State v. Hawaii Market Center
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State v. Hawaii Market Center
Case: State v. Hawaii Market Center (1971)
Subject Category: Security
Agency Involved: Hawaii Commissioner of Securities
Court: Hawaii Supreme Court
Case Synopsis: The Hawaii Supreme Court was asked to decide if the memberships sold by Hawaii Market Centers constitute a security to be regulated under Hawaii's state securities laws.
Legal Issue: What is the definition of an investment contract under Hawaii State Law?
Court Ruling: The Court ruled that the scheme in question was a security, but did so by adopting a new and different test than that used by other states. Hawaii Market Center (HMC) sold "founding" memberships to promoters who could earn money through selling additional memberships or referring others to shop at the store using the promoter’s buyer's cards. The program focused on the marketing to additional promoters and not on the sale of merchandise to end-users. The Hawaii Supreme Court decided that the scheme was an investment contract because the money earned by the promoter was more like the money earned by an investment than a referral sales plan. The Court declined to adopt the popular Howey definition of an investment contract, one where profits come solely from the efforts of others. Instead the court focused on the functional characteristics of an investment contract and concluded that in Hawaii an investment contract is the investment of initial value, subject to the risks of an enterprise, is induced by representations of profit, and the investor does not have practical and actual control over the decisions of the enterprise.
Practical Importance to Business of MLM/Direct Sales/Direct Selling/Network Marketing/Party Plan/Multilevel Marketing: Hawaii takes a functional approach to an investment contract, which may make their definition more expansive than other states'.
State v. Hawaii Market Center , 485 P.2d 105 (1971) : The Court ruled that the scheme in question was a security, but did so by adopting a new and different test than that used by other states. Hawaii Market Center (HMC) sold "founding" memberships to promoters who could earn money through selling additional memberships or referring others to shop at the store using the promoter’s buyer's cards. The program focused on the marketing to additional promoters and not on the sale of merchandise to end-users. The Hawaii Supreme Court decided that the scheme was an investment contract because the money earned by the promoter was more like the money earned by an investment than a referral sales plan. The Court declined to adopt the popular Howey definition of an investment contract, one where profits come solely from the efforts of others. Instead the court focused on the functional characteristics off an investment contract and concluded that in Hawaii an investment contract is the investment of initial value, subject to the risks of an enterprise, is induced by representations of profit, and the investor does not have practical and actual control over the decisions of the enterprise.
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STATE v. HAWAII MARKET CENTER, INC., 52 Haw. 642 (1971)
485 P.2d 105
STATE OF HAWAII, by its Commissioner of Securities, Plaintiff-Appellee,
v. HAWAII MARKET CENTER, INC., STUART M. COWAN, DON R. SELLEY, JAMES
ROSE and ARTHUR AWAYA, Individually and as Officers and/or Directors of
HAWAII MARKET CENTER, INC., Defendants-Appellants.
Supreme Court of Hawaii.
May 20, 1971.
APPEAL FROM FIRST CIRCUIT COURT, HONORABLE DICK YIN WONG,
RICHARDSON, C.J., MARUMOTO, ABE, LEVINSON AND KOBAYASHI, JJ.
OPINION OF THE COURT BY LEVINSON, J.
The legal issue presented by this case is whether the
"Founder-Member Purchasing Contract Agreements" issued by Hawaii
Market Center, Inc., one of the appellants, constitute securities
within the meaning of the Hawaii Uniform Securities Act
(Modified), HRS § 485-1(12).[fn1] An affirmative answer to this
question would bring into operation the registration requirements
of HRS § 485-8. Before determining the nature of these agreements
it is first necessary to delineate clearly the economic
relationship existing between Hawaii Market Center, Inc. and
persons who have contracted with it pursuant to these agreements.
Hawaii Market Center, Inc. (hereinafter referred to as HMC) is
a Hawaii corporation with a capitalization of $1000.00. The
corporation's expressed purpose was to open a retail store which
would sell merchandise only to persons possessing purchase
authorization cards. In order to raise capital for the financing
of this enterprise HMC recruited founder-members. The maximum
number of such members was set at five thousand.
Prospective founder members were asked to attend recruitment
meetings. At these meetings a speaker explained how members would
be eligible to earn (1) immediate income before the store became
operational, and (2) future income after the store became
operational. In order to earn such income an invitee was required
to become either a founder-member distributor or a founder-member
A person became a founder-member distributor by purchasing from
HMC either a sewing machine or a cookware set (each with a
wholesale value of $70.00) for $320.00. The purchaser also
executed a "Founder-Member Purchasing Contract Agreement" with
the corporation. This agreement states that a distributor is able
to earn money in five ways. He may: (1) distribute the 50
authorized buyer's cards, which have been issued to him and
thereafter earn a 10% commission on each sale resulting from the
use of one of these cards in the HMC store; (2) earn a $50.00 fee
each time a person he refers becomes a founder-member
distributor; (3) receive a $300.00 fee as compensation for
establishing a new member as a supervisor or upgrading an old
member from distributor to supervisor. The fourth and fifth
sources of income relate to the earning of credits which are
applied to a $900.00 fee paid by a distributor to his supervisor
if the distributor wishes to be upgraded.
