Securities Fraud: But Was It Even A Security?

What is a security, anyway? The California Court of Appeal tackled that question recently in a case about a loan between friends.

A good starting point is that the law considers a security to be an investment contract, but there’s more to it than that. You may be familiar with common examples like publicly-traded stocks and bonds, but sometimes it’s a tougher call.

California law recognizes two tests to determine whether a deal or transaction is a security. One is the state’s risk-capital test, and the other is the federal Howey test (from a U.S. Supreme Court case). California courts may apply either one to your case, their goal being to protect the public from shady investment schemes.

The narrower risk-capital test asks whether you indiscriminately solicited passive investments from the public at large. A passive investment is one whose success depends mainly or exclusively on the efforts of people other than the investors.

The broader federal test simply asks whether you solicited people to invest passively.

In this case, the defendant had persuaded a guy he knew to invest in his land-development deal. The investment was a $280,000 promissory note that promised to pay out as follows:

  1. If the land were sold, the guy would share in the net profits from the sale.
  2. If the land were developed, he would receive one residential acre of his choosing.
  3. If neither event took place within one year, he could call the note and get interest on top of principal at a rate of ten percent.

But things didn’t exactly pan out, and some years later, the local district attorney’s office charged the defendant with securities fraud.

The trial court partly dismissed the case because it ruled that the promissory note wasn’t a security but a simple loan.

The government appealed that ruling, but the appeals court agreed. Even under the federal test, the note wasn’t a security because it was carefully negotiated between the parties, and it called for repayment whether the venture succeeded or not. The defendant had even personally guaranteed it.

So the case could’ve been a breach of contract, or it could’ve been a fraud.

But it wasn’t a securities fraud because the note wasn’t a security.

When It Rains, It Pours

Here’s another case that blurs the line between civil and criminal laws.

It started as a civil dispute between a homeowner and contractor. The homeowner hired the contractor to paint her house and install ten windows. Six months later, he had painted her house and installed eight-and-a-half windows, but no one was happy. He wanted $8,000 more to finish the work, but she’d already paid him $61,000 and refused to pay more.

The contractor sued for the $8,000 balance, but he had a problem: apparently, he didn’t actually have a contractor’s license. Or he couldn’t produce a valid one, anyway.

He may not have realized that, in California, an unlicensed contractor can’t sue for a breach of contract no matter how good a job he may have done. Not only that but he can be sued for every penny that he was paid even if he did great work. Which is what happened here. The homeowner lawyered up and countersued for the $61,000 that she had paid him.

Then his luck got worse.

Because he couldn’t produce a contractor’s license, he was charged criminally with six misdemeanor counts of contracting without a license. Yes, it’s a crime, too. He pleaded no contest to one count, and the other six were dismissed. He was put on probation and ordered to pay restitution as part of it.

At the restitution hearing, the government demanded that he pay back the entire $61,000 that the homeowner had paid him plus her attorneys’ fees. He testified that he did the work right and that she owed him $8,000. She testified that he didn’t do it right because some of the paint had faded, chipped, bubbled, and peeled in the three years since. He argued that any damage was due to natural weathering because the house was so close to the ocean, and he called an expert who testified to that.

The trial court sided with the contractor, but on appeal, he was ordered to pay back everything, including her attorneys’ fees.

Why?  The law was clear that he didn’t have a right to the money no matter how well he performed, so legally, she never should’ve had to pay for his work in the first place.

Wasn’t this a criminal case, not a civil one? Yes, but the civil rule applied to criminal restitution.

Wasn’t this an unfair windfall for the homeowner? Perhaps.

But that’s the way the cookie crumbled.

Update: On August 22, 2017, a higher appeals court reversed this decision. It held that the civil rule doesn’t apply to criminal restitution, which is limited to a victim’s actual economic loss. And with that, all is right in the world again.

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