State v. Hawaii Market Center

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State v. Hawaii Market Center

Case: State v. Hawaii Market Center (1971)

Subject Category: Security

Agency Involved: Hawaii Commissioner of Securities

Court: Hawaii Supreme Court

             Hawaii

Case Synopsis: The Hawaii Supreme Court was asked to decide if the memberships sold by Hawaii Market Centers constitute a security to be regulated under Hawaii's state securities laws.

Legal Issue: What is the definition of an investment contract under Hawaii State Law?

Court Ruling: The Court ruled that the scheme in question was a security, but did so by adopting a new and different test than that used by other states. Hawaii Market Center (HMC) sold "founding" memberships to promoters who could earn money through selling additional memberships or referring others to shop at the store using the promoter’s buyer's cards. The program focused on the marketing to additional promoters and not on the sale of merchandise to end-users. The Hawaii Supreme Court decided that the scheme was an investment contract because the money earned by the promoter was more like the money earned by an investment than a referral sales plan. The Court declined to adopt the popular Howey definition of an investment contract, one where profits come solely from the efforts of others. Instead the court focused on the functional characteristics of an investment contract and concluded that in Hawaii an investment contract is the investment of initial value, subject to the risks of an enterprise, is induced by representations of profit, and the investor does not have practical and actual control over the decisions of the enterprise.

Practical Importance to Business of MLM/Direct Sales/Direct Selling/Network Marketing/Party Plan/Multilevel Marketing: Hawaii takes a functional approach to an investment contract, which may make their definition more expansive than other states'.

State v. Hawaii Market Center , 485 P.2d 105 (1971) : The Court ruled that the scheme in question was a security, but did so by adopting a new and different test than that used by other states. Hawaii Market Center (HMC) sold "founding" memberships to promoters who could earn money through selling additional memberships or referring others to shop at the store using the promoter’s buyer's cards. The program focused on the marketing to additional promoters and not on the sale of merchandise to end-users. The Hawaii Supreme Court decided that the scheme was an investment contract because the money earned by the promoter was more like the money earned by an investment than a referral sales plan. The Court declined to adopt the popular Howey definition of an investment contract, one where profits come solely from the efforts of others. Instead the court focused on the functional characteristics off an investment contract and concluded that in Hawaii an investment contract is the investment of initial value, subject to the risks of an enterprise, is induced by representations of profit, and the investor does not have practical and actual control over the decisions of the enterprise.

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STATE v. HAWAII MARKET CENTER, INC., 52 Haw. 642 (1971)

485 P.2d 105

STATE OF HAWAII, by its Commissioner of Securities, Plaintiff-Appellee,

v. HAWAII MARKET CENTER, INC., STUART M. COWAN, DON R. SELLEY, JAMES

ROSE and ARTHUR AWAYA, Individually and as Officers and/or Directors of

HAWAII MARKET CENTER, INC., Defendants-Appellants.

No. 4958.

Supreme Court of Hawaii.

May 20, 1971.

 

APPEAL FROM FIRST CIRCUIT COURT, HONORABLE DICK YIN WONG,

JUDGE.

RICHARDSON, C.J., MARUMOTO, ABE, LEVINSON AND KOBAYASHI, JJ.

Page 643

 

OPINION OF THE COURT BY LEVINSON, J.

 

  The legal issue presented by this case is whether the

"Founder-Member Purchasing Contract Agreements" issued by Hawaii

Market Center, Inc., one of the appellants, constitute securities

within the meaning of the Hawaii Uniform Securities Act

(Modified), HRS § 485-1(12).[fn1] An affirmative answer to this

question would bring into operation the registration requirements

of HRS § 485-8. Before determining the nature of these agreements

it is first necessary to delineate clearly the economic

relationship existing between Hawaii Market Center, Inc. and

persons who have contracted with it pursuant to these agreements.

