UNIT 3: THE SECURITY CONCEPT

In General
 The Securities Act and Exchange Act define a security with a list of certain financial
instruments and generic catchalls. Even if an instrument falls in one of the enumerated
categories, the statutory definitions exclude those instruments when “the context
otherwise requires.”
o Securities Act: The term "security" means any 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.
o Exchange Act: The term "security" means any note, stock, treasury stock, security future, 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.
 In deciding whether instruments are securities, there is an antinomy between rationalist, reductivist thinking
(something is or is not within a category) and an enlightened understanding that human beings are
hardwired to extend meaning to a socially constrained, non-formalistic, yet indeterminate way. Although
rational reductivist thinking wants a definition, at the margins, we find ourselves throwing out
propositional, linguistic model and returning to analogies or metaphors.
Investment Contract
 The Securities Act and Exchange Act contain a catch-all provision providing investment
contracts are securities.
Definition
 Under the Howey test, an investment contract 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.
 The Howey test applies in light of the “economic realities of the transaction.”
[1] A person invests his money
 To invest means to make a separate consideration to put money into an arrangement.
 Employer funded, fixed benefit pension plans in which employees make no direct
contributions and their participation is compulsory is not a security.
o On one hand, employees invest by exchanging labor in expectation of future
pension benefits.
o On the other hand, looking at the economic reality, the employee is selling his
labor primarily to obtain a livelihood.
 o In addition, the employee did not make payment into the pension.
o In addition, the plan benefits were fixed, because there was no fixed relationship
between fund contributions and the employee’s potential benefits.
o On the other hand, the employees plan benefits were fixed and depended on
employee becoming eligible under the plan rather than the plan’s investment
returns. Employee did not make payment into pension.
o In addition, ERISA’s comprehensive regulation of pension plans suggested
Congress was filling a regulatory void and made securities protection less
important.
 Voluntary employee funded, variable benefit pension plans in which employee payroll
deductions fund the plan and benefits depend on plan performance are securities.
o On one hand, ERISA’s comprehensive regulation of pension plans suggested
Congress was filling a regulatory void and made securities protection less
important.
o On the other hand, such plans involve voluntary contributions and plan benefits
depend largely on the acumen of the plan’s manager.
[2] In a common enterprise
 Courts differ on the commonality requierd to satisfy the second element.
 Some courts require horizontal commonality, which is the pooling of assets from multiple
investors so that all share in the enterprise’s profits and risks.
 Some courts require vertical commonality where investors’ fortunes are tied to the
promoter’s success rather than to the fortunes of fellow investors.
o Ponzi and pyramid schemes provide the requisite sharing in the enterprise’s
profits and risks.
 In a pyramid scheme, an investor attracts new subdistributors and
compensates the investor from proceeds of subdistributor’s sales.
 In ponzi scheme, an investor attract new investors with the promise of
high returns, but pays returns investors using money from the original or
new investors.
[3] Is led to expect profits
 Investor is solely attracted by the prospects of profit (whether fixed or variable), rather
than by a desire to consume or use the item purchased.
o Profits mean capital appreciation resulting from the initial investment’s
development or a participation in earnings resulting the use of the investors funds.
 Item purchased does not share stock characteristics when: there was no right to dividends
contingent on profits; the shares were not negotiable; voting rights were not proportionate
to the number of shares held; and the shares could not appreciate in value.
 Expecation of profits does not include: tax deductibility, rental savings, and income to the
cooperative from leading of commercial space.
[4] Solely from the efforts of the promoter or a third party
 A rebuttable presumption exists that the partnership interests of limited partners are
securities, while the partnership interests of general partners are not securities.
 To rebut this presumption, a partner must show he did/did not exercise effective control
over the business.
 Courts generally focus on the relationship of the parties at the time of the investment
rather than throughout the partnership’s evolution.
  To determine whether a partner does not exercise effective control, consider whether the
partner has
o No legal control: the partnership agreement leaves little power in investor’s
hands.
o No capacity to control: the partner is inexperienced and unknowledgeable about
the business’s affairs so he is incapable of intelligently exercising his partnership
or venture powers.
o No practical control: the partner is dependent on the promoter’s unique
managerial ability so he can not replace the promoter of the enterprise or
otherwise exercise meaningful partnership powers.
o Note: the presence of any one of these factors is sufficient and this list is not
exhaustive.
o Note: Some nominal participation alone does not negate the fourth element.
Stock
 The "sale of a business" doctrine assumed that the definition of an investment contract is
generic to all securities (including stock) and that transactions involving, in substance, a
sale of a business fail to meet the Howey test of an investment because, among other
matters, the purchaser does not expect to realize profits solely through the efforts of third
parties. Courts have rejected the sale of business doctrine.
 Courts hold not all instruments labeled stock are securities. But, when an instrument is
both labeled a stock and bears stock’s usual characteristics, the stock is a security and a
court is not required to consider the economic substance of the transaction.
 Characteristics usually associated with common stock include: the right to receive
dividends contingent upon an apportionment of profits; negotiability; the ability to be
pledged or hypothecated; the conferring of voting rights proportionate to the number of
shares owned; the capacity to appreciate in value.
Note
 Courts apply a family resemblance test to judge whether notes are securities. The family
resemblance test begins with a rebuttable presumption that every note is a security unless
it falls into a category of instruments that are not securities. Reves set out four factors to
determine the family into which the note fits.
Characteristic of Security Not a security
the note
Motivation of - Seller: Raise money for general - Purchase or sale of
seller and buyer use of business or to finance minor asset or consumer
substantial investments item.

