Trivectra v. Ushijima

Citations: 144 P.3d 1; 112 Haw. 90; 2006 Haw. LEXIS 479Docket: 25312

Court: Hawaii Supreme Court; September 11, 2006; Hawaii; State Supreme Court

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In the case of TriVectra, Inc. v. Ryan S. Ushijima, the Supreme Court of Hawai`i addressed an appeal from TriVectra, Inc. and its representatives, Curtis N. Gushi and Donovan D. Oda, contesting a judgment affirming the Commissioner of Securities' order that they cease securities transactions until compliance with the Uniform Securities Act (HRS ch. 485). The Commissioner determined that the Appellants had created investment contracts, leading to violations of the law. The order required them to provide customers with a rescission option and imposed a $100,000 fine.

On appeal, the Appellants raised several arguments: they claimed the Commissioner's interpretation of their activities as investment contracts was erroneous; that the findings and conclusions leading to the violations were incorrect; that they were denied the opportunity to respond to findings of fact and conclusions of law, violating their statutory rights; that the delay in issuing the final order infringed their right to timely decisions; and that the fine was arbitrary and an abuse of discretion.

The Supreme Court, after reviewing the arguments, found them meritless and upheld the circuit court's judgment. The background of the case involved the Appellants operating an internet business selling online shopping malls, which allowed users to host customized websites linked to major retailers. However, the Commissioner found that Oda, who had registered as an affiliate with Linkshare Corporation, lacked the authority to sublicense the retailer links, further supporting the conclusions of the Commissioner.

The agreement allowed mall owners to earn income through two primary avenues: (1) commissions from online merchants when third parties purchased via their website links, and (2) recruiting others to buy Online Store Memberships (OSMs). The Appellants sold OSMs at training meetings and through TriVectra's website, reportedly selling 300 to 400 OSMs by early 2000. However, participants indicated that recruitment was emphasized over generating sales commissions. Up to February 23, 2000, total purchases through OSMs amounted to only $154.43, yielding a mere $6.25 in commissions.

Compensation for recruiting new mall owners was structured through a multitiered program, promising substantial returns based on the recruitment of many new investors, as illustrated in TriVectra's marketing materials. The Appellants claimed that of a $79 fee, approximately $30 was allocated to technical support and $50 to commissions for those selling additional OSMs.

After an investigation by the DCCA, a Preliminary Cease and Desist Order (CDO) was issued against the Appellants. A hearing took place in December 2000, where OSM member Lori-Ann Navares testified that she was encouraged to focus on selling OSMs rather than earning commissions from operating them. She recounted purchasing ten OSMs for $600 and later paying $3,500 for at least forty OSMs based on a promise from a TriVectra representative to find buyers for them, although the expected number of buyers was not met. Despite the Appellants’ assertions that purchasing an OSM was not necessary to earn commissions, Navares testified that one could not earn commissions solely through recruitment without purchasing an OSM.

Marshall inquires about the necessity of purchasing access to the mall website, to which Navares confirms that it was required. During the DCCA hearing, allegations arose that the Appellants engaged in fraud under HRS ch. 485. The Appellees claimed TriVectra obtained OSM marketing links from Linkshare at no cost and alleged Oda's assignment of these links to members breached his agreement with Linkshare. The Appellants acknowledged that the OSM service was indeed available for free from Linkshare and that they failed to inform members of this fact. Oda countered that while the software was free, TriVectra provided essential technical expertise for website development.

The Appellants disputed claims that Oda violated his agreement by assigning subaffiliate links, presenting evidence from Linkshare’s General Counsel, Miriam Gadden. She testified that Linkshare had no record of permitting Oda more than one affiliate membership and that hosting 300-400 members under his account would violate their terms. However, she conceded that affiliates in Linkshare's Signature Program could have multiple subaffiliates, yet stated there was no written agreement with Oda for his participation in that program.

