The opinion of the court was delivered by: WEXLER
This litigation, consisting of seven cases consolidated before this Court for purposes of all pretrial and discovery proceedings pursuant to 28 U.S.C. § 1407 and an Order of the Judicial Panel on Multidistrict Litigation,
arises out of the lease and sale of energy conservation systems, allegedly designed for the primary purpose of providing tax shelters to investors. In accordance with the Court's Orders, plaintiffs have filed a single Consolidated Class Action Complaint ("Consolidated Complaint") covering five of these cases.
Additionally, there are before the Court the individual complaints filed in the two remaining cases, Duco v. OEC Leasing Corp. and Horn v. OEC Leasing Corp.3, which, although in front of this Court for all pretrial and discovery matters, will ultimately be returned for trial to the forums in which they were originally commenced.
The Court now must consider motions to dismiss filed by a number of the defendants and plaintiffs' motion for class certification.
For the purposes of deciding the motions currently pending, the Court must take as true the facts alleged by plaintiffs in the complaints. In considering a motion to dismiss, a court must view the material allegations of a complaint, along with such reasonable inferences as might be drawn in the plaintiffs' favor, as admitted. Gargiul v. Tompkins, 704 F.2d 661 (2d Cir. 1983), vacated on other grounds, 465 U.S. 1016, 104 S. Ct. 1263, 79 L. Ed. 2d 670 (1984); Murray v. City of Milford, 380 F.2d 468 (2d Cir. 1967). A court may dismiss a complaint only if it is clear that no relief could be granted under any set of facts that could be proved consistent with the allegations. Hishon v. King & Spalding, 467 U.S. 69, 104 S. Ct. 2229, 81 L. Ed. 2d 59 (1984). Furthermore, when a defendant seeks to dismiss a complaint, the court is restricted to evaluating the legal sufficiency of the pleadings. Scheuer v. Rhodes, 416 U.S. 232, 94 S. Ct. 1683, 40 L. Ed. 2d 90 (1974). The motion is addressed to the face of the pleadings and the court may look only within the four corners of the complaint or to statements or documents attached as exhibits to or clearly incorporated by reference in the pleadings. Fed. R. Civ. P. 10(c); Goldman v. Belden, 754 F.2d 1059 (2d Cir. 1985); Ryder Energy Distribution Corp. v. Merrill Lynch Commodities, Inc., 748 F.2d 774 (2d Cir. 1984).
A complaint's substantive allegations must also be accepted as true upon consideration of a class certification motion. Blackie v. Barrack, 524 F.2d 891 (9th Cir. 1975), cert. denied, 429 U.S. 816, 97 S. Ct. 57, 50 L. Ed. 2d 75 (1976). A court may not examine the merits of plaintiffs' claims when deciding such a motion. Eisen v. Carlisle & Jacquelin, 417 U.S. 156, 94 S. Ct. 2140, 40 L. Ed. 2d 732 (1974); In re Scientific Control Corp. Securities Litigation, 71 F.R.D. 491 (S.D.N.Y. 1976); Steinmetz v. Bache & Co., 71 F.R.D. 202 (S.D.N.Y. 1976).
Plaintiffs allege that the defendants in the consolidated cases jointly developed, participated in, and aided and abetted a sophisticated nationwide tax shelter scheme which systematically defrauded investors of tens of millions of dollars. Plaintiffs allege that defendants grossly inflated the fair market value of so-called "Energy Control Systems" ("Systems") through a series of sham sales transactions entered into among affiliated defendants. The Systems are essentially electronic switches which can turn electricity on or off according to a schedule established by a user. Defendants valued the systems at prices ranging, depending on the specific System, between $65,000 and $280,000. Other defendants then supplied "expert opinions" purporting to support the claimed value of the Systems.
