SEC v. Unique Financial Concepts

[PUBLISH]
IN THE UNITED STATES COURT OF APPEALS
FILED
FOR THE ELEVENTH CIRCUIT
U.S. COURT OF APPEALS
________________________ ELEVENTH CIRCUIT
11/18/99
No. 99-4033 THOMAS K. KAHN
________________________ CLERK
D. C. Docket No. 98-07147-CV–SH
SECURITIES AND EXCHANGE COMMISSION,
Plaintiff-Appellee,
versus
UNIQUE FINANCIAL CONCEPTS, INC.,
ERNEST J. PATTI, et al.,
Defendants-Appellants.
________________________
Appeal from the United States District Court
for the Southern District of Florida
_________________________
(November 18, 1999)
Before BLACK, HULL and MARCUS, Circuit Judges.
BLACK, Circuit Judge:
Appellants Unique Financial Concepts, Inc. (Unique), Ernest J. Patti (Patti),
Frederick N. Hollander (Hollander), and Nicholas D. DeAngelis (DeAngelis), appeal
a preliminary injunction enjoining Appellants from violating the anti-fraud and
securities registration provisions of Section 17(a) of the Securities Act of 1933, 15
U.S.C. § 77q(a). The district court found that Appellants’ activities were subject to
the Securities Act because Appellants were offering investment contracts in which
investor funds were to be pooled. The district court also found that the Commodity
Exchange Act (CEA), 7 U.S.C. §§ 1- _ , did not preclude Appellee Securities and
Exchange Commission (SEC) from regulating the investment opportunity offered by
Appellants. We affirm.
I. BACKGROUND
Hollander and Patti established Unique in October 1997. At its inception,
Unique purported to offer the sale of foreign currency options. Unique advertised
heavily on television, newspaper, and the Internet, promising large returns on small
investments. These promises were not based on actual investments made by Unique.
Prospective investors were sent a packet containing an offering document that
described the foreign exchange market, a customer agreement, and a disclosure of risk
statement.
2
The original customer agreement explained that the investments would be
pooled together and that Unique had sole discretion over the investments. In August
1998, Unique modified its customer agreement by removing the language concerning
the pooling of investments and Unique’s sole discretion over these investments.
After receiving initial investments from investors, Unique deposited the funds
into its bank account at Southern Bank in Fort Lauderdale, Florida. Unique sales
representatives advised the investors as to which currencies they should invest in and
how many puts and calls they should buy. The investor then spoke to a compliance
officer, who explained the details of the investment and requested the investors’ assent
to the purchase.
A portion of the investors’ funds then purportedly was wired to Capital
Management International (CMI) and Asset Management Funding (AMF) in the
Bahamas. According to Patti and other representatives of Unique, AMF was a holding
company for clearing houses, while CMI was the clearing house responsible for
carrying out Unique’s option trades. Unique also claims it later contracted with two
other Bahamian clearing houses, Forex International (Forex) and Nassau Bay
Clearing, Ltd.
After the initial investment, Unique aggressively solicited the investors for
additional investments. Eventually, however, Unique representatives were extremely
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hard to reach and often failed to return phone calls. The investors lost significant
amounts of money on their investments.
From October 1997 until October 22, 1998, Unique raised just over $6.5 million
from investors using the above scheme. Of this amount, only $2,489,801 (38%) was
wired to the Bahamas to the alleged clearing houses. The remainder of the investors’
money was divided as follows: approximately $700,000 was paid to Unique sales
representatives; approximately $1.2 million was paid for advertising (including
$760,786.32 paid to DRE consulting, a company co-owned by Patti from which he
received a substantial salary); approximately $300,000 was paid to Patti, Hollander,
and DeAngelis, the lead sales representative; and approximately $1.6 million was paid
for business and personal expenses, including checks made payable for car rentals and
personal loans. In addition, approximately $644,000 of the investors’ funds was
distributed to new investors.
II. THE PRELIMINARY INJUNCTION
The district court found that Appellants’ activities were subject to the Securities
Act and granted the SEC a preliminary injunction enjoining Appellants from violating
anti-fraud and securities registration provisions of the Securities Act, 15 U.S.C.
§ 77q(a). Significantly, the district court found that no credible evidence existed to
show that Appellants’ "clearinghouses" ever placed trades on behalf of investors.
4
The court emphasized that Appellants failed to introduce any written agreements
showing a relationship between Unique and the Bahamian clearing houses (Nassau
Bay, CMI, or Forex). Patti claimed that Appellants did not have any copies of the
contracts between the parties, and asserted, without citing any authority, that
Bahamian law prevented Appellants from obtaining copies of the agreements from
the Bahamas. The district court found that Patti lacked credibility and that the absence
of any written agreements was “highly suspect.” As a result, the court concluded that
“the contract may be damaging to the [Appellants] and that they may be purposefully
avoiding its production.”
