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Despite a federal appeals court ruling to the contrary, a state judge in Buffalo has determined that the sale and leaseback of pay telephones to investors was the sale of securities and is regulated by New York’s Martin Act. Justice Joseph G. Makowski, ruling last month in State of New York v. Todd J. Justin, denied motions for summary judgment seeking dismissal of Attorney General Eliot Spitzer’s complaint against Alan Justin Sr. and his sons, Todd Justin, Alan Justin Jr., Eric Justin and Patrick Justin, and securities and insurance salespeople affiliated with them who sold pay phones to 667 western New Yorkers, primarily senior citizens. Some $18.5 million was invested by the New Yorkers between 1998 and 2000 when ETS Payphones Inc. filed for bankruptcy. The Securities and Exchange Commission maintained in a separate suit against ETS that its founder, Charles E. Edwards, raised more than $300 million from more than 10,000 investors across the country. The Justins and their employees sold the pay phones in $7,000 units. The investors did not take possession of the coin-operated phones. They leased them back to ETS, and the company agreed to maintain and operate the phones and make monthly payments to the investors of $82 per telephone. The Justin defendants sought dismissal of the attorney general’s complaint on the basis of last year’s ruling by the 11th U.S. Circuit Court of Appeals in Securities & Exchange Commission v. ETS Payphones Inc., a case the U.S. Supreme Court agreed this spring to hear. The 11th Circuit reversed a district court in Georgia and ruled that the ETS sales of telephones was not a security under federal law, nor did the sales constitute a “Ponzi” scheme. Justice Makowski, noting that other state courts and state securities regulators have determined that ETS investments were securities, pointed out that what is deemed a security under New York’s Martin Act will not necessarily be deemed a security under the federal statutes. He disagreed with the 11th Circuit’s conclusion that the ETS investments were not investment contracts. Applying a 1946 Supreme Court test in SEC v. Howey, to determine whether a contract was an investment contract, Justice Makowski rejected the Justin defendants’ contention that the initial purchase of the telephone and then its lease were separate transactions. “[A]lthough investors allegedly ‘owned’ a telephone, a ‘location’ for that phone and the use of telephone wires, the ‘ownership’ piece was as in Howey (which dealt with portions of a citrus grove), merely a ‘convenient method of determining the investors’ allocable shares of the profits,’ while the transfer of ‘ownership’ of the phones, in this case, or the shares of the orange grove in Howey, was ‘purely incidental,’” the judge wrote. The second test under Howey — whether the investors were involved in a common enterprise — was also satisfied, he said. “[T]here was a direct nexus between the efforts of ETS and the ‘fortunes’ of the investors. “Whether the investor received his or her ‘guaranteed’ monthly payments depended entirely upon the efforts of ETS in servicing and maintaining the phones. The investor was entirely passive,” Makowski added. The 11th Circuit found that the third Howey criterion was missing: that the investors must have had a reasonable expectation of ‘profits to be derived solely’ from the efforts of ETS. The fixed lease payments, $82 a month per phone, were neither capital appreciation nor participation in earnings by the investor, the 11th Circuit said. INTERPRETATION REJECTED But Justice Makowski rejected that interpretation. “Holders of stocks and bonds, for example, are entitled by contract to interest or dividends; that fact does not prevent those instruments from being securities. Merely because investors were promised a specific return each month should not remove the program from the scrutiny of state regulators. Clearly, the ‘guarantee’ of a 14 percent return on investment [the $82 monthly payment] was the very promise that ‘guaranteed’ the resulting bankruptcy of ETS and the concomitant losses to investors,” he said. The ETS program was an investment contract and a security for purposes of the Martin Act, the judge concluded. Assistant Attorney General Dennis Rosen in Buffalo appeared for Spitzer. Frank T. Gaglione of Hiscock & Barclay in Amherst was counsel for the Justin defendants. Luigi Spadafora of Winget, Spadafora & Schwartzberg appeared for defendant Financial Network Investment Corp.

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