  Hawaii Market Center, Inc. (hereinafter referred to as HMC) is

a Hawaii corporation with a capitalization of $1000.00. The

corporation's expressed purpose was to open a retail store which

would sell merchandise only to persons possessing purchase

authorization cards. In order to raise capital for the financing

of this enterprise HMC recruited founder-members. The maximum

number of such members was set at five thousand.

Page 644

  Prospective founder members were asked to attend recruitment

meetings. At these meetings a speaker explained how members would

be eligible to earn (1) immediate income before the store became

operational, and (2) future income after the store became

operational. In order to earn such income an invitee was required

to become either a founder-member distributor or a founder-member

supervisor.

  A person became a founder-member distributor by purchasing from

HMC either a sewing machine or a cookware set (each with a

wholesale value of $70.00) for $320.00. The purchaser also

executed a "Founder-Member Purchasing Contract Agreement" with

the corporation. This agreement states that a distributor is able

to earn money in five ways. He may: (1) distribute the 50

authorized buyer's cards, which have been issued to him and

thereafter earn a 10% commission on each sale resulting from the

use of one of these cards in the HMC store; (2) earn a $50.00 fee

each time a person he refers becomes a founder-member

distributor; (3) receive a $300.00 fee as compensation for

establishing a new member as a supervisor or upgrading an old

member from distributor to supervisor. The fourth and fifth

sources of income relate to the earning of credits which are

applied to a $900.00 fee paid by a distributor to his supervisor

if the distributor wishes to be upgraded.

  A person became a supervisor by executing a founder-member

contract and purchasing both a sewing machine and a cookware set

for a total price of $820.00. A supervisor earns higher fees and

commissions than a distributor. In addition, a supervisor

receives an override commission if his distributor enlists a new

member. He also receives override commissions on all sales made

to holders of purchase authorization cards distributed by any

founder-member whose entry into the organization can be traced

back to the supervisor.

Page 645

  On September 23, 1969 the appellee, the State of Hawaii, by its

Commissioner of Securities, filed an action in the First Circuit

Court against HMC and its officers and directors. The State

sought to enjoin the further promotion and execution of the above

described founder-member contracts. The commissioner argued that

the contracts were unregistered securities whose distribution was

prohibited by the Uniform Securities Act (Modified). HRS § 485-8.

The appellants contended that the contracts in question were not

securities within the meaning of the Act.

  On October 20, 1969 the trial court entered its findings of

fact, conclusions of law and judgment in favor of the

Commissioner of Securities. After a thorough analysis of the

economic realities underlying the relationship between the

defendant corporation and its founder-members the court held that

the HMC agreements constituted "investment contracts" and

"certificates of interest or participation in a profit sharing

agreement" and, therefore, fell within the Hawaii statute's

definition of "security," as defined by HRS § 485-1(12). The

court enjoined the further promotion and execution of

founder-member purchasing contract agreements and the collection

and disbursement of funds pursuant to such agreements. The

appellants have appealed from this judgment and order. For the

reasons set forth below we affirm.

I. THE ESSENTIAL CHARACTERISTICS OF AN INVESTMENT CONTRACT UNDER

   THE HAWAII UNIFORM SECURITIES ACT (MODIFIED).

   A. The Test Embodied in the Howey Case is Too Mechanical to

      Protect the Investing Public Adequately.

  In arguing whether the interests represented by HMC's

founder-member contracts constitute investment contract

securities within the meaning of HRS § 485-1(12) both

Page 646

the appellant and the appellee rely for guidance principally upon

the Supreme Court decision in Securities & Exchange Commission

v. W.J. Howey Co., 328 U.S. 293 (1946). That case sought to

formulate a test for the existence of an "investment contract,"

such a contract being included within the definition of

"security" under the Federal Securities Act. The Court concluded

that an investment contract exists whenever "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." Securities &

Exchange Commission v. W.J. Howey Co., supra at 299.

