Katherine Jarozewski v. Julius Gamble et al. (2013)

MEMORANDUM OF DECISION RE DEFENDANT'S MOTION TO REARGUE (# 139)

Subsequent to the trial the court rendered a memorandum of decision in favor of the plaintiffs and against the defendants in count one alleging negligent misrepresentation, count two alleging intentional misrepresentation and count three alleging a violation of the Connecticut Uniform Securities Act (CUSA).   The defendants filed a motion to reargue the decision of the court insofar as it found that the defendants had violated CUSA. The gravamen of the defendants' motion is that the court incorrectly found that the defendants had violated CUSA and more specifically that the court incorrectly determined that the defendants were offering or selling a “security” as the term is used in Connecticut General Statutes section 36b–3(19).   The defendants essentially argue that, because the plaintiff invested money in an enterprise in which she was going to be and was for a short period of time an active participant, the transaction was not for a sale and purchase of a “security” as the term is defined in CUSA.

In addition to the facts which the court set forth in its original memorandum of decision, based on the evidence introduced at trial, the court additionally finds the following facts.  (1) The defendants initially solicited the plaintiff with an intent that she become an entirely passive investor.  (2) The plaintiff upon learning about the company negotiated an agreement pursuant to which she obtained a 15% interest in a limited liability company.   The four other individual defendants each held a 20% interest in the limited liability company.   The defendants agreed to provide the plaintiff with a 15% interest in limited liability company solely in consideration of her investment of $130,000 and not at all because they sought her participation.  (3) The defendants did however also agree to allow the plaintiff to participate in the affairs of the company.  (4) The interest of the defendants in the company was primarily a result of their efforts over a period of years on behalf of the company and not the result of a financial investment that meaningfully compared with the amount of money invested by the plaintiff.   Some of the defendants made short-term loans to the company which were repaid, in part, prior to the plaintiff's investment by the company's cash flow and, in part, at or about the time of the plaintiff's investment by the funds that she had invested.  (5) Based on the representations of one or more of the defendants the plaintiff intended and expected her $130,000 investment to provide liquidity for the most significant capital acquisition of the company, specifically the acquisition of advanced technological and computer equipment necessary for the company's success.   In part, her investment was used for this capital acquisition.  (6) While the defendants did agree to allow the plaintiff to participate in certain aspects of the company business and in fact the plaintiff did participate for a short period of time, the plaintiff never acquired meaningful control over the company's management decisions.

DISCUSSION

The issue is whether the offering of and eventual sale and purchase of a 15% interest in a limited liability company is the offering and sale of a “security” as defined by CUSA, when the offeror originally intended the purchaser to acquire a passive interest, but when the parties to the sale eventually agreed that the purchaser be an active participant in the operations of the company (though not a controlling member) and when the amount the purchaser paid for her interest was significantly in excess of what other members paid for their interest, and when her purchase price is intended to provide liquidity to the company for the acquisition of a significant capital equipment.

In determining the scope of CUSA and whether it covers the type of transaction the evidence shows occurred, the court will start with the statutory text.   General Statutes section 36b–3(19) states in pertinent part “security” means any ․ “investment contract” ․

Notably the statutory language, having identified an investment contract as one of the vehicles which constitutes a security continues then to add clarification to the term “investment contract” by stating that “security” includes ․ “(B) as an investment contract, an interest in a limited liability company or limited partnership ․” In its original memorandum of decision the court found that the subject transaction involved the sale and purchase of an interest in a limited liability company and therefore constituted an interest in an investment contract and a security.   Upon reconsideration the court agrees with the defendants that not all sales of interests in limited liability companies are sales of “securities.”   The court must consider the economic substance of the entire transaction in making that determination.   The court, having reviewed the evidence, however, concludes that the economic substance of the transaction was the offering of and eventual sale of a “security.”

Subsection (B) of CUSA was taken directly from the Uniform Securities Act section 102(28)(E).It is not surprising that subsection (E) of the Uniform Securities Act was added by the drafters to clarify the definition of an investment contract as a security, for as the commentary to section 102(28) suggests, both federal and state courts have recognized interests in limited liability companies and limited partnerships as securities in some instances.   Moreover the commentary references a study concluding that of the cases in which the definition of a security played a pertinent role, 58% concerned the so called “investment contracts.”

The defendants rely on the commentary in concluding that the sale of the interest in the subject company was not a security.   The passage of the commentary relied upon by the defendant reads as follows;

In interpreting all elements of the investment contract, the courts have emphasized substance not form.   A conventional partnership involving two individuals who actively participate in its management and who each own 50% interest of it profits have consistently not been viewed as an investment contract because profits do not come from the efforts of others.   On the other hand investments in limited partnership interest which are traded on stock exchanges consistently have been held to be investment securities because profits do come substantially from the efforts of others.   Indeed, interests in an entity called a general partnership may be a security when the general partnership functions like a limited partnership.   See e.g. Williamson v. Tucker, 645 F 2d 404, 424 (5th Cir.1981) cert. denied 454 U.S. 897 (1981).

Thompson/West, Uniform Laws Annotated, Volume 7C, (2006), p. 38–39.

Of course in the case at bar the plaintiff did not purchase a 50% interest in a general partnership nor did she purchase a limited partnership interest traded on a stock exchange.   The court must be guided by the introductory sentence and look to the substance and not the form of the transaction.   Connecticut appellate courts have stated that in applying and interpreting CUSA the court may be guided by both the Uniform Securities Act and its commentary as well as the interpretation of federal courts regarding the Securities Act of 1933.  Connecticut National Bank v. Giacomi, 233 Conn. 304, 319 (1995);  Lehn v. Dailey, 77 Conn.App. 621, 631–32 (2003).