The Systems were marketed to investors as tax shelters. Essentially, the investor would purchase what plaintiffs define as an "investment contract" security consisting of two separate agreements. The investor would enter into a long term lease agreement with one of the promoter defendants. The investor also had the option of signing a service agreement with another defendant company, often operated by the same individuals who controlled the promoter defendants, which would undertake to locate an appropriate end-user of the leased energy conservation device and install and maintain the System. Plaintiffs allege that defendants led investors to believe that leasing of the Systems would entitle them to large investment tax credits and depreciation deductions based upon the stated market value of the Systems. Furthermore, investors were led to believe that additional financial gains would result from a revenue sharing arrangement with regard to a large income stream that was to be generated by the energy savings which an end-user would purportedly achieve upon installing the System.
Plaintiffs claim that, in reality, the Systems are worth, at most, $3,000 apiece, and are totally incapable of generating an income stream even remotely approximating that which defendants represented would be available. The Internal Revenue Service has notified numerous investors that the claimed investment tax credit will be challenged and in fact already disallowed the tax shelter claimed by certain investors. The United States Department of Justice has instituted litigation on behalf of the Internal Revenue Service against several of the defendants, including a lawsuit currently pending in this Court.
The Attorney General of the State of New York is also currently investigating the alleged scheme.
Moreover, according to plaintiffs, the vast majority of the Systems has yet to be delivered or installed in an end-user's premises, and plaintiffs are unaware of any System which has been installed and is currently functioning in a manner consistent with the representations contained in defendants' offering materials and related documents.
The various complaints filed in the actions consolidated before the Court designate a multitude of individuals and companies as parties to the litigation. Additionally, although there is a significant overlap between the defendants named in the Consolidated Complaint and the complaints filed in the Duco and Horn actions ("Duco Complaint" and "Horn " Complaint," respectively), the named defendants in each of the actions are not completely identical. Furthermore, the complaints vary to some degree in the specific claims alleged. Accordingly, the Court will separately discuss the particular parties named and counts contained in each of the three complaints.
1. Consolidated Complaint
Defendants First Energy Leasing Corporation ("FELC") and OEC Leasing Corporation ("OEC") issued and promoted the System investment securities at issue in this litigation. First American Capital Corporation ("First American") allegedly provided FELC and OEC with their initial capitalization, office space, telephones, furniture, and overhead expenses. Plaintiffs contend that due to its controlling relationship with FELC and OEC, First American also constitutes an issuer and promoter of the System investment securities.
James Marci was the sole shareholder and President of FELC, Salesman Vice President of OEC, and an officer and President of First American during the periods relevant to the litigation. Jerome Cadden was a Vice President of FELC. Lee Rosenberg was FELC's Vice President, Marketing and appeared on a videotape used to promote the sale of the Systems. Mark Williams was a salesman for FELC. William Medina was President and a major stockholder of OEC. Additionally, Medina was an organizer, along with Frank Giuffrida, of defendant Franklin New Energy Corporation, ("FNEC"), which supplied Systems to OEC and possibly FELC. Giuffrida was FNEC's President and a major stockholder of that company. Michael Enden and Kenneth Carstow were OEC Vice Presidents. John Oster was an OEC employee.
Irwin Berman has been President of First American since December, 1983. Furthermore, at all times relevant to this litigation, Berman was a director and 20% shareholder of defendant Encon Enterprises, Inc. ("Encon"), which supplied equipment, including Systems, to FELC. Berman organized Encon along with defendants Lee Tobin, John DeRaffele, Estelle Cleary, and Virginia Marci, the wife of James Marci. Tobin was President of Encon, as well as a director of the company and a 20% shareholder. DeRaffele was Encon's Secretary, a director, and a 20% shareholder. Cleary and Virginia Marci were each directors and 20% shareholders of the company.
Besides FNEC and Encon, plaintiffs also name as defendants three other companies that purportedly supplied Systems and other equipment to FELC and OEC, at least indirectly. Plaintiffs allege that Energy Minder Corporation ("Energy Minder") supplied equipment to FNEC, which in turn resold it to OEC and possibly FELC to be leased to investors. Vanguard Energy Conservation Products, Inc. ("Vanguard") contracted to supply equipment to Encon, which in turn contracted to resell the equipment to FELC. Eckard Engineering, Inc. ("Eckard Engineering") designed and supervised the assembly of Systems for FNEC, Encon, and Vanguard.
