A “security” is statutorily defined in 15 USC 78a et seq. as;
[A]ny note, stock, treasury stock, security future, 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.
Over the years, many schemes for raising capital have been devised in attempts to avoid application of the securities laws. These schemes have been analyzed by the courts to determine whether they are “investment contracts,” and therefore “securities” under the Act.
The leading case on the definition of an investment contract is the U.S. Supreme Court case, SEC v. W. J. Howey Co. In Howey, the “scheme” in question was the sale of land containing fruit trees as well as “service contracts” to cultivate and market the crops, with an allocation of the net profits going to the purchaser.
Under the Howey test, an investment contract is “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.”
The “investment of money” prong of the Howey test requires that the investor commit his or her assets to the enterprise in such a manner as to subject the investor to financial loss. The focus of the inquiry is on what the purchasers were offered or promised. “The test [for determining whether an instrument is a security] is what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.”
The U.S. Supreme Court has defined “profits” as “either capital appreciation resulting from the development of the initial investment […] or a participation in earnings resulting from the use of investors’ funds.” The promised return may be fixed or variable and may be marketed as low-risk or “guaranteed.”
The Howey Court noted that its definition of a security “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” The courts have rejected attempts to narrow the definition of a security. As one opinion put it, “in searching for the meaning and scope of the word ‘security’ […] form should be disregarded for substance and the emphasis should be on economic reality.”
Courts have frequently examined the promotional materials associated with an instrument in determining whether it is a security. If the materials promise things like great returns or guaranteed income, the court will almost certainly find the instrument to be a security, and therefore subject to federal securities regulations.
The following are characteristics that will make it more likely that a court will consider an instrument to be a security, and therefore subject to securities regulations:
1. The right to receive dividends contingent upon an apportionment of profits;
2. Negotiability (i.e., transferability);
3. The ability to be pledged or hypothecated (i.e., used as collateral);
4. The conferring of voting rights in proportion to the number of shares owned;
5. The capacity to appreciate in value;
6. The motivations of the seller and buyer—the seller’s purpose is to raise capital and the buyer’s purpose is to earn a profit;
7. The plan of distribution—there is “common trading for speculation of investment” and the instrument is offered and sold to a broad segment of the public;
8. Public perception—the public reasonably perceives the instrument as an investment;
9. The instrument poses a risk to the investing public.
The definition of a security includes “notes.” Does this mean that all loans are covered by securities law? The Supreme Court has said that the phrase “any note” in the statutory definition of a security should not be interpreted to mean literally “any note” but must be understood against the backdrop of what Congress was attempting to accomplish in enacting the Securities Acts.
How does a court determine whether a note is a security? Federal courts apply the “family resemblance test.” This is how the Supreme Court articulated the test in Reves v. Ernst & Young:
First, we examine the transaction to assess the motivations that would prompt a reasonable seller and buyer to enter into it. If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a “security.” If the note is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash-flow difficulties, or to advance some other commercial or consumer purpose, on the other hand, the note is less sensibly described as a “security.”
Second, we examine the “plan of distribution” of the instrument to determine whether it is an instrument in which there is “common trading for speculation or investment.”
Third, we examine the reasonable expectations of the investing public: 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.
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 Acts unnecessary.
To summarize the above test;
1. If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a “security.”
2. If there is a plan to distribute the notes for trading and investment, the notes are likely to be considered securities.
3. If investors reasonably expect that the notes will be treated as securities, the courts are more likely to do so.
4. If some other regulatory scheme reduces the risk of the note, the courts are likely to find the application of the securities laws unnecessary.
The types of notes that are not “securities” include;
the note delivered in consumer financing, the note secured by a mortgage on a home, the short-term note secured by a lien on a small business or some of its assets, the note evidencing a character loan to a bank customer, short-term notes secured by an assignment of accounts receivable, or a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized) or a note by a bank given to a customer for current operations.
Example; X obtains a judgment in court against Y for $10,000 usd. X sells the judgment to Z for $1,000 usd providing X uses his efforts to collect on the judgment. Is the transaction between X and Z a securities transaction within the meaning of the Securities and Exchange Act of 1933?
Answer; An “investment contract” is defined as a transaction where a person invests money (which is at risk) in a common enterprise and is led to expect profits to be derived solely from the efforts of others and where the person does intend to use or consume any product produced. In the example given, Z gives $1,000 to X with an expectation of earning a profit of $9,000 (if the full judgment is collected) dependent upon X’s efforts in collecting. The key is whether or not Z has the right to control X’s efforts in collection and whether the collectability of the judgment. If Z has the right to control X’s efforts, then any profit is NOT derived solely from the efforts of others (since Z would presumably have the right to control those efforts. Further, if the judgment was collectable up to $1,000 based on the assets of Y, then Z’s money would NOT be at risk. So if Y had a home that he owned free and clear which was worth $100,000, the transaction between X and Z would not be considered a “security”. Equally so, if Z had the right to control X’s efforts, the transaction would not be considered a “security”.
THIS SHOULD NOT BE DEEMED TO BE LEGAL OR TAX ADVICE BUT IS FOR INFORMATIONAL PURPOSES ONLY. PLEASE CONSULT YOUR LOCAL TAX PROFESSIONAL.