Securities and Exchange Commission v. Charles Edwards

Charges Against Charles Edwards

Summary of the Facts

     The briefs facts of the case are that Charles Edwards owned and operated a corporation (ETS Payphones Inc.,) that sold payphones on a sale-and-leaseback business arrangement. The company would sell the pay telephones for $7000 and, thereafter, lease them back from buyers for fixed $84 monthly payments, which assured the buyers of a 14% yearly return. The buyers did not participate in the daily operations of the payphones nor did they collect the coin revenues or maintain payphones. Besides, the payphone’s sale agreement also had a buyback clause where the company promised to repay the buyers the entire purchase price when the lease expired.

     ETS Payphones, however, struggled to generate sufficient revenue to meet its obligation under the leasehold agreements and it largely relied on money from new investors. Subsequently, Edwards applied for bankruptcy protection. The Securities and Exchange Commission (SEC) filed an enforcement suit against Edwards claiming that the company sold unregistered securities and, in so doing, flouted the registration as well as antifraud requirements of federal securities laws.

Parties and their Positions

     The SEC was the petitioner in this case. Its position was that the sale-and-leaseback arrangements were equivalent to investment contracts and it also operated as a Ponzi Scheme since business used investors’ money to make the fixed leaseback payments. Therefore, the petitioner asserted that Edwards contravened the registration and antifraud provisions of the Securities Act, Exchange Act, and Rule 10b-5.
     The respondent was Charles Edward—the owner of ETS Payphones Inc. He professed that SEC position was wrong as the buyers did not share in the earnings of the business. Instead, the buyers received monthly payments through an obligation set under a lease agreement rather than the effort of a third party. Therefore, the investment contracts did not meet the definition of a security and, as such, the business was not subject to the federal securities laws.

Procedural History

     The District Court found that the leaseback arrangement was an investment contract which was equivalent to a security and, thereby, ought to have been regulated by the federal securities law. The District Court relied on the rationale made in SEC v. W.J. Howey Co, 328 U.S. 293 (1946) that any arrangement or contract that entails an individual putting their funds in common enterprise and earns a return from a promoter’s or third party’s effort is an investment contract. Using Howey’s definition of an investment contract to conclude that since the purchasers depended on ETS operation of the pay telephones and to earn the 14% annual return as well as the buyback price at the expiry of the price. Besides, the purchasers earned profits from the efforts of others as ETS, not the buyers, were responsible for the day-to-day management and maintenance of the payphones. Accordingly, the District Court found that Edwards flouted the registration requirements when he sold investment contract interstate commerce without registration as required the federal securities laws. In addition, he engaged in a fraudulent business by misleading investors that the payphone business was a profitable business while, he relied on the funds on new investors to fulfill his obligations under the lease agreements.

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         The Court of Appeals overturned the decision. The Eleventh Circuit reasoned that the leaseback arrangement was lacking key elements of an investment contract as described in Howey including capital appreciation and sharing in the enterprise earnings. The leaseback arrangement had a fixed monthly payment regardless of the profits or losses of the business. The returns were also not entirely depended on efforts of the promoter or third parties as Edwards instead they were a product of contract bargaining that gave Edward a contractual obligation to pay the purchasers.

    Legal Issue

         Is a sale-and-leaseback arrangement that provided a fixed instead of a variable rate of return an investment contract, and therefore, a security that is subject to the federal securities laws?

    Court’s Ruling

         Yes. An investment scheme that provided a fixed instead of a variable rate of return was an investment contract, and therefore, securities that are governed by federal securities laws.

    Reasoning of the Court

    Securities and Exchange Commission

         The facts that the Supreme Court found most important when the decision was: (1) that the respondent operated a business where investors/purchasers were mainly attracted “by the prospect of a return” on the investment; (2) and that the respondent was responsible for the management, monitoring, as well as maintenance of payphones. The court relied on test set forth in Howey which described an investment contract as one which the schemes entails investing money “in a common enterprise” where the return comes the efforts of a third party [promoter]. The Court insisted that this description was adjustable to fit different and several arrangements devised by businesses who use the funds others promising a return on their investments. The Court profits made “from the efforts of others” comprise, inter alia, dividends, periodic payments, as well as appreciation of invested value.