Plaintiffs contend that DeRaffele and Robert Cleary, the husband of Estelle Cleary, control Energy Minder, either directly or indirectly. William Eckard was and is one of two controlling shareholders of Vanguard. Eckard was similarly one of two controlling shareholders of Eckard Engineering until December 1984, when he became the sole shareholder of that company. Neil Chapman was employed by Eckard Engineering at all times relevant to these consolidated actions and supervised the assembly of Systems for Vanguard and Eckard Engineering.
Plaintiffs name as defendants a number of companies who entered into service agreements with investors and therefore, according to plaintiffs, qualify as issuers and promoters of the Systems securities. Control Technology, Inc. ("Control"), Weatherman Energy Management Energy Control Corporation ("Weatherman"), Allstate Service Company, d/b/a Allboro Energy Control Corporation ("Allstate"), Miken Controls, Inc. ("Miken"), Enerpak ("Enerpak"), Dodge Electric ("Dodge Electric"), Energy Savings Systems, Inc. ("ESS"), Precision Company ("Precision"), Niles EMS ("Niles"), Minuteman ("Minuteman"), Delaware Valley Management Systems ("Delaware"), and Temperature Technologies, Inc. ("Temperature Technologies") are each alleged to have entered into such agreements. Plaintiffs also claim that Control contracted with Eckard Engineering,
FNEC, and Vanguard to furnish OEC with Systems.
Lee Tobin, in addition to his relationship with Encon, was President and a major stockholder of Weatherman. John DeRaffele, in addition to his involvements with Encon and Energy Minder, was President and a major stockholder of Control, and a general partner of Allstate. Robert Cleary was apparently similarly involved not only with Energy Minder, but with Control and Allstate as President and a general partner, respectively.
Plaintiffs also allege that one Jack Nelson, an executive employee of Weatherman who has not been named as a defendant, appeared on the videotape used to promote the sale of Systems.
Plaintiffs name as defendants several "experts", including accountants, lawyers, and engineers, who purportedly provided reports and opinions relating to the energy conservation devices, the promoting companies, and the validity of the lease of the offered equipment as a tax shelter and potential income source.
Defendant Spierer, Woodward, and Holguin ("Spierer, Woodward") served as tax counsel to FELC and James Marci. Spierer, Woodward allegedly issued a tax opinion dated August 16, 1983 that FELC and Marci used in promoting and selling the System securities which are the subject of this litigation. Moreover, Steven Spierer, one of the partners in Spierer, Woodward, appeared in the videotape used to promote the investment securities.
Defendant Bernstein, Bernstein, Bernstein, Stein, Rush ("the Bernstein firm") is a law firm that served as tax counsel to OEC. Plaintiffs have also sued Zayle Bernstein, the senior partner of the Bernstein firm, in his individual capacity. Zayle Bernstein was Vanguard's other controlling shareholder and, until December 1984, also a controlling shareholder of Eckard Engineering. Defendant Grossman & Flask also served as tax counsel to OEC.
Defendant Touche Ross & Company ("Touche") is a partnership engaged in the practice of public accounting. Touche performed accounting services for FELC and James Marci, including the preparation of statements used by FELC and James Marci in promoting and selling the System securities. Furthermore, Touche, through Eric Hananel, a partner in the accounting firm who is also named as an individual defendant, participated in the promotion and sale of the securities by appearing on the videotape used to promote sales. As part of this videotape, Hananel, on behalf of Touche, commented favorably upon the securities. Defendant Stuart H. Becker & Company ("Becker") is also engaged in the practice of public accounting and allegedly supplied to FELC for use in promotion and sale of the securities the same information contained in Touche's statements.
Defendant Guaranteed Energy Management Systems, Inc. ("GEMS") provided FELC with a technical and financial analysis of the Systems dated November 18, 1983. FELC used this analysis in its promotion and sale of the System securities. Defendant Jose Chavez was the President and major shareholder of GEMS during all times relevant to this action.
