securities regulation

Securities Regulation

Definition of Security

(last updated 31 Jan 13)

Clay Wheeler

Statutory definitionSecurities Act § 2 Definitions

When used in this subchapter, unless the context otherwise requires--

(1) The term "security" means any note, stock, treasury stock, 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.

Statutory definitionEnumerated

• note, • stock, • treasury stock, • bond, • debenture, • collateral-trust certificate, • preorganization certificate or

subscription,• voting-trust certificate, • 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),

• any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency,

“Catch all”

• evidence of indebtedness, • certificate of interest or participation in

any profit-sharing agreement, • transferable share, • investment contract, • certificate of deposit for a security, • interest or instrument commonly

known as a "security", • 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.

SEC v. HJ Howey Co (US 1946)

“Howey test”

Supreme Court:

… an 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, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.

“Howey test”

Supreme Court:

… an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby

[1] a person invests his money

[2] in a common enterprise and

[3] is led to expect profits

[4] solely from the efforts of the promoter or a third party,

Some hypotheticals …

Security?

A

An investor buys shares of Citrus Corporation, a firm that owns citrus groves in Florida and that harvests and markets citrus fruits.

B

An investor buys a row of citrus trees from W.J. Howey Company. Howey-in-the-Hills, a related service company, cares for the grove and harvests/markets the crop.

C

An investor buys a citrus grove in Florida and contracts with a local farmer, Jones, to manage the farm. Jones does all the cultivation/ harvesting/marketing.

Shareholders

corporation Trees

Mgmt company

Investors Investor

Grove

FarmerJones

Apply Howey test …

investment contract … means

[1] a person invests his money [2] in a common enterprise and [3] is led to expect profits [4] solely from the efforts of the promoter or a third party,

Intl Bro. of Teamsters v. Daniel (US 1979)

Statutory definitionExchange Act § 3. Definitions and application

(a) Definitions. When used in this chapter, unless the context otherwise requires--

(10) The term "security" means any note, stock, treasury stock, 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.

Intl Bro. of Teamsters v. DanielSupreme Court:

“An employee who participates in a noncontributory, compulsory pension plan by definition makes no payment into the pension fund.”

“The existence of this comprehensive legislation [ERISA] governing the use and terms of employee pension plans severely undercuts all arguments for extending he Securities Acts to noncontributory, compulsory pension plans.”

Justice Lewis Powell

“Howey test (modified)”

Supreme Court:






[5] not subject to comprehensive legislative scheme

Apply Howey test …


[1] a person invests his money [2] in a common enterprise and [3] is led to expect profits [4] solely from the efforts of the promoter or a third party,[5] not subject to comprehensive legislative scheme

Apply Howey …

http://www.ussr.to/Russia/em/sgeng.htm

Apply Howey

SEC v SG Ltd

(1st Cir 2001)“stock” in

StockGeneration

UHF v Forman (US 1975)“stock” in Co-op City

SEC v Edwards(US 2004)

sale/leasebackpayphones

[1] invest money

[2] in common enterprise

[3] led to expect profits

[4] from efforts of others

Apply Howey

SEC v SG Ltd


StockGeneration




[1] invest money

Paid cash




Apply Howey

SEC v SG Ltd


StockGeneration




[1] invest money

Paid cash


Horizontal



Apply Howey

SEC v SG Ltd


StockGeneration




[1] invest money

Paid cash


Horizontal


Not game


Apply Howey

SEC v SG Ltd


StockGeneration




[1] invest money

Paid cash


Horizontal


Not game


Primarily promoters

Apply Howey

SEC v SG Ltd


StockGeneration




[1] invest money

Paid cashBought “stock”


Horizontal


Not game


Primarily promoters

Apply Howey

SEC v SG Ltd


StockGeneration




[1] invest money



Horizontal --


Not game


Primarily promoters

Apply Howey

SEC v SG Ltd


StockGeneration




[1] invest money



Horizontal --


Not gameExpected

housing


Primarily promoters

Apply Howey

SEC v SG Ltd


StockGeneration




[1] invest money



Horizontal --


Not gameExpected

housing


Primarily promoters

--

Apply Howey

SEC v SG Ltd


StockGeneration




[1] invest money


Bought payphone


Horizontal --


Not gameExpected

housing


Primarily promoters

--

Apply Howey

SEC v SG Ltd


StockGeneration




[1] invest money


Bought payphone


Horizontal --Many

purchasers


Not gameExpected

housing


Primarily promoters

--

Apply Howey

SEC v SG Ltd


StockGeneration




[1] invest money


Bought payphone


Horizontal --Many

purchasers


Not gameExpected

housingFixedreturn


Primarily promoters

--

Apply Howey

SEC v SG Ltd


StockGeneration




[1] invest money


Bought payphone


Horizontal --Many

purchasers


Not gameExpected

housingFixedreturn


Primarily promoters

--Exclusivelypromoters

Some hypotheticals …

When are real estate

investments “securities”?

Security?A - Beachfront Resorts offers buyers "rooms" in a beachfront hotel. All rents from hotel rooms are pooled, and each buyer receives a pro rata net rentals for her room. Buyers cannot occupy their rooms, except for 2 designated weeks each year. Beachfront Resorts emphasizes that rent will cover P&I.

B - Dubois is a real estate agent who offers Hawaiian condos. To sell condos, Dubois recommends that buyers consider a management contract with Hotel Corp-Pacific -- condo management and rent collection services. Dubois gets no compensation from HCP, and not all buyers use HCP. Under HCP's rent pooling agreement, rents from various condos are pooled; buyers can occupy for only 2 weeks/year. Dubois tells buyers rent pooling will pay P&I.

