principal, has not received any Prime Bank Instrument and has not received any information on the specific location of the CHA's funds. Thus, the SEC alleges that Konex and others misrepresented the true risk associated with an investment in the Roll Program.
Finally, the SEC claims that Neal and Polichemi, acting through their companies, have misrepresented the status of CHA's investment. They have repeatedly advised Lauer that CHA funds are in accessible accounts, but have not been able to produce any confirmation of the status or location of the funds. Nor have they returned the funds despite Lauer's repeated requests. A permanent injunction has been entered against defendants Konex, Neal, Copol and Polichemi by way of default.
Defendants Lauer and CCI claim that the SEC has no jurisdiction to bring this action and that this court has no jurisdiction to entertain the case. Defendants first argue that even if the Konex Roll Program was a legitimate investment program, the CHA's investment in that program would not constitute a "security" within the meaning of the federal securities laws because it does not meet the Seventh Circuit's horizontal commonality test. Second, defendants argue that when a "con man" uses the promise of an investment in "nonexistent securities" as the lure to separate a victim from his money (as opposed to the promise of an investment in "nonexistent" real estate, fake diamonds, or any other fraudulent bait), the act is one of conversion and not a violation of federal securities laws.
I. JURISDICTIONAL STANDARD
This action is brought pursuant to the special jurisdictional provisions of Section 22(a) of the Securities Act (15 U.S.C. § 77v(a)) and Section 27 of the Exchange Act (15 U.S.C. § 78aa). Those sections provide that the district courts of the United States shall have jurisdiction of violations of the Securities Act and Exchange Act and of all suits brought to enforce any liability or duty created by those Acts. 15 U.S.C. §§ 77v(a) and 78aa. This case is also brought pursuant to the general federal question jurisdiction provision of 28 U.S.C. § 1331.
The parties dispute the standard to be applied in ruling on this jurisdictional challenge. The district court has the responsibility to determine the existence of subject matter jurisdiction and to gather the facts necessary to make that determination. Christison v. Sutter, 740 F.2d 593, 597 n.4 (7th Cir. 1984). See also Western Transp. Co. v. Couzens Warehouse, 695 F.2d 1033, 1038 (7th Cir. 1982); Nuclear Eng'g Co. v. Scott, 660 F.2d 241, 252 (7th Cir. 1981). Moreover, "if the complaint had failed to allege a fact that was a predicate for the power of the federal court to act . . . the complaint would have failed for lack of jurisdiction." Haas v. Wieboldt Stores, Inc., 725 F.2d 71, 73 (7th Cir. 1984).
In this case, in order to state a claim under the Securities Acts, we must first establish that a "security" exists. The threshold question in any action brought pursuant to the Securities Acts is whether a security exists. See Meridian Software Funding, Inc. v. Pansophic, 1992 U.S. Dist. LEXIS 7225 (N.D. Ill. 1992). Therefore, we will examine the SEC's claims to determine whether it has adequately shown all the elements of a "security."
II. INVESTMENT CONTRACT
The first issue is whether the investment in the Roll Program sold by the defendants constitutes an investment contract and, thus, is a security within the provisions of the Securities Act and the Exchange Act. Both plaintiff and defendants agree that if this investment is a "security" at all, it is as an "investment contract." In addition to conventional securities such as stocks and bonds, both the Securities Act and the Exchange Act define the term "security" to include an "investment contract." 15 U.S.C. §§ 77b(1) and 78c(a)(10). Neither Act, however, defines what is an "investment contract."
In SEC v. W.J. Howey Co., 328 U.S. 293, 298-99, 90 L. Ed. 1244, 66 S. Ct. 1100 (1946), the United States Supreme Court defined an investment contract as: 1) an investment of money; 2) in a common enterprise; 3) with an expectation of profits to be derived solely from the efforts of others. The Supreme Court stated that the definition "embodies a flexible rather than static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits." Id. at 299. In addition, the Supreme Court stated "the statutory policy of affording broad protection to investors is not to be thwarted by unrealistic and irrelevant formulae." Id. at 301.