The Appellants introduced evidence showing Oda's application for the Signature Program and indications of approval from Linkshare. They also referenced internal Linkshare communications indicating TriVectra operated under the Signature Program. Gadden, however, did not agree that this established a legal agreement and refused to analyze a report (Exhibit B) presented by the Appellants, which listed numerous member ID numbers. She clarified that member ID numbers could simply indicate affiliate IDs and not necessarily subaffiliate status, emphasizing the importance of prefixes in understanding the IDs. The dialogue underscored the complexity of the membership status and the conditions under which Linkshare operated.

If an affiliate has sub-affiliates, it will possess additional identification numbers for those sub-affiliates, referred to as "Subaffiliate Identification" or "Sub ID Number." There are no prefixes to the member ID numbers in Exhibit B. To support claims of violations under HRS chapter 485 by the Appellants, the Appellees submitted an affidavit from Henry Tanji, indicating that neither Gushi nor Oda was registered as securities dealers, nor was TriVectra's OSM marketing program or its advertising materials registered as securities with the DCCA. On January 10, 2001, Marshall issued findings of fact (FOFs), conclusions of law (COLs), and a recommended order to dissolve a prior order and dismiss the case, determining that the Appellees did not prove that the Appellants offered or sold "investment contracts" or "securities." Marshall found that the $79 subscription fee was for a product rather than an investment. 

On January 26, 2001, DCCA filed exceptions to the recommended order, while TriVectra supported it and requested oral argument. Following oral arguments on April 27, 2001, the commissioner issued a final order on February 14, 2002, modifying FOFs and COLs, concluding that the Appellants' program constituted the sale of securities. The commissioner found that $49 of the $79 fee was investment value, satisfying the first prong of the Hawaii Mkt. Ctr. test, leading to violations of multiple sections of HRS chapter 485. The final order mandated the Appellants to cease all securities activities until compliant with HRS chapter 485, allowed rescission of contracts by Hawaii residents, and imposed a $100,000 fine. The Appellants appealed on March 28, 2002, and the circuit court affirmed the commissioner's order on August 27, 2002. The Appellants filed a notice of appeal to this court on September 10, 2002. The review of the circuit court's decision follows standards outlined in HRS 91-14(g), assessing the validity of the agency's decision.

HRS 91-14 outlines the standards for judicial review of contested cases, allowing courts to affirm, remand, reverse, or modify agency decisions if substantial rights of petitioners are prejudiced due to various factors, including violations of law, excess authority, unlawful procedures, errors of law, clearly erroneous findings, or arbitrary actions. Specifically, under HRS 91-14(g), conclusions of law (COLs) are reviewable for constitutional or statutory violations, procedural defects, findings of fact (FOFs), and agency discretion. A finding or mixed determination is deemed clearly erroneous if it lacks substantial evidence or if the appellate court is firmly convinced a mistake occurred. "Substantial evidence" is defined as credible evidence that can support a reasonable conclusion.

In this case, the circuit court upheld the commissioner’s COL that the Appellants were engaged in selling securities. The court applied a four-pronged test from Hawaii Mkt. Ctr. to determine if a transaction constituted an investment contract under HRS chapter 485. The test requires that an offeree provides initial value, faces risk, is induced by the offeror's promises, and lacks control over managerial decisions. The Appellants challenged the commissioner's classification of TriVectra's product as an investment contract, arguing that the commissioner erred in determining that $49 of the $79 fee was used for commissions and in defining that amount as "initial value" per the first prong of the investment contract test.

The Appellants argue that the $79.00 fee for the OSM website from TriVectra represents a fair market price and should be classified as "profit" rather than "initial value" associated with an investment contract. They contend that if the fee exceeds operating costs, it should be viewed as disposable profit for TriVectra, not as an initial value under HRS ch. 485, which regulates securities. The crux of the argument lies in the purchaser's expectation that their payment grants them the right to future income from the company. The Appellants assert that purchasing an OSM was not necessary to earn commissions from selling OSMs to others, suggesting any excess fee beyond operating costs is profit.

