S.E.C. v. Wallenbrock

• Decision Date: 12 December 2002
• Docket Number: No. 02-55481.,02-55481.
• Citation: 313 F.3d 532
• Parties: SECURITIES AND EXCHANGE COMMISSION, Plaintiff-Appellee, v. J.T. WALLENBROCK and Associates; Larry Toshio Osaki; Van Y. Ichscinotsubo; Citadel Capital Management Group, Inc., Defendants-Appellants.
• Court: U.S. Court of Appeals — Ninth Circuit

313 F.3d 532

SECURITIES AND EXCHANGE COMMISSION, Plaintiff-Appellee, v. J.T. WALLENBROCK and Associates; Larry Toshio Osaki; Van Y. Ichscinotsubo; Citadel Capital Management Group, Inc., Defendants-Appellants.

No. 02-55481.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted October 11, 2002.

Filed December 12, 2002.

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Robert C. Rosen, John B. Wallace, and Dave Lenny, Rosen & Associates, Los Angeles, CA, for the appellants.

Giovanni P. Prezioso, Meyer Eisenberg, Jacob H. Stillman, and Mark Pennington, Securities and Exchange Commission, Washington, DC, for the appellee.

Appeal from the United States District Court for the Central District of California, Edward Rafeedie, District Judge, Presiding. D.C. No. CV-02-00808-ER.

Before: GOODWIN, RYMER, and McKEOWN, Circuit Judges.

McKEOWN, Circuit Judge.

At issue in this interlocutory appeal is whether promissory notes purportedly secured by accounts receivable of Malaysian latex glove manufacturers constitute securities under the Securities Act of 1933, 15 U.S.C. § 77b(a)(1), and the Securities Exchange Act of 1934, 15 U.S.C. § 78c(a)(10) (collectively the "Securities Acts"). The Securities and Exchange Commission ("SEC") characterizes the notes as securities and part of a get-rich-quick Ponzi scheme, while the investment firm claims the notes are legitimate short-term loans that are exempt from the securities laws. Applying Reves v. Ernst & Young, 494 U.S. 56, 110 S.Ct. 945, 108 L.Ed.2d 47 (1990), we conclude that the notes are securities regulated by the Securities Acts.

BACKGROUND

In January of 2002, the SEC filed a civil enforcement action against J.T. Wallenbrock & Associates ("Wallenbrock"), along with its managing general partner, Larry Toshio Osaki, its employee, Van Y. Ichscinotsubo, and Citadel Capital Management Group, Inc. ("Citadel") (collectively "Wallenbrock"), to enjoin a fraudulent scheme to sell unregistered securities.

Although Wallenbrock's story changed over time, the salient points of the plan are as follows: From at least 1999 through January 2002, Wallenbrock sold promissory notes ostensibly secured by the accounts receivable of Malaysian latex glove manufacturers. According to the investment materials, the glove manufacturers typically had to wait eighty to ninety days after shipment to collect from the American buyers, during which time the manufacturers might lose up to 10% of their money due to exchange rate fluctuations. Wallenbrock would step in to fill that gap: when the manufacturer met with the buyer upon delivery and the buyer accepted the shipment, the buyer's future payment was assigned to Wallenbrock, who would then buy the account receivable for 75-80% of its value. Wallenbrock would carry the receivable until it received payment from the buyer, usually around ninety days after delivery. This arrangement seemed profitable for all parties involved — the manufacturers were willing to give a discounted rate in order to get cash immediately upon delivery, the buyers were able to delay their payments for eighty to ninety days, and Wallenbrock would make a quick profit by paying a discounted rate up front, using the influx of cash from the investors, and collecting the full amount from the buyers ninety days later.

Under this plan, the individual investor¹ and Wallenbrock would split the cost of the receivable, with each party owning a 50% undivided secured interest in the account receivable. The notes had a three-month maturity period with a guaranteed twenty percent return during that period. Over the course of several years, Wallenbrock sold more than $170 million worth of notes to over 1,000 investors in at least twenty-five states.

After an investigation, the SEC sought injunctive relief, alleging that Wallenbrock violated the registration requirements of the 1933 Act and general antifraud provisions of the Securities Acts.² Wallenbrock acknowledged that it had misrepresented its role in the accounts receivables business, and explained that instead of buying the accounts directly, it actually funneled money into a checking account and then to an offshore trust, which purchased the accounts. Wallenbrock consented to three orders: (1) a temporary restraining order enjoining future violations, pending a hearing on a preliminary injunction; (2) an order prohibiting the alteration of documents and permitting expedited discovery; and (3) an asset freeze.

