Unpublished Disposition, 884 F.2d 582 (9th Cir. 1988)

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U.S. Court of Appeals for the Ninth Circuit - 884 F.2d 582 (9th Cir. 1988)

Robert SHAW and Velda Shaw, Plaintiffs-Appellants,v.HIAWATHA, INC., Patrick J. Hall, Douglas Jones, Gene Hill,Dennis Roberts A.K.A. Douglas Campbell A.K.A.Dennis Murphy, Michael Ellis, N & NLocators, and Thomas J.Kuebler, Defendants-Appellees.

No. 88-6001.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted Feb. 7, 1989.Decided Aug. 25, 1989.

Before FLETCHER, PREGERSON and LEAVY, Circuit Judges.


MEMORANDUM* 

Plaintiffs Robert and Velda Shaw appeal the district court's order dismissing for lack of subject matter jurisdiction their complaint for securities fraud and related state law claims. The district court concluded that the agreement between the Shaws and the defendant, Hiawatha, is not a "security" as defined by the Securities Act of 1933 and the Securities Exchange Act of 1934. We reverse and remand.

FACTS

Robert and Velda Shaw responded to a Nov. 1, 1986 advertisement in the San Diego Union newspaper, inviting them to "SHARE THE WEALTH OF THE LOTTERY CRAZE...." Calling the number listed in the advertisement, the Shaws arranged a meeting with Patrick J. Hall, Executive Vice President of Hiawatha, Inc. Hall informed the Shaws that Hiawatha manufactured and sold the "Odds Maker," a machine designed to provide lottery ticket purchasers with a series of numbers to use on California State Lottery tickets. Hall stated that operators of the machines faced no meaningful competition, and that if the Shaws purchased the machines, they could recover their initial investment within one year.

Hall also said that Hiawatha makes money from ongoing ticket sales, and that it and the Shaws "would be in business together." Hall represented that Hiawatha would obtain the right to locate in all "7-11" convenience stores where lottery tickets are sold, and that Hiawatha would provide a "locator" who would find suitable locations for the Shaws' "Odds Maker" machines.

The next day, the Shaws met with Douglas Jones, another representative of Hiawatha, who reaffirmed many of the points made by Hall. Jones, who stated that he was in charge of Hiawatha's California operations, also represented that Hiawatha would have the Shaws in business within three weeks of full payment on the machines. On that date, the Shaws signed an "Intent and Commitment Agreement," and paid $5,000 to Hiawatha.

On Nov. 11, while visiting Hall at Hiawatha's Indiana offices, the Shaws expressed concern that parts of their prospective territory had high crime rates. Because of these fears, they demanded a right to approve expressly the locations selected for each machine. This discussion led to an "Addendum" to the contract providing in relevant part:

Hiawatha guarantees to Shaw [that] approved locations will be provided for each and every dispensing machine purchased by Shaw. In the event such location cannot be furnished, Hiawatha shall repurchase the machine and related equipment.

On Nov. 12, the Shaws paid an additional $27,250, and were again assured that Hiawatha would provide a "locator" to secure acceptable locations and install the machines. The locator's cost would be $50.00 per machine, or $5,000. On Nov. 24, the Shaws paid another $32,250 to Hiawatha.

Thomas J. Kuebler telephoned the Shaws on Dec. 1, 1986, and informed them that he was their assigned locator. After some negotiations, the Shaws advanced Kuebler $2,500 of the locator's fee. By March 16, 1987, Kuebler had secured locations for only 48 of the 100 machines, and had installed only 25, many in locations which had not been approved by the Shaws. On June 1, 1987, the Shaws filed this action, seeking a return of their $67,000 investment.

The Shaws' complaint contained four causes of action for alleged violations of federal securities laws, as well as several pendent state law claims. They alleged that Hiawatha made a number of material misrepresentations, including: (1) there was no competition to the machines, (2) the Shaws could recover their investment within one year; (3) Hiawatha had the right to locate in all "7-11" stores; (4) the Shaws would be in business within three weeks of purchase; (5) a locator would find suitable locations for all the machines; and (6) Hiawatha would refund the purchase price of the machines if suitable locations were not provided.

Defendants filed a motion to dismiss for lack of subject matter jurisdiction and improper venue. On March 22, 1988, the district court granted defendants' motion for lack of subject matter jurisdiction, finding that the contract was not an "investment contract," and therefore not a security, within the meaning of the federal securities laws. Because no other basis for federal jurisdiction was alleged, the entire complaint was dismissed. Because the district court implicitly found that no possible amendment would cure the perceived deficiency in the complaint, its order is final and appealable for purposes of 28 U.S.C. § 1291. See Ginter v. State Bar of Nevada, 625 F.2d 829, 830 (9th Cir. 1980); Smith v. Gross, 604 F.2d 639, 641 (9th Cir. 1979).

