Securities and Exchange Commission v. Charles E. Edwards

Brief Fact Summary.  Charles Edwards’s (Defendant) corporation sold payphones to the public at a guaranteed rate of return. The SEC (Plaintiff) brought a civil enforcement action against Edwards claiming he violated both registration requirements and antifraud provisions of the federal securities laws.

Synopsis of Rule of Law. Investment arrangements that promise a fixed rate of return can be considered an investment contract and therefore a security subject to the federal securities laws.

Facts. Charles E. Edwards was chairman, CEO and lone shareholder of the ETS Payphones, Inc., a company that sold payphones through independent merchants to the public.  ETS offered a contract where ETS leased back the payphone from the client for a fixed monthly sum, giving the clients a fixed annual return on the investment. ETS failed to make the payments necessitated by the leaseback contract due to the payphones not generating enough revenue, forcing the company to be reliant on new investors to fulfill its obligations. Following ETS’ filing for bankruptcy, the SEC brought a civil enforcement action, against Edwards and ETS, alleging the aforementioned had violated registration requirements and antifraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934. The district court ruled that the sale-and-leaseback agreement was an “investment contractâ€, and therefore must comply with federal securities laws. The court of appeals reversed, with the Supreme Court granting review.

Issue. Is an investment scheme guaranteeing a fixed return rate subject to federal securities laws as an investment contract?

Held. (O’Conner, J.) Yes. An investment scheme promising a fixed rate of return can be an investment contract and therefore considered a security that is susceptible to the federal securities laws. As defined by § 2(a)(1) of the 1933 Act and § 3(a)(10) of the 1934 Act, a “security†includes the term “investment contract†but fails to define the latter. The Court has determined the test for deciding whether a certain scheme falls under an investment contract is “whether the scheme involves an investment of money in a common enterprise profiting in its entirety from others effortsâ€.  “Profitsâ€, dividends, increased investment value or periodic payments to name a few, are profits investors seek on their investment, not the profits of the investment scheme itself.  This type of arrangement is desirable to the investing public by depictions of investment income. Individuals attracted to low risk investments, like those promising a fixed return, are generally more vulnerable to investment fraud. Following the reading furthered by Edwards, just by promising a rate of return, corrupt investment promoters were able to evade the securities laws. Edwards was erroneous in claiming that including a fixed return investment strategy with investment contracts conflicts with the precedent. The SEC regularlyupheld that a guarantee of a fixed return does not impede a scheme from being an investment contract. The court of appeals’ obligatory alternative holding of Edwards scheme failing to meet the criteria for an investment contract due to clients having are contractually due a fixed return isnot in accordance with this Court’s precedent. Reversed and remanded.

Discussion. Here, the Court utilized the landmark case that defined an “investment contractâ€, SEC v. W.J. Howey Co., 328 U.S 293 (1946).  The court of appeals interpreted the landmark case to exclude contracts with guaranteed returns. Concerned that marketers could avoid federal regulations by merely promising a fixed return to inexperienced investors, consumer groups filed amicus briefs in the case. It is obvious that the Court heeded the groups’ apprehensions, which specificallymentioned how impactful upholding the court of appeals interpretation is on inexperienced investors.