United States v. Leonard, No. 05-5523-cr (2d Cir. June 11, 2008) (Kearse, Calabresi, Katzmann, CJJ)
In this case, the court concludes that interests in film production companies were “investment contracts,” and hence securities, under federal securities law. It also holds, however, that the district court erred in treating the entire cost of the securities as the loss amount under the guidelines.
The defendants ran sales offices that peddled interests in LLC’s formed to finance the production and distribution of motion pictures. Potential investors were solicited over the phone and, if they expressed an interest, would be sent offering materials, including brochures, operating agreements, and other such documents. Investors could purchase $10,000 “units” by completing and mailing back a subscription agreement.
The defendants’ sales offices would receive a commission of around 45% for each unit sold. This was the fraud – although the offering materials indicated that a commission would be paid, they did not accurately disclose the size. Read generously to the defendants, they seemed to indicate that no more than 20% of the unit price would go toward sales commissions.
The Sufficiency of the Evidence
The defendants’ first claim was that there was insufficient evidence that the investment units were “securities.” The definition of “security” covers many types of instruments. Here, the specific question was whether the units were “investment contracts.” An investment contract is one where the investor “is led to expect profits solely from the efforts of the promoter or a third party.” Here, the defendants argued that the investors were supposed to help manage the LLC’s, and hence never expected to profit “solely” from the efforts of others.
There is a difference between companies that seek “passive investors,” which fall under the securities laws, and those in which there is a reasonable expectation of significant investor control, which do not. But here, this distinction was complicated by the fact that the investment units were shares in LLC’s. According to the circuit, LLC’s, due to their hybrid nature, require a case-by-case analysis of the “economic realities” of the underlying transaction.
Here, the organizational documents describe an investment that, on its face, was not a security. Those documents were intended to create the impression that subscribers would play an active role in the management of the companies. In reality, however, the members of the LLC’s “played an extremely passive role in the management and operation of the companies.” They voted rarely, and only a small number of them served on any committees. Thus, according to the circuit, “the vast majority of investors in both companies did not actively participate in the venture, exercising almost no control.” For example, the trial evidence showed that the managerial rights mentioned in the subscription documents were illusory, because others made almost every significant decision about the making of the films before the fundraising was even complete. Moreover, the investors themselves had no experience in film production, and played no role in shaping the organizational agreements themselves, casting further doubt as to whether the members were truly expected to have significant control over the enterprise.
And that was enough for the jury to properly conclude, considering “substance over form,” that, “from the start,” there was no reasonable exception of investor control.
The Loss Calculation
At sentencing, the district court held the defendants accountable under for the entire cost of the securities they sold, on the theory that the investors would not have participated if they knew the true size of the sales commissions. The circuit deferred to the district court’s finding about the investors’ decision to participate, but held that this did not “in and of itself” mean that the securities they received were “entirely without value.”
Since the investors actually obtained an interest in a company engaged in producing and distributing a motion picture, the district court should have deducted from the purchase price the actual value of the instruments. The court notes that these were “illiquid securities for which there is no public market,” and thus that it will be quite difficult to value them. Nevertheless, the district court must make a “reasonable estimate” of this figure.