STANDARD OF REVIEW

The district court treated defendants' motion as one for dismissal for lack of subject matter jurisdiction under Fed. R. Civ. P. 12(b) (1). We have held, however, that dismissal of similar actions on the basis that the transaction at issue is not a "security" under the federal securities laws relates to the merits of the claim, and is therefore a judgment based on failure to state a claim rather than on lack of subject matter jurisdiction. Mason v. Unkeless, 618 F.2d 597, 598-99 (9th Cir. 1980); Smith v. Gross, 604 F.2d at 641; Black v. Payne, 591 F.2d 83, 86 n. 1 (9th Cir.), cert. denied, 444 U.S. 867 (1979). See also Jackson Transit Authority v. Local Div. 1285, Amalgamated Transit Union, 457 U.S. 15, 21 n. 6 (1982); Bell v. Hood, 327 U.S. 678 (1946).1  This distinction is one of some significance. Unlike 12(b) (6) motions, 12(b) (1) motions need not be afforded summary judgment treatment even though the court goes beyond the pleadings. Under 12(b) (1), a court has wide discretion to allow affidavits, documents, and even a limited evidentiary hearing to resolve disputed jurisdictional facts. We have held, however, that such jurisdictional fact finding is inappropriate where, as here, jurisdiction and merits issues are intertwined. Sun Valley Gasoline, Inc. v. Ernst Enterprises, Inc., 711 F.2d 138, 139 (9th Cir. 1983).

Because the district court appears to have considered matters beyond the pleadings, its order must be construed as a grant of summary judgment in favor of the defendants. Mason, 618 F.2d at 598. We review the grant of summary judgment de novo. Darring v. Kincheloe, 783 F.2d 874, 876 (9th Cir. 1986).2  To affirm, we must determine, viewing the evidence in the light most favorable to the Shaws, that the defendants have established that there are no genuine issues of material fact, and that defendants are entitled to judgment as a matter of law.

DISCUSSION

The Shaws may recover under the federal securities laws only if Hiawatha offered the Shaws a "security" within the meaning of section 2(1) of the Securities Act of 1933, 15 U.S.C. § 77(b) (1), and section 3(a) (10) of the Securities Exchange Act of 1934, 15 U.S.C. § 78(c) (a) (10). These provisions, which are considered identical, Tcherepnin v. Knight, 389 U.S. 332, 335-36 (1967), define a security to include any "investment contract." In Securities & Exchange Comm'n v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946), the Supreme Court held that an investment contract consists of (1) an investment of money, (2) in a common enterprise, (3) with the expectation of profit produced solely by the efforts of others.

That the first element of the test has been met in this case is undisputed. However, the parties disagree about whether the second and third elements of the Howey test have been met.

The circuit courts are split over what satisfies the requirement of a common enterprise. Some require "horizontal commonality," or the pooling of assets among investors, in order to establish a common enterprise. See e.g., Hirk v. Agri-Research Council, Inc., 561 F.2d 96, 100-101 (7th Cir. 1977). The Ninth Circuit has rejected the more restrictive horizontal commonality rule in favor of a vertical commonality requirement. Vertical commonality dispenses with the pooling requirement. The vertical commonality requirement is met where the "fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment, or of third parties." Securities & Exchange Comm'n v. Glenn W. Turner Enter. Inc., 474 F.2d 476, 482 n. 7 (9th Cir.), cert. denied, 414 U.S. 821 (1973).

Viewing the evidence in the light most favorable to the Shaws, it appears that the Shaws' fortunes are dependent upon the efforts of Hiawatha in placing the machines. Unless the machines are successfully placed, the Shaws can make no money. Moreover, the Shaws maintain that the location of the machines is the principal factor affecting profitability.3  Thus, the Shaws' financial success depends, at least in some degree, on the work and expertise of Hiawatha.

Hiawatha argues that the investors' reliance on the efforts of the promoter is insufficient to establish vertical commonality. It argues that Brodt v. Bache & Co., 595 F.2d 459 (9th Cir. 1978), and similar cases establish that there must be a direct and mutual relationship between the success of the investor and success of the promoter. In other words, Hiawatha argues that the Shaws must show that Hiawatha's success depends upon the Shaws' success, a condition which it contends does not exist because it "presumably" made money on the sale of the machines.