Contrarily, evidence indicates that OSM ownership was indeed required for members to receive commissions from sales. TriVectra's marketing materials outline that commissions are a benefit for mall owners, who can earn income through direct sales and by sponsoring others to open OSMs. Testimony from a DCCA investigator and a member confirms that the Appellants never denied that OSM ownership was essential for earning commissions. Consequently, the commissioner concluded that any profit beyond operational costs was, in fact, initial value provided in exchange for the right to future income.

Additionally, the commissioner determined that $49.00 of the $79.00 fee constituted initial value. The Appellants claimed the fee reflected a fair market price and thus lacked excess initial value; however, the commissioner found that the actual operating cost was about $30.00, with the surplus used to pay commissions. The determination of initial value does not involve comparing fair market prices but rather assessing the wholesale price against the amount paid by the participant.

Appellants acknowledged that the OSM service offered to customers was available from Linkshare at no cost. However, Oda claimed that significant expertise was necessary to utilize the Linkshare software effectively. Despite TriVectra's technical contributions, the commissioner correctly determined that at least $49.00 was provided in consideration for future income rights, as the Appellants admitted this amount was allocated for OSM commissions. This finding aligned with the first prong of the Hawaii Mkt. Ctr. test.

Regarding the second prong, which assesses whether initial value is subject to the risks of the enterprise, the Appellants argued that since TriVectra was fully capitalized, member contributions were not at risk. Yet, the Hawaii Mkt. Ctr. ruling clarified that the classification of a product as a "security" does not depend on the business's capitalization status. Instead, it focuses on the economic realities of transactions, specifically the investor's risk when capital is placed in a venture over which they have no managerial control.

The court emphasized that a fully funded business could still issue investment contracts or securities to raise capital. Consequently, under the second prong, an investment contract is established if the capital contributed by investors is at risk of loss should the business fail. In TriVectra's case, members had to make an initial payment to participate in the OSM commission program, and while they needed to make sales to earn commissions, this initial investment converted them from typical sales representatives into equity holders. Their potential returns were contingent upon TriVectra's ability to sustain operations and fulfill commission obligations. Therefore, the commissioner was justified in concluding that these initial investments were indeed subject to the enterprise's risks.

The circuit court's affirmation of the commissioner's determination that the Appellants' product qualified as a "security" under HRS ch. 485 was correct.

The Appellants have not disputed the commissioner's findings regarding the last two prongs of the Hawaii Market Center test, which confirmed that members were attracted by promises of substantial future returns and lacked control over TriVectra's operations. Consequently, since the initial two prongs of the test were satisfied, the circuit court properly upheld the commissioner's conclusion that TriVectra's program constituted an investment contract and therefore a "security" under HRS 485-1(13). 

The circuit court also correctly affirmed that the Appellants violated specific provisions of HRS chapter 485. Under HRS 485-8, which prohibits the sale of unregistered securities, the Appellants admitted to selling 300 to 400 unregistered OSMs and did not claim any statutory exemptions. DCCA confirmed no registration records for the OSM product, leading to the conclusion that TriVectra violated HRS 485-8.

Regarding HRS 485-14, which requires registration for dealers or salespersons, the Appellants acknowledged their lack of registration while engaging in marketing TriVectra's product classified as a security under the Hawaii Market Center test. Thus, the circuit court rightly affirmed the commissioner's finding of a violation of HRS 485-14.

On HRS 485-25, a distinction is made regarding the requirement of scienter. The commissioner found the Appellants violated HRS 485-25(a)(1), which requires a showing of scienter, and noted that recklessness suffices for liability. However, the commissioner did not address scienter in findings related to HRS 485-25(a)(2) and (a)(3). Although there is no specific Hawai`i case law on this, parallels can be drawn from federal law, where the Supreme Court mandates scienter for certain securities violations under sections 10(b) and 17(a)(1) while not requiring it for sections 17(a)(2) and (a)(3), which focus on the conduct's effect rather than the actor's intent.

