Searsy v. Commercial Trading Corp.

• Court: Texas Supreme Court
• Writing for the Court: DENTON; CHADICK
• Citation: Searsy v. Commercial Trading Corp., 560 S.W.2d 637 (Tex. 1977)
• Decision Date: 30 December 1977
• Docket Number: No. B-6775,B-6775
• Parties: Blue Sky L. Rep. P 71,383, Fed. Sec. L. Rep. P 96,276 H. E. SEARSY et al., Petitioners, v. COMMERCIAL TRADING CORPORATION et al., Respondents.

Page 637

560 S.W.2d 637

Blue Sky L. Rep. P 71,383, Fed. Sec. L. Rep. P 96,276

H. E. SEARSY et al., Petitioners,

v. COMMERCIAL TRADING CORPORATION et al., Respondents.

No. B-6775.

Supreme Court of Texas.

Dec. 30, 1977.

Rehearing Denied Feb. 8, 1978.

Dean Carlton, Dallas, for petitioner.

Sessions, Sessions, Neill, Scucchi & Hatch, W. R. Sessions, Dallas, Walker, Bishop & Larimore, Tom L. Larimore and James R. Lamsens, Fort Worth, for respondent.

DENTON, Justice.

The question to be decided in this case is whether certain commodity options sold by Commercial Trading Corporation to plaintiffs are "securities" within the meaning of the Texas Securities Act. ¹ The trial court held that the commodity options in question are securities, and rendered judgment for plaintiffs for damages and rescission of the option sales. The court of civil appeals concluded that the commodity options are not "securities." Consequently, it reversed and rendered judgment that plaintiffs take nothing. 559 S.W.2d 663. We hold that the commodity options at issue are "securities" within the meaning of the statute, and accordingly reverse the judgment of the court of civil appeals and affirm the judgment of the trial court.

H. E. Searsy was one of eighty-four named plaintiffs who brought a class action suit against Commercial Trading Corporation (CTC) and Standard Trading Corporation (STC) for rescission and damages. The basis of the action was the sale by defendants of commodity options to plaintiffs, which were alleged to be unregistered securities. Under article 581-33 of the Texas Securities Act, the buyer of an unregistered security may sue to recover the consideration paid for the security plus interest thereon at six per cent per annum. ²

CTC was engaged in the business of selling "puts," "calls," and "double options" on commodity futures contracts. A "put" was an option to sell an underlying commodity futures contract for a specified price, while a "call" was an option to buy a futures contract. A "double option" was an option to either buy or sell a futures contract at a certain price. The price specified in the option was known as the "striking price," which was usually the current market price of a futures contract on the date of the option. The period of the option was a fixed and relatively short term, usually six months. Consideration for the sale of an option was the "premium." Approximately eighty-five per cent of the sales were of double options.

Profit was made on a double option when the market price varied from the striking price by an amount in excess of the premium. If the market rose to a price in excess of the premium, the double option holder would exercise his call option, "buying" the futures contract and then "selling" the contract at the higher market price. The put option was not exercised. Likewise, the investor in a falling market would exercise his put and abandon his call option.

Although customers of CTC may have believed that they owned options on futures contracts, in reality no actual purchases or sales of futures contracts ever took place between CTC and the investors. Upon the exercise of an option, the customer was credited with an amount equal to his profit. This money was often "rolled over" into the purchase of new commodity option contracts. Thus, no actual futures contract was ever delivered to either party, although the net cash result was the same as if there had been an actual purchase and sale. Commodity options such as these which are not a bona fide option in an actual futures contract are generally known as "naked" options. See Long, The Naked Commodity Option Contract As A Security, 15 Wm. & Mary L.Rev. 211 (1973).

The seller of options makes his profit (and pays the investors) from the "hedging" of option premiums. It was the duty of STC as CTC's affiliate to underwrite the options and conduct the hedging program for CTC. Basically, this involves covering the seller's market position by owning or holding sufficient assets to buy futures contracts, the actual commodities, or actual put or call options in futures contracts. Bromberg, Commodities Law and Securities Law, 1 J.Corp.L. 217, 258-60 (1975). STC's hedging program was conducted pursuant to an objective computer analysis combined with the subjective analysis of STC personnel. Thus, the ability of CTC to perform its contractual obligation to the investor was solely dependent on the skill and ability with which STC invested the money and hedged the contracts of the numerous investors whose funds CTC had received. King Commodity Co. of Texas v. State, 508 S.W.2d 439 (Tex.Civ.App. Dallas 1974, no writ).