Although Appellants did produce option reports and monitoring sheets detailing
the purported trades and client accounts, the district court noted that Appellants failed
to authenticate any of these reports. Specifically, the court pointed to the fact that
there were no transaction or wire verifications indicating that the clearing houses
executed any trades. Although Appellants did produce alleged trade confirmations,
these confirmations were sent from Appellants’ office, not from the Bahamian
clearing houses.
In addition, Patti testified that Appellants never received any bank records
indicating the occurrence of the alleged trades, that he did not know how the
Bahamian clearing houses executed the trades, and that he did not know how the
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clearing houses were compensated for their services. Furthermore, Appellants’
compliance officer testified that she did not know what the clearing houses did and
did not even know what the term clearing house meant. Finally, Appellants’
accountant, Morris Berger, stated that the “only thing we had to deal with is really the
Unique data. And we don’t have the Bahamian trading data . . . . Do I know that
there was actual trading in the Bahamas? The answer is, no, I don’t.”
Thus, the court concluded, “at this juncture Unique has failed to produce one
scintilla of independent evidence in support of its contention that investors’ funds
were invested in foreign currency options by clearinghouses in the Bahamas.” In
addition, the court stated that “at this stage of the litigation, it appears as though
Unique either misused or converted investors’ funds and have used an artifice to
defraud.”1
The district court nevertheless found that the “investments” offered by
Appellants should be considered investment contracts, and thus concluded that the
SEC did have jurisdiction to bring this claim. The court also held that the SEC had
established a prima facie case of violations of the anti-fraud and registration
1
In essence, the district court found that Appellants were operating a “Ponzi scheme.” See,
e.g., SEC v. Lauer, 52 F.3d 667, 670 (7th Cir. 1995). That is, rather than executing currency trades,
Appellants were keeping over 60% of the money. Appellants paid the rest of the money back to the
investors “to fool them into thinking they were making money and should therefore invest more.”
Lauer, 52 F.3d at 670.
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provisions of Section 17(a) of the Securities Act and issued a preliminary injunction
enjoining Appellants from committing further violations.
III. STANDARD OF REVIEW
A district court's grant of a preliminary injunction order involves a mixed
standard of review. The decision to grant the injunction is reviewed for abuse of
discretion. See Haitian Refugee Ctr., Inc. v. Baker, 953 F.2d 1498, 1505 (11th Cir.
1992). Questions of law supporting the injunction are reviewed de novo. See Tefel
v. Reno, 180 F.3d 1286, 1295 (11th Cir. 1999). Findings of fact are reviewed for clear
error. See SEC v. Carriba, 681 F.2d 1318, 1323 (11th Cir. 1982). When a
preliminary injunction is challenged on the basis of jurisdiction, a plaintiff need only
establish “a reasonable probability of ultimate success upon the question of
jurisdiction when the action is tried on the merits.” Majd-Pour v. Georgiana
Community Hospital, Inc., 724 F.2d 901, 902 (11th Cir. 1984) (quoting Industrial
Electronics Corp. v. Cline, 330 F.2d 480, 482 (3d Cir. 1964)).
IV. ANALYSIS
The central issue in this case is whether the district court abused its discretion
in finding that Appellee has shown a reasonable probability of ultimate success upon
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the question of the SEC’s jurisdiction over Appellants’ conduct.2 The determinative
question within this issue is whether the contracts offered and sold by Appellants were
investment contracts, and thus securities, under federal securities law.3 If the contracts
were investment contracts, then, contrary to Appellants’ assertion, the SEC had
jurisdiction under the federal securities laws to bring this suit.
A. Three Prong Howey Test
In S.E.C. v. W.J. Howey Co., 328 U.S. 293, 66 S. Ct. 1100 (1946), the Supreme
Court established the classic test for determining whether a transaction is an
“investment contract” within the meaning of Section 2(a)(1) of the Securities Act,
15 U.S.C. § 77b(a)(1). In Howey, the Court explained that for the purposes of the
2
Under Section 20(b) of the Securities Act of 1933, 15 U.S.C. § 77t(b), and Section 21(d)
of the Securities Exchange Act of 1934, 15 U.S.C. § 78u(d), the SEC is entitled to a preliminary
injunction when it establishes the following: (1) a prima facie case of previous violations of federal
securities laws, and (2) a reasonable likelihood that the wrong will be repeated. SEC v. Management
Dynamics, Inc., 515 F.2d 801, 806-07 (2d Cir. 1975); SEC v. Manor Nursing Centers, Inc., 458 F.2d
1082, 1100 (2d Cir. 1972). On appeal, Appellants challenge only the SEC’s jurisdiction over this
matter. Thus, we need not address whether the injunction granted in this case meets the above
requirements.