         The Supreme Court was unwilling to exclude contracts guaranteeing a fixed rate of return from the definition of security. It argued that there is no need to differentiate between the two promises because both involve investors being captivated by promise of earning a return from their investments. Edwards’ payphone business had also made a similar promise—an assurance of fixed monthly return. The Court further reiterated that none of the cases, that Howey used to formulate the definition of investment contract, made a distinction between fixed and variable returns. Instead of fixed or variable nature of returns, the fundamental elements when determining an investment contract are: (1) investment in common enterprise (2) reasonable profit from the effort of the promoter [third party].


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        When mortgage notes are sold with a package of management services and a promise to repurchase the notes in the case of default they will be equivalent to securities. This issue was clarified in In Re Abbett, Sommer & Co., 44 S. E. C. 104 (1969). Besides, the mortgage notes package, in this case, will be consistent with the Howey’s characterization of investment contracts—”investing funds with the anticipation of earning a return from the efforts of others”.


         I do agree with the Court’s decision in this case. The decision helped in making the decision more flexible to fit the different types of schemes where businesses tend persuade investing public to contribute funds to the business with the promise of getting a return. Indeed, as financial markets expands, businesses will become more creative and create complex investments to escape being subject to federal securities laws. It is important for the Court’s to have an adaptable definition of investment contract that will accommodate several forms of securities so as to protect investors. The Court in this case made it clear that regardless of whether the expected returns vary or are fixed, a scheme would be considered an investment contract if there is expected profit from the efforts of others. Nevertheless, as noted by Albert (2011), the is still an absence of absolute parameters that investors and businesses can use to identify investment contracts. The issue is characterized by uneven applications as evident in the case where the District Court and Court of Appeals had completely interpretation of the sale-leaseback arrangement. A more precise definition of the elements of an investment contract is needed to provide better protection to investors and boost their confidence on the capital markets.


    Albert, M. (2011). The Howey Test Turns 64: Are the Courts Grading this Test on a Curve?

    William & Mary Business Law Review, 2(1), 1-50.

    ETS Payphones Inc. through Charles Edwards and his team, purchased payphones from vendors for $7,000 only to leased them back, guaranteeing in exchange a monthly fixed payment amount of $84, averaging the buyers approximately 14% yearly returns. The company was looking onto the daily operations and maintenance of machines, and the coin loss revenue.

    SEC filed a suit in the court because the ETS Payphones did not register their securities which not only violates registration requirements but also violates the prime objective (mandate) of antifraud provisions of federal securities laws. According to thoughts of the SEC, sale-and-leaseback transactions looked like investment contracts and worked as a Ponzi scheme with the fresh investor’s money being used to deal with the finance.

    Charles Edwards, in his argument, opposed the SEC stance by stating that aside from the business not sharing the earnings from the business, the buyers received their monthly income by leasing the property. He argued that the structure of the business was inconsistent with the legal definition of what constitutes a security, and it shouldn’t be under the control of the federal securities laws.

    The examination of the District Court constituted the leaseback arrangement as an investment contract equivalent to a security resulted with the regulation under federal securitites law, so. Nevertheless, the Court of Appeals quashed this ruling and, having applied the Howey method, established that this setup did not contain constituent parts of a security present in Howey.

    In this case, the Supreme Court ruled that a claim alleging that a fund with fixed returns but not variable returns was a security under federal securities litigation. The Court stressed that the fundamental attributes which create an investment contract are the investment into a common enterprise and the profits generated by a third party’s effort, regardless of whether the returns appear a little fixed or highly variable.

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