Lino v. City Investing Co., 72-1672

CourtUnited States Courts of Appeals. United States Court of Appeals (3rd Circuit)
Citation487 F.2d 689
Docket Number72-1673.,No. 72-1672,72-1672
PartiesJohn L. LINO, Appellant in No. 72-1672, v. CITY INVESTING CO., a corporation, Appellant in No. 72-1673.
Decision Date20 August 1973

Lawrence G. Goodman, Goodman, Stoldt & Breslin, Hackensack, N. J., for John L. Lino.

Clyde A. Szuch, Harry F. Geair, Pitney, Hardin & Kipp, Newark, N. J., for City Investing Co.; Louis Loss, Cambridge, Mass., Richard E. Nolan, Daniel F. Kolb, Davis, Polk & Wardwell, New York City, of counsel.

Before HUNTER and WEIS, Circuit Judges, and NEWCOMER, District Judge.


JAMES HUNTER, III, Circuit Judge:

This case involves the interpretation of the federal securities laws to determine whether there is federal jurisdiction to hear John Lino's complaint.

Lino purchased two "Franchise Sales Center Licensing Agreements" from Franchise International ("FI"), a wholly-owned subsidiary of City Investing. Payment was made with cash and several promissory notes. He now contends that he was induced to purchase these agreements by certain material misstatements of City Investing which violated the following provisions of the federal securities laws: 15 U.S.C. §§ 77l(2), 77q(a), 78j(b) and 17 C.F.R. § 240.10b-5.

City Investing moved to dismiss the complaint for lack of federal subject matter jurisdiction. It argued that none of the instruments involved in the transaction were "securities" as defined in 15 U.S.C. §§ 77b(1) and 78c(a)(10). It also denied there was a "purchase" of a security within the meaning of 15 U.S.C. § 78j(b).

The district court held that the "Franchise Sales Center Licensing Agreements" purchased by Lino were not securities; but it determined that Lino's promissory notes were "securities" and that the transaction involved a "purchase" of them by FI. It therefore denied City Investing's motion to dismiss. This court granted City Investing leave to appeal the order of the district court pursuant to 28 U.S.C. § 1292(b). To avoid a fragmented appeal, we allowed Lino to appeal the holding that the licensing agreements were not securities. These appeals are now before us.

The factual landscape of this suit is relatively uncluttered. FI's "better mousetrap" apparently is a system of finding franchisees for franchisors seeking to market their products. FI and the franchisor contract with each other; FI then refers the franchisor's program to a "Franchise Sales Center Licensee"; the licensee must find an "area distributor" to represent each particular franchisor; the "area distributor" then finds various sub-franchisees1 who actually sell the products of the franchisor.

A franchise sales center licensee has exclusive rights to market FI approved franchise programs within certain areas. To become a licensee, a person must pay a certain fee to FI. To become an area distributor, one must also pay a certain fee to FI. To become a sub-franchisee, a person must again pay a certain fee.

Lino contracted with FI to become a licensee in two areas. Payment was by cash and by promissory notes. According to the agreements he signed and the accompanying brochure, Lino was to receive 37½ of the fees paid by the area distributors recruited by him. He was also to receive 12½ of any fees paid by the sub-franchisees within his area. FI also agreed to train the licensee in the techniques of establishing and operating one of its sales centers. It then was to provide him with whatever franchising programs it contracted to market and to advertise and promote the general concept of its Franchise Market Centers.

Lino, in turn, was obligated "to devote full time and best efforts" or to cause someone employed by him "to devote full time and best efforts" to the proper conduct of his sales center. According to the brochures incorporated into the agreement by reference, Lino also was required to find area distributors for each particular franchise program provided by FI and to train those distributors accepted by FI. All profit that Lino was to receive would come directly or indirectly from his recruiting and training of the area distributors.

In his complaint, Lino alleged that he was induced to purchase his agreements by certain misrepresentations of City Investing and its subsidiary, FI. The district court succinctly summarized Lino's allegation: "Specifically, FI allegedly stated that it would continue to be wholly owned by defendant and thus supported by its prestige and resources while, at the same time, it was aware of the existence of a lawsuit instituted by defendant seeking to rescind the agreement by which FI became defendant's subsidiary. Without defendant's support, plaintiff concludes, the franchises are worthless." Lino claims that the licensing agreements which he purchased are "securities" within the definition of 15 U.S.C. § 77b(1)2 and 78c(a) (10).3 Additionally, he claims that the personal promissory notes which he used in partial payment for these agreements also were "securities" under the same definitional sections. We will consider the franchise agreements first.