  The appellants urge us to adopt the Howey formula as the test

to be applied in the present case. It is contended that under the

Howey test the contracts in question are not investment

contracts because founder-members in the HMC plan are expected to

recruit new members and distribute purchase authorization cards

in order to earn income; they do not, therefore, "expect profits

solely from the efforts" of others. Gallion v. Alabama Market

Centers, Inc., 282 Ala. 679, 213 So.2d 841 (Ala. 1968); Emery

v. So-Soft of Ohio, Inc., 30 Ohio Op.2d 226, 199 N.E.2d 120

(Ohio Ct. App. 1964).

  The State also relies upon the Howey case but contends that

the test enunciated therein is not to be taken literally. It

argues that the efforts expected of the founder-members are

minimal in nature and, as a practical matter, the founders are

substantially dependent upon the management of the corporation

for a successful return on their investment. Thus the State

asserts, under the real meaning of the Howey rule, the disputed

agreements are investment contracts. D.M.C. of Colorado, Inc.

v. Hays, 3 CCH Blue Sky L. Rptr., ¶ 70,897 at 67,042 (Colo.

Dist. Ct. 2/26/71); see Florida Discount Centers, Inc. v.

Antinori, 226 So.2d 693 (Fla. Dist. Ct. App. 1969), aff'd 232

So.2d

Page 647

17 (Fla. 1970). We agree that the present agreements constitute

"securities" within the coverage of the Hawaii Uniform Securities

Act (Modified). We do not choose, however, to base this decision

on the restrictive formula laid down by the Supreme Court in the

Howey case.[fn2]

  The primary weakness of the Howey formula is that it has led

courts to analyse investment projects mechanically, based on a

narrow concept of investor participation.[fn3] See Gallion v.

Alabama Market Centers, Inc., supra; Emery v. So-Soft of Ohio,

Inc., supra. Thus courts become entrapped in polemics over the

meaning of the word "solely" and fail to consider the more

fundamental question whether the statutory policy of affording

broad protection to investors should be applied even to those

situations where an investor is not inactive, but participates to

a limited degree in the operation of the business.[fn4] In

fulfilling the remedial purposes of our state act, we believe a

sounder approach to securities regulation requires that courts

focus their attention on the economic realities of security

transactions: that is, "[t]he placing of capital or laying out of

money in a way intended to secure income or profit from its

employment" in an enterprise. State

Page 648

v. Gopher Tire & Rubber Co., 146 Minn. 52, 56, 177 N.W. 937,

938 (1920).

  B. The Risk Capital Approach to Defining an Investment

     Contract.

  The salient feature of securities sales is the public

solicitation of venture capital to be used in a business

enterprise. Silver Hills Country Club v. Sobieski, 55 Cal.2d 811,

815, 13 Cal.Rptr. 186, 188, 361 P.2d 906, 908 (1961);

Goodwin, Franchising in the Economy: The Franchise Agreement as

a Security Under Securities Acts, Including 10b-5

Considerations, 24 Business Lawyer 1311, 1320-21 (1969). This

subjection of the investor's money to the risks of an enterprise

over which he exercises no managerial control is the basic

economic reality of a security transaction. Coffey, The Economic

Realities of a "Security": Is There a More Meaningful Formula?,

18 W. Res. L. Rev. 367, 412 (1967); see Silver Hills Country

Club v. Sobieski, supra; see Securities & Exchange Commission

v. Latta, 250 F. Supp. 170, 173 (N.D. Cal. 1965), aff'd per

curiam, 356 F.2d 103 (9th Cir. 1965), cert. denied,

384 U.S. 940 (1966). Any formula which purports to guide courts in

determining whether a security exists should recognize this

essential reality and be broad enough to fulfill the remedial

purposes of the Securities Act. Those purposes are (1) to prevent

fraud, and (2) to protect the public against the imposition of

unsubstantial schemes by regulating the transactions by which

promoters go to the public for risk capital. HRS § 485-10(e).

