## Facts

- Promoters sold individuals breeding earthworms and participation in a program advertised as requiring little work and offering guaranteed success through a repurchase agreement at $2.25 per pound.
- Promotional materials represented that the promoters would handle marketing and that investors’ profitability depended on the promoters’ ability to repurchase worms at a price above market value.
- Gerald and Mary Smith purchased into the program as buyer-investors.
- The Smiths alleged the worms did not reproduce as represented and that the promised success rate was lower than advertised.
- The Smiths further alleged the repurchase price was inflated and could be sustained only by selling worms to new investors at similarly inflated prices, making profitability depend on continued recruitment rather than genuine market demand.
- The Smiths sued for rescission under federal securities law, alleging the arrangement was an unregistered security (an investment contract).
- The district court, after considering affidavits, dismissed without prejudice for lack of subject matter jurisdiction on the ground that no security was involved and later denied a Rule 60(b) motion to amend the record.

## Issues

1. Whether the earthworm-raising and repurchase arrangement constituted an investment contract, and therefore a security, under the federal securities laws.
2. Whether a ruling that no security is involved is jurisdictional or a merits disposition, and how the district court’s consideration of affidavits affected the procedural characterization.
3. Whether the district court erred in denying the plaintiffs’ Rule 60(b) motion to amend the record on appeal.

## Decision

- The Ninth Circuit reversed.
- The court treated the district court’s dismissal as summary judgment because the court considered affidavits and did not exclude them.
- The court held the transaction involved an investment contract under the Howey test and therefore involved a security.
- Because the security determination resolved the central issue, the court declined to decide the Rule 60(b) issue.
- The case was remanded for further proceedings.

## Legal Principles

- Whether an arrangement involves a “security” ordinarily goes to the merits, not subject matter jurisdiction.
- When matters outside the pleadings (such as affidavits) are considered and not excluded, a dismissal is properly treated as summary judgment.
- An investment contract exists when there is (1) an investment of money, (2) in a common enterprise, (3) with an expectation of profits to come primarily from the efforts of others.
- Courts determine whether an investment contract exists by focusing on economic reality, not the labels used by the parties.
- A program marketed as a business opportunity can be a security when investors’ profits depend mainly on the promoter’s managerial or entrepreneurial efforts, including the promoter’s marketing and ability to maintain a market for the product.

## Conclusion

The Ninth Circuit held that the earthworm-raising program, marketed as low-effort and profitable through an inflated repurchase promise dependent on the promoters’ marketing and recruitment, satisfied the Howey test and constituted an investment contract; it reversed the merits disposition for defendants and remanded.


Smith v. Gross, 604 F.2d 639 (9th Cir. 1979)