A number of engineering firms and individual engineers are also included among the "expert" defendants. Defendant Systems Planning Corporation ("SPC"), along with its wholly owned subsidiaries, defendants Daverman Associates, Inc. ("Daverman"), and Greiner Engineering Sciences, Inc. ("Greiner"), allegedly provided to FELC a technical analysis that FELC used in promoting and selling the securities which are the subject of this litigation. Defendants William Barrett and Thomas Chen are professional engineers employed by Daverman. Defendant Allan A. Kozich, a professional engineer doing business as Allan A. Kozich & Associates, (collectively, "Kozich"), allegedly provided FELC with a technical analysis containing numerous false and misleading statements. Defendant John W. Peterson is a professional engineer who also allegedly provided FELC with a technical analysis that FELC used in promoting and selling the securities.
Defendants Day & Zimmerman, Inc. ("Day & Zimmerman"), Viron Corporation ("Viron"), and Fluor Engineers, Inc. ("Fluor"), each purportedly provided to OEC, for distribution to investors, a technical or financial analysis of the Systems leased by OEC to investors. These analyses were in turn provided to investors as part of OEC's offering materials and documents. Defendant Nicholas Arteca is a professional engineer who also provided a technical analysis to OEC which was then provided to investors as part of OEC's offering material and documents.
The Consolidated Complaint designates nine individual plaintiffs as proposed class representatives, each of whom entered into lease and service agreements concerning one or more Energy Control Systems. Plaintiffs Donald Simlar and George Dudek each purchased an investment contract consisting of a lease agreement with FELC and a service contract with Control regarding one System. The contracts called for Simlar and Dudek each to pay FELC a prepaid lease fee of $5,000 and Control a prepaid fee of $1,500 plus subsequent additional fees. Plaintiff Paul Maciejewski entered into similar agreements with FELC and Weatherman. Plaintiff Bruce E. Kahler contracted with FELC and Weatherman regarding the lease and service of six Systems, while plaintiff William E. Waites entered into agreements with these companies concerning two Systems. Kahler's agreements called for the payment of a $30,000 prepaid lease fee to FELC and a prepaid fee of $1,500 and subsequent additional fees to Weatherman. Waites was required to prepay $10,000 to FELC and $3,000 to Weatherman, plus subsequent additional fees.
Plaintiffs Donald J. Berlage, Donald Krick, and Michael Burnham entered into similar arrangements with OEC and Weatherman. Berlage leased three Systems and contracted to prepay OEC $15,000 and Weatherman $5,250; Krick leased one System under a contract calling for prepaid fees of $5,000 and $1,750 to these two companies, respectively; Burnham leased one System under an agreement calling for prepaid fees of $9,000 and $2,150. Plaintiff Anthony Falcone leased one System and agreed to prepay $15,000 to OEC and $1,750 to Control, plus subsequent additional fees.
The Duco Complaint names as defendants OEC, Medina, Arteca, Control, Robert Cleary, Weatherman, Tobin, Zayle Bernstein, the Bernstein firm, and Eckard Engineering. The complaint additionally names two individuals not designated as parties in the Consolidated Complaint. George Lemonides, deemed an "Appraiser Defendant," purportedly drafted an opinion letter, used in the promotion and sale of the Systems, regarding the fair market value of and energy savings that would be generated by the Systems without undertaking any independent analysis or otherwise having an adequate basis for his conclusions. Larry Kars is an attorney who issued a tax opinion to OEC and Medina.
The Duco Complaint names seven plaintiffs: Duco, Inc., Lee Fair, Inc., Keico Enterprises, Inc., A.W. Adams, Paul R. Bradley, John T. Dobson, and Donald F. Trousdell. Each of the plaintiffs entered into a lease agreement with OEC and paid an advance fee of $5,000.00. Each plaintiff also entered into a service agreement with either Control or Weatherman and prepaid a $ 1,000.00 fee.
