El Khadem v. Equity Securities Corporation

• Decision Date: 20 March 1974
• Docket Number: No. 72-1380.,72-1380.
• Citation: 494 F.2d 1224
• Parties: Mary F. EL KHADEM, Plaintiff-Appellee, v. EQUITY SECURITIES CORPORATION, a corporation, et al., Defendant-Appellant.
• Court: U.S. Court of Appeals — Ninth Circuit

494 F.2d 1224 (1974)

Mary F. EL KHADEM, Plaintiff-Appellee, v. EQUITY SECURITIES CORPORATION, a corporation, et al., Defendant-Appellant.

No. 72-1380.

United States Court of Appeals, Ninth Circuit.

March 20, 1974.

John L. Endicott (argued), of Gibson, Dunn & Crutcher, Los Angeles, Cal., John B. Gregory, of Burch & Platt, San Diego, Cal., for defendants-appellants.

Arnold O. Steele (argued), La Jolla, Cal., for plaintiff-appellee.

Before WRIGHT and TRASK, Circuit Judges, and BYRNE, Sr.^* District Judge.

OPINION

EUGENE A. WRIGHT, Circuit Judge:

This is an action to recover damages for alleged violations of the Securities Act of 1933, the Securities Exchange Act of 1934, and state law. Defendants moved to dismiss, claiming that the case does not involve the purchase or sale of a "security" and therefore neither the Securities Act nor the Securities Exchange Act confer jurisdiction on the district court.¹ The district court held that the case does involve the sale of a security and denied the motion to dismiss. Appellants appeal,² and we affirm.

I BACKGROUND

Defendant Equity Securities Corporation is a registered and licensed dealer-broker of securities and is a wholly owned subsidiary of defendant Equity Funding Company of America. Defendant Lyman Spurlock is an investment advisor, employed by Equity Securities and acting as its agent. During the period in question, Lyman Spurlock served as investment counsellor to plaintiff, Mary El Khadem.

In her amended complaint, Ms. El Khadem alleged the following series of events. In 1968, Mr. Spurlock advised her to invest in a plan offered by Nationwide Investment Corporation.³ Under this plan Ms. El Khadem borrowed $40,000 from Nationwide to purchase mutual funds that in turn were pledged as collateral for the loan. Ms. El Khadem was also required to pledge cash collateral and to prepay interest. The plan afforded Ms. El Khadem a tax advantage derived from prepaying interest and gave her investment leverage in anticipation of a rising market.

Under the Nationwide agreement, Ms. El Khadem was required to pledge securities to Nationwide, including the mutual funds purchased with the borrowed $40,000, valued at 175% of her indebtedness. Nationwide was given the power to rehypothecate her collateral, up to the amount of her indebtedness, and pledge it to secure Nationwide's own borrowings for business purposes. Nationwide was also given the power to assign Ms. El Khadem's promissory note.⁴ The agreement did not require Nationwide to include in an assignment of her promissory note a provision that collection was conditioned upon return of the collateral to Ms. El Khadem. Nor did the agreement limit Nationwide's power to rehypothecate Ms. El Khadem's collateral to situations where Nationwide's creditors could foreclose only if Ms. El Khadem did not honor her promissory note.

Following a drop in the stock market, Ms. El Khadem was required to deposit more collateral to meet the 175% requirement. On the advice of Nationwide and defendants, she borrowed an additional $34,230 under conditions similar to the original $40,000 loan. The collateral, which then totaled $83,180, was converted to U.S. Treasury Bills.

The Nationwide plan was not registered as a security and no prospectus was issued. In June 1970, the Securities and Exchange Commission charged Nationwide with selling unregistered securities in violation of the Securities Act of 1933 and with fraud in violation of section 10(b) of the Securities Exchange Act of 1934. Thereafter, Nationwide suffered financial problems and was placed in receivership. Nationwide's creditors foreclosed on collateral pledged to them, including Ms. El Khadem's rehypothecated Treasury Bills. She now claims the value of her lost collateral as damages in this action.

Stripped of its formalities, the Nationwide plan was essentially as follows: Ms. El Khadem supplied Nationwide with cash and securities, in the form of prepaid interest and rehypothecatable collateral, and the use of her credit, in the form of an assignable promissory note, to capitalize Nationwide's business ventures. Nationwide used this capital for its own business purposes by rehypothecating it and pledging it to secure Nationwide's own borrowings. In return for supplying Nationwide with venture capital, Ms. El Khadem received a tax benefit and investment leverage.

The only question before this court is whether the Nationwide plan was a "security" as defined by the Securities Act of 1933 and the Securities Exchange Act of 1934. We hold that it was.