Analyzing the provisions of the 1933 Act and the 1934 Act, the Court has determined that while scienter is required for securities violations under HRS 485-25(a)(1), the requirements vary for HRS 485-25(a)(2) and (a)(3). Specifically, HRS 485-25(a)(2) does not require scienter if based on section 17(a), but does require it if based on section 10(b) and Rule 10b-5 due to the "manipulative or deceptive" language involved. The Uniform Securities Act, adopted by Hawai`i in 1957, mirrors the language of Rule 10b-5 and section 17(a), but its ambiguity complicates whether HRS 485-25's subsections derive from the 1933 Act or the 1934 Act. Courts can interpret ambiguous statutes using legislative history, the law's intent, and related laws. Judicial interpretations from other states, such as Kansas, Minnesota, Nevada, New Mexico, and Utah, support the view that HRS 485-25(a)(2) does not require intent to establish a violation. Certain cases affirm that like provisions in other jurisdictions align with the notion that no scienter is necessary for violations similar to HRS 485-25(a)(2). Conversely, HRS 485-25(a)(1) may still require scienter based on precedent.

In a civil enforcement action concerning HRS 485-25(a), it is established that a state of mind of at least recklessness must be demonstrated to prove a violation of HRS 485-25(a)(1). However, such a state of mind is not necessary for establishing violations under HRS 485-25(a)(2) or (a)(3). This interpretation aligns with the legislative history of HRS chapter 485, which seeks to harmonize Hawaii's securities laws with other states and federal law. The commissioner's findings indicated that the Appellants violated HRS 485-25(a)(1) by: (1) inducing Navares to pay Gushi for assistance in finding new buyers for securities; and (2) failing to disclose that TriVectra was using unauthorized software. The commissioner concluded that Gushi's assurance to Navares regarding buyer recruitment for $3,500 was recklessly made, relying on circumstantial evidence due to the challenges of proving intent directly. The circuit court upheld this finding, affirming the commissioner's conclusion of a reckless misrepresentation in connection with the sale of securities.

Appellants failed to disclose Linkshare's role in TriVectra's operations, leading the commissioner to find a violation of HRS 485-25(1). TriVectra did not inform potential buyers that the software it used was free from Linkshare and could have been obtained directly, demonstrating reckless disregard for the truth. Although Appellants dispute the fraudulent characterization of TriVectra's activities, asserting that confidentiality in business plans is lawful, the evidence suggests some level of approval from Linkshare for TriVectra's operations. Oda presented correspondence indicating imminent approval under Linkshare's Signature Program, and Linkshare's CIO acknowledged its operation of Oda's account. However, no written agreement confirming TriVectra's membership in the Signature Program was produced, nor could the identification numbers associated with TriVectra be conclusively linked as subaffiliate numbers. Linkshare's general counsel reported the absence of such an agreement. While some evidence indicated that TriVectra added value to Linkshare's free service through additional support, the essential product, the OSM, relied entirely on Linkshare's offerings. The Appellants did not disclose the free alternative to customers and failed to justify the value of their services adequately. Based on these findings, the circuit court affirmed the commissioner's determination that the Appellants violated HRS 485-25(a)(1) and (2), which prohibits making untrue statements or omitting material facts in connection with securities transactions.

The commissioner determined that TriVectra's failure to disclose its sourcing of OSM software from Linkshare, which was done free of charge and in violation of their agreement, constituted a material omission significant to reasonable investors. This conclusion was supported by the precedent set in Basic v. Levinson. Key points include: 

1. TriVectra was marketing a security under HRS ch. 485.
2. Gushi and Oda did not inform customers about the cost-free nature of Linkshare's services, which were publicly available, and that TriVectra's actions were against its agreement with Linkshare.
3. The omission was deemed a violation of HRS 485-25(a)(2), as it represented a material fact that investors would find important.

Additionally, the commissioner found violations under HRS 485-25(a)(3), which prohibits acts that could deceive investors. The deceptive practice involved withholding information about the free nature of Linkshare's software and the limited relationship with Linkshare. 