The Horn Complaint names OEC, Medina, FNEC, Control, Robert Cleary, Zayle Bernstein, the Bernstein firm, Day & Zimmerman, Weatherman, Tobin, Fluor, Touche, and Viron as defendants. Additionally, the complaint names not only the law firm of Grossman & Flask, which is designated as a defendant in the Consolidated Complaint, but also Robert D. Grossman, Jr., a partner in the firm. Conversely, the Horn Complaint names not only Nicholas Arteca, a professional engineer, but also the engineering firm of Nicholas Arteca, Inc. Like Duco, Horn deems George Lemonides and Larry Kars party defendants, although the Horn Complaint not only designates Larry Kars an individual defendant, but also names his law firm, Larry Kars, P.C. The Horn Complaint also names E. Ross Forman, Wade W. Larkin, and Vern Hopkins, engineers employed by Day & Zimmerman, Fluor, and Viron, respectively. Finally, Horn names two other engineering firms, Henry W. Kuklinski Enterprises, Inc. and Western Time Corporation, as well as Henry W. Kuklinski, a professional engineer with the former company, and M. C. R. McKenzie, a professional engineer with the latter.
The Horn Complaint names seventy one plaintiffs who purchased the investment contracts. Plaintiffs entered into lease agreements with OEC and Medina, paying varying sums, and into service agreements with Robert Cleary, Control, Tobin, or Weatherman, paying additional sums.
II. COUNTS OF THE COMPLAINTS
A. Consolidated Complaint
The Consolidated Complaint sets forth twelve separate counts, six against each of two basic categories of defendants, i.e., those whom plaintiffs designate as "FELC Defendants" and those designated "OEC Defendants." The FELC Defendants include, in addition to FELC itself, (a) the other "FELC Promoters:" First American and those defendants identified as organizers, principals, shareholders, and employees of FELC and First American; (b) the "FELC Suppliers," namely, Encon, FNEC, Vanguard, and Eckard Engineering and each of the defendant employees of these companies; (c) Daverman, Touche, Becker, GEMS, Spierer, Woodward, Kozich, and Peterson, and each of their defendant employees and principals, whom plaintiffs deem "FELC Experts." The "OEC Defendants" consist of OEC and (a) the other "OEC Promoters," i.e., First American and those defendants identified as organizers, principals, shareholders, and employees of OEC and First American; (b) the "OEC Suppliers," namely, FNEC, Vanguard, Eckard Engineering, and Energy Minder;
(c) "OEC Experts" Arteca, the Bernstein firm, Zayle Bernstein, Grossman & Flask, Day & Zimmerman, Viron, and Fluor, and each of the defendant employees of the companies within this category. The "Service Company Defendants"
are included as both FELC and OEC Defendants.
Count I of the Consolidated Complaint alleges that the FELC Defendants violated Section 10(b) of the Securities Exchange Act of 1934 ("1934 Act"), 15 U.S.C. § 78j(b), by either preparing, conspiring to prepare, or aiding and abetting one another in the joint preparation of offering materials and related documents which contained untrue statements and omissions of material facts. These misstatements and omissions were allegedly made either knowingly or in reckless disregard of the truth.
Count II of the Consolidated Complaint alleges that the FELC Defendants each fall within the definition of a "seller" under Section 12 of the Securities Act of 1933 ("1933 Act"), 15 U.S.C. § 771, and, given that the System securities were sold to investors without a registration statement being in effect, violated Sections 5 and 12(1) of the 1933 Act, 15 U.S.C. §§ 77e, 771(1). Count III contends that the FELC Defendants violated Section 12(2) of the 1933 Act, 15 U.S.C. § 771(2), through their participation in the offering and sale of investment securities by means of offering materials and related documents containing material misstatements and omissions.
Count IV charges the FELC Defendants with actual and constructive fraud by reason of their participation in a common scheme to defraud investors to whom each defendant owed the duty to advise them of the affirmative misstatements and omitted material facts. Furthermore, plaintiffs allege that each of the FELC Defendants either knew that his or its affirmative misrepresentations were untrue or made such statements recklessly and without any knowledge of their truth or falsity, and either knew at the time of his or its omission to state material facts that such facts were required to be stated in order to avoid misleading investors or recklessly omitted to state these material facts. Also, the FELC Defendants intended that investors act on the basis of the misrepresentations and omissions, and the investors, either directly or through their financial advisors, in fact reasonably relied on these misrepresentations and omissions to their detriment.
