Legal Brief:
Securities and Exchange Commission v.
ETS Payphones, Inc., and Charles E. Edwards,

UNITED STATES COURT OF APPEALS
FOR THE ELEVENTH CIRCUIT

CERTIFICATE OF INTERESTED PERSONS
AND CORPORATE DISCLOSURE STATEMENT

Pursuant to Eleventh Circuit Rule 26.1-1, the Commission submits the following as "a complete list of the trial judge(s), all attorneys, persons, associations of persons, firms, partnerships, or corporations that have an interest in the outcome of the particular case, including subsidiaries, conglomerates, affiliates and parent corporations, and other identifiable legal entities related to a party" known to Commission counsel:

Americom, Inc.
Axis Graphics, Inc.
Catherine A. Broderick, Esq.
Honorable Jack T. Camp, United States District Court
     for the Northern District of Georgia
City Public Phones, Inc.
Ethan H. Cohen, Esq.
Charles E. Edwards
Meyer Eisenberg, Esq.
ETS Management Services, LLC
ETS Payphones, Inc.
ETS Payphones of California, Inc.
ETS Vending, Inc.
William P. Hicks, Esq.
IAQ Duct Doctor, Inc.
Kutak Rock LLP
Legends Communications, Inc.
Liberty Motor Sports LLC
Susan S. McDonald, Esq.
Merritt Island LLC
MSC National, Inc.
Payphone Systems Acquisitions, Inc.
Phoenix Telecom of Puerto Rico, Inc.
Pleasant Hill Properties I, LLC
Powell, Goldstein, Frazer & Murphy LLP
Giovanni P. Prezioso, Esq.
S and R Telecommunications Consultants, Inc.
W. Scott Sorrels, Esq.
Jacob H. Stillman, Esq.
Edward G. Sullivan, Esq.
TPL, Inc.
TSC Payphone Corp.
Twinleaf, Inc.
Twinleaf Media, Inc.
U.S. Securities and Exchange Commission
Michael K. Wolensky, Esq.

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STATEMENT OF COUNSEL FOR THE SECURITIES AND EXCHANGE COMMISSION
REQUIRED BY 11TH Cir. R. 35-6(c)

I express a belief, based on a reasoned and studied professional judgment, that the attached panel decision is contrary to the following decisions of the Supreme Court of the United States and the precedents of this circuit and that consideration by the full court is necessary to secure and maintain uniformity of decisions in this Court: SEC v. W.J. Howey Co., 328 U.S. 293 (1946); SEC v. United Benefit Life Ins. Co., 387 U.S. 202 (1967); SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344 (1943); Albanese v. Florida Nat'l Bank of Orlando, 823 F.2d 408 (11th Cir. 1987); SEC v. Koscot Interplanetary, Inc., 497 F.2d 473 (5th Cir. 1974).

I express a belief, based on a reasoned and studied professional judgment, that this appeal involves one or more questions of exceptional importance:

1. Whether an investment is excluded from the term "investment contract" and the definition of "security" because of the promoter's promise of a fixed return, where authoritative decisions of two other circuits (see Fed. R. App. P. 35(b)(1)(B)) have held that it is not so excluded (SEC v. The Infinity Group Co., 212 F.3d 180, 187-188 (3d Cir. 2000), cert. denied, 121 S. Ct. 1228 (2001), and United States v. Carman, 577 F.2d 556, 563 (9th Cir. 1978)).
    
2. Whether an investment is excluded from the term "investment contract" and the definition of "security" because the investor's expected profits are "contractually guaranteed" by the promoter.