3
Under the Securities Act of 1933, a "security" is defined as:
[A]ny note, stock, treasury stock, bond, debenture, evidence of indebtedness,
certificate of interest or participation in any profit-sharing agreement, collateral-trust
certificate, reorganization certificate or subscription, transferable share, investment
contract, voting-trust certificate, certificate of deposit for a security, fractional
undivided interest in oil, gas, or other mineral rights, or, in general, an interest or
instrument commonly known as a "security," or any certificate of interest or
participation in, temporary or interim certificate for, receipt for, guarantee of, or
warranty or right to subscribe to or purchase, any of the foregoing.
15 U.S.C. § 77b(a)(1) (emphasis added).
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Securities Act, an investment contract is “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....” Howey, 328 U.S. at 298-99, 66
S. Ct at 1103. This Court has divided the Howey test into the three elements: “(1) an
investment of money, (2) a common enterprise, and (3) the expectation of profits to
be derived solely from the efforts of others.” Villeneuve v. Advanced Business
Concepts Corp., 698 F.2d 1121, 1124 (11th Cir. 1983), aff’d en banc, 730 F.2d 1403(11th Cir. 1984). Both parties agree the first prong of this test has been satisfied.
There is distinct disagreement, however, as to the second and third prongs.
1. Common Enterprise Prong
With respect to the second prong, we have adopted the concept of vertical
commonality, holding that a common enterprise exists where “the fortunes of the
investor are interwoven with and dependent on the efforts and success of those
seeking the investment or of third parties.” Villeneuve, 698 F.2d at 1124 (quoting
SEC v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476, 482 n.7 (9th Cir. 1973)).4
We previously had observed that “the fact that an investor’s return is independent of
that of other investors in the scheme is not decisive. Rather, the requisite
4
Unlike the more stringent concept of horizontal commonality, utilized by the Second, Third,
Sixth, and Seventh Circuits, see, e.g., Stenger v. R.H. Love Galleries, 741 F.2d 144, 146 (7th Cir.
1984), this flexible standard does not require investor funds to be pooled nor does it require profits
to be shared on a pro rata basis.
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commonality is evidenced by the fact that the fortunes of all investors are inextricably
tied to the efficacy of the [promoter].” SEC v. Koscot Interplanetary, Inc., 497 F.2d
473, 479 (5th Cir. 1974).5 More recently, we have affirmed the formulations of
Villeneuve and Koscot, instructing that “[t]he thrust of the common enterprise test is
that the investors have no desire to perform the chores necessary for a return.”
Eberhardt v. Waters, 901 F.2d 1578, 1580-81 (11th Cir. 1990).
Significantly, the fact that an investment company’s operations are a sham and
thus might not actually satisfy the common enterprise prong of the Howey test does
not mean that the investment company can avoid the Securities Act. As the Seventh
Circuit has noted, “[i]t would be a considerable paradox if the worse the securities
fraud, the less applicable the securities laws.” SEC v. Lauer, 52 F.3d 667, 670 (7th
Cir. 1995); see also First National Bank v. Russell, 657 F.2d 668, 673 n.16 (5th Cir.
1981) (noting that the SEC has jurisdiction even the “security purportedly traded is
nonexistent or fictitious . . . . A contrary result would encourage rather than curb
fraud.”) (internal citation omitted).
Thus, in order to qualify as an investment contract, “it is enough that the
[parties] merely offer the essential ingredients of an investment contract.” Howey, 328
5
In Bonner v. City of Prichard, 661 F.2d 1206, 1209 (11th Cir. 1981) (en banc), this Court
adopted as binding precedent all decisions of the former Fifth Circuit handed down prior to close
of business on September 30, 1981.
10
U.S. at 301, 66 S. Ct. at 1104. After all, “[t]he Securities Act prohibits the offer as
well as the sale of unregistered non-exempt securities.” Id; see also SEC v. C.M.
Joiner Leasing Corp., 320 U.S. 344, 352-53 (1943) (noting that “[i]n the enforcement
of [the Securities Act,] it is not inappropriate that promoters’ offerings be judged as
being what they were represented to be”).