Count V alleges that the FELC experts breached a duty of reasonable care to investors in the rendering of their technical and financial analyses and legal opinions and thus should be held liable for common-law negligence. Count VI alleges that the FELC defendants are liable for treble damages under the Racketeer Influenced Corrupt Organizations Act ("RICO"), 18 U.S.C. §§ 1961 - 68.
Counts VII - XII set forth analogous claims against the OEC Defendants.
The Duco Complaint also contains twelve counts, but is structured differently from the Consolidated Complaint. OEC, Medina, Control, Robert Cleary, Weatherman, and Tobin are denominated "Promoter Defendants," Arteca and Lemonides, "Appraiser Defendants," Zayle Bernstein, the Bernstein firm and Kars, "Attorney Defendants," and Eckard Engineering, a "Miscellaneous Defendant." Count I alleges false and misleading material misrepresentations and omissions upon which defendants intended plaintiffs to rely and plaintiffs did in fact so rely. Count II alleges professional negligence by the Attorney Defendants, while Count III states a claim against Zayle Bernstein individually for his actions as a partner in the Bernstein firm and a principal of Eckard Engineering. Count IV asserts that the Appraiser Defendants failed to exercise due care in the preparation of their opinion letters. Count V sets forth a claim against all the defendants for breach of fiduciary duty.
Count VI alleges a violation of § 12(2) of the 1933 Act by all defendants, and Count VII asserts that all defendants acted in violation of § 10(b) of the 1934 Act. Count VIII contains allegations of breach of contract by Control and Weatherman, while Count IX contends that these defendants acted fraudulently and deceitfully by refusing to return monies paid to them by plaintiffs. Count X is premised upon an alleged violation by all defendants of the Georgia Securities Act of 1973, Ga. Code Ann. § 10-5-1 et seq. Count XI sets forth a breach of contract claim against OEC, and Count XII seeks the recovery of attorneys fees because of defendants' alleged bad faith. Unlike the Consolidated Complaint, the Duco Complaint does not include any claims under § 12(1) of the 1933 Act or RICO.
The Horn Complaint sets forth seventeen separate counts against various defendants. Unlike the Consolidated Complaint and Duco Complaint, however, it does not specifically establish different categories of defendants. Count I claims that defendants violated § 12(2) of the 1933 Act. Count II asserts additional "controlling persons" liability under § 15(a) of the 1933 Act, 15 U.S.C. § 77o, since defendants purportedly controlled the unlawful conduct alleged in Count I. Count III sets forth a claim under § 17(a) of the 1933 Act, 15 U.S.C. § 77g, contending that defendants' conduct constituted a deceptive device, scheme, and artifice to defraud, and acts and practices that operated as a fraud or deceit upon plaintiffs. Count IV asserts § 15(a) liability, based upon the conduct alleged in Count III. Count V alleges the existence of a claim under § 10(b) of the 1934 Act.
Count VI contends that defendants have engaged in securities fraud under the Ohio "blue sky" law, Ohio Rev. Code Ann. Ch. 1707. Count VII alleges negligence by all the defendants, while Counts VIII and IX specifically allege malpractice by the attorney defendants and negligence by the engineer defendants, respectively. Count X asserts that defendants committed common-law fraud. Count XI alleges the existence of a violation of the Ohio Business Opportunity Purchaser's Protection Act, Ohio Rev. Code Ann. Ch. 1334. Count XII is a RICO count. Count XIII states that FNEC and Energy Minder each breached implied warranties that the Systems were merchantable and fit for the purpose for which they were intended. Count XIV alleges breach of the lease agreements, and Count XV asserts that defendants breached express statements, promises, and warranties that plaintiffs' investments would provide plaintiffs with certain tax benefits. Count XVI charges defendant Touche with accountants' malpractice. Count XVII seeks punitive damages for defendants' purportedly reckless, outrageous, and malicious conduct. Like the Duco Complaint, but unlike the Consolidated Complaint, the Horn Complaint does not contain a claim of a § 12(1) violation.