______________________________

ATTORNEY OF RECORD FOR THE
SECURITIES AND EXCHANGE COMMISSION

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TABLE OF CONTENTS

TABLE OF AUTHORITIES

CASES

*Abbett, Sommer & Co., Inc., 44 S.E.C. 104 (1969)

*Albanese v. Florida Nat'l Bank of Orlando, 823 F.2d 408 (11th Cir. 1987)

Meason v. Bank of Miami, 652 F.2d 542 (5th Cir. Aug. 6, 1981)

People v. White, 124 Cal. App. 548 (Dist. Ct. App. 1932)

Resolution Trust Corp. v. Stone, 998 F.2d 1534 (10th Cir. 1993)

Reves v. Ernst & Young, 494 U.S. 56 (1990) passim

*SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344 (1943)

SEC v. Koscot Interplanetary, Inc., 497 F.2d 473 (5th Cir. 1974) passim

*SEC v. The Infinity Group Co., 212 F.3d 180 (3d Cir. 2000), cert. denied, 121 S. Ct. 1228 (2001)

*SEC v. United Benefit Life Ins. Co., 387 U.S. 202 (1967)

SEC v. Universal Service Ass'n, 106 F.2d 232 (7th Cir. 1939)

*SEC v. W.J. Howey Co., 328 U.S. 293 (1946) passim

*SEC v. Zandford, 122 S. Ct. 1899 (2002)

Stevens v. Liberty Packing Corp., 111 N.J. Eq. 61, 161 A. 193 (1932)

United Housing Found. Inc. v. Forman, 421 U.S. 837 (1975)

United States v. Austin, 462 F.2d 724 (10th Cir. 1972)

*United States v. Carman, 577 F.2d 556 (9th Cir. 1978)

STATUTES

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STATEMENT OF ISSUES THAT MERIT EN BANC CONSIDERATION

Whether an investment is excluded from the term "investment contract" and the definition of "security" (1) because of the promoter's promise of a fixed return and (2) because the investor's return is "contractually guaranteed" by the promoter.

STATEMENT OF THE COURSE OF PROCEEDINGS AND CASE DISPOSITION

In this law enforcement action, the Commission charged that Charles E. Edwards, owner of ETS Payphones, Inc., fraudulently sold units in a payphone sale/lease/buyback program in which 10,000 investors in 38 states invested about $375 million. Edwards promoted the scheme to the general public as a safe and profitable investment - urging that the plan was "virtually recession-proof," that investors would receive "immediate, steady cash flow" (R1-1-Exh. 15 at 8) and stating in bold type "Watch the Profits Add Up" (R1-1-Exh. 17 at 8), but failing to disclose that ETS's operation of payphones was never profitable and that the company was on the verge of bankruptcy, for which it filed in September 2000.

The district court found for purposes of entering preliminary relief that the interests sold were securities - specifically, "investment contracts" - as defined in Section 2(a)(1) of the Securities Act, 15 U.S.C. 77b(a)(1), and Section 3(a)(10) of the Securities Exchange Act, 15 U.S.C. 78c(a)(10). The district court concluded that the ETS units were investments in a common enterprise with the investors led to expect profits through ETS's management of the payphone operations, and thus that the units met the definition of investment contract adopted in SEC v. W.J. Howey Co., 328 U.S. 293, 298-299 (1946) ("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"). See 123 F. Supp. 2d at 1352-1354. With respect to the "efforts" element, the district court made a factual finding that under the lease agreements "investors retain little, if any control" and that "Defendant [Edwards] manages, maintains, and operates the pay phones." 123 F. Supp. 2d at 1351.

Yet, a panel of this Court reversed and directed dismissal of the complaint, holding that, although an "investment of money is apparent" (Op. 5-6) and ETS investors purchased the phones "for the purpose of earning a return on the purchase price" (Op. 7), these interests did not meet the Howey test because the investors' return - the monthly "lease" payments on the phones they bought and leased back to ETS - was fixed rather than variable with ETS's profits. The panel held that a fixed return cannot constitute "profits" under Howey. Op. 7-8. The panel further held that even if the investors' fixed return were profits under Howey the ETS units still were not investment contracts because "the investors were entitled to their lease payments under their contracts with ETS" (Op. 9), reasoning:

Because their returns were contractually guaranteed, those returns were not derived from the efforts of Edwards or anyone else at ETS; rather, [the lease payments] were derived as the benefit of the investors' bargain under the[ir] contract[s] [with ETS].