Under HRS 485-25(a)(7), the commissioner ruled that the Appellants published marketing materials without prior filing or exemption, confirming another violation. Lastly, the commissioner acted within his authority by modifying the recommended order without further hearings, having reviewed all relevant evidence and arguments presented. The decision to modify was deemed appropriate and consistent with statutory requirements.

HRS § 91-11 mandates an additional evidentiary hearing only when decision-making officials have not fully considered all evidence in a contested case. In the current case, the commissioner reviewed all evidence and the Appellants did not introduce any new evidence that was overlooked. Consequently, the commissioner did not violate HRS § 91-11 by not allowing the Appellants to reiterate previous arguments while modifying or reversing the recommended order under HAR § 16-201-46.

Regarding the $100,000 fine, the Appellants argued it was arbitrary and capricious, constituting an abuse of discretion. An abuse of discretion is defined as a decision that exceeds reasonable bounds or disregards legal principles. While the commissioner acknowledged that the Appellants acted cooperatively and did not find malicious intent, the marketing claims made by the Appellants misled individuals about potential earnings, requiring unrealistic recruitment numbers. Despite only minimal commissions being generated, the fine was deemed reasonable and justified based on the evidence presented, as the commissioner did not exceed legal boundaries in imposing it.

Lastly, the issuance of the final order was deemed to be within a "reasonable time" as per HRS § 91-12 and HRS § 485-18.7. Although there was a nine-month delay between hearings and the final order, the Appellants contended this was excessive and contrary to legislative intent for prompt resolution. However, the timeline of events, including the initial recommended order and subsequent oral arguments, supports the conclusion that the delay did not violate statutory requirements for timely disposition.

The parties assert that the continued enforcement of the Cease and Desist Order (CDO) until a final order is issued causes unreasonable and irreparable harm to businesses that may ultimately be found innocent of violations. They reference HRS 485-18.7(b), which mandates scheduling an initial hearing within fifteen days of a request related to the CDO, and HRS 485-18.7(c), which states that the commissioner must issue a final order but does not specify a timeframe for doing so. HRS 91-12 requires the commissioner to notify parties of a final order within a reasonable time after it is issued, but it is silent regarding the timeline for issuing that final order. Despite this silence, the court has applied a "reasonable time" standard in previous cases, such as Paul's Elec. Serv. Inc. v. Befitel, where a two-and-a-half-year delay by the Department of Labor and Industrial Relations was deemed unreasonable due to a lack of justification for the delay.

In this case, although a nine-month wait between the oral argument and the final order is considerable, the commissioner adhered to all procedural requirements and there is no evidence that the delay resulted from an unjustified agency decision. The court concluded that the nine-month timeframe did not constitute an abuse of discretion or unlawful procedure, affirming the circuit court's judgment. A concurring and dissenting opinion by Justice Acoba, while assuming that certain statutory provisions do not require a scienter element, acknowledges the majority's reliance on federal case law in interpreting state statutes.

The case involves a remand to the Circuit Court of the First Circuit to assess the presence or absence of scienter among the Respondents-Appellants—TriVectra, Inc., Curtis N. Gushi, and Donovan D. Oda—in relation to the imposition of a maximum civil penalty of $100,000 under HRS 485-20.5(a). The Commissioner of Securities, Ryan S. Ushijima, imposed this fine without considering scienter as a mitigating factor, despite the majority opinion noting that HRS 485-25(a)(2) and (a)(3) align with the Securities Act of 1933, where scienter is not a required element but can influence relief decisions. The Appellants argued that the fine was arbitrary and capricious. The majority acknowledged that the Commissioner did not find malicious or willful intent from the Appellants. Therefore, the remand is deemed appropriate for the Commissioner to evaluate scienter in relation to the fine's assessment, as it should be a relevant factor in determining the appropriateness of the penalty.

HRS 485-18.7 mandates that upon issuing a cease and desist order, the commissioner must notify the respondent of the order and the reasons for it. The respondent can request a hearing within thirty days, which will occur within fifteen business days unless extended by the commissioner. The cease and desist order remains effective during the hearing unless altered by the commissioner, and any penalties will only apply after a final order is issued. Following the hearing, the commissioner will issue a final order that may affirm, vacate, or modify the initial order.

