The US District Court for the Northern District of Illinois ruled that proposed investments in life settlements by a single purchaser (as opposed to investors in a pooled transaction) are not securities for purposes of SEC Rule 10b-5's prohibition against manipulative or deceptive practices.
In a memorandum opinion and order issued Monday, September 27,
2010 in Zang v. Alliance Financial Services Of Illinois,
Ltd., that court determined that an investor who paid a
financial services company a retainer and fees to arrange life
settlements and surety bonds to serve as collateral for a financing
whose proceeds could be used by this investor to fund his purchase
of a another business had not made a valid federal securities law
claim in relation to the refusal of that company to refund such
amounts though it had failed to complete those transactions.
Facts of the Case
In June 2007, John Zang contacted Alliance Financial Services of Illinois, Ltd. ("Alliance") in response to an advertisement promising companies for purchase with no principal payments. Alliance represented to Zang that it would use its best efforts to locate a company for Zang to purchase and would arrange financing for the purchase in exchange for a fee on closing and an upfront refundable retainer of $5,000. The financing would involve purchasing life settlements. The proposal also involved purchasing surety bonds for these policies to ensure maturity within seven years, and then pledging these policies and surety bonds as collateral for a bank loan.
Alliance failed to locate suitable companies and Zang found
those for himself. Zang instructed Alliance to pursue purchases of
each. Alliance insisted Zang fund an additional $32,500 to cover
down payments for the purchases and to fund Alliance's efforts
to obtain financing. Neither deal was consummated and Alliance
refused to refund any of the $37,500 Zang had paid. In June 2008,
Zang filed a complaint against Alliance and its president alleging
violations of state laws and federal laws, including Section 10(b)
of the Securities Exchange Act of 1934 and SEC Rule 10b-5. He
alleged Alliance and its president had made material misstatements
and engaged in deceptive acts in connection with the purchase or
sale of securities—namely the life settlements that
Alliance failed to arrange. The court found that Zang failed to
state a claim under Section 10(b) and Rule 10b-5, but allowed him
to amend his pleading of fraud under the Exchange Act.
The Court's Analysis
Rule 10b-5 prohibits the making of any untrue statement of material fact, or the omission of a material fact that would render statements made misleading, in connection with the purchase or sale of any security.1 The Court's analysis focused on whether the alleged misstatements were "in connection with the purchase or sale of securities."
To be a "security" for purposes of the Exchange Act a life settlement would have to be an "investment contract."2 The Supreme Court formulated a definition for "investment contract" in the case SEC v. W.J. Howey Co.3 Under the "Howey test" an investment contract is a contract, transaction or scheme whereby (1) a person invests money (2) in a common enterprise and (3) is led to expect profits produced solely by the efforts of others. The key issue in the Zang case was whether a life settlement met the "common enterprise" requirement of the Howey test.
Courts in different jurisdictions use either of two tests for this "common enterprise" requirement. Zang advocated for the use of the "vertical commonality" test applied by Illinois state courts and the Fifth and Ninth Circuits, which requires that the fortunes of the investor are interwoven with those of the investment promoter. But the Court stated that it was constrained to use the "horizontal commonality" test prescribed by the Seventh Circuit (and other circuits), under which multiple investors must pool their investments and receive pro rata profits. Defendants contended, and Zang admitted, that he had not shared or otherwise pooled his money with other investors to generate a profit collectively, and therefore that he had not pleaded facts to satisfy the common enterprise requirement under a horizontal commonality test. The Court agreed, and found that Zang's allegations did not satisfy the common enterprise requirement of the Howey test.
We find this outcome to contrast in very interesting ways with
the recent guidance of the SEC about circumstances in which life
settlements are securities, and caution readers that courts in
other jurisdictions may not apply the same test or reach the same
conclusions this court did when this issue is presented in other
life settlements related transactions.
Footnotes:
1. 17 C.F.R. § 240.10b-5.
2. 15 U.S.C. § 78c.
3. 328 U.S. 293, 298 (1946).
O'Melveny & Myers LLP routinely provides advice to clients on complex transactions in which these issues may arise, including finance, mergers and acquisitions, and licensing arrangements. If you have any questions about the operation of the applicable statutory provisions or the case law interpreting these provisions, please contact any of the attorneys listed on this alert.
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