STATEMENT OF FACTS

The investment ETS sold was a package consisting of a payphone with a lease/management agreement and a buyback commitment: The investor bought a phone for $6,750 through PSA, Inc., an ETS subsidiary, leased it back to ETS for five years, and was paid a fixed return of $82 per month - a 14% return -- regardless of how much revenue his particular phone generated. R1-1-Exh. 15 at 11, Exh. 18 at 6. Under the buyback provision, ETS agreed to refund the full purchase price at the end of the five-year lease, or within 180 days of the investor's request for a refund. Id.

Investors in the ETS units were passive, with no role in managing or operating the payphones. ETS's promotional materials stated that ETS chose locations for and installed the phones, managed and maintained them, and retrieved coins from them. R1-1-Exh. 18 at 5-6.

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ARGUMENT

A.  The panel decision involves questions of exceptional importance -- removing from the protections of the securities laws many types of investments that have long been recognized as covered by those laws. The decision's technical, formulaic approach to the interpretation of the term "investment contract" and the definition of "security" provides an easy means for unscrupulous promoters to evade the securities laws by restricting the promised return on an investment to a fixed amount. Not only is the decision contrary to decisions of the Supreme Court and of courts of appeals, but it also significantly narrows the coverage of the securities laws. For over half a century "investment contract" has been a critical vehicle for bringing within the securities laws a host of investments that do not fit within the more specific items included in the definition of security. The panel's holding undermines the Commission's ability to carry out its mandate to protect the public from fraud and other abuses in all forms of investments, including both debt and equity securities, at a time when the need for investor protection is more apparent than ever.

B.  The panel's very narrow interpretation of investment contract and security conflicts with the statutory language and purpose. Congress "enacted a definition of 'security' sufficiently broad to encompass virtually any instrument that might be sold as an investment." Reves v. Ernst & Young, 494 U.S. 56, 61 (1990). The words "investment contract" in no way suggest that investments with fixed returns are excluded. Moreover, "investment contract" was included in the definition as a catch-all term for investments that might not fit easily within other more specific items. Just as the specific items include fixed-return investments ("bond," "debenture," "note," and "evidence of indebtedness"), there is no justification for excluding fixed return investments from a catch-all term.

The federal securities laws are "construed 'not technically and restrictively, but flexibly to effectuate [their] remedial purposes.'" SEC v. Zandford, 122 S. Ct. 1899, 1903 (2002). Specifically with respect to the term "security," a broad reading is required because "Congress' purpose in enacting the securities laws was to regulate investments, in whatever form * * * and by whatever name," and the courts are "not bound by legal formalisms, but instead take account of the economics of the transaction." Reves, 494 U.S. at 61 (emphasis in original). See also SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 351 (1943). In interpreting "investment contract" in Howey, the Supreme Court emphasized that the definition "embodies a flexible * * * principle * * * capable of adaptation to meet the * * * variable schemes devised by those who seek the use of the money of others on the promise of profits." 328 U.S. at 299. "The statutory policy of affording broad protection to investors is not to be thwarted by unrealistic and irrelevant formulae" (id. at 301) -- yet that is precisely what the panel has done in this case.

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C.  The ETS interests are investment contracts. This Court and others have viewed Howey as establishing that an investment contract exists when: (1) a person invests money; (2) in a common enterprise; and (3) is led to expect profits from the managerial or entrepreneurial efforts of the promoter or a third party. See, e.g., SEC v. Koscot Interplanetary, Inc., 497 F.2d 473, 477 (5th Cir. 1974).

There is no dispute that the first element of Howey is met here, since "an investment of money is apparent." Op. 6. There can be no serious question that the second element - a common enterprise - is present as well.¹ The panel's decision turned instead on its view that the fixed return investors received did not constitute "profits" under Howey's third element and also on its conclusion that, even if the lease payments could be considered profits, the third element would not be satisfied because the payments were "contractually guaranteed" and thus not derived from the efforts of others. The panel's decision is incorrect in both respects.

