SECURITIES REGULATION Fall 2013 – Steinberg
Definition of a “Security”
Securities Act of 1933 § 2(a): Unless the context otherwise requires, (1) the term “security” means 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 . . . or, in general, any interest or instrument commonly known as a “security.”
I. Investment Contract
a. SEC v. Howey (SCOTUS) (p37)
i. The Aggregation Approach – looking beyond a strict statutory construction and examining the economic reality of the transaction to determine whether a property interest combined with some for of service contract constitutes a security
ii. Howey Test: An investment contract means a contract, transaction, or scheme whereby there is an:
1. Investment of Money
2. In a Common Enterprise
3. Expectation of Profits
4. Solely From the Efforts of the Promoter or Third Party
b. Investment of Money – Usually money, though it’s not necessary (baseball card example)
c. Common Enterprise
i. Horizontal Commonality – Investor + Other Investors
1. Look to the relationships that exist between an individual investor and the pool of other investors
2. A pooling of the interests of the investors is essential to finding the existence of an horizontal commonality
a. Must be some relationship which ties the fortunes of each investor to the success of the overall venture
3. All courts hold this sufficient to meet Howey
ii. Vertical Commonality – Promotor + Investors
1. Two definitions
a. Restrictive – exists where the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment or third parties (direct relation between success and failure of the promoter and that of his investors) (e.g., Howie, the greater the profit from oranges, the greater the profit of both investor and promoter)
i. If the a financial advisor’s fee structure includes him getting a % of the portfolio’s appreciation, rather than just a flat fee
b. Broad – evidence by the fact that the fortunes of all investors are inextricably tied to the efficacy of the promoter’s efforts
i. Merely requires a link between the fortunes of the investors and the effort of the promoters
ii. Example, flat fee for financial advisor
2. Disagreement whether this satisfies the Howey element
d. Expectation of Profits
i. SEC v. Edwards (2004 SCOTUS) (p43)
1. Facts: People would connect payphones, and then enter a service K. The investors got a return (14% a year) for 5 years, and then there’s a buy-back agreement at the end of the 5 years (almost like a bond)
2. Holding: “Profits” means financial return on investment. There is no distinction between promises of fixed returns and promises of variable returns
3. Includes dividends, other periodic payments, or the increased value of the investment
4. In Froman (see below), the court stated that “[b]y profits, the court has meant either capital appreciation resulting from the development of the initial investment or a participation in earning resulting from the use of investor funds
a. In Edwards, the court ruled that this list had been misinterpreted as exclusive
ii. A security does not exist when the purpose is to consume the “investment”
e. Solely From the Efforts of the Promoter or Third Party
i. Steinberg: The issue is whether the essential managerial or entrepreneurial efforts are those of a promoter or third party rather than the investor themselves. If the investor has meaningfully participated in the management of the venture in which it has invested such that it has more than minimal control over the investment’s performance, it does not meet the solely for efforts of other test.
ii. Continental Marketing Corp. v. SEC (1967 10th Cir.) (p41)
1. Facts: Domestic Beaver Industry – everyone bought service contracts to be performed by affiliates of the promoter (and not promoter itself)
2. Holding: As long as efforts are by third parties, it’s “efforts by others.”
a. The ownership or control by the promoter over the third person is not essential to an investment contract
f. Business Entities or Ventures
i. Limited Partnership
1. Sum: Interests in an LP are generally securities because Limited Partners ordinarily rely on the General Partners to exercise the essential managerial efforts. However, in situations where limited partners have the capability to exert meaningful managerial or entrepreneurial efforts (RUPA 303(b) safeguard), the Howey investment contact test may not be met
2. Key Point: It will be an ad hoc analysis of the pship agreement and the individual partners’ actions
a. See Problem B page 36: Doolittle has not purchased a security, but Biddle and Frank have
b. Gordon v. Terry – LPs had explicit voting power on whether or not pieces of land should be sold and at what time, and thus failed the Howey test.