The SEC claims that each of the elements of the Howey test has been met. Defendants concede that the first and third elements have been met.
Defendants' sole argument is that the requirements of the second element, the common enterprise, have not been met.
The Seventh Circuit requires a common enterprise which is satisfied by the "horizontal commonality" test. Wals v. Fox Hills Dev. Corp., 24 F.3d 1016, 1018 (7th Cir. 1994); Milnarik v. M-S Commodities, Inc., 457 F.2d 274, 276-78 (7th Cir.), cert. denied, 409 U.S. 887, 34 L. Ed. 2d 144, 93 S. Ct. 113 (1972). Horizontal commonality is "a pooling of interests not only between the developer or promoter and each individual 'investor' but also among the investors . . . in short, a wheel and not just a hub and a spoke." Wals, 24 F.3d at 1018 (citation omitted).
According to defendants' argument, since only one investor is specifically identified, no security in the form of an investment contract can be found to exist because the requisite horizontal commonality is lacking. Defendants believe that the existence of a security in this case rises or falls solely on the question of whether there are other investors besides the CHA who were defrauded and whose funds were pooled with CHA funds. The SEC disagrees that there is only one investor whose money was pooled in this scheme. However, even assuming that the CHA was the sole investor, the SEC argues that such fact alone would not be dispositive on the question of whether a security exists. We believe that the commonality element has been met in this case.
A. Pooling of Investor Funds
1. Actual Pooling
Defendants contend that no horizontal commonality exists because there was only one investor. At this point, whether any other investor funds actually were pooled with CHA funds is unclear. The SEC is unable to specifically name other investors. However, as part of the solicitation of Lauer, Neal told Lauer that there were four to five other investors as well as a trust investor. Neal told Lauer that he was handling the administration for these investors. Neal has testified that the CHA's initial $ 10 million investment was combined with $ 90 million from other investors to make the first (April 1993) and second (May 1993) successful trades in Prime Bank Instruments. In addition, Lauer has admitted, and the relevant documents reflect, that the CHA's investment would be pooled with money from others.
The SEC is in the process of conducting discovery to determine the number of investors in the Roll Program. The SEC has propounded interrogatories and document requests to defendants Polichemi and Copol requesting information relating to the offer and sale of Prime Bank Instruments. Moreover, this court has ordered defendants Copol, Polichemi, Neal and Konex to identify all investors who were solicited, offered or sold Prime Bank Instruments. In conducting such discovery, the SEC has learned that defendant Copol solicited investments in Prime Bank Instruments from numerous other investors. Specifically, the SEC has learned that two California and two Florida residents invested in Prime Bank Instruments with Copol. While there is no indication at this point that these investors were involved in the Konex Program, it does appear that Copol received funds from other investors in connection with the purchase and sale of Prime Bank Instruments. Thus, we believe that the SEC has sufficiently proven at this point that the CHA's funds were to be pooled with funds from other investors in an investment contract which intended to buy and sell purported Prime Bank Instruments.
2. Design of the Scheme
Assuming that actual pooling did not occur, the SEC argues that federal subject matter jurisdiction still exists because the requisite pooling of funds necessary to establish horizontal commonality is demonstrated by the design and marketing of the scheme, as well as the intent of the parties as derived from the statements made by Lauer and Neal.
In this case, it is clear that the Konex Roll Program contemplated the pooling of investor funds and was so presented to Lauer during the solicitation of the CHA's initial investment. Other investors were solicited in an effort to raise additional funds for the Roll Program. Konex and Copol needed to raise and pool $ 100 million to purportedly trade Prime Bank Instruments. If that amount were raised, all investors would profit from the purported trading of Prime Bank Instruments. If the money were not raised, investors would not profit because there would be no trading. Under these circumstances, investors' fortunes would rise and fall together in a common enterprise.