Both parties agree that whether the franchise agreements in question here were securities depends on whether the agreement can be classified as an "investment contract."4

The classic definition of an investment contract comes from S. E. C. v. Howey, 328 U.S. 293, 298-299, 66 S.Ct. 1100, 1103, 90 L.Ed. 1244 (1946):

". . . 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).

City Investing stresses the word "solely" to us in the above definition. It contends that if there is any participation by the investor in the scheme, an investment contract is not present. Some courts have read the Howey opinion that narrowly. E. g., Mr. Steak, Inc. v. River City Steak, 460 F.2d 666 (10th Cir. 1972), aff'g. 324 F.Supp. 640 (D.Colo.1970); Chapman v. Rudd Paint & Varnish Co., 409 F.2d 635, 639-641 (9th Cir. 1969);5 S. E. C. v. Koscot v. Interplanetary, Inc., Civil No. 17134 (N.D.Ga. April 20, 1973); Franchise Opportunities, Inc. v. Franchises Int'l., Inc., N.D.Ohio, Civ. No. 69-768, Sept. 6, 1972 (essentially same facts as this case).

That approach provides certainty but we find that that consideration is outweighed by other factors. The Supreme Court has emphasized 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. Howey, supra, 328 U.S. at 299, 66 S.Ct. at 1103. Accord, S. E. C. v. Joiner, 320 U.S. 344, 351, 64 S.Ct. 120, 88 L.Ed. 88 (1943); Tcherepnin v. Knight, 389 U.S. 332, 338, 88 S.Ct. 548, 19 L.Ed.2d 564 (1967). The court has stressed that the securities acts are remedial legislation which must be broadly construed. Tcherepnin v. Knight, supra at 336, 88 S.Ct. 548.

In view of these statements, the Ninth Circuit has decided not to read "solely" literally when considering the efforts made by an investor. Instead, it has held that an investment contract may be present where there is an investment in a common enterprise and:

"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." S. E. C. v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476, 482 (9th Cir. 1973).

The S.E.C. has made a similar statement:

"It must be emphasized that the assignment of nominal or limited responsibilities to the participant does not negative the existence of an investment contract; where the duties assigned are so narrowly circumscribed as to involve little real choice of action or where the duties assigned would in any event have little direct effect upon receipt by the participant of the benefits promised by the promoters, a security may be found to exist. As the Supreme Court has held, emphasis must be placed upon economic reality. See Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946). While the Commission has not taken the position that a franchise arrangement necessarily involves the offer and sale of a security, in the Commission\'s view a security is offered or sold where the franchisee is not required to make significant efforts in the operation of the franchise in order to obtain the promised return."

Securities Act Release No. 5211 (Nov. 30, 1971), reported in 1971-72 Transfer Binder C.C.H. Fed.Sec.L.Rep. # 98446.

Finally, at least one state court has emphasized that an investment contract exists where the investor does not have to make significant efforts in the operation of a franchise. State v. Hawaii Market Center, Inc., 485 P.2d 105 (Hawaii 1971).

We find these authorities persuasive. The reasoning of the Supreme Court, the Ninth Circuit, the S.E.C. and Supreme Court of Hawaii leads us to hold that an investment contract can exist where the investor is required to perform some duties, as long as they are nominal or limited and would have "little direct effect upon receipt by the participant of the benefits promised by the promoters." Sec. Act Release No. 5211, supra. As the Ninth Circuit realized, to adopt a position similar to City Investing's would lead to easy evasion of the act "by adding a requirement that the buyer contribute a modicum of effort." S. E. C. v. Glenn W. Turner, supra at 482.

The district court recognized that it had to examine "the substance and economic reality of the situation rather than the formal characteristics of the parties in interest. Citations omitted." Joint Appendix, 182A. It then analyzed the agreement and the brochure incorporated into the...

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