Court Rulings on ‘Exotic Securities’ Anger Enforcers
State and federal securities law enforcers complain that they have been hamstrung in efforts to shut down so-called “boiler room” operations in Southern California because two recent appeals court rulings have created a no-man’s land in the regulation of gold and other commodities they call “exotic securities.”
However skeptically an enterprise may be viewed by the public watchdogs, pitchmen who sell such investments over the telephone now are sheltered from the enforcers. It’s back to “let the buyer beware” when considering an investment in gold ore or other commodities, authorities say.
Regulators use uncommonly harsh words about the two court rulings, one federal and one state:
“An invitation to commit fraud,” said W. G. McDonald, assistant commissioner of enforcement for the California Department of Corporations.
“A license to steal money,” said Irving Einhorn, regional administrator here for the Securities and Exchange Commission.
As the result of earlier court decisions, federal and state regulators had formerly been able to ride herd on all sorts of so-called exotic securities.
These encompass precious metals, gemstones, oil, real estate, cattle, beavers and a variety of manufactured products--including such unlikely investment vehicles as tractor-trailer trucks, motion pictures and master recordings of music, which unsophisticated investors rarely think of these as securities.
Abuses Listed
“Typically,” regulators recently argued before the California Supreme Court, “it is unregulated promoters, and not representatives of legitimate business, who offer these ‘exotic’ investments, which are highly prone to fraudulent abuse.”
The types of abuse include such things as overvaluing the underlying asset, unfeasibility of the proposed venture, nonexistent tax benefits and misuse of investor funds, the court was informed.
Boiler rooms, with salesmen operating banks of telephones, are known for using investment ideas that seem timely or alluring to hook unwary investors.
The two court decisions represent a sharp departure from the way the law had been interpreted on exotic investments, according to regulators.
The first of the two involved contracts sold by Belmont Reid & Co. for specially minted gold coins, but for which the gold was to be mined at a future time. The firm was sales agent for a Nevada corporation that was to produce the gold, Continental Minerals Corp. Continental failed to deliver the coins and later was forced into involuntary bankruptcy.
The SEC filed the Belmont Reid case in 1984. In July, 1986, the 9th U.S. Circuit Court of Appeals upheld a federal judge in Northern California who had ruled that the investments in 1980 were not securities under the law.
No Appeal Made
Einhorn says other federal appeals courts around the country have ruled differently in similar cases.
But the SEC did not appeal the Belmont Reid ruling to the U.S. Supreme Court, and the case has now come back to haunt not only the SEC but state regulators.
The fruits of the federal court ruling popped up 13 months later in a significant state case. The California Court of Appeals overturned a lower court ruling and voided a desist-and-refrain order issued by the Corporations Department. That order had stopped sales of an unregistered gold-ore investment promoted last year by R. G. Reynolds, a radio-television financial adviser who operated out of Burbank.
Persuaded that it should follow the 9th Circuit’s ruling in Belmont Reid, the appeals court decided that, in the Reynolds case, investment contracts in “gold-bearing dump ore” were not securities. The California Supreme Court refused on Nov. 10 to review that decision.
The SEC and Corporations Department say that, since the two court rulings, gold ore and gold mining interests have quickly become popular with the infamous boiler rooms of Southern California. McDonald says the Southland now has more of such telephone investment operations than any other place.
More Shops Opening
“The boiler rooms are not stupid,” McDonald says. “In the last two months we’ve seen six to 10 boiler rooms start offering mineral aggregate and gold mining, including coins.”
Einhorn, too, says that “a number of shops are opening up, patterning themselves after” the setup in the Belmont Reid case.
Regulators are seeking ways to rectify the situation. McDonald may seek the re-enactment of the state’s old commodities law. It was scrapped after the federal government preempted the field in the 1970s with the Commodities Futures Trading Commission.
But two notorious gold scams of the early 1980s cost public investors a total of $160 million and revealed gaping holes in federal commodities regulation, McDonald says. They were Alan Saxon’s Los Angeles-based Bullion Reserve of North America and Florida-based International Gold Bullion Exchange.
