Definition Of A Security - Securities Regulation

Definition of a Security

1. Statutory definitions

   1. Securities Act § 2(a)(1) provides that "unless the context otherwise requires," the term "security" means:

      1. "any note, stock, treasury stock, security future, security-based swap, 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, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, 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, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing."

   2. Exchange Act § 3(a)(10) provides that "unless the context otherwise requires," the term "security" means:

      1. "any note, stock, treasury stock, security future, security-based swap, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a “security”; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited."

   3. Important Examples:

      1. Notes, stock, bonds, debentures, certificates of deposits, investment contracts, certificates of interest in profit sharing agreements, and interests commonly known as securities

2. Howey Test re Investment Contract

   1. "[A]n 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." SEC v. W.J. Howey Co. (pg. 23)

      • Elements: (1) Investment of money with expectation of profits, (2) common enterprise, and (3) profits solely from the efforts of the promoter or third party.

      1. In Howey, the Court noted that "all of the elements of a profit-seeking venture are present here. The investors provide the capital and share in the earnings and profits; the promoters manage, control and operate the enterprise." Howey (pg. 24)

      2. "Congress intended the application of [the securities laws] to turn on the economic realities underlying a transaction, and not on the name appended thereto. . . ." United Housing Foundation, Inc. v. Forman (pg. 30)

      3. "The touchstone is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others." United Housing Foundation, Inc. v. Forman (pg. 31)

      4. "By profits, the Court has meant either capital appreciation resulting from the development of the initial investment . . . or a participation in earnings resulting from the use of the investors' funds. . . . In such cases the investor is 'attracted solely by the prospect of a return' on his investment. . . ." United Housing Foundation, Inc. v. Forman (pg. 31)

      5. "[W]hen a purchaser is motivated by a desire to use or consume the item purchased - 'to occupy the land or to develop it themselves' as the Howey Court put it - the securities laws do not apply." United Housing Foundation, Inc. v. Forman (pg. 31)

   2. In Marine Bank v. Weaver, the Court found that the agreement involved was distinguishable from the agreement in Howey and was thus not a security because (1) the instrument was a private transaction and not offered to a number of potential investors, and (2) it wasn't the case that the instrument involved was one that would have an equivalent value to most persons and could have been traded publicly. (pg. 25)

   3. "[A]n investment scheme promising a fixed rate of return can be an 'investment contract' and thus a 'security' subject to the federal securities laws." SEC v. Edwards (pg. 37)

   4. "[T]he Howey economic reality test was designed to determine whether a particular instrument is an 'investment contract,' not whether it fits within any of the examples listed in the statutory definition of 'security.'" Landreth Timber Co. v. Landreth (pg. 46)

   5. The Meaning of a Common Enterprise

      1. SPLIT

         • Vertical Commonality: The principle inquiry here 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.

         • Theoretically, under this approach, a common enterprise even though there is only one investor.

           • SPLIT

             • Broad Vertical Commonality

               • Some courts 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. See, e.g., SEC v. ETS Payphones, Inc. (pg. 38)

             • Strict Vertical Commonality

               • Other courts 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. See, e.g., SEC v. Alliance Leasing Corp. (pp. 38-39)

         • Horizontal Commonality

           • Requires a pooling of investor funds

           • Horizontal commonality may exist when promised returns are fixed rather than variable provided there is the requisite pooling of investor funds. See, e.g., SEC v. Infinity Group Co. (pg. 39)

           • This approach emphasizes the common enterprise among investors rather than the common enterprise between a promoter and investors

   6. Profits from the Managerial Efforts of Others

      1. With respect to the phrase "profits solely from the efforts of the promoter or a third party," the Ninth Circuit has held that "the word 'solely' should not be read as a strict or literal limitation on the definition of an investment contract, but rather must be construed realistically, so as to include within the definition those schemes which involve in substance, if not form, securities." SEC v. Glenn W. Turner Enterprises (pg. 31)

      2. The critical inquiry os "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." SEC v. Glenn W. Turner Enterprises (pg. 41)

         • Most lower courts have followed this approach.

      3. Where investors are attempting to use the sword of the federal securities laws, they generally fare poorly when attacking traditional types of franchise or distributorship arrangements. See, e.g., Crowley v. Montgomery Ward & Co. (concluding that the "economic reality is that the contributions of the franchisees significantly and substantially affect the profits expected from the enterprise" and thus holding that the franchises did not involve investment contracts)

3. Alternative "Risk Capital" Test (used by many state courts)

   1. In Silver Hills Country Club v. Sobieski, where the country club developers had financed improvements through the sale of club membership, the court concluded that the memberships were securities because "[p]etitioners are soliciting the risk capital with which to develop a business for profit. . . . Only because he risks his capital along with other purchasers can there be any chance that the benefits of club membership will materialize." (pg. 27)

   2. As to risk, a security will not exist under the risk capital test unless capital provided by investors is at substantial risk. The existence of collateralization or other security may negate the possibility that a transaction involves a security.

   3. As to capital, it is clear that the term capital is not used in the narrow accounting sense to distinguish loans from equity contributions but...