Spring 2013

Securities Regulation

Linda Boss

Module III Notes (Definition of Security)

January 31st

CHAPTER 3: THE DEFINITION OF A ‘SECURITY’

Rules and Statutes

1.  Securities Act

  1. 2(a)(1)
  2. definition of a “security”
  3. the broad term that’s focused on and interpreted in this statute is ‘investment contract’
  4. combination of numerated items and catch-all phrases
  5. we focus on investment contracts, notes bonds and debentures
  6. 2(a)(3)
  7. the term “sale” or “sell” shall include every contract of sale or disposition of a security or interest in a security, for value.
  8. The term “offer to sell”, “offer for sale” or “offer” shall include every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.
  9. “offer to buy” shall not include preliminary negotiations or agreements between an issuer and any underwriter or among underwriters who are or are to be in privity of contract with an issuer
  10. 3(a)(3)
  11. except as hereinafter expressly provided, the provisions of this title shall not apply to any of the following classes of securities—
  12. any note, draft, bill of exchange, or banker’s acceptance 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;

2.  Exchange Act

  1. 3(a)(10)
  2. definition of ‘security’
  3. 3(a)(14)
  4. definition of ‘sale’ and sell’
  5. specifies what is meant in securities futures and security-based swaps
  6. 27
  7. jurisdiction of offenses and suits
  8. 29
  9. validity of contracts
  10. (a) any condition, stipulation or provision binding any person to waive compliance with any provision of this title or of any rule or regulation thereunder, or of any rule of a self-regulatory organization, shall be void.

I.  Do the Securities Laws Apply?

a.  It’s important to know if something is a ‘security’ and regulated under securities laws

i.  If Rule 10b-5 applies, contractual limits on remedies will be ineffective

ii.  Federal jurisdiction and nationwide service applies

iii.  Monitoring and enforcement of the SEC applies

iv.  SEC registration for sale of securities

b.  40 years after enactment, definition of security was very broad

c.  in 1972, court constricted definition of a security

d.  Security is a tough concept to define

i.  A single member LLC buying 100% of shares of a corporation, that is not a security

ii.  Some courts say a ‘stock’ is a ‘stock’ and a single person buying all the shares of a stock is a security transaction

  1. Why do we force companies to disclose to investors?
  2. We want to allocate capital in efficient ways
  3. The people and society would lose
  4. We reduce agency costs
  5. You’re more wiling to deal w/ a company if we know an agent is subject to controls, including disclosure, so that an investor can make good decisions when voting or withdrawing or buying more
  6. It’s also a way of dealing w/ lots of people that want control over a company
  7. Just disclose the same information to all of them
  8. Overcome the problem that collective investors can’t coordinate and force management to do the things they want management to do
  9. If you purchase an unregistered security, all you have to show is that it was a security and unregistered, and you get your money back plus interest.

II.  “Investment Contract”

a.  SEC v. H.J. Howey Co. (1946)

i.  Facts

1.  Howey Company had an orange grove

2.  It kept half the groves for itself and sold the other half to the public to help finance development

3.  The purchasers mainly live far away and have no control over the development or management of the orange grove

4.  the purchasers were only entitled to a cut of the profits, and that was the sole motive to enter into the contract

5.  the groves are not divided in any way to show individual ownership by different persons

ii.  Issue

1.  Were these contracts ‘investment contracts’ and therefore subject to securities laws

iii.  Procedure

1.  District Court said these weren’t investment contracts, just real estate and agreement contracts from seller to buyer

2.  Appellate Court agreed, and said investment contract must be speculative or promotional in character, and tangible interest sold has to have intrinsic value independent of the success of the enterprise as a whole

iv.  Holding

1.  This is an investment contract because it is a ‘contract transaction or scheme’ where—

a.  A person invests his money;

b.  In a common enterprise;

c.  Is led to expect profits

d.  Which are derived solely from the efforts of the promoter or a third party

i.  Later cases, some say primarily from the efforts or others

2.  Note that each element must be satisfied

v.  Reasoning

1.  Investment contract isn’t defined in Securities Act, but under common law form is disregarded for substance and emphasis placed on economic reality

