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Smith v. Gross

Court of Appeals for the Ninth Circuit
1979 U.S. App. LEXIS 11797, 604 F.2d 639 (1979)
ELI5:

Rule of Law:

An investment scheme constitutes an "investment contract" and thus a security under federal law if it involves an investment of money in a common enterprise with profits expected to be derived from the undeniably significant managerial or entrepreneurial efforts of others, particularly when the investor's success is inextricably tied to the promoter's ability to maintain the scheme.


Facts:

  • Seller Gross, through a promotional newsletter, solicited Gerald and Mary Smith to invest in raising earthworms.
  • Gross promised the Smiths that the worms would double in quantity every sixty days and that the time involved would be minimal.
  • Gross guaranteed he would buy back all bait-size worms the Smiths produced at $2.25 per pound, assuring them he would handle all marketing.
  • The Smiths purchased the worms, relying on Gross's promise to repurchase their entire production at the guaranteed price.
  • The Smiths later learned that worms multiply at a much slower rate than represented, making the promised profits unattainable through farming alone.
  • The guaranteed repurchase price of $2.25 per pound was substantially higher than the actual market price for worms.
  • Gross could only afford to pay the inflated repurchase price by continually finding and selling worms to new investors at similarly inflated prices.

Procedural Posture:

  • Gerald and Mary Smith filed a lawsuit against Gross, Gaddie, and two corporations in U.S. District Court for violations of federal securities laws.
  • The defendants filed a motion to dismiss for lack of subject matter jurisdiction, or in the alternative, for summary judgment.
  • The district court, considering affidavits from both parties, granted the motion to dismiss for lack of subject matter jurisdiction.
  • The district court's dismissal was based on its finding that no security was involved in the transaction.
  • The Smiths (appellants) appealed the district court's judgment to the U.S. Court of Appeals for the Ninth Circuit.

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Issue:

Does an agreement to raise and sell earthworms constitute an investment contract subject to federal securities laws when the investors' profits depend on the promoter's promise to repurchase the worms at an inflated price, which the promoter can only afford by finding new investors?


Opinions:

Majority - Per Curiam

Yes, this earthworm raising agreement constitutes an investment contract. The court applied the three-part test from S.E.C. v. W.J. Howey Co., which defines an investment contract as (1) an investment of money, (2) in a common enterprise, (3) with profits to come from the efforts of others. The court found a 'common enterprise' existed because the Smiths' fortune was interwoven with and dependent upon the efforts and success of Gross. Specifically, the Smiths could only realize the promised profits if Gross succeeded in finding new investors to fund the inflated buy-back price. The third prong was also met because the 'undeniably significant' efforts were not the Smiths' ministerial task of raising worms, but rather Gross's essential managerial efforts in promoting the scheme and finding new investors to sustain it. The court found this case virtually identical to Miller v. Central Chinchilla Group, Inc. and distinguished it from franchise agreements where a franchisee's success depends on their own independent efforts.



Analysis:

This case reinforces a flexible, substance-over-form application of the Howey test for determining what constitutes an investment contract. It clarifies that the 'common enterprise' and 'efforts of others' prongs are met when an investor's potential for profit is inextricably linked to the promoter's essential managerial or marketing efforts, even if the investor performs some minimal tasks. The decision serves as a key precedent for identifying securities in schemes that resemble pyramid or Ponzi structures, where the promoter's ability to attract new capital is the true driver of investor returns, not the underlying business activity. It cautions that courts will look at the economic reality of a transaction to determine if it falls under the protection of securities laws.

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