S.E.C. v. Commodity OptionsIntern., Inc.

• Decision Date: 10 May 1977
• Docket Number: No. 75-2385,75-2385
• Citation: 553 F.2d 628
• Parties: Fed. Sec. L. Rep. P 96,072 SECURITIES AND EXCHANGE COMMISSION, Plaintiff-Appellee, v. COMMODITY OPTIONS INTERNATIONAL, INC., a California Corporation, Double Option Systems, Inc., a California Corporation, Josef Rotter, Individually and as president and director of Commodity Options International, Inc., and Double Option Systems, Inc., C. R. Richmond & Co., a California Corporation, and Curtis R. Richmond, Individually and as president and director of C. R. Richmond & Co., Defendants-Appellants.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 628

553 F.2d 628

Fed. Sec. L. Rep. P 96,072

SECURITIES AND EXCHANGE COMMISSION, Plaintiff-Appellee, v. COMMODITY OPTIONS INTERNATIONAL, INC., a California Corporation, Double Option Systems, Inc., a California Corporation, Josef Rotter, Individually and as president and director of Commodity Options International, Inc., and Double Option Systems, Inc., C. R. Richmond & Co., a California Corporation, and Curtis R. Richmond, Individually and as president and director of C. R. Richmond & Co. Defendants-Appellants.

No. 75-2385.

United States Court of Appeals Ninth Circuit.

May 10, 1977.

Darrell L. Johnson, Lindholm & Johnson, Los Angeles, Cal., for defendants-appellants.

David Ferber, Frederic T. Spindel, Howard B. Scherer, Attys., Securities Exchange Commission, Washington, D. C., Charles R. Hartman, III, Los Angeles, Cal., argued for plaintiff-appellee.

On Appeal from the United States District Court for the Central District of California.

Before MERRILL, ELY and CHOY, Circuit Judges.

MERRILL, Circuit Judge:

The sole question presented by this appeal is whether naked double options to buy and sell commodity futures contracts are investment contracts and thus are "securities" as defined by § 2(1) of the Securities Act of 1933, 15 U.S.C. § 77b(1). ¹ Contending that they are securities, the Securities and Exchange Commission (SEC) sought an injunction to prevent appellants from offering and selling such options until a registration statement as to them was in effect as required by the Act. ² The injunction was granted by the district court and this appeal followed. We affirm.

Commodity Options International, Inc. (COI), and Double Option Systems, Inc. (DOS), are California corporations, operated substantially as a single entity, with their principal place of business in Beverly Hills, California. Josef Rotter is president of COI and controlling shareholder of both COI and DOS. Both corporations engage in the business of issuing double options to buy or sell commodity futures contracts. Appellant C. R. Richmond & Co. (CRR), is a California corporation engaged in securities transactions as broker-dealer. It is charged in this action with acting as agent for COI and DOS in the sale of double options. Appellant Curtis R. Richmond is its president and sole stockholder. ³ From July, 1972, until March, 1973, CRR offered and sold about 125 naked double options to about 100 customers by use of means and instruments of transportation and communications in interstate commerce and of the mails. Appellants did not write the options themselves. COI and DOS wrote the options and paid CRR commissions on their sales. Appellants transmitted all funds received from their customers for the purchase of the options to COI and DOS, and when customers "exercised" or liquidated their options the appellants transmitted funds from COI and DOS to the customers.

A closer examination of the particular options offered and sold by appellants first requires a general description of trading in commodities and commodity futures contracts:

"Commodity trading encompasses two areas of transactions. There is a current or spot market for virtually any type of commodity item for which there is sufficient interest and, therefore, trading volume. Secondly, there is a futures market that involves various commodities due to be grown, produced or otherwise made available at some later point in time. It is this latter market which makes commodity trading unique since the time element factor together with frequent changes in supply-demand forces due to natural, market, legal, etc. factors can produce substantial price-level changes. Potential price-level changes combined with 'margin trading' practices can create significant profit/loss situations with relatively modest capital commitments. (Margin trading is the practice of putting up only a fraction of the purchase price on a commodity contract usually 5-10 percent. A small increase in price relative to the actual funds committed can produce a large profit, percentagewise, and, of course, a price decline has the opposite effect. This situation is said to involve 'leverage'). Regular or 'long' transactions involve the purchase of commodities with the anticipation of a subsequent price rise and their ultimate profit at the time of sale of the commodities. 'Short' transactions involve the initial sale of commodities to be delivered in the future with the deposit of margin (customer equity) and the promise of a future purchase of the same commodity in the same quantity due for delivery at the same time, etc. The anticipation here is that future price will decline and produce a profit to the speculator." ⁴