A person became a supervisor by executing a founder-member
contract and purchasing both a sewing machine and a cookware set
for a total price of $820.00. A supervisor earns higher fees and
commissions than a distributor. In addition, a supervisor
receives an override commission if his distributor enlists a new
member. He also receives override commissions on all sales made
to holders of purchase authorization cards distributed by any
founder-member whose entry into the organization can be traced
back to the supervisor.
On September 23, 1969 the appellee, the State of Hawaii, by its
Commissioner of Securities, filed an action in the First Circuit
Court against HMC and its officers and directors. The State
sought to enjoin the further promotion and execution of the above
described founder-member contracts. The commissioner argued that
the contracts were unregistered securities whose distribution was
prohibited by the Uniform Securities Act (Modified). HRS § 485-8.
The appellants contended that the contracts in question were not
securities within the meaning of the Act.
On October 20, 1969 the trial court entered its findings of
fact, conclusions of law and judgment in favor of the
Commissioner of Securities. After a thorough analysis of the
economic realities underlying the relationship between the
defendant corporation and its founder-members the court held that
the HMC agreements constituted "investment contracts" and
"certificates of interest or participation in a profit sharing
agreement" and, therefore, fell within the Hawaii statute's
definition of "security," as defined by HRS § 485-1(12). The
court enjoined the further promotion and execution of
founder-member purchasing contract agreements and the collection
and disbursement of funds pursuant to such agreements. The
appellants have appealed from this judgment and order. For the
reasons set forth below we affirm.
I. THE ESSENTIAL CHARACTERISTICS OF AN INVESTMENT CONTRACT UNDER
THE HAWAII UNIFORM SECURITIES ACT (MODIFIED).
A. The Test Embodied in the Howey Case is Too Mechanical to
Protect the Investing Public Adequately.
In arguing whether the interests represented by HMC's
founder-member contracts constitute investment contract
securities within the meaning of HRS § 485-1(12) both
the appellant and the appellee rely for guidance principally upon
the Supreme Court decision in Securities & Exchange Commission
v. W.J. Howey Co., 328 U.S. 293 (1946). That case sought to
formulate a test for the existence of an "investment contract,"
such a contract being included within the definition of
"security" under the Federal Securities Act. The Court concluded
that an investment contract exists whenever "a person invests his
money in a common enterprise and is led to expect profits solely
from the efforts of the promoter or a third party." Securities &
Exchange Commission v. W.J. Howey Co., supra at 299.
The appellants urge us to adopt the Howey formula as the test
to be applied in the present case. It is contended that under the
Howey test the contracts in question are not investment
contracts because founder-members in the HMC plan are expected to
recruit new members and distribute purchase authorization cards
in order to earn income; they do not, therefore, "expect profits
solely from the efforts" of others. Gallion v. Alabama Market
Centers, Inc., 282 Ala. 679, 213 So.2d 841 (Ala. 1968); Emery
v. So-Soft of Ohio, Inc., 30 Ohio Op.2d 226, 199 N.E.2d 120
(Ohio Ct. App. 1964).
The State also relies upon the Howey case but contends that
the test enunciated therein is not to be taken literally. It
argues that the efforts expected of the founder-members are
minimal in nature and, as a practical matter, the founders are
substantially dependent upon the management of the corporation
for a successful return on their investment. Thus the State
asserts, under the real meaning of the Howey rule, the disputed
agreements are investment contracts. D.M.C. of Colorado, Inc.
v. Hays, 3 CCH Blue Sky L. Rptr., ¶ 70,897 at 67,042 (Colo.
Dist. Ct. 2/26/71); see Florida Discount Centers, Inc. v.
Antinori, 226 So.2d 693 (Fla. Dist. Ct. App. 1969), aff'd 232
17 (Fla. 1970). We agree that the present agreements constitute
"securities" within the coverage of the Hawaii Uniform Securities
Act (Modified). We do not choose, however, to base this decision
on the restrictive formula laid down by the Supreme Court in the
The primary weakness of the Howey formula is that it has led
courts to analyse investment projects mechanically, based on a
narrow concept of investor participation.[fn3] See Gallion v.
