Securities & Exch. Com. v. Koscot Inter., Inc.

CourtUnited States Courts of Appeals. United States Court of Appeals (5th Circuit)
Citation497 F.2d 473
Docket NumberNo. 73-2339.,73-2339.
PartiesSECURITIES AND EXCHANGE COMMISSION, Plaintiff-Appellant, v. KOSCOT INTERPLANETARY, INC., et al., Defendants-Appellees.
Decision Date15 July 1974

Richard E. Nathan, Asst. Gen. Counsel, David J. Romanski, Atty., David Ferber, Sol., S. E. C., Washington, D. C., James E. Long, John M. Kelly, S. E. C., Atlanta, Ga., for plaintiff-appellant.

Jeffrey Allen Tew, Miami, Fla., for Turner Enterprises.

Theodore I. Koskoff, Bridgeport, Conn., for G. Turner.

Before RIVES, GEWIN and RONEY, Circuit Judges.

GEWIN, Circuit Judge:

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 '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 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 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.

"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. ..." (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 recruits 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...

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