1.  The panel's holding that a fixed return investment cannot be an investment contract conflicts with decisions of the Supreme Court, courts of appeals and the Commission. The first question of which en banc review is sought is whether a fixed return can be "profits" under Howey. The panel's holding that it cannot conflicts with Howey itself, which expressly referred to "income" as a form of "profits" and cited as examples of correct investment contract decisions three involving schemes with fixed returns. Howey did not restrict investment contracts to equity securities or to investments with a variable return - a restriction that would contravene Congress's intent to encompass all arrangements involving the use of the money of others on the promise of a return. Indeed, Howey adopted the definition of "investment contract" followed by state courts in construing Blue Sky laws, a definition that used the words "income or profit." 328 U.S. at 298 ("a contract or scheme for 'the placing of capital or laying out of money in a way intended to secure income or profit from its employment'"). The use of the word "profits" a few lines later in Howey is merely shorthand for "income or profit." This is confirmed by Howey's statements that the investors were "attracted solely by the prospects of a return on their investment" (id. at 300, emphasis added) -- without referring specifically to "profits" and without suggesting that the return cannot be fixed -- and that "it is immaterial whether the enterprise is speculative or non-speculative" (id. at 301). That Howey did not exclude fixed returns from "profits" is also confirmed by its citation with approval of three fixed return cases (328 U.S. at 298 n.4, 299 n.5): People v. White, 124 Cal. App. 548, 550-551 (Dist. Ct. App. 1932)(fixed $7,500 return on investment of $5,000); SEC v. Universal Service Ass'n, 106 F.2d 232, 237-238 (7th Cir. 1939) (expectation of "30% profit per annum"); Stevens v. Liberty Packing Corp., 111 N.J. Eq. 61, 65, 161 A. 193, 195 (1932) ("return of $56 a year upon a $175 investment").

Further, the panel's decision conflicts with Joiner and SEC v. United Benefit Life Ins. Co., 387 U.S. 202 (1967), which held that whether an investment contract is involved is determined by the way the promoters presented the scheme to potential investors. See Joiner, 320 U.S. at 352-53 (result turns on "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 prospects"); United Benefit, 387 U.S. at 211 (same). "In the enforcement of an act such as this * * * promoters' offerings [should] be judged as being what they were represented to be." Joiner, 320 U.S. at 353. Since Edwards told prospective investors they would receive "profits" ("Watch the Profits Add Up"), he cannot claim that they did not expect to receive profits.

The panel's decision also is inconsistent with a Fifth Circuit decision that is binding in this Circuit. In Koscot, investors in a pyramid scheme were offered fixed payments for each new person brought into the scheme, regardless of the overall profitability of the enterprise. The investor was "sold the idea that he will get a fixed part of the proceeds of the sales [to others]. * * * What he buys is a share in the proceeds of the selling efforts of [the promoter]." 497 F.2d at 485.

The panel's decision also conflicts with decisions of two other circuits which expressly rejected the argument that a fixed return does not constitute "profits" within the meaning of Howey. In SEC v. The Infinity Group Co., 212 F.3d 180, 187-88 (3d Cir. 2000), cert. denied, 121 S. Ct. 1228 (2001), the Third Circuit rejected the argument that the fixed returns offered - a 138% or 181% return on the amount invested -- did not constitute "profits," stating that "the definition of security does not turn on whether the investor receives a variable or fixed rate of return," and noting that in Howey the Court had stated that "it is immaterial whether the enterprise is speculative or non-speculative." Similarly, in United States v. Carman, 577 F.2d 556, 563 (9th Cir. 1978), the Ninth Circuit held that the interests sold were investment contracts despite the fact that "the return was in the form of fixed interest." The package sold included a note, a service contract, and a repurchase agreement. Id. at 560. The court rejected the argument that the fixed return meant that the investors were not dependent on the promoters for profits, reasoning that the investors were dependent on the success of the enterprise -- particularly its ability to collect on the notes and to honor its buyback agreement -- to receive their returns. Id. at 563. "This risk of loss [if the enterprise failed] is sufficient to bring the transaction within the meaning of security, even where the anticipated financial gain is fixed." Id.²

