The opinion of the court was delivered by: LASKER
Enticed by an ad in The New York Times promising "the best of all business worlds", plaintiff, William Wieboldt, purchased from Simplified Business Services ("SBS") for $12,500 a franchise to operate a Simplified Business and Tax Center. He also acquired 1,500 SBS shares at $2.50 per share. Wieboldt's investment was not as lucrative as he had hoped, a fact which eventually led him to bring this suit against SBS, some of its officers and directors and its advertising agency. The two corporate defendants are now bankrupt.
The thrust of the complaint is that the franchises purchased by Wieboldt and others were investment contracts which defendants failed to register before sale with the Securities & Exchange Commission ("S.E.C."), as required by the Securities Act of 1933, and sold by means of fraudulent misrepresentations in violation of the Securities Exchange Act of 1934 and the common law. A corollary to this theory is that the sale of SBS common stock was unlawful because the registration statement covering it failed to indicate that SBS's activities in connection with the sale of the franchises violated the securities laws.
Defendants, Weiss and Dorskind, directors of SBS, move to dismiss the complaint on the ground that the franchises are not securities and their sale is not subject to the Acts. Alternatively, they move to strike certain portions of the complaint and the demand for punitive damages.
Whether Wieboldt's franchise is an investment contract is the central issue in the case. An examination of the master franchise agreement (attached to stipulation of October 2, 1972) indicates beyond doubt that it is not.
The agreement provides that the purchaser of the franchise is to operate, under the supervision of SBS, a simplified business and tax center within a given area. In return for assistance in establishing the center and training, SBS is to receive 10% of annual gross sales. Furthermore, five satellite franchises are to be established within the territory under the authority of the franchisee.
The essential nature of the agreement and the language of the contract
demonstrate plainly that both SBS and the franchisee are intended to have an active role in carrying out its terms. This fact distinguishes the master franchise from other arrangements which have been found to be investment contracts for purposes of the securities laws.
An understanding of the nature of investment contracts begins with the often cited Supreme Court cases, S.E.C. v. C. M. Joiner Leasing Co., 320 U.S. 344, 64 S. Ct. 120, 88 L. Ed. 88 (1943) and S.E.C. v. W. J. Howey Co., 328 U.S. 293, 66 S. Ct. 1100, 90 L. Ed. 1244 (1946). Joiner held that, to determine whether an agreement is an investment contract, it is not sufficient to look at what it is labeled or appears to be; "the test rather is what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect." 320 U.S. at 352-353, 64 S. Ct. at 124. Subsequently, Howey articulated what implicitly underlies the Joiner decision: namely, the definition of an investment contract as "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 the promoter or a third party." 328 U.S. at 298-299, 66 S. Ct. at 1103. This definition reflects the underlying facts in both Supreme Court cases: That the purchasers were numerous, scattered in area and devoid of training or opportunity enabling them to participate actively in the enterprise. As a result, the profit-making potential of the investment was realizable only by the promoters or by third parties who, unlike the purchasers, were in a position effectively to control the operation of the enterprise. Accordingly, the purchasers were mere passive investors and the sale of the investment contracts gave rise to "all the evils inherent in the securities transactions which it was the aim of the Securities Acts to end." Joiner, supra, 320 U.S. at 349, 64 S. Ct. at 123.
The opposite is true here. Unlike Joiner and Howey, the situation here does not involve numerous, scattered, ignorant investors. On the contrary, SBS sold only eight franchises such as plaintiff purchased. (Charles Affidavit, par. 3.) The franchisees were given designated franchise areas which were to be under their personal supervision. Although no prior experience was required of them, the contract anticipated that they would receive, at the hands of SBS, the training necessary to conduct the business. In short, as noted above, active participation by the franchisees in operating the business was provided for by the terms of the franchises. Accordingly, the agreement here does not meet the Howey test that "the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others." 328 U.S. at 301, 66 S. Ct. at 1104 (emphasis added). On the contrary, the master franchise agreement contemplates that profits, if any, will be derived primarily from the efforts of the franchisee.
Thus, unlike Joiner and Howey, in which the Court found the agreements to be investment contracts, the instant case closely resembles the facts in Chapman v. Rudd Paint & Varnish Co., 409 F.2d 635 (9th Cir. 1969). Like Wieboldt, Chapman was moved by optimistic advertising to purchase a franchise. Referring to the distributionship as a "'Turn-Key' operation into which the investor merely steps," the brochure which sold Chapman on the deal minimized the efforts of the franchisee and maximized those of the franchisor. Id. at 641. The promotional material even used terms such as "investor," "investment," "investment requirement" and "investment schedule". Id. at n. 6. However, the agreement itself, on its face, required active efforts on the part of the franchisee, and the court, therefore, declined to find the existence of a security.
The facts in Chapman closely parallel Wieboldt's involvement with SBS. Wieboldt's interest was first engaged by a newspaper ad describing the business opportunity in glowing terms and containing the paragraph:
"IDEAL ABSENTEE-OWNERSHIP or INVESTMENT OPPORTUNITY TOO! If you are looking beyond ownership/management only, let us show you the unique advantages this dynamic business offers to those interested in investment, and/or absentee ownership." Exhibit A to Wieboldt affidavit.
However, apart from this paragraph, the ad speaks in terms of active participation: "You will have under your direct supervision at least five 'satellite' franchises;" "now is the time to establish yourself . . . [and] build a future in this booming field." Id. Furthermore, the language and terms of the actual agreement are incompatible with the notion that the franchisee is a passive investor.
Although it also provides for an active role for SBS, that part was to consist primarily of providing equipment, training and supervision to the franchisee. As Chapman observes, "the very fact that [the agreement] emphasizes the amount of assistance the company will provide implies that the distributor is also to contribute an effort." 409 F.2d at 641. We see no distinction between Chapman and the instant case.
Wieboldt, in fact, basically concedes that, following the mainstream of cases discussed above, his franchise could not be considered an investment contract. However, he urges the adoption of a "liberalized and broadened concept" of investment contracts (Plaintiff's Memorandum at 20) based on the "risk capital" test. Although this approach, which derives from the well-known California case, Silver Hills Country Club v. Sobieski, 55 Cal. 2d 811, 13 Cal. Rptr. 186, 361 P.2d 906 (1961), is clearly an expansion of the traditional definition of an investment contract, Wieboldt maintains that it is not incompatible with it.
Moreover, he persuasively argues that its adoption would be in keeping with the fundamental purposes of the Acts.
Broadly speaking, according to the "risk capital" approach, a franchise is a security if the franchisee's monetary contribution to the enterprise constitutes part of its initial capitalization, while his personal participation in its activities does not give him any effective control over it. The theory behind the test is that, under those circumstances, the profit-making potential of his investment is essentially realized by the franchisor and the Howey ...