1974 WL 472 (N.D.Ill.)

SEC

v.

Steed Industries, Inc., et al.

No. 74 Civ. 1053

United States District Court; N.D. Illinois, E.D.

October 15, 1974

MCGARR, District Judge.

Memorandum Opinion and Order

*1 On April 16, 1974, a complaint was filed by the Securities and Exchange Commission against a corporate defendant doing business as Steed Industries, Inc., and a large number of individuals associated with the Steed enterprise.

The complaint describes the defendant Steed Industries as an Illinois-based pyramid promotional company. The S. E. C. alleges that, in addition to offering to some extent to sell products through its distributors, Steed's basic pursuit is the creation and expansion of a pyramid promotion or endless chain scheme. The complaint goes on to allege that the primary emphasis of defendant Steed's operation is the recruitment of investors at manager and director levels who in form will be distributors of the defendant's products but who in fact will devote their efforts almost entirely to an attempt to locate other investors for the defendant to recruit. There is a promise to investor/recruiters that they will share in the profits derived by the investments of subsequent investors they bring to the defendant's various recruitment meetings.

It is the contention of the S. E. C. that the Steed Industries promotional program creates the illusion of a retail business but in fact discourages the retailing of the products involved, and encourages only recruitment and the promises of investor profits based upon the activity of the recruits they procure. It is further the contention of the S. E. C. that the levels of participation in the Steed enterprises promotional activity, mainly that of distributor, manager, and director, are in reality interests and participations in a common enterprise in which each investor will, after having made his investment, share in profits derived from the success of the defendants in inducing other persons who have been introduced by the investor to participate in the scheme. This, says the S. E. C., constitutes a security and the activities of Steed constitute sales of securities. Based upon this conclusion, the complaint goes on to allege material misrepresentations and material omissions to prospective investors in the sale of the security defined in the complaint.

After the filing of the complaint and the consent to a temporary restraining order to preserve the status quo and bring about a cessation of the sales activities, a variety of defendants' motions to dismiss were filed. It quickly became apparent that the principal issue and a threshold issue in the case was whether the pyramid sales scheme alleged in the complaint and the investment opportunities or participations sold thereby were in fact a security as defined under the laws deemed applicable to this situation by the Securities and Exchange Commission.

In a memorandum opinion and order dated June 13, 1974, the Court granted the motion of Steed Industries, Inc. and other individual defendants for a separate trial on the issue of whether the various classes of Steed distributorships are securities as defined in the complaint. On July 8, 1974, and for four days thereafter, evidence was taken on the issue of whether the practices described in the Securities and Exchange Commission complaint in fact took place, and whether these practices, investment opportunities and participation schemes in fact constituted securities under the law. Subsequent to this hearing, the parties filed post-trial memoranda and the issue of whether defendants offered or sold a security argued therein is the subject matter of this opinion.

*2 As the result of the hearing and contentions of the parties, this Court finds that the Government has proved a scheme propounded by the defendant Steed Industries and its various officers and employees which substantiates the pyramid promotional scheme allegations of the complaint. The promotional program of Steed demonstrated by the evidence reveals activities tainted by fraud and a scheme which has led to a significant monetary loss by a large number of people who can realistically be called victims. The situation, fraught as it is with misrepresentations and failure to disclose material facts while inducing the investing public to put money in the hands of defendants, is a situation which virtually demands the intervention of Government to stop further fraud and to protect hapless potential investors. The issue before this Court at this time, however, is the much more limited question of whether that goal can properly be sought by the Securities and Exchange Commission under the statutes defining that agency's jurisdiction.

An analysis of the statutes establishing the Securities and Exchange Commission's jurisdiction in this area begins with Section 2(1) of the Securities Act of 1933 (115 U. S. C. § 77b(1)), which includes among the types of securities over which the S. E. C. is being granted jurisdiction, a type of security described in the statute as "an investment contract". It is the contention of the S. E. C. in the instant case that the interests offered and sold by the defendants are "securities" because they are "investment contracts". The issue before the Court thus focuses on the meaning of that term in the Act as illuminated by the decisions and on the issue of whether pyramid promotion or multilevel sales activities of the Steed organization constitute an investment contract as therein defined.

Our principal guide in this endeavor is the case of Securities and Exchange Commission v. W. J. Howey Co., 328 U. S. 293, 66 S. Ct. 1100, 90 L. Ed. 1244. Two statements in that decision are salient here:

"In other words, an 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, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise."

(p. 1249)

"It permits the fulfillment of the statutory purpose of compelling full and fair disclosure relative to the issuance of 'the many types of instruments that in our commercial world fall within the ordinary concept of a security.' H. Rep. No. 85, 73d Cong., 1st Sess., p. 11. It embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits."

(p. 1250)

*3 In commenting upon the definition of investment contracts taken from the Howey case and set forth above, the Fifth Circuit Court of Appeals in Securities and Exchange Commission v. Koscot Interplanetary, Inc., et al., - F. 2d - (1974), has restated the holding in that case in terms of the three- element test and the convenience of this device has led to its widespread use by other courts in discussing this issue.

"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., S. E. C. v. Glenn W. Turner Enterprises, 474 F. 2d 476 (7th Cir.), cert. denied, 414 U. S. 821, 94 S. Ct. 117, 38 L. Ed. 2d 53 (173); 1050 Tenants v. Jakobson, 365 F. Supp. 1171, 1176 (S. D. N. Y. 1973)."

(p. 5799)

Subsequent development of the law has centered around whether the word "solely" in the third element of the test quoted above must be literally applied. In recognition and furtherance of the substance rather than form principle of the Howey decision (90 L. Ed. at 1249), the Ninth Circuit in S. E. C. v. Glenn W. Turner Enterprises, 474 F. 2d 476, found an investment contract to exist in a factual situation where the efforts of investors played a minimum role in the production of profits, thus moving away from a literal acceptance of the principle in Howey that the profits must be derived "solely" from the efforts of individuals other than investors.

A lengthy exposition for the justification of this liberalized application of Howey is found in S. E. C. v. Koscot, - F. 2d -, C. A. 5, July 15, 1974. In this case, the Fifth Circuit refused to allow a literal application of the word "solely" in the Supreme Court opinion in the Howey case to thwart the obvious remedial purposes of the legislation.

This Court adopts the rationale of the Fifth Circuit decision in the Koscot case, and in keeping with this conclusion, determines the test to be applied to the facts in this case to be that announced by the Ninth Circuit in S. E. C. v. Glenn W. Turner Enterprises, Inc., 474 F. 2d 476 (1973). In that case, the Court announced that the critical issue 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.

Applying the test thus stated, it is the conclusion of the Court that in the fact situation presented here, the efforts made by those other than the investor are the undeniably significant ones. For this reason, it is the conclusion of the Court that those persons investing money in the Steed enterprise, whether distributors, managers or directors, are entering into investment contracts, which contracts are interests commonly known as securities within the definition of "security" as set forth in the Securities Act, 15 U. S. C. § 77b(1).