Moreover, the compensation to be paid investors was based upon the difference between what the Prime Bank Instruments were purportedly bought for and the amount for which they were sold. Finally, Copol and Konex were to be compensated, as was the CHA and other investors, for each successful purchase and resale of Prime Bank Instruments. Thus, Copol's and Konex's profits were directly linked in a common interest with the CHA and other investors. Thus, we find that the SEC has proven a "wheel" of common interests sufficient to satisfy the Seventh Circuit's horizontal commonality test. See, e.g., Wals, 24 F.3d at 1018.
The central issue in the cases cited by defendants involved whether a discretionary commodities trading account constituted a security, or whether the purchase of certain assets, including paintings and a time-share in a condominium unit, intended to be purchased by a single investor, similarly constituted a security under the horizontal commonality test. See, e.g., Milnarik v. M-S Commodities, Inc., 457 F.2d 274 (7th Cir.), cert. denied, 409 U.S. 887, 34 L. Ed. 2d 144, 93 S. Ct. 113 (1972) (individual investor discretionary commodities trading account held not to involve pooling); Hirk v. Agri-Research Council, Inc., 561 F.2d 96 (7th Cir. 1977) (individual investor discretionary commodities trading account held not to involve pooling); Stenger v. R.H. Love Galleries, Inc., 741 F.2d 144, 146 (7th Cir. 1984) (purchase of paintings with repurchase agreements); Frederiksen v. Poloway, 637 F.2d 1147, 1152 (7th Cir.), cert. denied, 451 U.S. 1017, 69 L. Ed. 2d 389, 101 S. Ct. 3006 (1981) (purchase of a marina with employment contract. "After the sale, [the defendant] was an employee of ECC, not a participant in an enterprise whose profits were shared").
In the cases cited by defendants, the fortunes of the investors did not rise and fall together, and each investor was unaffected by the profits or losses of the other investors. "Each contract . . . is unitary in nature and each will be a success or failure without regard to the others. Some may show a profit, some a loss, but they are independent of each other." Milnarik, 457 F.2d at 277. Thus, unlike the facts of this case where investors' profits would rise and fall in a common enterprise, that element of commonality was missing in the cases cited by defendants.
In addition to the contemplated pooling, Konex's Roll Program was also sold like a security. For example, prospective investors, including Lauer, were solicited for the Roll Program by finders located across the country by means of cold calls and otherwise. These finders were provided with information by Konex to use in their solicitation efforts. Solicitation letters were also used in the offer and sale of these Roll Program securities. Similarly, the finders were paid a fee if an investment was in fact made. Finders presented the investment as a safe high-yield investment. Lauer admits that he invested funds in the Roll Program to earn a high rate of return. The program was marketed as having a dominant investment intent in view of the emphasis on the extraordinary returns which could be earned on an investment. See Adams v. Cavanagh Communities Corp., 847 F. Supp. 1390, 1399 (N.D. Ill. 1994). Therefore, the marketing of the investment indicates that it is a security.
Some courts also have held that the intent of the parties should be examined in determining the existence of horizontal commonality. See Glazer v. National Commodity Research and Statistical Services, Inc., 388 F. Supp. 1341 (N.D.Ill. 1974), aff'd, 547 F.2d 392 (7th Cir. 1977). In Glazer, the court held:
What plaintiffs are arguing, in effect, is that an agreement which is not an 'investment contract' can be transformed into an investment contract by the unilateral fraud of one party in violation of the original understanding. Whether an 'investment contract' exists depends, like any other contract, upon the original intention of the parties to the arrangement.
