When does a deal involve securities regulation? Part 2: The “Howey” Test

This post is the second in a series exploring when securities laws impact business transactions.

In my previous post, I provided a general overview of the definition of a “security” under federal securities laws.  The Securities Act of 1933 provides for a very far reaching definition of a security, including “any note, stock… investment contract…, or, in general, any interest or instrument commonly known as a ‘security’…”  As explained in my prior post, this definition, taken literally, can result in both overinclusiveness and underinclusiveness.  I’ll discuss the issue of overinclusiveness and how it is addressed in future posts; this post will discuss how the inclusion of an “investment contract” within the definition of a security allows the definition to include classes of investments that are not specifically listed, like limited liability company interests and limited partnership interests, which are both concepts that had not even been invented when the Securities Act was passed.

The principal case which defined the term “investment contract” under federal law is SEC v. W.J. Howey Co., 328 U.S. 293 (1946).  In the case, the defendant, Howey was sued by the SEC to enjoin it from selling plots of land that had citrus trees planted on them.  Along with the plots of land, Howey offered management contracts where the purchaser would lease the plots back to Howey and Howey would harvest them.  However, the purchaser was not required to enter into such a management contract and could purchase the land without doing so.  Nonetheless, the Supreme Court held that the land sale together with the management contract collectively constituted an investment contract, and thus a security.

In this decision, the Supreme Court set forth a test, now known as the Howey test, for determining whether a transaction constitutes an investment contract.  Under the Howey test, a contract or transaction is an investment contract if “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.”  Please note however that while the Supreme Court in Howey stated that the profit must arise “solely” from the efforts of others, later decisions by lower courts and the Supreme Court[1] have expanded this, so even if the investor has the power to be involved, the transaction may still be an investment contract if the efforts of others predominate.  Therefore, there are three essential components for this test: (1) investing money in a common enterprise, (2) the expectation of profit, and (3) the profit arising primarily from the efforts of people other than the investor.

In future posts, I’ll explore how the Howey test operates in specific situations.  In addition, I’ll also explore situations where some classes of investments are excluded from the definition of a “security” even if they are listed within the federal definition.

Footnotes

[1] More recently in United Housing Foundation v. Forman, 421 U.S. 837 (1975), the Supreme Court stated that an investment contract is “an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”  The word “solely” was conspicuously left out.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

About Alexander J. Davie

Alexander Davie is a corporate and securities attorney based in Nashville, Tennessee. Businesses of many varieties rely on his counsel and judgment throughout all stages of their growth. In particular, fund managers and investment management professionals seek the expertise Alex gained when he served as general counsel to a private investment fund. Alex also has significant experience and enjoys working with companies and entrepreneurial ventures, especially within the technology industry. As a believer in technology's ability to enrich people's lives and allowing people to connect with each other in new ways, he is passionate about helping tech startups achieve success. He is active in Nashville's startup community as a mentor at the Nashville Entrepreneur Center and participates in numerous other events geared towards making Nashville a nationally ranked location for starting a business.

You can read more about Alex here.

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