It is not at all clear that the investor need show that the promoter's fortunes are dependent upon the success of the investor. The Glenn Turner language suggests that a plaintiff need only show that its success is dependent on the efforts of the promoter or others. 474 F.2d at 482 n. 7. See also Smith v. Gross, 604 F.2d at 643 (focusing on the fact that the fortunes of the investors were dependent upon markets created by the efforts of the defendants). However, even if the former showing is necessary, that requirement is met here. It appears that Hiawatha is to receive a five cent "location" commission on each ticket sold, or nearly one-third of the net revenues derived from ticket sales. Thus, Hiawatha's remuneration, like that of the Shaws, is dependent to a certain extent upon the success of the scheme. In addition, it is not clear from the record whether Hiawatha makes a profit on the sale of the machines. Even if we assume it does, there is still a direct correlation between the Shaws' financial success and that of Hiawatha.4 

Moreover, the Shaws allege that Hiawatha agents made oral representations that it and the Shaws "would be in business together." In addition, a letter from Hiawatha Executive Vice-President Patrick Hall to the Shaws stated that " [a]ll of us at Hiawatha wish you the utmost success and look forward to a long and profitable relationship." Representations of this sort are relevant to a fact-finder's determination that there is a common enterprise, particularly where, as here, there is evidence of an ongoing economic relationship between the investors and promoter.

B. Expectation of Profits Produced by Others' Efforts

In evaluating the third element of the Howey test, the expectation of profits from the efforts of others, we look to whether "the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise." Glenn Turner, 474 F.2d at 482.

Citing several case in which franchise agreements were held not to be investment contracts, Hiawatha contends first that the Shaws' profits are dependent upon their own efforts in managing the machines. However, the franchise cases are distinguishable. The day-to-day operations of a franchise restaurant require substantial managerial skill and effort. These managerial efforts are likely to affect the profitability of the enterprise. The Shaws' task of collecting money and replacing tickets, although necessary to the continued profitability of the "Odds Maker" scheme, are not the type of "essential managerial efforts" contemplated by this court in Glenn Turner.

The fact that the investor is required to do some activity to ensure the viability of the enterprise does not bar a finding that the third element of the Howey test is met. For example, in Smith v. Gross, 604 F.2d at 642-43, we held that a scheme in which investors were solicited to buy and raise earthworms to be repurchased by the sellers was an investment contract. We focused particularly on the defendant's representations that the efforts required of the investor would be minimal, and the fact that the investor's profits depended upon the ability of the defendants to secure additional investors to purchase the investors' worm output. Id. See also Miller v. Central Chinchilla Group, Inc., 494 F.2d 414 (8th Cir. 1974) (contracts under which investors purchase and breed chinchillas for repurchase by defendants held to be an investment contract). The Shaws' responsibility for replacing tickets and collecting money cannot be considered any more central to the enterprise than the investors' responsibility for maintaining and breeding chinchillas and earthworms in Miller and Smith. See also Glenn Turner, 474 F.2d at 482 (the fact that investors are required to contribute a modicum of effort does not preclude finding the scheme to be an investment contract).

The Shaws maintain, and Hiawatha agreed in its papers before the district court, that the location and promotion of the machines were the essential efforts affecting profitability of the "Odds Maker" enterprise. However, the Shaws and Hiawatha disagree over who has control of these efforts. Hiawatha argues that the contract expressly provides that the Shaws have ultimate control over the placement of the machines.5 

The Shaws contend that Hiawatha controls the profitability of the machines. The Shaws admit that they had a right to refuse any of the locations chosen by Hiawatha's locator, but that such decisions were to be based only on the risk of crime at the location. According to the Shaws, it was up to the locator to ensure that the location was a profitable one. In that respect, this case is analogous to Albanese v. Florida Nat'l Bank of Orlando, 823 F.2d 408 (11th Cir. 1987). In Albanese, the plaintiffs purchased ice machines from Polar Chips International, Inc. (PCI). Under various contracts, PCI agreed to manage or lease back the ice machines. PCI was to arrange placement of the machines, service them, and collect money from them. When the purchasers found that the machines did not exist, they brought securities law claims. The district court granted summary judgment for the defendants, but the court of appeals reversed, finding that the scheme was an investment contract. Focusing on whether the investor retained significant control over the profitability of the investment, the court noted:

First, the investors' power to specify locations was in reality limited to places that PCI had available. According to the record, it was PCI who contacted the owners of various institutions and arranged for placement of the ice machines. The investors could not specify just any location for their machines; they had to choose from the sites already procured by PCI. Investors could request a location not on PCI's list, but even then the investors were dependent upon PCI's expertise and labor in arranging the placement.

