State Ex Rel. Miller v. Pace
2004 WL 736872, 677 N.W.2d 761, 2004 Iowa Sup. LEXIS 115 (2004)
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Rule of Law:
A financial arrangement where investors purchase an asset and lease it back to a management company, expecting fixed returns primarily derived from the managerial efforts of others, constitutes an "investment contract" and thus a "security" under Iowa law. An unregistered individual who directly sells such unregistered instruments is primarily liable as an "agent" and subject to consumer fraud penalties for misrepresentations or material omissions, even without intent to deceive.
Facts:
- Edwin Pace was a licensed insurance agent, but his securities license had lapsed prior to his involvement in the sales at issue.
- From 1997 through June 2000, Pace marketed and sold Customer-Owned, Coin-Operated Telephones (COCOTS) in Iowa, often targeting the elderly.
- Pace exclusively sold COCOTs under a sale/leaseback plan where investors purchased a payphone and simultaneously leased it to a management company, receiving fixed monthly payments ($75-$82) for three to five years without any involvement in the payphone's operation or management.
- Pace earned a 10-12% commission on each COCOT sale, which typically ranged from $5000 to $7000.
- On September 24, 1999, the Iowa Securities Commission publicly issued a cease and desist order against one of Pace's marketing companies, Tri-Financial Group, and its management company, identifying COCOTs as unregistered securities. Pace ceased selling through Tri-Financial but continued with other companies.
- In May and July 2000, the Iowa Securities Bureau sent letters to Pace, informing him that his sale/leaseback program was an investment contract (a security) requiring registration, and that selling them as an unregistered agent might violate Iowa law.
- Pace stopped selling payphones after receiving the second letter in July 2000.
- Subsequently, two management companies involved in Pace's sales (ETS and Alpha Telecom) declared bankruptcy, resulting in investors no longer receiving lease payments and a bankruptcy court determining the management company, not the investors, owned the payphones.
- Pace made numerous false representations to investors, including that the investments were guaranteed, safe, properly registered, would yield high returns, that investors would own an asset, and that management companies were financially strong. He also omitted material facts, such as the high risk, the likely Ponzi scheme nature of the program, and his unregistered status as a securities agent.
Procedural Posture:
- The State of Iowa filed a petition in district court (trial court) charging Edwin Pace with violations of the Iowa Uniform Security Act (Iowa Code chapter 502), the Iowa Business Opportunity Act (Iowa Code chapter 523B), and the Iowa Consumer Fraud Act (Iowa Code section 714.16).
- The district court found Pace liable for all alleged violations, ruling that the sale/leaseback program was an investment contract and a security, that Pace offered and sold unregistered securities as an unregistered agent, and that his conduct constituted securities fraud, business opportunities fraud, and consumer fraud.
- The district court ordered Pace to pay $302,000 in restitution, disgorge all commissions, pay civil penalties, and enjoined him from further violations.
- Edwin Pace appealed the district court's decision to the Iowa Supreme Court (appellant).
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Issue:
Does a sale/leaseback program involving payphones, promising fixed monthly payments to investors who have no managerial control, constitute a "security" under Iowa Code chapter 502, thereby making an unregistered individual who directly sells such unregistered instruments primarily liable as an "agent" and subject to consumer fraud penalties for misrepresentations and material omissions, without violating due process or ex post facto laws?
Opinions:
Majority - Justice Ternus
Yes, the payphone sale/leaseback program constitutes a "security" under Iowa law, and Edwin Pace is primarily liable as an unregistered "agent" for selling unregistered securities and committed consumer fraud, without any violation of his due process or ex post facto rights. The court affirmed the district court's ruling, first determining that the sale/leaseback program was a "security" under Iowa Code section 502.102(19). Applying the "Howey test," which is derived from SEC v. W.J. Howey Co. and incorporated into Iowa's administrative code, the court found the program met the criteria: an investment in a common enterprise with the expectation of profit to be derived through the essential managerial efforts of someone other than the investor. The court, aligning with the U.S. Supreme Court's decision in SEC v. Edwards, clarified that the "expectation of profit" refers to the investor's anticipated return, and whether that return is fixed or variable is not determinative, only that it depends on the efforts of others. Since investors in Pace's scheme contributed no managerial efforts and their returns necessarily resulted from the labor of others, the COCOT was an investment contract and thus a security. Second, the court rejected Pace's argument that he was an "affiliate" rather than an "agent." An "agent" under Iowa Code chapter 502 is an individual representing an issuer in effecting sales of securities, subject to primary liability for selling unregistered securities without registration. An "affiliate" incurs secondary liability and has a potential lack-of-knowledge defense. The court concluded Pace was a primary violator, directly making the prohibited offers and sales of unregistered COCOTs while representing marketing and management companies. As a primary violator, he could not claim the lack-of-knowledge defense available only to secondary parties. Third, the court affirmed the finding of consumer fraud under Iowa Code section 714.16. This statute requires a lesser showing than common law fraud, permitting relief for an unfair practice, deception, or misrepresentation, or the omission of a material fact with the intent that others rely on it, without requiring an intent to deceive or knowledge of falsity. The court upheld the trial court's findings that Pace made numerous false and misleading representations and omitted material facts to consumers, relying on the trial court's credibility determinations. Finally, the court dismissed Pace's constitutional claims. It held that the judicial determination that COCOTs were securities was a retroactive application of existing law, not a new punitive measure, and thus did not violate due process or ex post facto clauses. The court also found Pace had sufficient "fair warning" because Iowa Code chapter 502, including the definition of "investment contract" based on Howey and prior Iowa cases (State v. Tyler, State v. Kraklio), existed long before his sales. The court also rejected the claim that due process required a cease-and-desist order before a civil enforcement action, noting that a civil lawsuit with notice and hearing provides adequate due process.
Analysis:
This case significantly reinforces the broad interpretation of "security" under Iowa's Uniform Securities Act, aligning state law with the U.S. Supreme Court's Howey and Edwards decisions. It clarifies that fixed returns do not preclude an investment from being a security if profits are derived from others' efforts, thereby expanding the scope of regulated investments. The ruling also tightens liability for primary sellers, confirming that individuals directly effecting unregistered security sales are "agents" without access to the "lack-of-knowledge" defense available to secondary "affiliates," thus increasing the burden on sellers to ensure compliance. Furthermore, it highlights the consumer-protective nature of Iowa's consumer fraud statute by affirming that intent to deceive or knowledge of falsity is not required for liability, making it easier to prosecute unfair practices.
