactions in which the
Continental Commodities claims that the issuance of the notes did not constitute a sale under either Act essentially because it did not receive any value from the recipients. But an examination of the record reveals that an agreement to forbear bringing legal action was a condition exacted by Continental Commodities for the issuance of the notes. The text of a telegram from customer Gerald Rubman to Charles Long is illustrative: "Gentlemen it is understood that as a condition of withholding legal action, I am to receive within seven days a check for sixty percent of my deposit together with a promissory note for the balance of funds due and payable me [sic]." And as the affidavits alluded to above indicate, Continental Commodities represented that by issuing the notes, it bought not only SEC permission to continue operating, but also time within which it could sue the West Coast Commodities Exchange, seeking a reversal of its prohibition against trading on unregistered commodities options.
The question of whether in these circumstances a sale was effected under the relevant portions of the Acts is one yet to be addressed by the courts. An affirmative response seems to be suggested by two vintage cases involving suits for unlawful insider trading where courts held sales to have been effected where securities were issued in payment for past debts. See Blau v. Albert, 157 F.Supp. 816, 820 (S.D.N.Y.1957); Smolowe v. Delendo Corp., 46 F.Supp. 758, 763 (S.D.N.Y.1942), aff'd, 136 F.2d 231 (2d Cir.), cert. denied, 320 U.S. 751, 64 S.Ct. 56, 88 L.Ed. 446 (1943). Moreover, in Zeller v. Bogue Electric Manufacturing Corp., supra, the Second Circuit apparently did not deem the absence of tangible consideration flowing from Belco to Bogue concomitant with the issuance of the note to be an impediment to jurisdiction. This conclusion can be supported under the reasoning that the initial open account loans extended by Belco constituted the requisite return to Bogue for the note it subsequently issued — reasoning equally appropriate here.
We would also note that Continental Commodities most assuredly would be deemed to have engaged in a sale had it issued promissory notes not to its customers but to other members of the investing public and applied the proceeds to its customer indebtedness. The net effect of this hypothetical transaction and the instant transaction is the same — time is bought hopefully to enable the enterprise to revive itself. The potential jeopardy to the salutary purposes of
We also hold that for jurisdictional purposes, the requisite fraud in connection with the sale or purchase of a security has been alleged. The complaint charges that Continental Commodities made several fraudulent representations at the time the notes were issued, inter alia, that the SEC had frozen $3,000,000 of Continental Commodities money and had approved its remuneration plan. It also charges that Continental Commodities misrepresented the amount of money it had on reserve to back investments at the time customers initially invested in commodities options. This latter alleged misstatement can be considered as having a continuing effect up to and beyond the time the notes were issued. Accordingly these purported misrepresentations fall clearly within the "in connection with" requirement, as adumbrated in Superintendent of Insurance v. Bankers Life & Casualty Co., supra, Sargent v. Genesco, Inc., supra, and Smallwood v. Pearl Brewing Co., supra.
To reiterate, we hold only that the record before the district court on the SEC's motion for a preliminary injunction was sufficient to establish jurisdiction under the Securities Act of 1933 and the Securities Exchange Act of 1934. We intimate no view as to the verity of the SEC's assertions of fraud or the wisdom of issuing a preliminary injunction. Accordingly, this cause is reversed and remanded with instructions to consider the propriety of granting a preliminary injunction and other appropriate relief.
Reversed and remanded.
15 U.S.C. § 77q (1970) provides that:
17 C.F.R. § 240.10b-5 states that:
This position tracks in part the description of exempted notes appearing in H.R.Rep. No.85, 73d Cong., 1st Sess. 15 (1933). The release, and its support in the legislative history of the Acts is discussed extensively in Comment, The Commercial Paper Market and the Securities Acts, 39 U. of Chicago L. Rev., 362, 380-396 (1972).
Our conclusion on this score should not be read to undermine the observation in Bellah v. First National Bank of Hereford, supra, that under the release criteria, that Bellah's lack of financial viability cannot metamorphize commercial paper into investment paper. This observation was confined to circumstances where the impecunious maker seeks to invoke the protections of the Act. Bellah v. First National Bank of Hereford, supra at 1112 n. 3. Accordingly, it is inapposite where, as here, the maker seeks to avoid the Act's sanctions.