CTC also gave extensive investment counseling with regard to the purchase and exercise of its commodity options. The customers were generally unsophisticated in commodities market matters, and indeed, CTC pointed out to potential customers that they need not know anything about the commodities market. Rather, CTC personnel would guide them in the proper investment decisions to make. CTC literature also pointed out that the double option provided a high profit potential without having to fight the market by trying to guess whether it would go up or down. Only market volatility was required for the investor to make a profit.

CTC and STC were placed in receivership in November, 1973. Plaintiffs brought suit against CTC, STC, the individual stockholders, and the receiver for rescission and damages resulting from defendants' sale of unregistered securities. They also sought damages for common law fraud and other statutory violations. After a jury trial, judgment was rendered for plaintiffs for $187,758.80. The court of civil appeals reversed and rendered judgment that plaintiffs take nothing. The issue squarely before this Court is whether the commodity options sold by CTC fall within the definition of "security." If so, plaintiffs are entitled to rescission and return of all consideration paid since the commodity options were not registered as securities.

Securities are defined in the Texas Securities Act, art. 581-4(A) as follows:

The term "security" or "securities" shall include any share, stock . . . note, bond, debenture, mortgage certificate or other evidence of indebtedness . . . or any certificate or instrument representing or secured by an interest in any or all of the capital, property, assets, profits or earnings of any company, investment contract or any other instrument commonly known as a security, whether similar to those herein referred to or not. (Emphasis added.)

The terms "investment contract" and "evidence of indebtedness" appear to have been taken from an almost identical definition of "security" in the Federal Securities Act of 1933, 15 U.S.C. § 77b(1) (1971).

Investment Contract

The term "investment contract" was construed by the United States Supreme Court in S. E. C. v. W. J. Howey Co., 328 U.S. 293, 301, 66 S.Ct. 1100, 1104, 90 L.Ed. 1244, 1251 (1946) as follows 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.

The definition has been widely accepted in state and federal cases. Texas courts have also accepted and used it. Clayton Brokerage Co. of St. Louis v. Mouer, 520 S.W.2d 802 (Tex.Civ.App. Austin, writ ref'd n. r. e.), dism'd as moot on rehearing per curiam, 531 S.W.2d 805 (Tex.1975); King Commodity Co. of Texas v. State, 508 S.W.2d 439 (Tex.Civ.App. Dallas 1974, no writ).

The Howey test embodies four requirements: (1) investment of money; (2) a common enterprise; (3) expectation of profits; (4) solely from the efforts of others. The Howey case involved a promoter who sold small plots of land which were to be used as citrus groves. Along with the land sale contract, the Howey-in-the-Hills Service Company offered a service contract for the development and cultivation of the land as well as the marketing of fruit raised thereon. Almost all of the investors purchased the service contract with the plots of land. The Supreme Court held that under the above quoted definition the contracts were "investment contracts" and therefore securities. The Howey test has been applied in many cases to hold various forms of money-making schemes to constitute investment contracts.

There is little dispute as to the first and third elements of the Howey test in this case. The purchase of commodity options was obviously an "investment of money" with the "expectation of profits." The controversy is whether the sale of commodity options by CTC to investors constituted a "common enterprise," with investors' profits to come "solely from the efforts of others."

CTC argues that the common enterprise or "commonality" element is lacking because the profits of each customer depended on the fluctuations of the commodity market and the customer's own investment decisions. Furthermore, they contend that there was no direct relationship between options sold to different customers. We agree that there was no horizontal commonality in this case. Horizontal commonality is between investors and means that the success of one investor is concomitant with the success of other investors. Obviously, different customers of CTC had varying investment results because different commodity options were bought and exercised at different times. The more recent weight of authority, however, permits a showing of vertical commonality common enterprise between investor and promoter, so that the success of the investor is dependent upon the efforts and success of the promoter. S. E. C. v. Koscot Interplanetary, Inc., 497 F.2d 473 (5th Cir. 1974); S. E. C. v. Glenn 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). Here, the ability of CTC to perform its contractual obligation was solely dependent on the success of the hedging program conducted by STC. Approximately seventy per cent of...