ii. General Partnership
1. Because general partnerships do not possess the same restrictions on participation in management as limited partnership interests, they usually fail to satisfy the Howey “from the efforts of others” test
2. But see Williamson v. Tucker (5th)
a. A general partnership or joint venture interest can be designated a security if the investor can establish, for example, that:
i. Limited Power: (1) an agreement among the parties leaves so little power in the hands of the partner or venture that the arrangement in fact distributes power as would a limited partnership; or
ii. Limited Knowledge: (2) the partner or venture is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers; or
iii. Dependence: (3) the partner or venture is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers
3. Majority of courts use this rule, but some courts reject this because the possibility of self-serving testimony under prong 2, and just use pship agreement
iii. Limited Liability Partnership
1. Could be deemed IC depending upon the circumstances, but due to more limited liability exposure, LLP partners are more likely to be passive investors, and thus have a security interest
iv. Limited Liability Company
1. Fact intensive inquiry
2. Can be either member-managed, or managed by a board of managers
a. Manger-Managed – courts treat like a partnership – e.g., the managers are like general partners, while the members are like limited partners, so more likely to be security (unless meaningful managerial/entrepreneurial control)
b. Member-managed – courts treat like a GP (and then you apply the Williamson Test)
3. Because of the limited liability, some courts don’t apply the Williamson factors, and thus have no presumption against the interest being an investment contract, because the LLC members have limited liability
v. Franchises
1. Generally held not to constitute investment contracts
a. Pursuant to franchise agreements, the franchisee generally exerts substantial efforts
b. But if franchisee does not exert control, investment contract
c. Moreover, where a franchise agreement is really a pyramid scheme, in which profits are sought from the sale of other franchises through the main efforts of the promoter and/or third parties, an investment contract normally will be recognized
vi. Condominiums
1. When a condo is sold with the emphasis on the profit to be gained from renting the condo out, then courts often view it as an investment contract
2. SEC Position: Securities Act Release No. 5347 (1973) – the offering of a condo in conjunction with any of the following is a security (nonexclusive):
a. The condo, with any rental arrangement or other similar service, are offered and sold with emphasis on the economic benefits to the purchaser to be derived from the managerial efforts of the promoter, or a third party designated or arranged for by the promoter, from rental of the units
b. The offering of participation in a rental pool agreement
c. The offering of a rental or similar arrangement whereby the purchaser must hold his unit available for rental for any part of the year, must use an exclusive rental agent or is otherwise materially restricted in his occupancy or rental of his unit
3. Hocking v. Dubois (9th Cir)
a. Buyer hires an agent and shows him condos, says I have a friend I can put you in contact with that will run it for you and rent it out. So he buys it and runs it through the lady (rental agreement). He sues the real estate agent for a security. 5th Circuit panel held it was secur
e whether it is an instrument in which there is “common trading for speculation or investment.”
i. Lower courts look to facts, not potential
d. Third: we examine the reasonable expectations of the investing public:
i. The Court will consider instruments to be “securities” on the basis of such public expectations, even where an economic analysis of the circumstances of the particular transaction might suggest that the instruments are not “securities” as used in that transaction.
e. Finally: we examine whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Act unnecessary
3. Unclear whether all four factors must be met or whether it is a balancing test
4. Confusion about notes of less than 9 months duration
a. The 1934 act technically excludes “notes” with a maturity of less than 9 months
b. Majority: declined to decide whether the presumption applies
c. Concurrence: the nine-month exclusion applies to commercial paper, not investment securities. Thus, only short-term high quality commercial paper issued to fund current operations and offered to sophisticated investors should qualify for the exclusion
i. Most lower court cases have followed this post-Reeves
d. Dissent: notes of less than nine months duration as a matter of law are not “notes” within federal securities law
e. However, after Edwards, these could be investment contracts bc of periodic payment
f. Accordingly, short term notes paying an attractive rate of interest that are mass marketed to individual investors likely are investment contracts under the Howey test
ii. Application of this test reveals the following notes are not securities
1. The note delivered in consumer financing
2. The note secured by a mortgage on a home
3. The short-term note secured by a lien on a small business or some of its assets
4. The note evidencing a character loan to a bank customer
5. Short-term notes secured by an assignment of accounts receivable
6. A note formalizing an open-account debt incurred in the ordinary course of business
7. Notes evidencing loans by commercial banks for current operations
Primary Issuer Transactional Exemptions From Registration
I. Introduction
a. The general rule is that, absent an exemption, all offers or sales of securities must be registered pursuant to § 5 of the Securities Act of 1933
b. There are two general types of exemptions: transactional exemptions and securities exempt from registration
c. Exempt Securities vs. Transaction Securities
i. Exempt securities – some just don’t have to be registered – e.g., generally notes of less than 9 months duration
1. Of course, the antifraud provisions of securities laws always apply
ii. Transactional Exemptions – this is most of what we’re talking about
1. This relates to the issuer – could be a corporation, LLC, LP, etc. (corporation issues to shareholders, LLC issues to members, LP issues to limited partners)
2. The exemptions are transactionally based, meaning for each separate transaction, an exemption must be perfected
a. Persons seeking to resell their stock must have a registration statement filed with the SEC unless they also have an exemption
3. The party seeking the exemption has the burden of proving that it has perfected the exemption
a. This burden is carried by such party establishing that it has satisfied the necessary conditions for invoking the exemption
b. Need to keep a Burden of Proof file
