Securities Regulation
· Development of a Framework for Defining an Investment Contract
o SEC v. W.J. Howey Co.
§ Howey co. sold land sales contract and a service contract where the buyer buys acres at a set price, and under the service contract, Howey has a leasehold interest in the land and cultivates, sells, markets orange groves, and the owners of the land get a pro rata share of profits based on their ownership
§ Question is, is this an investment contract? Court lays out a test
§ An investment contract is:
· an investment of money
o purchaser must give up some tangible and definable consideration in return for an interest
· in a common enterprise
o horizontal commonality: involves the pooling of assets from multiple investors so that all share in the profits and risks of the enterprise, OR
o vertical commonality
§ broad: requires that the well being of all investors be dependant upon the promoter’s efforts/expertise
§ narrow: requires that that the investor’s fortunes be interwoven with the efforts AND success of the promoter
· with profits to come
o two situations
§ capital appreciation from the original investment
§ participation in earnings resulting from the use of investors’ funds
· solely from the efforts of others
o solely is not to be given literal meaning
o whether the efforts made by those other than the investor are the “undeniably significant ones”
§ those managerial efforts which affect the failure or success of the enterprise
§ This was horizontal commonality here b/c all investments were pooled together.
· In fact, it was difficult to tell which orange trees you actually owned b/c there was only a small sign which indicated who owned what
§ B/c of the service contract, the profits were to come solely from the efforts of others
· It didn’t matter that the service contract with Howey was optional, the court said that the mere offering of an investment contract without registering violated the ’33 Act.
o Marine Bank v. Weaver
§ Court was reluctant to bring privately negotiated transactions under the scope of the Securities Act
§ There is also an economies of scale argument against holding privately negotiated transactions under the Sec. Act b/c it is very expensive to register a security and if there is only one investor, the per unit cost of registration requirements would be very high.
o Varying approaches: State Regulation and the Risk Capital Test
§ Difference between state securities laws and federal securities laws is that the state laws are designed to protect individual investors while the federal laws are designed to protect the integrity of the markets
§ a number of states have adopted the Risk Capital Test
· as to risk, a security will not exist under the test unless capital provided by investors is at substantial risk
o the existence of collateralization or other security may negate the possibility that a transaction involves an investment
· 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 rather means the economic capital which is placed subject to the risk of loss through operation of the scheme in question
· So, in Silver Hills, a company wanted individuals to purchase
§ Risk capital test may differ from the test in a number of respects
· risk capital test does not necessarily require a common enterprise among investors
· the test avoids the requirement that profits be derived solely from the efforts of others
· test accommodates an analysis based upon the degree of risk assumed by the investor
o Howey Applied
§ Investment Versus Consumption
· United Housing Foundation v Forman
o whether shares of “stock” entitling a purchaser to lease an apartment in a NYC co-op was a “security.”
o To acquire the apartment, a purchaser must buy shares of stock in the holding corp for each room desired. Sole purpose of acquiring the shares was to occupy an apartment
§ Shares were non-transferrable, no voting rights in accordance with shares owned
o Even though titled a “stock,” not a stock. Terminology is not dispositive
§ Features of a stock:
· right to receive “dividends contingent upon an apportionment of profits
· negotiability
· ability to be pledged or hypothecated (used as collateral)
· voting rights in proportion to the number of shares owned
o the most common feature of stock
· ability to appreciate in value
o Second, not an “investment contract” b/c no profits expected
§ By profits, either capital appreciation resulting from the development of the initial investment or a participation in earnings resulting from the use of investor’s funds
· The investor is attracted solely by the prospectus of a return on his investment
§ As here, when a purchaser is motivated by a desire to use or consume the item purchased, the securities laws don’t apply
§ Purchasers also argued that there were expected profits in the form of tax deductions associated with the investment benefits in the form of below market rents, and also that there rents would be reduced by the developers commercial leasing of the common areas
· However, court said that these profits if any were too speculative and too insubstantial to fall under the Securities Act
§ Common Enterprise and Profits Solely from the Efforts of Others
· SEC v. Edwards (2004)
o Howey test is flexible so
· None of the licensees had any sales experience, and the designated areas were often far away from where the licensees lived, so the Court concluded this was a security
§ Timing of Efforts of the Promoters or Others
· SEC v. Life Partners
o If the promoter’s efforts are predominantly on the front end, and the value of those efforts have been impounded into the promoter’s fees or the purchase price, and if neither the promoter nor anyone else is expected to make further efforts that will affect the outcome of the inv., then the need for Sec. Regulation is greatly diminished.
o Associated Formalities: Interests in Corporations, Partnerships, and LLCs as Securities
§ Stock as a Security
· United Housing suggested that the Howey test for an investment contract might apply to all types of securities
o This gave rise to “sale of business” doctrine exempting from the federal securities laws sales of all or most of a closely held corporation
o This doc. was laid to rest in Landreth Timber Co. v. Landreth
· Landreth
o Court adopts a literal approach to “stock”
o If what is being sold is a traditional stock, the kind where an investor purchases shares of a corp. or business, then stock is to be given its literal definition.
o If it is other circumstances, then you might need the analysis in United Housing.
o Also, the Howey test is only for determining whether a particular instrument is an “investment contract” and doesn’t apply to any of the other examples of securities listed in the Act
· How to reconcile Marine Bank with Landreth
o Both involved one on one transactions
o However, Marine Bank said that one on one unique transactions are not covered under Sec. Reg.
§ However, Landreth involved sale of stock, which is not a unique transaction
o Also, FDIC covered the transaction in Marine Bank, so the courts were probably not as inclined to step in and regulate
§ Partnership Interests as Securities
· Because partnership interests are not enumerated by statute as a security, the issue in partnership cases generally centers on the presence of an investment contract and specifically on whether investors are dependent for their profits on the efforts of others