2.  Court adopted common law definition above, now known as the Howey test

3.  Immaterial whether enterprise is speculative or not, or whether there’s a sale of property with or without intrinsic value

vi.  CLASS NOTES

1.  SEC is trying to close down this entire operation, not just a normal enforcement action

2.  Draws interpretation from state blue-sky laws

3.  The tests and definitions for ’33 act applies across the board for the ’34 act as well

a.  There are some slight wrinkles [notes, e.g.] but for the most part, they’re the same thing

4.  Note that it can also be a scheme; doesn’t have to necessarily be a contract or agreement

5.  Horizontal commonality—pooling assets w/ lots of other people in the hopes of a pro rata return

6.  Can you have an investment contract w/ one investor?

a.  Some courts say yes, if you’re using vertical commonality

7.  Note that the service contract was an option—you could buy the land w/o the service contract

a.  But it doesn’t matter what the investors accepted, it’s what they were actually offered

8.  Here they say you look at form over substance, but we’ll see in later cases they’ll say we’re going to look at form...

b.  “A Person Invests his Money”

i.  International Brotherhood of Teamsters v. Daniel (1979)

1.  Facts

a.  Employee was in the union, which negotiated a noncontributory compulsory pension plan, as long as the employee gave continuous service for 20 years

b.  Employee retired, but had a 6 month break, so didn’t get pension plan

c.  Employee sued under securities act, claiming pension plan to be an ‘investment contract’

2.  Issue

a.  Is a noncontributory, compulsory pension plan a ‘security’ within meaning of securities act?

3.  Procedure

a.  District court denied motion to dismiss, holding it to be an investment contract

b.  7th circuit affirmed

4.  holding

a.  supreme court reversed—not an investment contract and not covered under securities act

5.  reasoning

a.  the employee doesn’t invest anything—he makes no payment toward the pension plan

b.  a person who invests chooses to give up a specific consideration in return for a separable financial interest with the characteristics of a security

c.  contributing labor is not an investment, it’s a way to obtain a livelihood

d.  payments by the employer were not ‘on behalf’ of an individual employee, since there was no fixed relationship between contributions to the fund and an employee’s potential benefit

i.  someone who works 20 years gets the same amount as someone who works 40

6.  ERISA covers pension plans, not the securities act

7.  CLASS NOTES

a.  Argument is that his pension plan was an investment contract; and it wasn’t fully disclosed what he was investing in

b.  not an investment contract/security

c.  saying your contributing your labor isn’t consideration; saying the contribution from your wages isn’t consideration is bullshit

d.  what does make sense in this case is that ERISA was passed right after this guy’s issue, and it’s ERISA’s deal, not securities laws

e.  so they screw this guy to set up precedent for ERISA

f.  if non-contributory, no money out of your own pocket, you’re forced to invest in this plan, then that’s ERISA

g.  adds a new element to the Howey test—the security has to not be subject to a comprehensive legislative scheme [like ERISA]

ii.  Notes

1.  The presence of an alternative federal regulatory regime that fully protects investors strongly influences whether something is a security governed by securities regulation

a.  However, lower courts care little about state regulation when applying the Howey test

2.  Voluntary pensions that require employee contributions are securities, but securities act exempts them from securities requirements

3.  Voluntary/non-contributory pensions and mandatory/contributory pensions are not securities according to SEC

c.  “In a Common Enterprise”

i.  with whom must the investor have something ‘in common’?

ii.  SEC v. SG Ltd. (1st Cir. 2001)

1.  Facts

a.  SG ran a virtual ‘game’ online where players put real money up for ‘virtual shares’ of ‘virtual companies’ on a ‘virtual stock exchange’

b.  SG represented that this was a ‘game without any risk’ for a privileged company stock and guaranteed a 10% return monthly

c.  800 ‘players’ bought stocks using real money, which SG kept when the system collapsed

2.  issue

a.  were the ‘virtual shares’ traded on a ‘game’ investment contracts and therefore subject to the securities act

