Securities Regulation Outline

Securities Regulation Outline – Spring 2009

1) The Framework of Securities Regulation
2) The Definition of a Security
a) General Rule – To come within the registration requirement of section 5 of the 1933 Act, the property interest that is offered or sold must be a “security”
b) Section 2(a)(1) of the 1933 Act defines three broad categories of “securities” subject to the section 5 registration requirement:
i) (1) Interests or instruments specifically mentioned in the Act
(1) The 33 Act expressly classifies certain financial instruments or interests as “securities.” However, the Act also provides that its definition of securities will not apply if “the context otherwise requires”
(2) Thus, even items expressly classified as securities under the 33 Act may not be securities if the context dictates otherwise
(3) The Supreme Court has provided guidance for 2 such items: stock and notes
(a) Stock – If the so-called stock possesses the characteristics normally associated with stock – carries dividend and voting rights, it is negotiable, it can be pledged, and it can appreciate in value – then it is a security under the 33 Act
(i) Landreth Timber: A purchaser of 100% of the stock in a corporation can bring a claim under the 33 and 34 Acts, even though the transaction involved the purchase of the entire business, and even though the parties could have constructed the transaction so as to avoid the transfer of stock (by transferring the assets of the business)
1. It may seem obvious that stock in a corporation is a security – however, before Landreth, some courts had applied the “sale of business doctrine” to sales of 100% of the stock in closely held corporations – Under that doctrine, the federal securities didn’t apply
(ii) If the so-called stock lacks the normal indicia of stock, then the courts may look to the “economic reality” of the situation to determine that no security is involved
1. United Housing Foundation v. Forman: The Supreme Court refused to hold that the sale of stock in a nonprofit housing cooperative involved a security – the stock lacked the usual indicia of a stock: it was not transferable, no dividends – the purchasers essentially bought the living quarters for their personal use
(b) Promissory Notes – like stock, promissory notes are specifically listed as “securities” in section 2(a)(1) of the 33 Act – Notes, however, present a special problem, because many notes clearly are not securities (e.g. mortgage notes, or note signed by a consumer buying an automobile on credit)
(i) “Family Resemblance Test” To determine whether a note is a security, courts apply the “family resemblance test.” The test includes a presumption and exceptions to the presumption
1. Presumption that a Note is a Security – Because notes a specifically mentioned as securities in the 33 Act, there is a presumption that every note is a security
2. Exceptions – Reves v. Ernst & Young – Recognizing, however, that not all notes are securities, the Supreme Court adopted a list of notes that are not covered y the presumption – these notes bearing a “family resemblance” to them, are deemed not to be securities under the 33 Act
a. The following would not be securities:
i. Consumer financing notes
ii. Home mortgages
iii. Short-term loans secured by assets of a small business
iv. “Character” loans to bank customers
v. Short-term secured financing of accounts receivable
vi. Short-term, open-account debts incurred in the ordinary course of business (especially when collateralized)
vii. Commercial Bank loans for current operations
3. SEC v. Wallenbrock: The SA provides an exemption to Notes with a maturity date of less than 9 months, but the SC has held this presumption to apply only to commercial paper used to finance business operations and sold only to highly sophisticated investors
(ii) Four Factors for Interpretation
1. In Reves, the SC provided some guidance for deciding when a Note bears a family resemblance to a note on the above list:
a. (1) The Motivations of the seller and buyer of the note (e.g. was the transaction for investment or to finance the purchase of a consumer item)
b. (2) The Plan of Distribution of the instrument, if any (e.g. if the instrument is traded, the likelihood that it is a security increases)
c. (3) The Reasonable Expectation of the Investing Public (e.g. does the public reasonably expect to have the 33 Act protections in this kind of transaction?)
i. Reves court stated that public expectation may result in defining a security even if the economic analysis of the transaction suggests the note is not a security
d. (4) The Existence of a Comparable Scheme of Regulation diminishes the likelihood that a Note is a security in a particular case
(iii)Other Instruments Specifically Mentioned in the Act
1. Pre-organized Subscriptions for Securities
2. Fractional, undivided interests in oil, gas, or other mineral right
3. Collateral trust certificates (a type of bond secured by collateral, frequently other securities, deposited with a trustee)
4. Certain Types of Receipts for Securities, including American depository receipts for foreign securities
5. Equipment Trust Certificates and certificates of interest in unincorporated investment trusts
ii) Investment Contracts
(1) The broadest classification of securities in section 2(a)(1) is the catchall reference to “investment Ks” – the SEC and the courts have construed this phrase so as to apply the registration requirements of section 5 of the 33 Act to a wide variety of financial schemes
(a) Traditional Howey Test
(i) Investment of Money
(ii) In a Common Enterprise
1. Under the so-called “horizontal” test for a common enterprise, there must be a sharing or pooling of funds or other assets by several investors and profits derived from these combined funds
a. This test presupposes multiple investors, but some courts have held the expectation of multiple investors as satisfying this test, even if only one investor is actually defrauded
2. Some court rely on a broad “vertical” common enterprise test – where a common enterprise will be found if the investor is relying on the efforts of the promoter to make a profit
a. Thus there would be a common enterprise when the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment
3. A narrower vertical common enterprise test requires that the investment manager’s fortune rise and fall with that of the investor
a. Ex. A broker paid a flat for managing an account with not fit the test because he would only be providing a service
(iii)For the Purpose of Making a Profit
1. SEC v. Edwards – 2 Forms of “Profit”
a. (1) Capital Appreciation resulting from the development of the initial investment
b. (2) Participation in Earnings resulting from the use of investor’s funds
i. The is no difference between the promise of fixed returns and promises of variable returns
(iv)Solely from the Efforts of Third Parties
1. SEC v. Glen Turner: The modern formulation of this Howey factor requires only that the success of the enterprise depend substantially on the efforts of persons other than the investor
2. Timing of Third Party Efforts – SEC v. Life Partners:
a. Investors acquired interest in the life insurance policy of a terminally ill person at a discounted price – the court held such transactions not to be securities because once the investment was made, nothing the promoters could do had effect on the value of the investment
3. SEC v. Edwards: Simply because a purchaser had a contractual entitlement to a return or a solid promise does not mean the expectation of profit does not come solely from the efforts of others
4. Comparable Regulation – Marine Bank v. Weaver -The Supreme Court has held that if a detailed scheme of federal regulation applies to a particular instrument or contract, the 33 Act does not apply
iii) Any Interest Commonly Known as a Security
(1) In addition to the specifically listed items in section 2(a)(1) and the ambiguous invest K, the 33 Act also provides a catchall provision that sweeps into the definition of a security, “in general, any interest or instrument generally known as a security”
iv) Instruments that are not Securities:
(1) Under an Investment K Analysis:
(a) General Partnerships, Franchises, LLCS (depending on the management agreement)
(b) Purchasing an interest for consumption or personal use
(c) Employee pension plans
(d) Conventional certificates of deposit
(e) Unsecured notes, the terms of which are negotiated face to face and given to a bank in consideration of a loan
(f) Instruments that are regulated by other federal law
(g) The notes on the list that have failed the Family Resemblance Test
(h) Certificates evidencing loans from commercial banks to their customers for use by customers in