In the 1945 landmark case of Securities and Exchange Commission v. Howey Company, the United States Supreme Court noted that the term “investment contract” was undefined by federal securities law but was a term commonly used in many state blue sky laws.   The “investment contract” term had been broadly construed by the state court so as to afford the investing public a full measure of protection.   Form was disregarded for substance and emphasis was placed upon economic reality.  Securities and Exchange Commission v. Howey Company, 328 U.S. 293, 298 (1945).  “An investment contract thus came to mean a contract or scheme for ‘the placing of capital or laying out of money in a way intended to secure income or profit from its employment.’  “ Howey, supra, quoting State v. Gopher Tire & Rubber Company, 146 Minn. 52, 56, 177 NW 937, 938.

Since the decision in Howey there has been much litigation over what types of transactions constitute investment contracts and the definition of investment contract has evolved in order to promote the remedial purposes of both the federal and state laws designed to protect the investing public.

The Howey court originally stated that for purposes of the federal securities law an investment contract “means 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 its promoter or a third party ․” Howey at 298–99 (emphasis added).   Since this decision, however, many federal and state courts have determined that the Howey requirement that profits come “solely” from the efforts of others was dicta and should not be taken literally.   Different courts have adopted different approaches in rejecting the literal interpretation.   Some courts have held that an investment contract requires only proof that “the efforts made by those other than the investor are undeniably the significant ones, those essential managerial efforts which affect the failure or success of the enterprise.”  Security and Exchange Commission v. Glen W. Turner Enterprises, Inc., 474 F.2d 476, 482 (9th Cir.1983), cert. denied, 414 U.S. 821.   See also Security and Exchange Commission v. Koscot Interplanetary, Inc., 497 F.2d 473 (5th Cir.1974).  “Where the investors' duties were nominal and insignificant, their roles were perfunctory or ministerial where they lack any real control over the operation of the enterprise, the courts have found investment contracts.”  Fargo Partners v. Dain Corp., 540 F.2d 912, 914–15 (8th Cir.1976).

Some state courts have adopted a “risk capital test.”   In Commissioner of Securities v. Hawaii Market Center, Inc., 485 P.2d 105, 47 ALR 3rd 1366 the court suggested that the basic economic reality of a security transaction is the subjecting of an investor's money to a risk of an enterprise over which the investor has no managerial control.

The holding of Hawaii Market Center has been summarized as holding that “investment contract” is created whenever

(1) An offeree furnishes initial value to an offeror, (2) a portion of this initial value is subjected to the risks of the enterprise, (3) the furnishing of the initial value is induced by the offer or promises or representations which give rise to a reasonable understanding that a valuable benefit, over and above the initial value, will accrue to the offeree as a result of the operation of the enterprise, (4) the offeree does not receive the right to exercise any practical and actual control over the managerial decisions of the enterprise.  Blue Sky Laws–Investment Contracts 47 ALR 3rd 1375, 1382–83 (1973).   See also Healy v. Consumer Business Systems, Inc., 482 P.2d 549 (Oregon App.1971).

The court has reviewed the evidence in this case and its finding in light of the foregoing authorities and must conclude the subject transaction constituted both the offer and sale of the security.   The elements outlined in the Hawaii Market Center case all exist in the case at bar.   The court finds that (1) the plaintiff furnished value to the defendants;  (2) that the plaintiff's initial investment was entirely subject to the risks of the enterprise;  (3) that the plaintiff was induced by the defendant's representations that gave rise to the plaintiff's reasonable beliefs that a valuable benefit would accrue to her as a result of the operation of the enterprise;  and (4) that the plaintiff though allowed to participate in activities of the enterprise did not receive the right to exercise any practical or actual control over the managerial decisions of the enterprise.   Moreover the court finds that the facts in the case at bar lend themselves to a finding that the transaction constituted the sale of a security consistent with the holdings in Glen W. Turner Enterprises, Inc., supra and Koscot Interplanetary, Inc., supra in that the representations made by the defendants led the plaintiff to believe that “the efforts made by [the defendants] ․ were undeniably the significant ones, those essential managerial efforts which effect the failure or success of the enterprise.”   The defendants developed the business;  the defendants convinced the plaintiff that they understood the business;  the defendants convinced the plaintiff that they were aware of markets in which the business would thrive;  and the defendants convinced the plaintiff that with her financial investment they could acquire the necessary equipment which would allow the enterprise which they were running to generate profits which would in turn generate a return on the plaintiff's investment.   In summary, looking at the economic reality of the transaction, the defendants were seeking a significant cash investment in their existing business and that is exactly what they got.

The fact that the plaintiff was allowed to participate in the operations of the company as a minority member does not in and of itself eliminate or in any way contradict the overall economic nature of the transaction which was an investment in an ongoing business.   Moreover, the defendant violated the provisions of CUSA when they made material misrepresentations at the time they were offering the plaintiff solely a passive investment.   This violation could not be cured by a subsequent agreement in which the plaintiff was permitted to participate to some extent in the activities of the enterprise.   Indeed it was that original violation which led to the eventual acquisition of the interest acquired by the plaintiff, and the damages she ultimately sustained.   The defendant's misrepresentations in inducing the plaintiff to make this investment were violations of the Uniform Securities Act. The court has reconsidered its original holding and affirms the same.

GENUARIO, J.

Genuario, Robert L., J.