The commodity futures market operates through futures contracts and dealing in these contracts has become the most active aspect of commodities exchanges. One article explains the reason in this fashion:

"Today, futures contracts are standardized contracts with terms being determined by the exchanges. Futures contracts thus became fully identical and interchangeable. This interchangeability allows a seller to 'offset' his obligation to deliver a commodity by an equal and opposite transaction. Similarly, a buyer could liquidate his obligation to accept a commodity by entering into a contract of sale of futures contracts of the equal amount. Standardization of contracts thus served to add two new dimensions to commodity futures trading. In addition to serving as an alternative to selling the actual goods on the 'spot' market, futures trading became a means of financial protection through the practice of 'hedging' as well as an important field of investment for speculators."

Jones & Cook, The Commodity Futures Trading Commission Act of 1974, 5 Mem.St.U.L.Rev. 457, 460 (1975).

One need not resort to actual purchase of a futures contract in order either to hedge one's position or to speculate. Options to purchase or to sell futures contracts are now extensively dealt in. By paying a premium the purchaser can obtain either a "call" option one to buy a futures contract at a stated price (the "striking price," usually the market price at the time the option is purchased) at any time during the period covered by the option, or can obtain a "put" option one to sell a futures contract at the striking price at any time during the option period. One writer explains the transaction as follows:

"The purchaser of a call theoretically makes his profit when the market for the underlying commodity futures rises. If this occurs, he exercises his option, purchasing the commodity futures contracts from the seller of the option at the striking price and reselling them in the open market; his profit is the difference between the striking price and his selling price, less the fee (premium) he paid for the option. In the case of a put, the option purchaser is betting that the market for commodity futures contracts which he holds will fall. If his hopes are realized, he (purchases contracts on the open market,) delivers the contracts to the option seller and receives the striking price; his profit derived from the option is the difference between the striking price and the market price at the time he exercises the option, less the option premium."

Long, The Naked Commodity Option Contract As a Security, 15 Wm. & Mary L.Rev. 211, 213 (1973).

It is also possible to buy both a put and call option on the same commodity at the same time for the same striking price. Such a purchase is called a "straddle" or double option.

These options are what may be called "conventional" options in which the optionor actually has the underlying commodity futures contract to which the option relates or the right to obtain such a contract. In recent years dealing in what have come to be called "naked" options has commenced. With reference to this Professor Long has written:

"Although ostensibly representing an option to buy or sell underlying commodity futures contracts, the naked option contract is in substance nothing more than a bet between the investor and his dealer that the price of a given commodity future will rise or fall during a particular time period. The label 'naked' is applied because dealers in such options do not maintain adequate inventories of the underlying futures and there generally is no intent that they will ever change hands. The device, therefore, is quite unlike conventional commodity option contracts, which normally do involve the actual exchange of the underlying commodity futures contracts upon exercise of an option."

Id. at 211-12. Further, he writes:

"(The conventional) option does serve a valid economic purpose by permitting the actual user of the commodity to hedge against a fluctuation in the price of the commodity and thereby shift his risk of loss to others. On the other hand, because naked option contracts generally are not settled by the actual exchange of underlying futures contracts and thus do not serve any hedging fuction, they are nothing more than a vehicle for speculative investment."

Id. at 226. See also Long, Commodity Options Revisited, 25 Drake L.Rev. 75, 82-87 (1975).

It is the naked double option with which we are here concerned; it is the naked double option that COI and DOS were engaged in selling, with CRR acting as agent. The record contains much of the promotional material used in soliciting sales of these options. From this material it appears that the double options were handled as follows by COI and DOS:

They were issued for commodities (principally sugar) that are not subject to regulation under federal commodities exchange acts. They were written for eighteen months. If exercised before that date, a rebate on the premium was paid in addition to any profit realized. The usual sale contract contemplated that when a specified profit over the amount of the premium paid has been realized through the market having either advanced or declined to the necessary extent (30...