The panel's decision also conflicts with the Commission's administrative interpretation that "investment contract" includes investments in mortgages that pay profits in the form of fixed interest payments, if accompanied by service agreements minimizing the risk of loss to investors. See Abbett, Sommer & Co., Inc., 44 S.E.C. 104, 107-109 (1969)(mortgage notes accompanied by services including investigation of property and mortgagor, collection of monthly payments for investors, and undertaking to repurchase notes). As the Supreme Court recently held, in SEC v. Zandford, 122 S.Ct. at 1903, the Commission's reasonable interpretation is entitled to deference.

Dicta in two Supreme Court decisions have not narrowed the "profits" described in Howey. In United Housing Found. Inc. v. Forman, 421 U.S. 837 (1975), the Court, in describing its holdings in prior "investment contract" cases, stated: "By profits, the Court has meant either capital appreciation resulting from the development of the initial investment * * * or a participation in earnings resulting from the use of investors' funds." Id. at 852. Contrary to the panel's view (Op. 7-8), Forman's reference to a "participation in earnings" did not create a new test that narrowed Howey to variable return investments. Indeed, the Court made it clear in Forman that the profit element of Howey is satisfied where "the investor is 'attracted solely by the prospects of a return' on his investment" (421 U.S. at 852) - an apt description of an investor's expectation of receiving either a variable or a fixed return. The Forman statement about profits was made, not to distinguish fixed from variable returns, but rather to distinguish the situation where an investor is attracted only by the prospects of a return on his money, which is a security, from one where "a purchaser is motivated by a desire to use or consume the item purchased," which is not. Id. at 852-853. Moreover, to conclude as the panel did that a fixed return is not a "participation in earnings" because it is not measured by the earnings of the enterprise is to give the word "participation" an unduly narrow meaning. Irrespective of the measure of the return, an investor expects a "participation" in earnings when, as here, he is led to expect that the source of his return will be the company's earnings. Cf. Koscot, 497 F.2d at 485 (describing fixed payments promised to investors as "a share in the proceeds" of the business). Edwards urged the public to invest in the ETS enterprise based on his representations that the company was profitable, recognizing that investors would expect to receive their returns from the company's earnings.

Nor was Howey's definition of an investment contract as a transaction in which an investment of money is expected to return "income or profit" narrowed by a dictum in Reves. In Reves, the Court considered the test for determining whether an interest denominated as a note is a security, concluding that the Howey test does not apply and, indeed, that "the Howey test is irrelevant to the issue before us today." 494 U.S. at 64, 68 n.4. In describing the "irrelevant" Howey test, the Court stated that "profits" had been defined "restrictively" in Howey and assumed that under Howey "a rate of interest not keyed to the earning of the enterprise" would not constitute "profits." 494 U.S. at 68 n.4. That statement, however, pertains to a matter not before the Court in Reves. Further, as discussed above, the Howey decision itself demonstrates that the Court had never adopted the restrictive view of profits the Reves opinion attributed to it. Rather, Howey shows that the Court intended to include in "profits" "income or profit" -- the same plain meaning of "profits" the Court adopted for the return on notes in Reves: "'a valuable return on an investment,' which undoubtedly includes interest." 494 U.S. at 68 n.4.

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2.  The panel's second holding - the novel and unsupported view that where profits are "contractually guaranteed" investors do not rely on the efforts of others - is wrong. Under Howey, the focus of the "efforts" element is not on whether profits are "contractually guaranteed," but rather on whether it is the promoter or the investors themselves who manage the enterprise expected to generate the profits. See 328 U.S. at 299-300 ("manage[ment] by [the promoters] or third parties with adequate personnel and equipment [was] essential if the investors [we]re to achieve their paramount aim of a return on their investments"). In Albanese v. Florida Nat'l Bank of Orlando, 823 F.2d 408, 412 (11th Cir. 1987), this Court correctly focused on the fact that the investors as a practical matter had no control over their investments, which were instead managed by the promoters. The same was found by the district court to be true in this case. See 123 F. Supp. 2d at 1351 (Edwards "manages, maintains, and operates the pay phones"). The panel did not conclude that the trial court's finding was clearly erroneous. Indeed, as the panel recognized, "the funds generated by the payphones helped ETS meet its [lease and buyback] obligations" (Op. 8). Yet, the panel incorrectly focused on the fact that the promise to pay was "contractually guaranteed," rather than on the fact that it was Edwards who managed the ETS enterprise, from the earnings of which investors expected to receive their returns.