3.  procedure

a.  district court said this was a game and therefore not a securities contract

4.  holding

a.  it is irrelevant whether it’s titled as a ‘game’, this is an investment contract when applying the howey test—no other test is relevant

5.  reasoning

a.  investment contracts do lie within the commercial world, but it is irrelevant whether the arrangement is characterized as a business deal or a game if it is defined as an investment contract under the howey test

b.  investment of money

i.  representation of 10% monthly profit likely shows participants purchased in anticipation of investment

c.  common enterprise

i.  horizontal commonality

1.  pooling of assets from multiple investors so that all share in the profits and risks of the enterprise

ii.  vertical commonality

1.  investor’s fortunes are tied to the promoter’s success rather than to the fortunes of his or her fellow investors

2.  Broad vertical commonality

a.  Requires well-being of all investors dependent upon promoter’s expertise

3.  Narrow vertical commonality

a.  Requires investors’ fortunes be interwoven and dependent upon the efforts and success of those seeking the investment or of third parties

  1. Adopts horizontal commonality standard

1.  Need pooling

a.  SG represented clients were pooled into single account

2.  Need sharing of profit/risk

a.  Ponzi or pyramid schemes inherently involve sharing profits/risk and pooling

6.  CLASS NOTES

a.  You’d only play this game to make money; you make money by more people contributing—clear ponzi scheme

b.  The SEC is concerned about this because they want people to remain confident in investing markets

c.  Also SEC doesn’t have to show any fraud, just failure to disclose in a prospectus—so that’s easier than just convicting them of fraud or mail fraud

d.  They paid cash, it was horizontal common enterprise, the game was not a game it was led to expect profits, and the efforts were from primarily promoters

d.  “Is Led to Expect Profits”

i.  “led” suggests that the actions of the promoter induce the investor to part w/ his or her money

ii.  United Housing Foundation, Inc. v. Forman (1975)

1.  Facts

a.  Non-profit co-op was created for low income families

b.  Shares of stock were sold to residents entitling them to lease an apartment

c.  When price of a unit went up, after shares were sold, residents sued co-op alleging they made false material misrepresentations under federal securities laws

2.  Procedure

a.  Co-op says hey; not a security. Go away.

b.  District court grants dismissal for co-op

c.  Second circuit reverses

i.  Labeled ‘stock’ = stock/security

ii.  Alternatively; it’s an Investment contract

d.  Supreme court reverses

3.  Issue

a.  Is a share sold to a resident, so that the resident can live in a non-profit co-op at a reduced rate, a ‘security’ under securities regulation laws?

4.  Holding

a.  No

5.  Reasoning

a.  The sale of securities has the purpose of raising capital to make a profit

b.  Securities transactions are economic in character

c.  These have 0 characteristics of stock; it matters 0 what its label is, so not a stock

d.  Also not an investment contract because—

i.  An investor is ‘attracted solely by prospects of a return’ on his investment

ii.  When a purchase is motivated by a desire to use or consume the item purchased, securities laws don’t apply.

iii.  The motivation behind these ‘stocks’ was to live at the apartment, not make a profit

iv.  Representations by co-op repeatedly said the venture was nonprofit in nature

v.  Getting a deduction in taxes or a cheaper place to live is not making a profit

vi.  Howey test isn’t satisfied = not a security

6.  CLASS NOTES

a.  Why even call this stock? So tenants can say they own their place; not just renting.

b.  Makes it seem more like a neighborhood—not the projects. It’s a marketing tool.

c.  Stock is not stock in circumstances where the investment clearly is not subject to SEC securities laws and has a completely different purpose than normal stock

d.  They bought stock,the expectation was housing, not profits

iii.  Syndication transaction

1.  Promoter sells limited partnership interests to investors

2.  Limited partnership purchases some sort of complex

3.  Promoter manages real estate and pays a portion of rent to limited partners over time

4.  Investment contract under securities laws

iv.  SEC v. Edwards (2004)

1.  Facts

a.  Payphone money scheme where people invested in payphones and the company paid them a guaranteed fixed return on their investment

b.  When they went bankrupt, sued for material misrepresentations under securities laws