The opinion of the court was delivered by: GERHARD A. GESELL
This case, which is now before the Court on plaintiffs' motion for partial summary judgment, is brought on behalf of a certified class of hundreds of customers of Latin Investment Corporation ("LIC"). Plaintiffs seek damages against certain key promoters of LIC -- defendants Fernando Leonzo, Leonel Salinas, and Jose Cortes -- for security frauds perpetrated against plaintiffs, as alleged in Counts One and Two of the second amended complaint.
A statement of unopposed material facts establishes, on the basis of extensive discovery, that a gross fraud was intentionally perpetrated against the plaintiffs, who in many cases are illiterate or unsophisticated Spanish-speaking members of the El Salvadoran community in this area. As a result of misrepresentations, material omissions, and blatant self-dealing on the part of LIC and the individual defendants Fernando Leonzo, Leonel Salinas, and Jose Cortes, the class lost over $ 6 million of savings that had been entrusted to LIC.
Defendants have not challenged the truth of these facts; nor do they oppose the motion. They are not represented by counsel. The Court has therefore carefully reviewed the underlying materials supporting the statement of material facts, and finds them accurate. Only one issue of law remains.
The central question before the Court is whether or not, given the facts set forth in plaintiffs' statement, the passbook and accompanying documents issued to LIC customers when they first opened their accounts constitute a security as a matter of law within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934. Because defendants no longer have counsel, the Court decided that this legal issue could best be resolved with the benefit of a court-appointed amicus. Harvey L. Pitt, Esquire, a partner of Fried, Frank, Harris, Shriver and Jacobson, was requested by the Court
to file as amicus curiae. The SEC, which is plaintiff in a related action, has filed an amicus brief supporting the position of the plaintiffs.
LIC's Articles of Incorporation stated that LIC would "represent, sell, act as agent, distribute, recommend and otherwise promote, investments suitable to the community it shall work with," and that it would "engage in any other management, activities or other functions necessary to support the business of the investment club." The three defendants mentioned above solicited funds for LIC from members of the class. In so doing, they knowingly and intentionally falsely represented that LIC was a bank. When plaintiff class members deposited money with LIC, they received in return a savings passbook and agreement. The customers were guaranteed a fixed rate of interest on all accounts, and were advised that by maintaining a minimum balance for a period specified, they would be eligible for dividends to be declared by the LIC Board of Directors from investment earnings. In addition to a fixed return and a share of the profits, passbook holders were led to understand that their funds would be pooled for investment purposes and backed by other funds or institutions.
Although defendants represented that LIC was a bank and led customers to think that they were putting money in a bank account, LIC's actual operations were not consistent in any respect with its being a bank. LIC operated a Ponzi-type scheme for its promoters. It neither earned nor paid interest. The funds were used by defendants for themselves and their friends, and not in any way for the customers' benefit. The business was not licensed as a bank and thus was wholly unregulated by the banking laws.
Defendants' use of the word "bank" was illegal and misleading, and it caused tragic results for many recent immigrants from El Salvador. The mere fact that LIC fraudulently used a term like "savings passbook" in order to lure investors is no reason to hold that the passbook and related documents were not, in effect, a security. To make that determination, the Court must examine the actual nature of those documents in terms of the definition of "security."
Based on current law, the savings passbooks must be considered securities within the meaning of both the 1933 and 1934 Acts, and thus subject to regulation and control under those Acts. The term "security" is defined in Section 2(1) of the Securities Act, 15 U.S.C. § 77b(1), and Section 3(a)(10) of the Securities Exchange Act, 15 U.S.C. § 78c(a)(10), specifically to include both "notes" and "investment contracts." These terms are broad and flexible, and are to be understood in the light of substance, not nomenclature. As the Supreme Court has stated,
In defining the scope of the market that it wishes to regulate, Congress painted with a broad brush. It recognized the virtually limitless scope of human ingenuity, especially in the creation of "countless and variable schemes devised by those who seek the use of the money of others on the promise of profits". . . . It enacted a definition of "security" sufficiently broad to encompass virtually any instrument that might be sold as an investment.
Reves v. Ernst & Young, 494 U.S. 56, 60-61, 108 L. Ed. 2d 47, 110 S. Ct. 945 (1990) (quoting SEC v. W.J. Howey Co., 328 U.S. 293, 299, 90 L. Ed. 1244, 66 S. Ct. 1100 (1946)). To remain consistent with Congress' intent in passing these statutes, the legislation "should be construed broadly to effectuate its purposes. . . . [Thus, in] searching for the meaning and scope of the word 'security' in the Act, form should be disregarded for substance and the emphasis should be on economic reality." Tcherepnin v. Knight, 389 U.S. 332, 336, 19 L. Ed. 2d 564, 88 S. Ct. 548 (1967).
Despite the fact that LIC often called itself a bank and even purported to adopt such conventions as a savings passbook, the organization was clearly a business venture established to raise money for investment. LIC held itself out as an investment concern, as its middle name indicates, and advertised in the phone book as "Latin Investments and Savings." In actual practice as well, LIC functioned as an investment business. Its customers were guaranteed a rate of return higher than that offered by banks and savings and loan companies; and even more tellingly, LIC offered its customers the prospect of earning dividends from investment of their pooled funds. LIC customers were also given the option of placing their funds in accounts that would be invested in local Hispanic-owned businesses. All of these factors suggest that LIC was issuing its customers securities. Reves, 494 U.S. 67 at 67-70; United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 852, 44 L. Ed. 2d 621, 95 S. Ct. 2051 (1975); SEC v. R.G. Reynolds Enterprises, Inc., 952 F.2d 1125, 1130-33 (9th Cir. 1991); Holloway v. Peat, Marwick, Mitchell & Co., 900 F.2d 1485, 1487-88 (10th Cir.), cert. denied, 112 L. Ed. 2d 396, 111 S. Ct. 386 (1990).
LIC did not function as a bank and it had no authority to do so. There was no supervision or control over its affairs by either local or national banking authorities. On the contrary, the form investment agreement issued to its customers included very few of the provisions characteristic of those categories of notes and banking instruments that have been judicially excepted from the definition of security. See Reves, 494 U.S. at 67-70. LIC simply misrepresented itself as a bank in order to defraud unsophisticated investors. To suggest that because of its having misrepresented itself as a bank, LIC should have been able to avoid the banking regulations while it was in business, and should now be able to avoid the securities regulations by invoking the exceptions applicable to banks, flies in the face of Congress' intent, in enacting the securities laws, to regulate investment instruments not otherwise covered by the banking laws. See Reves, 494 U.S. at 67; Marine Bank v. Weaver, 455 U.S. 551, 557-59, 71 L. Ed. 2d 409, 102 S. Ct. 1220 (1982). Moreover, such a suggestion would foolishly ignore the economic reality of what was taking place. See Tcherepnin, 399 U.S. at 336. As amicus Mr. Pitt notes, the SEC has in the past -- in cases similar to the related case to this action -- brought actions for violations of the federal securities laws based on a party's issuance of passbook accounts. See Brief of Harvey Pitt as Amicus Curiae at 14 n.54. But rather than developing a blanket rule, the SEC has apparently left each situation to be judged on its own ...