DEFINITION OF SECURITY

Investment contract - Howey Test

1. SA 2(a)(1) of ’33 Act

   1. "Security" means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, investment contract… any interest or instrument commonly known as a "security” . .

2. Howey Test: “An investment contract for purposes of the Securities Act means a contract, transaction, or scheme whereby 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, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise”

   1. Investment of money

      1. One must invest with money in the hope of receiving profits from the efforts of others, and must not be purchasing a commodity for personal consumption or living quarters for personal use

   2. Common enterprise

      1. Vertical commonality: emphasizes the relationship between the investors and the promoter; principal inquiry is whether the activities of the promoter are the controlling factor in the success or failure of the investment, and a common enterprise may exist even though there is no pooling of investors’ funds or interests

         1. Broad vertical commonality: look to the uniformity of the impact of the promoter and require only a connection between the efforts of the promoter and the collective successes or losses of the investors

         2. Strict vertical commonality: require a direct relationship between the success (as opposed to the efforts) of the promoter and that of the investors. This requires the promoters and investors to share the risks of a venture

         3. Under either approach to vertical commonality, a common enterprise arguably may exist even if there is only a single investor

      2. Horizontal commonality: requires a pooling of investors’ funds

         1. Typically will involve a pro rata distribution of profits or sharing of losses among investors

         2. Not present if there is a single investor

         3. In contrast to vertical commonality, this approach emphasizes the common enterprise among investors, rather than the common enterprise between a promoter and investors

      3. Howey doesn’t endorse one form of commonality (horizontal or vertical) over another

   3. Expect profits

      1. Must be motivated by profits. Profits refer to either capital appreciation resulting from the development of the initial investment, or a participation in earnings resulting from the use of investors’ funds

         1. By contrast, when a purchaser is motivated by a desire to use or consume the item purchased – such as low cost housing – no security exists

   4. From the efforts of others

      1. The critical inquiry is whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise

      2. An investment contract may exist even though there is some investor participation in a venture

         1. Don’t have to rely “solely” on efforts of others

3. There is no reason to distinguish between promises of fixed returns and promises of variable returns for purposes of the test

   1. An investment scheme promising a fixed rate of return can be an “investment contract”

4. Problems

   1. Gold coins are not securities

      1. If the value goes up, it’s because of the market for gold not because of efforts of others

   2. Limited edition Jaguar - problem 2-1 p. 41

      1. Can be security

      2. Efforts of others: promotion of Jaguar, design can affect value of the car

5. Risk capital test

   1. many states define investments contracts under a risk capital analysis

   2. A security will not exist unless capital provided by investors is at substantial risk

   3. Silver Hills Country Club case: membership of country club is security

6. The private nature of a transaction does not mean it’s not a security

   1. Why would we need a private offering exemption if private offerings could not be securities?

“Stock,” Partnerships and LLCs as Securities

7. Characteristics usually associated with common stock: (1) the right to receive dividends contingent upon an apportionment of profits; (2) negotiability; (3) the ability to be pledged or hypothecated; (4) the conferring of voting rights in proportion to the number of shares owned; and (5) the capacity to appreciate in value

   1. Look to the economic reality of the instrument, not the label

8. Partnerships

   1. A general partnership or joint venture interest [less likely to be security] can be designated a security if the investor can establish that (1) an agreement among the parties leaves so little power in the hands of the partner or venture that the agreement in fact distributes power as would a limited partnership; or (2) the partner or venture is so inexperienced and unknowledgeable in business affairs that he is...

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