Alabama Market Centers, Inc., supra; Emery v. So-Soft of Ohio,
Inc., supra. Thus courts become entrapped in polemics over the
meaning of the word "solely" and fail to consider the more
fundamental question whether the statutory policy of affording
broad protection to investors should be applied even to those
situations where an investor is not inactive, but participates to
a limited degree in the operation of the business.[fn4] In
fulfilling the remedial purposes of our state act, we believe a
sounder approach to securities regulation requires that courts
focus their attention on the economic realities of security
transactions: that is, "[t]he placing of capital or laying out of
money in a way intended to secure income or profit from its
employment" in an enterprise. State
v. Gopher Tire & Rubber Co., 146 Minn. 52, 56, 177 N.W. 937,
B. The Risk Capital Approach to Defining an Investment
The salient feature of securities sales is the public
solicitation of venture capital to be used in a business
enterprise. Silver Hills Country Club v. Sobieski, 55 Cal.2d 811,
815, 13 Cal.Rptr. 186, 188, 361 P.2d 906, 908 (1961);
Goodwin, Franchising in the Economy: The Franchise Agreement as
a Security Under Securities Acts, Including 10b-5
Considerations, 24 Business Lawyer 1311, 1320-21 (1969). This
subjection of the investor's money to the risks of an enterprise
over which he exercises no managerial control is the basic
economic reality of a security transaction. Coffey, The Economic
Realities of a "Security": Is There a More Meaningful Formula?,
18 W. Res. L. Rev. 367, 412 (1967); see Silver Hills Country
Club v. Sobieski, supra; see Securities & Exchange Commission
v. Latta, 250 F. Supp. 170, 173 (N.D. Cal. 1965), aff'd per
curiam, 356 F.2d 103 (9th Cir. 1965), cert. denied,
384 U.S. 940 (1966). Any formula which purports to guide courts in
determining whether a security exists should recognize this
essential reality and be broad enough to fulfill the remedial
purposes of the Securities Act. Those purposes are (1) to prevent
fraud, and (2) to protect the public against the imposition of
unsubstantial schemes by regulating the transactions by which
promoters go to the public for risk capital. HRS § 485-10(e).
Therefore, we hold that for the purposes of the Hawaii Uniform
Securities Act (Modified) an investment contract is created
(1) An offeree furnishes initial value to an offeror,
(2) a portion of this initial value is subjected to
the risks of the enterprise, and
(3) the furnishing of the initial value is induced by
the offeror's promises or representations which
give rise to a reasonable understanding that a
valuable benefit of some kind, over and above the
initial value, will accrue to the offeree as a
result of the operation of the enterprise, and
(4) the offeree does not receive the right to
exercise practical and actual control over the
managerial decisions of the enterprise.
The above test provides, we believe, the necessary broad
coverage to protect the public from the novel as well as the
conventional forms of financing enterprises. Its utility is best
demonstrated by its application to the facts in the instant case.
II. THE CONTRACTS IN QUESTION CONSTITUTE INVESTMENT CONTRACTS
WITHIN THE MEANING OF HRS § 485-1(12).
A. The Initial Value Subjected to the Risks of the
Each person who executes a "Founder-Member Purchasing Contract
Agreement" is required by Hawaii Market Center, Inc. to make a
"one-time retail purchase" of $320.00 in order to become a
distributor and $820.00 in order to become a supervisor. The
record indicates that the total wholesale cost to HMC of the
purchased merchandise is $70.00 and $140.00 respectively. The
appellants have made no attempt to characterize these
transactions as the simple purchase of merchandise, nor do we
deem them such. The terms of the offer and the inducements held
out to the prospects clearly indicate that the substantial
premiums paid by founder-members to HMC are given in
consideration for the right to receive future income from the
corporation. These overcharges constitute the offerees'
investments or contributions of initial value, such value being
subjected to the risks of the enterprise.
It is uncontested that the recruitment of founder-members was
motivated by the need to raise capital to finance the opening of
the proposed Hawaii Market Center store. Inextricably bound to
the success of this enterprise is the ability of the
founder-members to recoup their initial investment and earn
income. The recruitment fee paid to distributors and supervisors,
during the pre-operational phase of the plan, rests upon the
promoters' ability to sell the success of the plan to prospective
members. In addition, those members who choose to rely solely on
the second method of earning income, the payment of commissions
based on sales, receive no return at all on their investment
unless the store functions successfully. This latter point is
particularly important because recruitment of members increases
geometrically. Therefore, since membership is limited to five
thousand, a very large percentage of founder-members will be
totally dependent on sales commissions to recover their initial
investment plus income. It is thus apparent that the security of
the founder-members' investments is inseparable from the risks of
the enterprise. The success of the plan is the common "thread on
which everybody's beads [are] strung." Securities & Exchange
Commission v. C.M. Joiner Leasing Corp., 320 U.S. 344, 348
B. The Promise of a Valuable Return on the Offeree's
The appellants contend that because of the nature of the
receipts promised to founder-members the trial court erred in
finding the existence of a security. They stress
that founder-members do not participate in the profits of the
enterprise. They are promised fixed fees and commissions, which
are payable regardless of the existence of profits. Therefore, it
is argued, the essential profit sharing element of a security is
lacking. Commonwealth ex rel. Pennsylvania Securities
Commission v. Consumers Research Consultants, Inc., 414 Pa. 253,
256, 199 A.2d 428, 429 (1964). Once again, this argument
ignores the economic realities underlying securities regulation.