Id. at 1344 (quoting Wasnowic v. Chicago Bd. of Trade, 352 F. Supp. 1066, 1070 (M.D. Pa. 1972)). The intent of the parties may be derived "by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect. In the enforcement of an act as this it is not inappropriate that promoters' offerings be judged as being what they were represented to be." SEC v. United Benefit Life Ins. Co., 387 U.S. 202, 211, 18 L. Ed. 2d 673, 87 S. Ct. 1557 (1967) (quoting SEC v. Joiner Leasing Corp., 320 U.S. 344, 352-58, 88 L. Ed. 88, 64 S. Ct. 120 (1943)). See also Howey, 328 U.S. at 301 ("it is enough that the respondents merely offer the essential ingredients of an investment contract.")
The economic reality of the transaction is that the Roll Program is a security. The manner in which the investment was marketed, the contemplated pooling of investor funds, and the intent of the parties, all satisfy the horizontal commonality test and hence establish the existence of a security. We believe that the SEC and the federal courts are not required to simply stand by when confronted by a massive fraud like this one and wait until multiple victims are separated from millions of dollars before seeking relief.
III. "NONEXISTENT SECURITIES "
Lauer and CCI next claim that the federal securities laws do not apply because Prime Bank Instruments do not exist. Defendants argue that if any fraud occurred, it was not done in connection with the offer, purchase or sale of a security and, therefore, federal securities laws do not apply.
First, we believe that "securities" do exist in this case. The securities at issue are investment contracts in the Konex Roll Program. Lauer entered into contracts establishing the investment in the Roll Program. These contracts constitute a purchase or sale of securities. What does not exist is the business of buying and trading Prime Bank Instruments for profit because there is no market for such instruments to be traded. The Konex Roll Program is itself an investment contract which falls within the definition of a security for both the Securities Act and Exchange Act. As a result, the federal securities laws apply since there is fraud in connection with the offer, purchase or sale of securities.
However, even assuming the Roll Program involved a "nonexistent security," many courts have extended jurisdiction under the federal securities laws to cases alleging fraud in connection with the offer, purchase and sale of securities which do not actually exist. "The fact that the securities did not exist does not remove this action from the operation of the federal securities laws." Mishkin v. Peat, Marwick, Mitchell & Co., 744 F. Supp. 531, 553 n.10 (S.D.N.Y. 1990).
Defendants cite Smith v. Chicago Corp., 566 F. Supp. 66, 68 (N.D. Ill. 1983) in support of their position. In that case, plaintiffs ordered the purchase of securities but their money was instead misappropriated. The court found that the plaintiffs had no standing to sue because they could not allege "that anyone purchased or sold any securities." Id. at 69. Furthermore, the court found that plaintiffs "did not make any decision relevant to the purchase of securities based on [the broker's] representations." Id. at n.4.
Other courts have narrowly construed Smith. In First Nat'l Bank of Chicago v. Shearson, Lehman Bros., Inc., 1988 U.S. Dist. LEXIS 17186, at 28 (N.D. Ill. 1989), for example, the court distinguished Smith because, in the case before the court, the plaintiff had signed a contract and that contract established a sale of a security, whereas in Smith there was no such contract. The court noted that:
although the plaintiffs in Smith directed their broker to purchase specific securities, they did not go so far as to enter into a contract to buy these securities. In contrast, the plaintiff here took all steps necessary to acquire [such securities]. . . . Furthermore, the plaintiff here, unlike the plaintiffs in Smith, did rely on fraudulent misrepresentations in deciding whether to acquire an interest in the securities.
Id. at 28.
In this case, Lauer entered into contracts establishing the investment in the Roll Program. These contracts, by definition, constitute a "purchase" or "sale" of a security. The fact that trading in Prime Bank Instruments never occurred is irrelevant because "those who enter into a contract to buy securities are entitled to the same protection as those who actually buy securities". Butterworth v. Integrated Resources Equity Corp., 680 F. Supp. 784, 786 (E.D. Va. 1988).
Similarly, defendants Neal and Polichemi made misrepresentations to Lauer which Lauer repeated in his solicitation letters to prospective investors. Lauer also lulled and misled his employer about the investments he had made. Therefore, we find that the SEC has sufficiently made out a case for fraud in connection with the purchase or sale of a security and, thus, federal securities laws do apply.