Subsequent discovery revealed that Wallenbrock's no-risk investment opportunity was in fact a high-stakes pyramid scheme. The millions of dollars flowing through the bank account went, not to an offshore trust, as Wallenbrock claimed, but to pay off earlier investors and to finance risky start-up companies. The district court therefore granted the SEC's request for the appointment of a receiver. In this interlocutory appeal under 28 U.S.C. § 1292(a)(2), Wallenbrock challenges the imposition — though not the merits — of the temporary orders and the appointment of the receiver, claiming that the district court lacked subject matter jurisdiction because the notes are not securities.

DISCUSSION

The sole issue on appeal is whether the notes are "securities." Although Wallenbrock frames the issue as one of the district court's subject matter jurisdiction, because the question of whether "the case involved a security was itself a federal question," El Khadem v. Equity Sec. Corp., 494 F.2d 1224, 1225 n. 1 (9th Cir. 1974), the district court had subject matter jurisdiction under 28 U.S.C. § 1331. Thus, Wallenbrock's real contention is that the injunction should not have been issued because the notes were not securities. We review these interlocutory orders for an abuse of discretion. Johnson v. Special Educ. Hearing Office, 287 F.3d 1176, 1179 (9th Cir.2002). Because this appeal rests on the legal question of the definition of a security, an error in that determination would necessarily constitute an abuse of discretion. Id.

The 1934 Act begins with the open-ended language that "[t]he term `security' means any note." 15 U.S.C. § 78c(a)(10). The presumption that a promissory note is a security, however, is rebuttable. Reves, 494 U.S. at 65, 110 S.Ct. 945. Because "Congress was concerned with regulating the investment market, not with creating a general federal cause of action for fraud," id., we analyze whether the note is actually a type that Congress intended to regulate.

Under Reves, we inquire first whether the promissory note bears a "family resemblance" to a judicially-created list of non-security instruments. Id. at 65, 67 (citing Exchange Nat'l Bank of Chicago v. Touche Ross & Co., 544 F.2d 1126, 1138 (2d Cir.1976)). If so, then the note is not a security.³ Reves, 494 U.S. at 67, 110 S.Ct. 945. If the note does not strongly resemble one of the enumerated exceptions, we then determine whether the note is a type that should be added to the list. Id. Although courts have treated this analysis as two separate steps, both inquiries involve the application of the same four-factor test, and so the two essentially collapse into a single inquiry.⁴ Although the multi-factor test was originally conceived as a method of ascertaining whether an instrument resembles a non-security, the Supreme Court has since framed it as an analysis of "whether an instrument denominated a `note' is a `security,'" id., and we follow the same convention. See also id. at 65-66 ("It is impossible to make any meaningful inquiry into whether an instrument bears a `resemblance' to one of the instruments identified by the Second Circuit without specifying what it is about those instruments that makes them non-`securities.'").

We structure our inquiry, then, on an examination of the four Reves factors: (1) the "motivations that would prompt a reasonable seller and buyer to enter into" the transaction; (2) the "plan of distribution" of the instrument; (3) the "reasonable expectations of the investing public"; and (4) "whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument." Id. at 66-67, 110 S.Ct. 945. Failure to satisfy one of the factors is not dispositive; they are considered as a whole. See, e.g., McNabb v. S.E.C., 298 F.3d 1126, 1132-33 (9th Cir.2002) (holding that, although the third factor supported neither side's position, the notes in question nevertheless constituted securities).

Based on the Reves factors, we conclude that the promissory notes do not bear a sufficiently strong family resemblance to the judicially-created list of non-securities, nor do they warrant addition of a new category to the list. We must also assess whether Wallenbrock's notes fall within the Securities Acts' exception for notes with a maturity period of less than nine months. See 15 U.S.C. §§ 77c(a)(3), 78c(a)(10) ("The term `security' ... shall not include ... any note ... which has a maturity at the time of issuance of not exceeding nine months...."). Because the notes are not of the nature contemplated by the exception, the nine-month safe harbor does not apply and the notes are regulated by the Securities Acts.

I. APPLICATION OF THE REVES FACTORS

Although the notes may superficially resemble one of the listed exceptions — "short-term notes secured by an assignment of accounts receivable," Exchange Nat'l Bank, 544 F.2d at 1138 — that similarity is not the end of our analysis, as Wallenbrock urges, but the beginning. Wallenbrock argues that we should adopt a literal approach: because the notes are ostensibly secured by accounts receivable, they are exactly like the category of notes excluded from the definition of a security. In examining the notes, however, we look to the "economic realities" of the transaction. Reves, 494 U.S. at 62, 110 S.Ct. 945. It is not the moniker or label that is dispositive, but the economic characteristics of the notes. See id.

A. MOTIVATION FOR...