Saxon told customers that he was storing their gold in a Utah mountain vault, but it was discovered after his suicide that almost no gold had actually been purchased with $60 million of investors’ funds. The Florida scheme used a deferred-delivery option that allowed the theft of nearly $100 million in investor funds, McDonald notes. Much of the loss in both cases was suffered by Californians.
Largely as a result of these massive frauds, he says, Congress did away with federal preemption and declared “open season” on commodity-based investment fraud and encouraged state and local authorities to attack commodities fraud under their laws. That has now been frustrated in California by the court rulings, McDonald says.
For his part, Einhorn says the SEC plans to file a fraud suit soon in a case similar to Belmont Reid. If the 9th Circuit rules the way it did the last time, the SEC will “take it all the way” to the Supreme Court this time, Einhorn vows.
But that could take two or three years, even if a case is filed in the near future.
Just what is a security under the law? Statutes and a body of case law has developed various tests of what falls under the heading.
The classic test in federal law dates to a 1946 decision by the U.S. Supreme Court in an SEC case against W. J. Howey Co. over its sale of orange trees.
“The test (for a security),” the High Court decision said, “is whether the scheme involves an investment of money in a common enterprise, with profits to come solely from the efforts of others.”
In the R. G. Reynolds gold ore case, the state appeals court said the phrase “solely from the efforts of others” has been interpreted since 1946 to mean “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.”
California statutory and case law is similar but has developed two separate tests for determining what is a security.
The governing statute states flatly that an investment contract is as much a security as a share of stock. But the California Supreme Court has said the securities laws do not contain an “all-inclusive formula” for testing the facts and that what constitutes a security is to be decided on a case-by-case basis.
In addition to the federal test based on the Howey case, state appeals courts have arrived at an alternate criterion, called the risk capital test. This involves such factors as whether funds are being raised for a business venture and whether investors’ money is substantially at risk.
Request Denied
In Belmont Reid, the SEC maintained that a contract to prepay for a set of coins at 33% to 48% below the world market price of gold was a security. The reasoning: Efforts of the promoters were vital to success of the investment.
But, calling the case “a close one,” a panel of judges on the court held that the purchasers were depending for their profit on the anticipated increase in the world gold price rather than on the managerial skill of Continental Minerals.
The 9th Circuit later declined an SEC request that the court as a whole consider the case and vote on it.
The federal court was “simply wrong in its interpretation of securities law,” contends McDonald, who says the court was “beguiled” by the idea of gold and silver having intrinsic value.
The decision “created a situation making it extremely difficult for us to enforce the securities laws in the precious metals area (and) turns 40 years of securities law on its head,” asserts McDonald.
In the state case against R. G. Reynolds and William Moreland, head of the company that was to mine the gold ore, an administrative law judge and a trial judge earlier backed the state’s contention that the investors and the sellers were engaged in a “common enterprise”--one of the criteria for a security.
The state contended that investors depended on the efforts of Moreland in order for them to get and market the stockpiled raw ore that he was selling in the remote hill country of Kern County.
However, when the case got to the appeals court, it decided that the Belmont Reid decision by the 9th Circuit “has clear application.”
“We find,” the state appeals court said, “that the circumstances before us fail to establish a ‘common enterprise’ or that investor profits are to come ‘solely’ or even substantially from the efforts of others.”
In a vain effort to get the California Supreme Court to hear the case on appeal, attorneys George A. Crawford and Elisa B. Wolfe of the Corporations Department told the High Court that the appeals court decision “contradicts a long line of cases finding that investments involving the purchase of an asset coupled with an agreement to provide essential management services are ‘securities.’
Wouldn’t Review Case
“If allowed to stand, the decision will create substantial confusion as to important questions of law and will seriously cripple efforts to enforce California’s Corporate Securities Law of 1968.”
The attorneys added that state and federal appeals courts, concentrating on the practical or economic realities of exotic investments, “have invariably found them to be securities.”
And they cited an academic study that found responsibility for enforcing securities laws on exotic securities has been shifting from the SEC to state agencies such as the Corporations Department.
However, the state Supreme Court not only declined to review the case but refused an alternative request that it decertify the appellate opinion for publication, which would have barred it as a precedent for future cases.
