Tuesday, February 23, 2021

Supreme Court rejects petition on extension of broker-dealer registration beyond secondary markets

By Rodney F. Tonkovic, J.D.

The Supreme Court will not hear petitions asking for clarification of the broker-dealer registration requirements and when LLC interests are securities. The first petition accused the SEC of disregarding the language of the securities laws by extending the broker-dealer registration requirements to "underwriters," or so the petitioners claimed. The second sought a uniform standard in the application of the Howey test, arguing that the "label-driven, LLC-only" test employed by the Tenth Circuit ignored the totality of the circumstances in that case. Both petitions were filed in late December 2020, and the respondent in each case waived the right to respond.

Registration for primary markets? The petitioners in Feng v. SEC (20-862) asked the Court to address whether the SEC exceeded its statutory authority by applying broker-dealer registration requirements to the petitioners, who were acting as underwriters. In 2015, the SEC charged attorney Hui Feng with offered and sold EB-5 investments to legal clients while collecting undisclosed commissions from the promoters of the investments. The Commission charged Feng with fraud under the securities laws and with failing to register as a broker-dealer.

In the district court, Feng argued that he was an immigration attorney and not a broker, but the district court held that the evidence established that he acted as a broker and was in violation of the registration requirement. The Ninth Circuit affirmed, agreeing with the lower court's use of the "totality-of-the-circumstances" analysis to find that Feng's work more resembled broker activity than traditional legal work.

The petition argued that the SEC has improperly expanded the Exchange Act's broker-dealer registration requirement to encompass primary offerings of securities. The Exchange Act, the petitioners said, regulates trading in the secondary market, and those operating in the primary market do not trigger the broker-dealer registration requirements of the Act. The petition asserted, however, that the Commission has routinely exceeded this authority by extending the registration requirements beyond secondary markets and over-the-counter trading.

In this case, the petitioners served to introduce issuers to potential investors for primary market transactions that did not involve an exchange or over-the-counter market transaction. This, they argued, placed them squarely in the category of "underwriter" under the Securities Act, and underwriters are not required to register. Until this case, the petitioners remarked, this "obvious statutory overreach" had gone unchallenged. The SEC waived its right to respond.

LLC interests not securities. In Foxfield Villa Associates, LLC v. Robben (20-868), the petitioners argued that their investments in a real estate venture were "investment contracts" subject to the securities laws. The petitioners alleged that they were fraudulently induced into purchasing owner ship interests in a limited liability company. The district court granted summary judgment to the defendants on the securities fraud claim after concluding that the membership interests were not securities.

At issue on appeal was whether the petitioner's interests fell under the Exchange Act's definition of a "security." The Tenth Circuit panel focused on whether the interests were investment contracts under Howey and allowed that the interests were investments in a common enterprise. The result, then, hinged on whether the profits the investors expected to gain came "solely from the efforts of others." After delving into the six factors used by the Tenth Circuit in analyzing this problem, the facts showed that the petitioners had the requisite access to information and contractual powers to control the profitability of those investments and were not so dependent on the respondents that they could not exercise ultimate control over their investments.

The petition took issue with what it characterized as the Tenth Circuit's use of an "LLC-only test" that ignored the reality of the situation. In this case, the petitioners contended, the entity was nominally titled an LLC, but promoter intended that the investors would "have nothing to do" with the enterprise. A rigid application of the Howey test (and other factors introduced by its progeny) is no longer appropriate as, over time, LLCs and other such entities have been afforded great flexibility in their structure. In reality, the petition said, if the court had looked beyond the formalities of the parties' written agreement, it would have discovered that the promoter had orally promised that he alone would manage the enterprise and that the investors would remain passive. If this case had been brought in circuits that focused on the "totality of the circumstances," such as the Second, Fifth, or Ninth, the result would have been different. The respondents waived their right to respond.

Read the Docket. These cases, and others before the Court may be referenced in the latest version of the Supreme Court Docket, a regular feature of Securities Regulation Daily. Issued opinions, granted petitions, pending petitions, and denied petitions are listed separately, along with a summary of the questions presented and the current status of each appeal.