823 F.2d at 412 (emphasis added). Here, the Shaws have presented evidence that they were ultimately dependent upon Hiawatha's purported expertise in arranging for profitable locations for the machines.

The district court concluded that the Shaws were responsible for placement and promotion of the "Odds Maker" machines. Its conclusion apparently was based exclusively on its interpretation of the express terms of the contract between the Shaws and Hiawatha. The court also found that the contract provided that the Shaws were to collect the money from the machines, replace the tickets, and promote the machines. Thus, it concluded that, "under the express terms of the contract, defendants had no significant control over the profitability of the enterprise."

The district court's approach, urged on appeal by Hiawatha, represents an erroneous application of the law. It is well-established that when determining whether a given scheme is a security, the courts must disregard mere form and examine the economic reality of the scheme. Glenn Turner 474 F.2d at 481 (citing Tcherepnin v. Knight, 389 U.S. at 336). As the Tenth Circuit noted in Aldrich v. McCulloch Properties, Inc., 627 F.2d 1036, 1039-40 (10th Cir. 1980), courts must examine promotional materials, merchandising approaches, and oral assurances as well as contractual arrangements in determining whether a sale scheme involves a security.

The Shaws have alleged that, despite the language of Article VI of the contract, the actual placement of the machines was the job of Hiawatha's locator. To the extent that the district court disregarded these allegations and the evidence supporting them as foreclosed by the language of the contract, it erred in applying the law. Even if it considered the Shaws' allegations, it apparently did not view the evidence in the light most favorable to the Shaws, as it was required to do on summary judgment.

The district court also concluded that the Shaws were responsible for promotion of the machines. However, this appears to be a disputed issue of fact as well. The language of the district court's memorandum opinion suggests that the court may have resolved this issue improperly by drawing a factual inference unfavorable to the Shaws.

CONCLUSION

Based on the wording of the contract between the Shaws and Hiawatha, the district court determined that the Shaws were responsible for the key factors controlling profitability of the enterprise, location and promotion of the "Odds Maker" machines. However, the district court appears to have ignored evidence that Hiawatha was, in practice, responsible for these critical managerial efforts. We conclude that responsibility for location and promotion of the machines is a question of fact, which must be resolved in light of the promotional materials and oral assurances of Hiawatha, as well as the express terms of the contract. Therefore, this case is

REVERSED and REMANDED.

 *

This disposition is not appropriate for publication and may not be cited to or by the courts of this Circuit except as provided by Ninth Circuit Rule 36-3

 1

Viewed another way, the district court could not properly have dismissed the complaint for lack of subject matter jurisdiction. Where federal jurisdiction is based on an allegation that a federal statute has been violated, dismissal for want of jurisdiction is appropriate only where the federal claim is insubstantial or frivolous. Bell v. Hood, 327 U.S. at 682-83; Black v. Payne, 591 F.2d at 86, n. 1. That is not the case here. As we discuss infra, whether the scheme offered by Hiawatha is a security is a rather close question which turns on issues of material fact

 2

Even if the district court's order is treated as a dismissal for lack of subject matter jurisdiction, the standard of review is the same. Mobil Oil Corp. v. City of Long Beach, 772 F.2d 534, 538 (9th Cir. 1985) (questions of federal subject matter jurisdiction reviewed de novo)

 3

Whether this is actually true is unclear. However, the Shaws allege that this is the case. Moreover, the defendants stated below in their Points and Authorities in Support of Defendants' Motion to Dismiss that location and promotion are the key factors determining the profitability of the venture

 4

Such a correlation appears to be sufficient even if the promoter makes a profit on sale of materials to the investor. In Glenn Turner, the defendants' scheme involved the sale of materials aimed at improving self-motivation and sales ability. The purchaser of these materials also received the opportunity to sell similar materials to others, receiving part of the purchase price as a commission. The materials cost $2,000-$5,000, and consisted of some tape recordings, a limited amount of written instructions, and group training sessions. It is clear that the Glenn Turner defendants made a profit on the training materials. That fact did not prevent the court from finding a common enterprise in that case

 5

Hiawatha refers to the Article VI, section two provision of the contract, which states: "The parties agree that the location of such equipment as the 'Odds Maker' machine and of all 'Odds Maker' machines owned or controlled by the owner shall be the sole and total responsibility of the owner." They contend that this argument is supported by the "Addendum" which guarantees "approved" locations. However, the Shaws contend that the "Addendum" is limited in scope, and would not have been necessary had the literal terms of Article VI, section 2 of the contract accurately reflected the understanding of the parties with respect to their relative responsibilities for machine location