Of course, the fact that the ETS investors had a "contractual" right to the promised return does not defeat the existence of an "investment contract," since that would effectively read that category out of the statute. Nor is an investment contract precluded by the "guarantee" of the return. First, even a true guarantee by a third party would not defeat the existence of an investment contract, but rather would establish the existence of an additional type of security. The Securities Act definition of security includes a "guarantee of" any of the other devices enumerated in the definition. Second, in this case the only "guarantee" was ETS's own contractual promise to pay a return, making it meaningless unless the company was able to make the promised payments. Moreover, regardless of whether the guarantee were by ETS or a third party, the investors were still dependent on the ability of the guarantor to pay, and thus their returns were dependent on the efforts of others.

If the panel's use of the term "guaranteed" referred to the fixed nature of the return, the panel's belief that a fixed return meant that investors were not dependent on the efforts of others is equally mistaken. Purchasers of fixed return investments, like purchasers of variable return investments, are dependent on the efforts of others to manage successfully the enterprise in which they invest. Indeed, the disclosure requirements applicable to public offerings of both debt and equity securities include information about the company's earnings. See Section 7(a) of the Securities Act, 15 U.S.C. 77g(a) & Schedule A, 15 U.S.C. 77aa(26). Edwards himself recognized that investors would expect to receive their returns from the earnings of the payphone operation, urging the public to invest in ETS because, he falsely claimed, the company was profitable.

D.  The ETS interests fall within other categories in the definition of security. Since Congress intended the definition of security to "encompass virtually any instrument that might be sold as an investment" and since "the economics of the transaction under investigation," not "legal formalisms," are determinative (Reves, 494 U.S. at 60, 61), the statutory purpose would be undermined if the ETS interests are excluded from the scope of "security." Of the various securities listed in the statute, investment contract best describes the ETS interests. For this reason, the Commission's principal argument below focused on investment contract. The district court in its opinion, and the parties likewise in this Court, addressed only that term. While we believe that the ETS interests are investment contracts, we also believe, particularly if they are precluded from satisfying Howey because of the fixed return, that the economic realities here establish that the ETS interests come within one or more of the fixed return investments listed in the definition of "security." The panel erred in ordering dismissal of the complaint for lack of subject matter jurisdiction without considering - or remanding for the district court to consider - whether the interests are "securities," even if they are not investment contracts. See Meason v. Bank of Miami, 652 F.2d 542, 547, 550-551 (5th Cir. Aug. 6, 1981).

As we argued below (R4-19 at 4-6), the ETS interests may properly be characterized as "notes" or the even broader "evidences of indebtedness" (see United States v. Austin, 462 F.2d 724, 736 (10th Cir. 1972)). Unlike ordinary leases, the ETS interests were vehicles for investment and in economic substance operated like debt securities and other interests "commonly known as a security." Moreover, if analyzed as a "note" under the Reves family resemblance test, ETS's contractual obligation would fall within the definition of security. Under Reves, the presumption that a note is a security (494 U.S. at 65) can be rebutted if the note resembles certain categories of non-investment type notes (id.), none of which is involved here. In determining whether a note resembles a non-investment type note, Reves applied four factors, all of which weigh in favor of finding the ETS interests to be notes that are securities.³

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CONCLUSION

Rehearing or rehearing en banc should be granted.

Attachment

A version of this brief that includes the addendum etc. is available in PDF format

http://www.sec.gov/litigation/briefs/ets-payphones.htm