IV. FRAUD IN THE OFFER OF A SECURITY
The SEC also alleges violations of Section 17(a) for fraud in the offer of a security. 15 U.S.C. § 77q (a). Section 17(a) of the Securities Act "prohibits the offer as well as the sale of unregistered non-exempt securities." Howey, 328 U.S. at 301. See also Pfohl v. Pelican Landing, 567 F. Supp. 134, 138 (N.D. Ill. 1983) (the Acts "extend to persons who offer to sell what they describe as securities, because the Acts reach fraud in the offer itself.")
The SEC is empowered to bring actions premised on the fraudulent offer of investment contracts involving Prime Bank schemes. Moreover, in a § 17(a) case, requiring the existence of multiple investors prior to finding a security would write out the element of an "offer" from the Securities Act and render that section a nullity. Thus, the conclusion that multiple investors must part with their money before a case predicated on the offer of an investment contract can be brought contradicts the very inclusion of the term "offer" in § 17(a).
In this case, the SEC has shown, and defendants have not contested, that fraud also occurred in the offer of a security. The SEC has shown that Lauer solicited prospective investors through a letter which he knew contained false and misleading information. Lauer admits making these false solicitations to increase the administrative fees paid to CCI. Similarly, Lauer participated in at least one meeting with prospective investors in the Konex Roll Program. Thus, the SEC has shown the existence of fraud by Lauer and CCI in the offer of a security as contemplated by § 17(a) of the Securities Act of 1933.
We believe that the facts of this case fall within the parameters established by the Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293, 90 L. Ed. 1244, 66 S. Ct. 1100 (1946). This is not a discretionary trading account or the purchase of a time share unit or other specific asset. In view of the dominant investment purpose and the obvious marketing of the scheme in a securities-like fashion, we believe that this is one of the "countless and variable schemes" intended to be covered by the federal securities laws. See Howey, 328 U.S. at 299. Given the principle that the federal securities laws are to be construed flexibly, not technically or restrictively, we find the requisite pooling and thus the existence of a security. See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 199, 11 L. Ed. 2d 237, 84 S. Ct. 275 (1963).
Moreover, we believe that this action, as well as the numerous other actions filed by the SEC relating to the Prime Bank schemes, furthers the securities laws' broad remedial purpose and statutory policy of protecting public investors. See Howey, 328 U.S. at 301. "The fundamental purpose under the Securities Act is 'to eliminate serious abuses in a largely unregulated securities market.'" Reves v. Ernst & Young, 494 U.S. 56, 60, 108 L. Ed. 2d 47, 110 S. Ct. 945 (1990) (quoting United Hous. Found., Inc. v. Forman, 421 U.S. 837, 849, 44 L. Ed. 2d 621, 95 S. Ct. 2051 (1975)). Nothing could be more fundamental to that purpose than the regulation of these instruments, which are marketed like securities and which have a dominant investment intent, which are sold throughout the United States and internationally and which have taken at least $ 57 million out of the United States capital markets.
There is currently no federal regulatory scheme specifically directed at purported Prime Bank Instruments. We believe that the absence of any other regulation and the broad remedial purpose of the federal securities laws require that a security be found such that the SEC and court can enjoin these fraudulent schemes. See Reves, 494 U.S. at 70-73. When it created the federal securities laws, Congress could not have contemplated that regulators or the courts would stand by idly when there is no other regulation that oversees these fraudulent international investments which remove millions of dollars in investor funds from America's capital markets. To so hold, would render meaningless the purpose of our system of securities regulation.
For the foregoing reasons, the challenge of defendants John D. Lauer and Clifton Capital Investors L.P. to the jurisdiction of this court is denied.
Wayne R. Andersen
United States District Judge
Dated: September 20, 1994