It should be irrelevant to the protective policies of the
securities laws that the inducements leading an investor to risk
his initial investment are founded on promises of fixed returns
rather than a share of profits. The reference point should be the
offeree's expectations, not the balance sheet of the offeror
corporation. The unwary investor lured by promises of fixed fees
deserves the same protection as a participant in a profit sharing
plan. For this reason courts have avoided a narrow definition of
"profits." They have recognized securities sales even where the
promised benefits to the offeree were indirect, arising from an
anticipated increase in the value of the property received,
rather than direct payments from the offeror. Securities &
Exchange Commission v. C.M. Joiner Leasing Corp., supra at
348-49; Roe v. United States, 287 F.2d 435, 439 (5th Cir.),
cert. denied, 368 U.S. 824 (1961). Thus, the fact that in the
instant case HMC guaranteed the offerees amounts of money
independent of enterprise profits does not undermine the
investment nature of the transactions.
C. The Lack of Managerial Control Over the Enterprise.
Finally, as previously stated, it is irrelevant to the remedial
purposes of the Securities Act that an investor participates in a
minor way in the operations of the enterprise.
Courts should focus on the quality of the participation. In order
to negate the finding of a security the offeree should have
practical and actual control over the managerial decisions of the
enterprise. For it is this control which gives the offeree the
opportunity to safeguard his own investment, thus obviating the
need for state intervention. Coffey, The Economic Realities of a
"Security": Is There a More Meaningful Formula?, supra at
In the present case the founder-members possess none of the
incidents of managerial control which would preclude the finding
of a security. The members have no power to influence the
utilization of the accumulated capital. Nor will they have any
authority over those decisions which will affect the operation of
the store, if it is successfully established. Judged by an
ability to protect their original investment, the offerees in
this case are powerless. Thus, under the economic realities
approach presently advocated, they properly belong to the class
of investors falling within the remedial purposes of the
Securities Act. Therefore we hold that the present agreements are
investment contracts within the meaning of the Hawaii Uniform
Securities Act (Modified) and must be registered with the
Commissioner of Securities prior to distribution.
[fn1] HRS § 485-1(12) provides:
"Security" means any note, stock, treasury stock,
bond, debenture, evidence of indebtedness,
certificate of interest or participation in any
profit-sharing agreement, collateral-trust
certificate, preorganization certificate or
subscription, transferable share, investment
contract, voting trust certificate, certificate of
deposit for a security, certificate of interest in an
oil, gas, or mining title or lease, or, in general,
any interest or instrument commonly known as a
"security," or any certificate of interest or
participation in, temporary or interim certificate
for, guarantee of, or warrant or right to subscribe
to or purchase, any of the foregoing. "Security" does
not include any insurance or endowment policy or
annuity contract under which an insurance company
promises to pay a fixed number of dollars either in a
lump sum or periodically for life or some other
[fn2] The Supreme Court in the Howey case was interpreting a
federal statute. Although the language of that statute is similar
to our own securities law, we are not, contrary to the assertions
of the appellants, bound to follow blindly the federal
interpretation. This court will construe the provisions of state
statutes "not in total disregard of federal interpretations of
identical language, but with reference to the wisdom of adopting
those interpretations for our state." State v. Texeira, 50 Haw. 138,
142 n. 2, 433 P.2d 593, 597 n. 2 (1967).
[fn3] In the Howey case the Supreme Court was faced only with
the question whether a scheme involving no actual investor
participation was an investment contract. That court has not yet
decided whether an investment plan involving non-managerial
investor participation also falls within the concept of an
investment contract security.
[fn4] For a discussion of the need to protect non-managerial
investors who participate in an enterprise see Goodwin,
Franchising in the Economy: The Franchise Agreement as a
Security Under Securities Acts, Including 10b-5 Considerations,
24 Business Lawyer 1311, 1318-19 (1969).
[fn5] This test is suggested by Professor Coffey in his excellent
article analysing the essential economic characteristics of
security transactions. Coffey, The Economic Realities of a
"Security": Is There a More Meaningful Formula?, 18 W. Res. L.
Rev. 367, 377 (1967)
David T. Robertson (Hyman M. Greenstein and Larry S.
Vines on the briefs) for defendants-appellants.
Roy M. Miyamoto, Deputy Attorney General (Bertram T.
Kanbara, Attorney General, Olen E. Leonard, Jr., Gerald Y.Y.
Chang, Deputy Attorneys General, with him on the brief) for