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Note: John F. Chase (Victim) filed a multi-count complaint alleging that ten named defendants, acting in various roles, promoted an investment scheme promising a USD 10,000,000 return for every USD 250,000 invested in standby letters of credit. As part of this scheme, Victim entered into an “Irrevocable 17.5% Success Fee Participation & Pay order Agreement” (Success Fee Agreement) whereby Victim would pay the defendants a 17.5% fee on proceeds Victim received “within 7 to 12 days” from the time of Victim’s investment. Pursuant to a separate agreement, Victim wired USD 500,000 into the attorney trust account of another named defendant on the basis that none of the wired money would “be disbursed from the trust account until [defendant] provided [Victim] proof that two banking instruments, including a standby letter of credit, had been issued and transmitted.” The wired money, however, immediately left the trust account and Victim was neither provided proof that a standby LC was issued nor returned any money.

After several defendants defaulted and two prevailed on motions to dismiss, another defendant moved to dismiss the case for lack of subject matter jurisdiction on the basis that the two Racketeer Influenced and Corrupt Organizations Act (RICO) claims alleged by Victim were preempted by the Private Securities Litigation Reform Act of 1995 (PSLRA). The United States District Court for the District of Maine, Hornby, J., granted the motions to dismiss, finding the RICO claims preempted, and reserving any other judgment.

The PSLRA narrowed the types of conduct qualifying as predicate acts supporting a RICO claim.1 Thus, the Judge had to determine whether the scheme alleged by Victim constituted a “purchase or sale of securities” within the meaning of federal securities law such that the claim while potentially actionable under RICO was preempted by the PSLRA. The Judge noted SEC v. Lauer, 52 F.3d 667 (7th Cir. 1995) as the “closest appellate case” which also dealt with “Prime Bank Instruments”. In Lauer, the Seventh Circuit “rejected the argument that the scheme was not the sale of securities even though” such prime bank instruments do not exist. As Victim had adequately alleged a fraudulent scheme, the Judge turned to whether there was fraud in the “purchase or sale of securities.” While federal securities law includes “investment contracts” under a general rubric of securities, the Judge noted that the term is undefined. In SEC v. W.J. Howey Company, 328 U.S. 293 (1946), however, the Supreme Court defined “investment contracts” as a scheme involving (1) an investment of money; (2) a common enterprise; with (3) profits to come solely from the efforts of others. Victim conceded that the alleged scheme satisfied elements (1) and (3) of Howey, but disputed whether it constituted a “common enterprise”. On this element, the Judge noted the division among Circuit Courts over whether the “common enterprise” element:

requires a relationship by which investors pool their funds or other assets (called a horizontal approach), or only a relationship between the investor and the promoter (the vertical approach) and – if the latter – whether the test for vertical commonality is “broad” (satisfied if an investor depends on the promoter’s expertise for any profits) or “narrow” (satisfied only if the investor’s profits and the promoter’s profits are “interwoven,” or interdependent).

The First Circuit previously approved of the horizontal approach without expressly deciding whether the vertical approach would suffice. Applying the facts alleged by Victim, the Judge noted the “intimations of horizontal commonality” but ultimately opined that the First Circuit would decline to find such commonality as Victim argued that the defendants had “never claimed” to be pooling the invested money of others so that all would share in the risks and profits of the scheme. The Judge noted that the allegations supported a finding of either broad or narrow vertical commonality because Victim (a) “certainly depended on the promoters’ expected expertise from any profits”, and (b) the expected profits for Victim and the defendants “were directly related” under the Success Fee Agreement and other aspects of the scheme. Having satisfied the elements for an “investment contract” provided in Howey¸ the Judge concluded that the fraudulent scheme involved the purchase or sale of securities and Victim was thus precluded by the PSLRA from asserting RICO claims.

The Judge reserved any ruling on underlying state law claims in order for Victim to attempt to satisfy federal diversity jurisdiction.

[MJK]

1
The PSLRA text amending RICO states that “no person may rely upon any conduct that would have been actionable as fraud in the purchase or sale of securities to establish a violation of [RICO].”

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