C - Fox Hills Golf Villas offers "weeks" at its golf complex condos. Buyers can use their week of occupancy in two ways: (1) rent their condo (on their own or through Fox Hills) and receive a rental payment, or (2) occupy the condo themselves. Fox Hills emphasizes that buyers who choose to rent will be able to cover P&I.

D - Disney World Opportunities ("Dwops") offers residential lots in a resort community near Disney World. Dwops requires buyers to pay "dues" for a Dwops-operated country club and other community facilities, such as a club house, gardens, swimming pool, tennis courts, and water treatment. Dwops emphasizes to investors the potential appreciation of the lots.

More line-drawing …

• Business interests• “Insurance proceeds”• “Stock”• “Notes”

Definition of “security”

Business organizations• Corporate “stock”

– “Sale of business” doctrine– Compare to sale of assets– Stock is stock

• Partnership interests– Active partners– Passive partners– Williamson test

• Hybrid entity interests (LP / LLP / LLC)– Rules of thumb– Changes over time

Viatical settlement• Ministerial vs management• Disclose risk of AIDS cure

Williamson v. Tucker (5th Cir. 1981)

[A]n investor who claims his general partnership or joint venture interest is an investment contract has a difficult burden to overcome....

... A general partnership or joint venture interest can be designated a security if the investor can establish ... that 1. an agreement among the parties leaves so little power in the hands

of the partner or venturer that the arrangement in fact distributes power as would a limited partnership; or

2. the partner or venturer is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers; or

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.

Security Non-security

Corporation

(C corp / S corp)

• Stock (PHC)• Stock (CHC)

Limited partnership (LP / LLLP)

• Limited partner interest

• General partner interest

Limited liability company (LLC) • Member interest

(manager-managed)• Member interest

(member-managed)

General partnership (GP / LLP)

• Williamson test(1) agreement disempowers(2) investor unsophisticated(3) manager dominates

• General partner interest

Hypothetical?A - Albert and Amanda invest in an S-corporation that they formed under the New Columbia BCA. Albert and Amanda are the only shareholders, and they enter into a shareholders' agreement in which they do away with the board of directors and agree to co-manage the business. Albert and Amanda are both sharp cookies.

B - Bif and Barbie invest as limited partners in a limited partnership that acquires houses for investment. General partner, Goodacre Investments, is charged under the limited partnership agreement to develop, lease and sell the properties. Under the agreement, Bif and Barbie retain authority to approve the purchase and develop new properties, and to remove Goodacre. Bif and Barbie are who they are.

C - Carl and Carol are 2 of 23 investors who invest in Rivanna Trawlers Unlimited, a general partnership. RTU buys fishing boats and hires an outside management company. Things go poorly and the partners get rid of the management company. They then sue the management company for fraud – under the federal securities laws.

D Daniella, a securities associate with Dewey & Howe LLC, is excited when she learns she will be made “member“ of the firm. She is told that she will have to invest $20,000. She is also told it would be unseemly for her to ask any questions about the firms’ operating agreement, even though "due diligence" is a regular part of her practice. When Daniella becomes a member, she learns that the firm faces an SEC investigation for its work with Enron. She had no idea.

.

More line-drawing …

“Notes”• Commercial vs.

consumer• Family resemblance

test• Relationship to –

– ’33 Act exemption – ’34 Act exception

Federal securities laws

Securities Act § 2(a)(1) When used in this Act, unless the context otherwise requires--

(1) The term "security" means any note ...

Securities Act § 3

(a) Exempted securities. Except as hereinafter expressly provided, the provisions of this Act shall not apply to any of the following classes of securities:

(3) Any note … which arises out of a current transaction or the proceeds of which have been or are to be used for current transactions, and 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;

Exchange Act § 3

(a) When used in this Act, unless the context otherwise requires --

(10) The term "security" means any note ....but shall not include currency or any note, draft, bill or 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.

http://www.law.uc.edu/CCL/33Act/sec2.html



Federal securities laws

U = All investments

Securities

Notes

Not subject to’34 Act – “note”

< 9 mos

Subject to’34 Act

Subject to

’33 Act

Not subject to’33 Act

Not register “current tx”

< 9 mos

Reves v. Ernst & Young (US 1990)

Family resemblance test presume "note" = "security"

Unless

(1) motivation of seller and buyer

(2) plan of distribution

(3) reasonable expectations of investing public

(4) other factors reduce risk (regulatory scheme)

Co-op

Members

Compare tests

Family resemblance test (Reves v. Ernst & Young)

(1) motivation of seller and buyer (2) plan of distribution (3) reasonable expectations of

investing public (4) other factors reduce risk

(regulatory scheme)

Investment contract (Howey & progeny)





[5] not subject to comprehensive legislative scheme

Security?A -Adelaide buys a motorcycle and gives her bank a promissory note in which she promises to repay her loan in 36 equal payments over 36 months. The note is secured by the bike.

B - Big Motors (a NYSE-listed company) raises capital for current operations by issuing unsecured promissory notes (maturing in six months) in $1 million denominations to institutional investors. First Lynch Securities acts as a "best efforts" underwriter.

C - Co-Op raises capital for its gasohol operations by selling unsecured (and uninsured) promissory notes to its members. The notes, issued in small denominations and payable on demand, pay variable rates of interest competitive with bank CDs.

D – Do-Something, Inc. raises capital for its operations by offering unsecured promissory notes in $1,000 denominations at high interest rates to many investors. The notes mature in 6 months and, if not redeemed, are payable in 6-month intervals thereafter.

The end

securities regulation

Documents

certificate of deposit

preorganization certificate

interim certificate

collateraltrust certificate

votingtrust certificate

hypotheticals security

term security

aninvestment contract