Op-Ed — Supreme Court Answers Call of Investors

By Kenneth M. Rosen, Assistant Professor of Law, The University of Alabama

Martha Stewart’s trial, former Tyco CEO Dennis Kozlowski’s penchant for lavish parties and furnishings, and former HealthSouth CEO Richard Scrushy’s ankle adornments and interstate travel plans have overshadowed a recent Supreme Court decision with potentially great significance to investors.

In Securities and Exchange Commission v. Edwards, the Supreme Court dealt with a case alleging that agreements associated with the sale of payphones violated the federal securities laws. As Justice Sandra Day O’Connor noted in writing for a unanimous Supreme Court, not only does opportunity fail to knock for investors at times, “sometimes it hangs up.”

The Edwards case reminds us that constant vigilance from both investors and regulators is necessary to detect new frauds. Cases grabbing recent headlines, at their core, often involve harms to investors who bought and sold shares of stock in corporations. Yet, the types of securities deserving protection under federal law are not restricted to stocks, nor are the dangers of securities fraud limited to shareholders. Certain payphone purchasers now know this lesson all too well.

The SEC’s complaint filed in federal district court alleged that ETS Payphones, Inc., headed by Charles Edwards, did more than simply sell payphones. Most purchasers of the phones entered leaseback and management agreements with ETS, under which the purchasers would receive a set monthly payment for the use of their payphones. In addition to this fixed 14% annual return, ETS often promised a full refund of the investor’s initial purchase price for the telephone package within 180 days of an investor’s request or at the end of the lease.

Unfortunately, a sure thing is not always certain. Over time, revenues from the telephones apparently proved insufficient for ETS to satisfy its lease payments. Additional investors’ funds were needed to meet payment obligations. ETS eventually filed for bankruptcy protection.

Paying off earlier investors with new investments, thus leaving the impression of a legitimate, successful venture, looks like a classic fraud scenario known as a Ponzi scheme. Old-fashioned Ponzi schemes may not provide the glitz of celebrity securities fraud trials, but left unchecked, such schemes can continue to cost additional investors more and more of their savings.

Ironically, the promised rate of return to the ETS investors led a federal appeals court in Atlanta to find that the agreements were not investment contracts protected by the federal securities laws. The appeals court reasoned that a contract with a fixed rate of return did not have the element of risk for profits associated with typical investment contracts that are securities, and that the case should be dismissed. In rejecting the appeals court’s conclusion, Justice O’Connor takes a pragmatic approach and correctly explains that promises of lower risk “are particularly attractive to individuals more vulnerable to investment fraud, including older and less sophisticated investors.”

In addition to permitting the case to move forward, the Supreme Court’s decision is especially significant for at least two reasons. First, as we increasingly obsess over the securities law travails of celebrities, SEC enforcement efforts must not ignore less publicized frauds. As illustrated by the facts alleged in the Edwards case – apparently 10,000 people invested $300 million in the ETS arrangements – the harms of such frauds can be large and reach many investors.

Second, as we try to restore confidence in our markets after recent corporate scandals, in both famous and less well-known securities fraud cases, courts should be as pragmatic in interpreting the federal securities laws as was the Supreme Court in Edwards. Had the Supreme Court let the lower court’s opinion stand in Edwards, additional fraudsters could well have avoided securities law liability merely by changing their false promises from large, variable returns to large, fixed ones.

Although initially enacted decades ago, the federal securities laws still can accommodate new forms of investment and combat unusual frauds. By flexibly interpreting those laws to further Congress’ intent to fight fraud aggressively, courts can answer the call of investors.

Professor Kenneth M. Rosen previously served as Special Counsel at the U.S. Securities and Exchange Commission. He is an assistant professor of law at The University of Alabama School of Law.