State by Commissioner of Securities v. Hawaii Market Center, Inc., 4958

• Decision Date: 20 May 1971
• Docket Number: No. 4958,4958
• Citation: 52 Haw. 642,47 A.L.R.3d 1366,485 P.2d 105
• Parties: , Blue Sky L. Rep. P 70,908, 47 A.L.R.3d 1366 STATE of Hawaii, by its COMMISSIONER OF SECURITIES, Plaintiff-Appellee, v. HAWAII MARKET CENTER, INC., et al., Defendants-Appellants.
• Court: Hawaii Supreme Court

Page 105

485 P.2d 105

52 Haw. 642, Blue Sky L. Rep. P 70,908,

47 A.L.R.3d 1366

STATE of Hawaii, by its COMMISSIONER OF SECURITIES, Plaintiff-Appellee, v. HAWAII MARKET CENTER, INC., et al., Defendants-Appellants.

No. 4958.

Supreme Court of Hawai'i.

May 20, 1971.

Syllabus by the Court

1. In fulfilling the remedial purposes of the Hawaii Uniform Securities Act (Modified) attention should be focused on the economic realities of security transactions.

2. The subjection of an investor's money to the risks of an enterprise over which he exercise no managerial control is the basic economic reality of a security transaction.

3. Any formula which purports to guide courts in determining whether a security exists should recognize the economic realities of security transactions and be broad enough to fulfill the remedial purposes of the Securities Act.

4. The purposes of the Hawaii Uniform Securities Act (Modified) for (1) to prevent fraud, and (2) to protect the public against the imposition of unsubstantial schemes by regulating the transactions by which promoters go to the public for risk capital.

5. For the purpose of the Hawaii Uniform Securities Act (Modified) an investment contract is created whenever:

(1) an offeree furnishes initial value to an offeror, and

(2) a portion of this initial value is subjected to the risks of the enterprise, and

(3) the furnishing of the initial value is induced by the offeror's promises or representations which give rise to a reasonable understanding that a valuable benefit of some kind, over and above the initial value, will accrue to the offeree as a result of the operation of the enterprise, and

(4) the offeree does not receive the right to exercise practical and actual control over the managerial decisions of the enterprise.

David T. Robertson (Hyman M. Greenstein, Honolulu, and Lanny S. Vines, Birmingham, Ala., on the briefs), for defendants-appellants.

Roy M. Miyamoto, Deputy Atty. Gen., Honolulu (Bertram T. Kanbara, Atty. Gen., Olen E. Leonard, Jr., Gerald Y. Y. Chang, Deputy Attys. Gen., Honolulu, with him on the brief), for plaintiff-appellee.

Before RICHARDSON, C. J., and MARUMOTO, ABE, LEVINSON and KOBAYASHI, JJ.

LEVINSON, Justice.

The legal issue presented by this case is whether the 'Founder-Member Purchasing Contract Agreements' issued by Hawaii Market Center, Inc., one of the appellants, constitute securities within the meaning of the Hawaii Uniform Securities Act (Modified), HRS § 485-1(12). ¹ An affirmative answer to this question would bring into operation the registration requirements of HRS § 485-8. Before determining the nature of these agreements it is first necessary to delineate clearly the economic relationship existing between Hawaii Market Center, Inc. and persons who have contracted with it pursuant to these agreements.

Hawaii Market Center, Inc. (hereinafter referred to as HMC) is a Hawaii corporation with a capitalization of.$1000.00. The corporation's expressed purpose was to open a retail store which would sell merchandise only to persons possessing purchase authorization cards. In order to raise capital for the financing of this enterprise HMC recruited founder-members. The maximum number of such members was set at five thousand.

Prospective founder members were asked to attend recruitment meetings. At these meetings a speaker explained how members would be eligible to earn (1) immediate income before the store became operational, and (2) future income after the store became operational. In order to earn such income an invitee was required to become either a founder-member distributor or a founder-member supervisor.

A person became a founder-member distributor by purchasing from HMC either a sewing machine or a cookware set (each with a wholesale value of $70.00) for $320.00. The purchaser also executed a 'Founder-Member Purchasing Contract Agreement' with the corporation. This agreement states that a distributor is able to earn money in five ways. He may: (1) distribute the 50 authorized buyer's cards, which have been issued to him and thereafter earn a 10% commission on each sale resulting from the use of one of these cards in the HMC store; (2) earn a $50.00 fee each time a person he refers becomes a founder-member distributor; (3) receive a $300.00 fee as compensation for establishing a new member as a supervisor or upgrading an old member from distributor to supervisor. The fourth and fifth sources of income relate to the earning of credits which are applied to a $900.00 fee paid by a distributor to his supervisor if the distributor wishes to be upgraded.