At trial, the district court found that the language of the original customer
agreement, in conjunction with its conclusion that Appellants’ operations were a
sham, supported the existence of a common enterprise. The agreement, in relevant
part, reads as follows:
By executing this agreement, Client authorized [Unique] in its sole
discretion to use the total funds on deposit in the omnibus account which
includes the funds of the undersigned to execute single trades or
transactions and to apportion the gains, losses, commissions, and
clearing expenses proportionally to each account. The results of each
trade will be apportioned and applied proportionately (per unit) to all
accounts open on the trade and rounded down to the nearest US dollar.
(emphasis added).
On appeal, Appellants contend that, despite the language of the original
agreement, in actual practice it did not operate a horizontal investment pool but rather
maintained individual, independent investment accounts. As support for this
contention, Appellants point to cash flows between Appellants and the Bahamian
clearing houses, the alleged trade reports, as well as testimony regarding the trades
and trade reports. Appellants claim we should rely on the actual operation of its
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investment contracts, rather than the language of the original agreement, to hold that
Appellants’ investment accounts do not meet the common enterprise prong.
However, given the absence of any credible documentation of trades, the
absence of any persuasive testimony concerning these trades, as well as the fact that
Appellants invested less than 40% of investors’ money, we conclude the record
supports the district court’s finding that Appellants’ operations were a sham.
Consequently, we look, as did the district court, to the terms of the offer to determine
whether Appellants’ activities are covered by the Securities Act. As noted above, the
terms of the offer explicitly state that investors’ funds will be pooled and apportioned
proportionately by Appellants to each account. This language clearly presents an offer
for an investment in a common enterprise and thus supports the common enterprise
prong of the Howey test.6
2. Expectation of Profits Prong
There is also distinct disagreement over whether Appellants’ operations meet
the “expectation of profits” element of the Howey test. In Howey, the Supreme Court
explained that this prong requires that investors expect their “profits to come solely
from the efforts of others.” Howey, 328 U.S. at 301, 66 S. Ct. at 1104. The courts
6
Appellants claim that the language of the original agreement was a mistake, and that the
language was changed to accurately reflect Unique’s operations. The district court, however, made
a factual finding that Appellants switched their customer agreement in August 1998 specifically to
avoid liability under the federal securities laws.
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have suggested several interpretations of the word “solely,” with the disagreement
centered on whether “solely” means all or merely predominant. The view this Court
adopted in Koscot, 479 F.2d at 483, asks “whether 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.” SEC v. Glenn W. Turner
Enterprises, Inc., 474 F.2d 476, 482 (9th Cir. 1973). One year after Koscot, the
Supreme Court reaffirmed Howey and revisited this question in United Housing
Foundation, Inc. v. Forman, 421 U.S. 837, 95 S. Ct. 2051 (1975). In Forman, the
Supreme Court held that “the touchstone” of an investment contract for purposes of
the Securities Acts is “the presence of an investment in a common venture premised
on a reasonable expectation of profits to be derived from the entrepreneurial or
managerial efforts of others.” Id. at 852, 95 S. Ct. at 2060. We subsequently
explicitly embraced the Forman test.7 See Villeneuve v. Advanced Business Concepts,
Co., 730 F.2d 1403, 1404 (11th Cir. 1984) (en banc).
In addition, this Court has clearly stated that “the crucial inquiry [for the third
prong] is the amount of control that the investors retain under their written
agreements.” Albanese v. Florida Nat’l Bank, 823 F.3d 408, 410 (11th Cir. 1987)
7
In Villeneuve, we refrained from deciding whether Forman and Koscot are consonant. We
refrain from resolving this issue here as well.
13
(citing Williamson v. Tucker, 645 F.2d 404, 423-24 (5th Cir. 1981)). While we have
yet to resolve the precise level of control dictated by Forman (and refrain from doing
so here), we conclude Appellants’ operation meets any reasonable interpretation of
“solely.”
First, contrary to Appellants’ assertion, Appellants did not manage non-
discretionary investment accounts in which individual investors made all key strategic
decisions. Rather, as noted above, the record supports the district court’s finding that
Appellants did not engage in any actual trading, but instead operated a fraudulent
scheme which misappropriated investors’s funds. Thus, the investors retained no
control over their investments, since there were no investments to control. Second,
the original customer agreement specifically gave Appellants the “sole discretion to
use the total funds” deposited by the investors. (emphasis added). Consequently, both
the language of the agreement and Appellants’ actual operations support the district
court’s finding that Appellants’ operations met the third prong of the Howey test.
Because a review of the record indicates that all three prongs of the Howey test
have been met, we conclude Appellee did establish a reasonable probability of
ultimate success upon the question of jurisdiction. The district court therefore did not
abuse its discretion in granting the preliminary injunction.