Linkshare's Signature Program allows affiliates to direct commissions to charities or third parties with Linkshare's approval. The commissioner found that Oda did not register for this program, and TriVectra violated its agreement by subleasing Oda's account. This finding was upheld upon review, indicating no clear error by the commissioner.

HAR 16-201-46 stipulates that if timely exceptions are filed and a party requests oral argument, all parties must have the opportunity to present their cases. The authority will consider the entire record and issue a written decision that may adopt, modify, or reverse the hearings officer's recommendation.

HRS 485-8 states that selling or offering securities in the state is unlawful unless the security is exempt or registered. HRS 485-14(a) makes it illegal for individuals to operate as dealers or salespersons without registration. Amendments to HRS 485-14 from 2000 to 2004 are noted but are immaterial to the current case.

HRS 485-25(a) prohibits fraudulent actions in relation to the offer, sale, or purchase of securities, including using deceptive practices, making false statements, or engaging in actions that would defraud others.

Advertising materials must be filed with the commissioner’s office before publication, unless exempted by the commissioner. HRS 485-1(13) defines a security as an investment contract, with amendments made in 1998, 2000, 2003, and 2004 that do not impact the current issue. HRS 485-1(2) defines "salesperson" as any individual representing a dealer or issuer in selling securities, while HRS 485-1(3) defines a "dealer" as a person involved in transactions of securities for their account. The commissioner concluded that the Appellants, by selling a security, acted as either a dealer or salesperson, supporting a violation of HRS 485-14, a conclusion the Appellants did not contest on appeal. Relevant legislative amendments to HRS 485-1 in 2000 and 2003 are noted but deemed immaterial. 

Federal regulations (17 C.F.R. 240.10b-5) prohibit any fraudulent schemes or misstatements in the sale of securities, mirroring the provisions of HRS 485-25(a). Additionally, 15 U.S.C. 77q makes it unlawful to use deceptive practices in securities sales, and 15 U.S.C. 78j addresses unlawful actions using interstate commerce or mail in the purchase or sale of securities.

Manipulative or deceptive practices in violation of SEC regulations are prohibited in the interests of public protection and investor safety. The Ninth Circuit Court has established that "knowing or reckless conduct" suffices to prove a violation of section 17(a)(1), a conclusion supported by other federal courts. This standard aligns with the interpretation of scienter under Rule 10b-5, where recklessness is deemed adequate for establishing violations. Section 101 of the Uniform Securities Act states it is unlawful for any person to employ deceitful devices in connection with securities transactions, including making untrue statements or omissions of material facts. The court refrains from addressing whether scienter is necessary in private claims under HRS 485-20, referencing a related case that required plaintiffs to establish scienter and reliance for damages, viewing HRS 485-25(a)(2) as a fraud statute linked to Rule 10b-5. The recent USA 2002 legislation indicates that no culpability needs to be proven in civil actions. HRS 485-20.5(a) allows the commissioner to seek civil penalties for violations, capped at $100,000 per offense, with penalties for repeat offenses specified under HRS 104-24. The interpretation of HRS 485-25(a)(2) and (3) remains subject to legal debate.

Provisions in HRS 485-25(a) are interpreted to include a scienter requirement, as the language aligns with the common law definition of fraud, which involves a false representation intended to deceive another to their legal detriment. Specifically, HRS 485-25(a)(3) explicitly mentions "fraud or deceit," indicating an intent to defraud must be present. Legislative history supports that the objective of these provisions is to combat securities fraud. Furthermore, the principle of strict liability should not be readily inferred from statutes, as noted in case law. However, the issue of whether scienter applies to HRS 485-25(a)(2) and (3) was not raised by the Appellants and thus remains unexamined. The U.S. Supreme Court defines "scienter" as a mental state involving intent to deceive, manipulate, or defraud.