A number of the defendants have moved to dismiss plaintiffs' complaints. In conformance with the directions of the Court, these defendants have filed a joint memorandum in support of their motions containing arguments common to the moving defendants ("Joint Memorandum"). Additionally, several defendants have filed supplemental individual memoranda setting forth grounds for dismissal particularly applicable to plaintiffs' specific claims against them. The Court will first address the arguments contained in the Joint Memorandum, then turn to any points made by individual defendants that have not already been adequately covered by the Court's discussion of defendants' joint contentions.
A. General Applicability of the Federal Securities Laws
1. Definition of an "investment contract"
Plaintiffs assert claims under the Securities Act of 1933, 15 U.S.C. §§ 77a-77bbbb, and the Securities Exchange Act of 1934, 15 U.S.C. §§ 78a-78111. Defendants contend, however, that the agreements allegedly entered into between the investors and defendants do not fall within the definition of "securities" covered by the federal securities laws.
The definitions of the term "security" are virtually identical under the 1933 and 1934 Acts, compare 15 U.S.C. § 77b(1) with 15 U.S.C. § 79(c)(a)(10), and have been interpreted in a consistant manner by the courts, e.g., United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 847 n.12, 95 S. Ct. 2051, 2058, 44 L. Ed. 2d 621 n.12 (1975); Tcherepnin v. Knight, 389 U.S. 332, 342, 88 S. Ct. 548, 556, 19 L. Ed. 2d 564 (1967); S. Rep. No. 792, 73d Cong. 2d Sess. 14 (1934). Plaintiffs, who have the burden of pleading facts sufficient to show that a security is at issue, LaSalle National Bank v. Arthur Anderson & Co., 531 F. Supp. 702, 706 (N.D. Ill. 1982), have alleged that the lease and sale agreements together constitute an "investment contract", which is one of the descriptive phrases included within both the 1933 and 1934 Acts' statutory definitions of security.
The United States Supreme Court set forth the approach to be taken in determining the existence of an investment contract in the landmark case of Securities and Exchange Commission v. W.J. Howey Co., 328 U.S. 293, 66 S. Ct. 1100, 90 L. Ed. 1244 (1946). Howey was a suit by the Securities and Exchange Commission ("SEC") to enjoin the respondents from the offer and sale of units of a citrus grove development coupled with a contract for cultivating, marketing, and remitting the net proceeds to the investor. The respondents were two corporations under direct common control and management. One corporation owned tracts of citrus acreage that it offered to the public, while the other was a service company engaged in cultivating and developing many of these groves and harvesting and marketing the crops. The corporations offered each prospective customer both a land sales and a service contract after informing the customer that it was not feasible to invest in a grove unless service arrangements were made. Upon full payment of the purchase price, the land was conveyed to the purchaser by warranty deed. While purchasers were free to make arrangements with other service companies, the superiority of the respondent service company was stressed, and 85% of the acreage sold to investors was in fact covered by service contracts with the respondent corporation. The purchasers were predominantly business and professional people who lacked the knowledge, skill, and equipment necessary for the care and cultivation of citrus trees, and were attracted to the offer by the expectation of substantial profits. 328 U.S. at 294-96, 66 S. Ct. at 1101-02.
The applicability of the federal securities laws to the transactions at issue in Howey depended on whether, under the circumstances, the land sales contract, warranty, deed, and service contract together constituted an investment contract. The Court observed that the term "investment contract" is not defined either by statute or by relevant legislative reports, but was common to many state "blue sky" laws in existence prior to the passage of the 1933 Act. State courts had broadly construed the term so as to afford the investing public a full measure of protection, and emphasized economic reality and substance over form. 328 U.S. at 297-98, 66 S. Ct. at 1102-03. The Court then held that, for purpose of the federal securities laws, 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 the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or ...