B. The Commodities Exchange Act
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Appellants also argues that the Commodities Trading & Futures Commission
(CFTC),through the Commodities Exchange Act (CEA), 7 U.S.C. §§ 1- _, divests the
SEC of authority to bring this action. The essential issue is whether the trading of
futures of investment contracts is a securities transaction subject to the SEC’s
jurisdiction, a futures transaction subject to the CFTC’s jurisdiction, or both. Thus,
this case “requires an inquiry into the relative boundaries of jurisdiction between the
CFTC and the SEC as intended by Congress.” Messer v. E.F. Hutton & Co., 847 F.2d
673, 674-75 (11th Cir. 1988).
The “exclusive jurisdiction” provision of the CEA defines the ambit of the
CFTC’s exclusive jurisdiction over the commodities market. It reads, in relevant
part, as follows:
[T]he CFTC shall have exclusive jurisdiction with respect
to accounts, agreements (including any transaction which
is of the character of, or is commonly known to the trade as,
an “option,” “privilege,” “indemnity,” “bid,” “offer,” “put,”
“call,” “advance guarantee,” or “defined guarantee,”) and
transactions involving contracts of sale of a commodity for
future delivery, traded or executed on a contract market
designated pursuant to section 7 of this title or any other
board of trade, exchange or market . . . .
7 U.S.C. § 2 (emphasis added). In contrast, the “SEC savings clause” preserves SEC
authority over its traditional regulatory functions despite the CFTC’s jurisdiction. It
reads, in relevant part, as follows:
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[E]xcept as hereinabove provided, nothing contained in this section shall:
(i) supersede or limit the jurisdiction at any time conferred on the
Securities and Exchange Commission or other regulatory authorities
under the laws of the United States or any State, or
(ii) restrict the Securities and Exchange Commission and such
other authorities from carrying out their duties and responsibilities in
accordance with such laws.
7 U.S.C. § 2.
Appellants note that this Court, in Messer, has upheld the exclusive jurisdiction
of the CFTC over certain future trades. See Messer, 847 F.2d at 675. Appellants then
claim the transactions in this case involved commodities futures, in the form of
individual foreign currency options, and thus fall within the exclusive jurisdiction of
the CFTC. We disagree.
While the exclusive jurisdiction provision applies to the offer and sale of a
commodity for future delivery, Appellants concede that the SEC savings clause
preserves the SEC’s jurisdiction over the offer and sale of investment interests in a
commodity pool.8 Thus, if we conclude Appellants offered investment interests in a
commodity pool, we also must conclude the SEC has jurisdiction over this case.
8
Although, given Appellants’ concession, we need not address this issue, there is extensive
evidence that Congress intended the SEC to have concurrent jurisdiction over commodity pools.
See, e.g., 7 U.S.C. § 6m(2); H.R. Rep. No. 97-565 (Part I) at 82 (1982), reprinted in 1982
U.S.C.C.A.N. 3871, 3931.
16
This Court has not defined the term commodity pool, but the CFTC regulations
define “pool” as “any investment trust, syndicate or similar form of enterprise
operated for the purpose of trading commodity interests.” 17 C.F.R. § 4.10(d)(1)
(1998). This definition encapsulates Appellants’ investor scheme. As discussed
above, the district court explicitly found that the investors’ funds were to be pooled
and distributed on a pro rata basis for the (alleged) purpose of trading commodity
interests. Appellants thus were offering an investment opportunity in a commodity
pool which even Appellants admit is subject to the SEC’s jurisdiction.
Appellants’ reliance on Messer for the claim that the CFTC has exclusive
jurisdiction over this case is misplaced. In Messer, this Court concluded that T-bond
futures, a type of commodity, were under the exclusive jurisdiction of the CFTC. The
T-bond futures at issue in Messer were traded in individual discretionary accounts.
See Messer, 847 F.2d at 674, 679. In this case, however, as discussed above, the
foreign currency options (allegedly) were traded in an investment or commodity pool.
This distinction is critical. Commodities, such as the T-bond futures in Messer, are
within the exclusive jurisdiction of the CFTC. Commodity pools, such as the foreign
currency options pool in this case, are within the concurrent jurisdiction of the CFTC
and the SEC.
17
We therefore conclude the CEA did not divest the SEC of authority to bring
this action.
IV. CONCLUSION
The district court did not abuse its discretion in granting the preliminary
injunction. Appellants’ activities were investment contracts covered under the
Securities Act. The SEC thus established a reasonable probability of success on the
question of jurisdiction. In addition, the CEA did not divest the SEC of authority to
bring this action.
AFFIRMED.
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