II WAS THE NATIONWIDE PLAN A SECURITY?

The Securities Act of 1933 and the Securities Exchange Act of 1934 define a "security" as including an "investment contract."⁵ The district court held that the Nationwide plan was an "investment contract" and therefore a "security" as defined by the Acts.⁶

As this court recently noted in S. E. C. v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476, 480-481 (9th Cir.1973), the Securities Act of 1933 and the Securities Exchange Act of 1934 are remedial legislation requiring broad and liberal construction. See S. E. C. v. W. J. Howey Co., 328 U.S. 293, 299, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946); Tcherepnin v. Knight, 389 U.S. 332, 336, 88 S.Ct. 548, 19 L.Ed.2d 564 (1967). The Acts must be interpreted liberally to effect their purpose of ensuring full and fair disclosure to purchasers of securities and protecting the public from speculative or fraudulent schemes of promoters.⁷ S. E. C. v. Glenn W. Turner Enterprises, Inc., supra, 474 F.2d at 480-481. Thus, in S. E. C. v. Joiner Corp., 320 U.S. 344, 351, 64 S.Ct. 120, 123, 88 L.Ed. 88 (1943), the Supreme Court noted that

the reach of the Act does not stop with the obvious and commonplace. Novel, uncommon, or irregular devices, whatever they appear to be, are also reached if it be proved as matter of fact that they were widely offered or dealt in under terms or courses of dealing which establish their character in commerce as "investment contracts," or as "any interest or instrument commonly known as a `security.\'"

Similarly, the Court has noted that the definition of a security "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," S. E. C. v. W. J. Howey Co., supra, 328 U.S. at 299, 66 S.Ct. at 1103, and that while "searching for the meaning and scope of the word `security' in the Act, form should be disregarded for substance and the emphasis should be on economic reality," Tcherepnin v. Knight, supra, 389 U.S. at 336, 88 S.Ct. at 553.⁸

In light of the foregoing, we must determine whether the economic realities of the Nationwide plan, rather than its formal structure as a loan and security agreement, are such that it is an "investment contract" as the district court held. Our principal guidance is derived from S. E. C. v. W. J. Howey Co., supra.

In Howey, the Court held that a real property transfer of citrus groves, together with an agreement whereby the grantor cultivated and marketed the crops, was an investment contract and therefore a security as defined by the Acts. The Court stated that "the test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others." Id. 328 U.S. at 301, 66 S.Ct. at 1104. The Court relied on the facts that "the investors provided the capital and shared in the earnings and profits; the promoters managed, controlled and operated the enterprise." Id. at 300, 66 S.Ct. at 1104.

Defendants contend that the Nationwide plan does not meet the test laid down in Howey. First, they argue that Ms. El Khadem did not provide Nationwide with capital but rather that she received investment capital in the form of a loan. Notwithstanding the fact that Ms. El Khadem received a loan for investment purposes, however, she did provide Nationwide with capital for its business operations in the form of rehypothecatable collateral and an assignable promissory note.⁹ It was with this capital that Nationwide could finance its business ventures. Putting their argument slightly differently, appellants argue that under the Nationwide plan as written, Ms. El Khadem bore no risk of losing her capital. This is merely another way of saying that Ms. El Khadem did not provide Nationwide with risk capital at all. Since her collateral could be rehypothecated only in an amount not exceeding her indebtedness to Nationwide, appellants contend that she could not suffer any out-of-pocket loss. The mere fact that Nationwide rehypothecated her collateral in violation of this limitation should not, appellants suggest, render a plan a security that was not a security when written.

Appellants correctly point out that the Nationwide plan must be analyzed as of the time Ms. El Khadem agreed to it. If subsequent acts by Nationwide in violation of the agreement could convert the plan into a security, legitimate expectations would be defeated. Appellants are mistaken, however, in their contention that Ms. El Khadem risked no loss, and therefore did not provide risk capital under the plan as written. Since her capital could be rehypothecated only to the extent of her indebtedness, she risked loss only if it were possible both to lose the rehypothecated collateral and to be required to pay on the promissory note. An examination of the agreement reveals this possibility.

Although the promissory note was not negotiable,¹⁰ Nationwide seemingly retained the right to assign Ms. El Khadem's obligation free of a duty to redeem her collateral. The agreement granted Nationwide "full and complete right and power to assign this agreement or any part thereof, and to rehypothecate for Nationwide's financing purposes any or all collateral of borrower," emphasis added limited to Ms. El Khadem's indebtedness. The use of the conjunctive...