Therefore, we hold that for the purposes of the Hawaii Uniform

Securities Act (Modified) an investment contract is created

whenever:[fn5]

Page 649

  (1) An offeree furnishes initial value to an offeror,

      and

  (2) a portion of this initial value is subjected to

      the risks of the enterprise, and

  (3) the furnishing of the initial value is induced by

      the offeror's promises or representations which

      give rise to a reasonable understanding that a

      valuable benefit of some kind, over and above the

      initial value, will accrue to the offeree as a

      result of the operation of the enterprise, and

  (4) the offeree does not receive the right to

      exercise practical and actual control over the

      managerial decisions of the enterprise.

  The above test provides, we believe, the necessary broad

coverage to protect the public from the novel as well as the

conventional forms of financing enterprises. Its utility is best

demonstrated by its application to the facts in the instant case.

II. THE CONTRACTS IN QUESTION CONSTITUTE INVESTMENT CONTRACTS

    WITHIN THE MEANING OF HRS § 485-1(12).

    A. The Initial Value Subjected to the Risks of the

       Enterprise.

  Each person who executes a "Founder-Member Purchasing Contract

Agreement" is required by Hawaii Market Center, Inc. to make a

"one-time retail purchase" of $320.00 in order to become a

distributor and $820.00 in order to become a supervisor. The

record indicates that the total wholesale cost to HMC of the

purchased merchandise is $70.00 and $140.00 respectively. The

appellants have made no attempt to characterize these

transactions as the simple purchase of merchandise, nor do we

deem them such. The terms of the offer and the inducements held

out to the prospects clearly indicate that the substantial

Page 650

premiums paid by founder-members to HMC are given in

consideration for the right to receive future income from the

corporation. These overcharges constitute the offerees'

investments or contributions of initial value, such value being

subjected to the risks of the enterprise.

  It is uncontested that the recruitment of founder-members was

motivated by the need to raise capital to finance the opening of

the proposed Hawaii Market Center store. Inextricably bound to

the success of this enterprise is the ability of the

founder-members to recoup their initial investment and earn

income. The recruitment fee paid to distributors and supervisors,

during the pre-operational phase of the plan, rests upon the

promoters' ability to sell the success of the plan to prospective

members. In addition, those members who choose to rely solely on

the second method of earning income, the payment of commissions

based on sales, receive no return at all on their investment

unless the store functions successfully. This latter point is

particularly important because recruitment of members increases

geometrically. Therefore, since membership is limited to five

thousand, a very large percentage of founder-members will be

totally dependent on sales commissions to recover their initial

investment plus income. It is thus apparent that the security of

the founder-members' investments is inseparable from the risks of

the enterprise. The success of the plan is the common "thread on

which everybody's beads [are] strung." Securities & Exchange

Commission v. C.M. Joiner Leasing Corp., 320 U.S. 344, 348

(1943).

    B. The Promise of a Valuable Return on the Offeree's

       Investment.

  The appellants contend that because of the nature of the

receipts promised to founder-members the trial court erred in

finding the existence of a security. They stress

Page 651

that founder-members do not participate in the profits of the

enterprise. They are promised fixed fees and commissions, which

are payable regardless of the existence of profits. Therefore, it

is argued, the essential profit sharing element of a security is

lacking. Commonwealth ex rel. Pennsylvania Securities

Commission v. Consumers Research Consultants, Inc., 414 Pa. 253,

256, 199 A.2d 428, 429 (1964). Once again, this argument

ignores the economic realities underlying securities regulation.

  It should be irrelevant to the protective policies of the

securities laws that the inducements leading an investor to risk

his initial investment are founded on promises of fixed returns

rather than a share of profits. The reference point should be the

offeree's expectations, not the balance sheet of the offeror

corporation. The unwary investor lured by promises of fixed fees

deserves the same protection as a participant in a profit sharing

plan. For this reason courts have avoided a narrow definition of

"profits." They have recognized securities sales even where the

promised benefits to the offeree were indirect, arising from an

anticipated increase in the value of the property received,

rather than direct payments from the offeror. Securities &

Exchange Commission v. C.M. Joiner Leasing Corp., supra at

348-49; Roe v. United States, 287 F.2d 435, 439 (5th Cir.),

cert. denied, 368 U.S. 824 (1961). Thus, the fact that in the

instant case HMC guaranteed the offerees amounts of money

independent of enterprise profits does not undermine the

investment nature of the transactions.