- Buyer: Obtain profit from the - Correct for seller’s

note’s return cash flow problems.

- Advance some other

commercial or
consumer purpose
Plan of An instrument in which there is No common trading.
distribution common trading for speculation
or investment.
Public Public thinks they are securities No public expectation
expectations even if economics says not. this is a security (look at
ads, e.g.)
 Other regulatory Doesn’t exist Does exist and reduces
schema risk

 Courts hold notes used in consumer lending, notes secured by a home mortgage, and
short term notes secured by an assignment of accounts receivable are in the family of
nonsecurities.
Hypotheticals
Hypothetical 1
The receipt of cubic zirconium is compensation, which is not a security. The essence it’s not a
security is because it doesn’t meet the second and fourth elements. The receipt of common stock
is a security. It is located on the laundry lists of the Security Act and Exchange Act. It is labeled
as common stock and possesses the characteristics of such stock.
Hypothetical 2
Hypothetical 3
This is a profit sharing arrangement. It is a common enterprise with an expectation of profit. It is
most likely an investment of a person’s money, because the employee makes individual decision
whether to remain employed and receive the compensation.

Cases
SEC v. W.J. Howey Co.
The defendants, W. J. Howey Co. and Howey-in-the-Hills Service, Inc., were corporations
organized under the laws of the state of Florida. W. J. Howey owned large tracts of citrus groves
in Florida. Howey kept half of the groves for its own use, and sold real estate contracts for the
other half to finance its future developments. Howey would sell the land for a uniform price per
acre (or per fraction of an acre for smaller parcels), and convey to the purchaser a warranty deed
upon payment in full of the purchase price. The purchaser of the land could then lease it back to
the service company Howey-in-the-Hills via a service contract, who would tend to the land, and
harvest, pool, and market the produce. The service contract, lasting 10 years withotu cancellation
option, gave Howey-in-the-Hills “full and complete” possession of the land specified in the
contract, leaving no right of entry nor any right to the produce harvested. There was no right to
specific fruit. Purchasers of the land had the option of making other service arrangements, but
W. J. Howey, in its advertising materials, stressed the superiority of Howey-in-the-Hills’ service.
Howey marketed the land through a resort hotel it owned in the area, promising significant
profits in the sales pitch it provided to those parties who expressed interest in the groves. Most of
the purchasers of the land were not Florida residents, nor were they farmers. Rather they were
business and professional people who were inexperienced in agriculture and lacked the skill or
equipment to tend to the land by themselves.
The transactions in the case were investment contracts according to the court. The respondents
offered more than fee simple interests in land with management services. The offer opportunity
to contribute money and share in the profits of the large citrus fruit enterprise managed and
partly owned by respondents. They offered the opportunity to persons in distant localities
without the equipment and experience needed to cultivate and market the citrus product. These
people were obviously attracted only for the return prospects on the investments. The small size
of plots made individual cultivation for profit unrealistic.

International Brotherhood of Teamsters v. Daniel

SEC vs. SG Ltd.

SG set up a website offering online denizens an opportunity to purchase shares in eleven
virtual companies on virtual stock exchange. SG arbitrarily set purchase and sell prices. SG
pushed its privileged companies proclaiming that such companies’ stock increased in price on
average. SG also capped losses on stock at 5% and accumulated insurance reserve for losses.
Court found investors invested their money. SG argued the money paid was for an entertainment
commodity. Court found that SG’s representation of firm 10% guarantee of return per money on
share purchases plainly supports the money given was an investment.
Court found horizontal commonality existed. SG’s website explicitly stated players’
money was accumulated on the SG current account and was not invested anywhere. Investors
also shared in profits and risks of the enterprise. The investor returns are correlated across the
investor group based on investment amount just like stock. SG’s 10% flat guaranteed return
applied to all privileged company shares, expected returns were dependent upon the number of
shares held, the economic assurances were based on the promoter’s ability to keep the ball
rolling, the investment was proclaimed to be free from risk, and participants were promised that
their principal would be repaid in full upon demand.

United Housing Foundation vs. Forman

A cooperative housing foundation required residents to buy shares of stock in the corporation to
secure housing. Residents were entitled to one vote in the cooperative, regardless of the number
of shares held. The shares were nonnegtioable and operated as a refundable deposit; a resident on
leaving the cooperative was obligated to resell the shares at their original price to the
corporation. The court held the shares had no characteristics of a stock investment. The
purchaser’s intent was to solely acquire a place to live. Also, tax deductibility, rental savings,
and income to the cooperative from leading of commercial space are not expectation of profits.
Tax benefits are available to every home owner. Possibility of net income from leasing was too
speculative and insubstantial.