A person became a supervisor by executing a founder-member contract and purchasing both a sewing machine and a cookware set for a total price of $820.00. A supervisor earns higher fees and commissions than a distributor. In addition, a supervisor receives an override commission if his distributor enlists a new member. He also receives override commissions on all sales made to holders of purchase authorization cards distributed by any founder-member whose entry into the organization can be traced back to the supervisor.

On September 23, 1969 the appellee, the State of Hawaii, by its Commission of Securities, filed an action in the First Circuit Court against HMC and its officers and directors. The State sought to enjoin the further promotion and execution of the above described founder-member contracts. The commissioner argued that the contracts were unregistered securities whose distribution was prohibited by the Uniform Securities Act (Modified). HRS § 485-8. The appellants contended that the contracts in question were not securities within the meaning of the Act.

On October 20, 1969 the trial court entered its findings of fact, conclusions of law and judgment in favor of the Commissioner of Securities. After a thorough analysis of the economic realities underlying the relationship between the defendant corporation and its founder-members the court held that the HMC agreements constituted 'investment contracts' and 'certificate of interest or participation in a profit-sharing agreement' and, therefore, fell within the Hawaii statute's definition of 'security,' as defined by HRS § 485-1(12). The court enjoined the further promotion and execution of founder-member purchasing contract agreements and the collection and disbursement of funds pursuant to such agreements. The appellants have appealed from this judgment and order. For the reasons set forth below we affirm.

I. THE ESSENTIAL CHARACTERISTICS OF AN INVESTMENT CONTRACT UNDER THE HAWAII UNIFORM SECURITIES ACT (MODIFIED).

A. The Test Embodied in the Howey Case is Too Mechanical to Protect the Investing Public Adequately.

In arguing whether the interests represented by HMC's founder-member contracts constitute investment contract securities within the meaning of HRS § 485-1(12) both the appellant and the appellee rely for guidance principally upon the Supreme Court decision in Securities & Exchange Commission v. W. J. Howey Co., 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946). That case sought to formulate a test for the existence of an 'investment contract,' such a contract being included within the definition of 'security' under the Federal Securities Act. The Court concluded that an investment contract exists whenever '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.' Securities & Exchange Commission v. W. J. Howey, Co., supra at 299, 66 S.Ct. at 1103.

The appellants urge us to adopt the Howey formula as the test to be applied in the present case. It is contended that under the Howey test the contracts in question are not investment contracts because founder-members in the HMC plan are expected to recruit new members and distribute purchase authorization cards in order to earn income; they do not, therefore, 'expect profits solely from the efforts' of others. Gallion v. Alabama Market Centers, Inc., 282 Ala. 679, 213 So.2d 841 (Ala.1968); Emery v. So-Soft of Ohio, Inc., 30 Ohio Op.2d 226, 199 N.E.2d 120 (Ohio Ct.App.1964).

The State also relies upon the Howey case but contends that the test enunciated therein is not to be taken literally. It argues that the efforts expected of the founder-members are minimal in nature and, as a practical matter, the founders are substantially dependent upon the management of the corporation for a successful return on their investment. Thus the State asserts, under the real meaning of the Howey rule, the disputed agreements are investment contracts. D.M.C. of Colorado, Inc. v. Hays, 3 CCH Blue Sky L. 70,897 at 67,042 (Colo.Dist.Ct. 2/26/71); see Florida Discount Centers, Inc. v. Antinori, 226 So.2d 693 (Fla.Dist.Ct.App.1969), aff'd 232 So.2d 17 (Fla.1970). We agree that the present agreements constitute 'securities' within the coverage of the Hawaii Uniform Securities Act (Modified). We do not choose, however, to base this decision on the restrictive formula laid down by the Supreme Court in the Howey case. ²

The primary weakness of the Howey formula is that it has led courts to analyse investment projects mechanically, based on a narrow concept of investor participation. ³ See Gallion v. Alabama Market Centers, Inc., supra; Emery v. So-Soft of Ohio, Inc., supra. Thus courts become entrapped in polemics over the meaning of the word 'solely' and fail to consider the more fundamental question whether the statutory policy of affording broad protection to investors should be applied even to those situations where an investor is not inactive, but participates to a limited degree in the operation of the business. ⁴ In fulfilling the remedial purposes of our state act, we believe a sounder approach to securities regulation requires that courts focus their attention on the economic realities of security transactions: that is, '(t)he placing of capital or laying out of money in a way...