    C. The Lack of Managerial Control Over the Enterprise.

  Finally, as previously stated, it is irrelevant to the remedial

purposes of the Securities Act that an investor participates in a

minor way in the operations of the enterprise.

Page 652

Courts should focus on the quality of the participation. In order

to negate the finding of a security the offeree should have

practical and actual control over the managerial decisions of the

enterprise. For it is this control which gives the offeree the

opportunity to safeguard his own investment, thus obviating the

need for state intervention. Coffey, The Economic Realities of a

"Security": Is There a More Meaningful Formula?, supra at

396-98.

  In the present case the founder-members possess none of the

incidents of managerial control which would preclude the finding

of a security. The members have no power to influence the

utilization of the accumulated capital. Nor will they have any

authority over those decisions which will affect the operation of

the store, if it is successfully established. Judged by an

ability to protect their original investment, the offerees in

this case are powerless. Thus, under the economic realities

approach presently advocated, they properly belong to the class

of investors falling within the remedial purposes of the

Securities Act. Therefore we hold that the present agreements are

investment contracts within the meaning of the Hawaii Uniform

Securities Act (Modified) and must be registered with the

Commissioner of Securities prior to distribution.

  Judgment affirmed.

[fn1] HRS § 485-1(12) provides:

  "Security" means any note, stock, treasury stock,

  bond, debenture, evidence of indebtedness,

  certificate of interest or participation in any

  profit-sharing agreement, collateral-trust

  certificate, preorganization certificate or

  subscription, transferable share, investment

  contract, voting trust certificate, certificate of

  deposit for a security, certificate of interest in an

  oil, gas, or mining title or lease, or, in general,

  any interest or instrument commonly known as a

  "security," or any certificate of interest or

  participation in, temporary or interim certificate

  for, guarantee of, or warrant or right to subscribe

  to or purchase, any of the foregoing. "Security" does

  not include any insurance or endowment policy or

  annuity contract under which an insurance company

  promises to pay a fixed number of dollars either in a

  lump sum or periodically for life or some other

  specified period.

[fn2] The Supreme Court in the Howey case was interpreting a

federal statute. Although the language of that statute is similar

to our own securities law, we are not, contrary to the assertions

of the appellants, bound to follow blindly the federal

interpretation. This court will construe the provisions of state

statutes "not in total disregard of federal interpretations of

identical language, but with reference to the wisdom of adopting

those interpretations for our state." State v. Texeira, 50 Haw. 138,

142 n. 2, 433 P.2d 593, 597 n. 2 (1967).

[fn3] In the Howey case the Supreme Court was faced only with

the question whether a scheme involving no actual investor

participation was an investment contract. That court has not yet

decided whether an investment plan involving non-managerial

investor participation also falls within the concept of an

investment contract security.

[fn4] For a discussion of the need to protect non-managerial

investors who participate in an enterprise see Goodwin,

Franchising in the Economy: The Franchise Agreement as a

Security Under Securities Acts, Including 10b-5 Considerations,

24 Business Lawyer 1311, 1318-19 (1969).

[fn5] This test is suggested by Professor Coffey in his excellent

article analysing the essential economic characteristics of

security transactions. Coffey, The Economic Realities of a

"Security": Is There a More Meaningful Formula?, 18 W. Res. L.

Rev. 367, 377 (1967)

  David T. Robertson (Hyman M. Greenstein and Larry S.

Vines on the briefs) for defendants-appellants.

  Roy M. Miyamoto, Deputy Attorney General (Bertram T.

Kanbara, Attorney General, Olen E. Leonard, Jr., Gerald Y.Y.

Chang, Deputy Attorneys General, with him on the brief) for

plaintiff-appellee.

Page 653