What Is A Security Under The Federal Securities Laws?

We thought it would be a good time to review one of the basic concepts of the securities laws: What Constitutes A Security?

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. 15 U.S.C. §77b(a)(1).

The importance of the definition of “security” becomes apparent in the area of private actions for securities fraud because the standard for establishing securities fraud is much lower than that for common law fraud.

The Supreme Court has adopted a flexible and liberal approach in determining what constitutes a security. In its famous decision of SEC v. W.J. Howey Co., 328 U.S. 293, 90 L.Ed. 1244, 66 S.Ct. 1100 (1946), the Court held that land sales contracts for citrus groves in Florida, coupled with warranty deeds for the land and a contract to service the land, were “investment contracts” and thus securities. The Court stated that

[a]n 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. 66 S.Ct. at 1103.

According to the Court, it is immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise. 66 S.Ct. at 1104.

The Howey investment contract analysis has been the starting point in determining the status of transactions in the securities area. In applying this analysis, courts have traditionally looked to the substance of the transaction to decide whether a security is involved and have made the determination regardless of the label placed on the interest by the parties to the transaction. Courts have found that countless schemes designed to produce profits for the participants, such as the sale of franchises, fur-bearing animals, and shares in fishing boats and cemetery lots, were covered by the 1933 Act. See 2 Louis Loss and Joel Seligman, SECURITIES REGULATION, pp. 948 – 956 (3d ed. 1989); Carl W. Schneider, The Elusive Definition of a Security — An Examination of the “Investment Contract” Concept and the Propriety of a Risk Capital Analysis Under Federal Law, 12 Tex.Tech.L.Rev. 911 (1981).

One significant question is whether an interest in a limited liability company is a security. In Robinson v. Glynn, 349 F.3d 166 (4th Cir. 2003), the Fourth Circuit held that an interest in an LLC is not a security. The Fourth Circuit held that the plaintiff investor was not seeking to profit “solely” from the efforts of others. The court claimed that he had significant control over the company, including the right to appoint two board members. However, in SEC v. Merchant Capital, 483 F.3d 747 (11th Cir. 2007), the Court held that interests in limited liability partnerships were “investment contracts” under Howey. Also, see United States v. Leonard, 529 F.3d 83 (2d Cir. 2008) (affirming criminal convictions for violating the securities laws and holding that interests in an LLC sold by Defendants were securities under the Howey investment contract test.). As the Leonard court noted, an LLC requires a case by case analysis to determine whether the purchaser had significant control over the operations of the company. 529 F.3d. at 89.

In SEC v. Edwards, 540 U.S. 389, 157 L.Ed.2d 813, 124 S.Ct. 892 (2004), the Supreme Court reaffirmed the validity of Howey, supra. In Edwards, the defendant controlled ETS Payphones, Inc., which sold payphones to the public. The payphones were sold under a sale and leaseback agreement, under which the investor would “purchase” the payphone and then lease it back to ETS in exchange for a payment of $82 each month. For each investor, the $82 payment represented a 14-percent return on the investment. After ETS filed for bankruptcy protection, the SEC filed a civil enforcement action against Edwards, alleging that he had violated the registration requirements of 15 U.S.C. §§77e(a) and 77e(c). The Eleventh Circuit in SEC v. ETS Payphones, Inc., 300 F.3d 1281 (11th Cir. 2002), held that the sale and leaseback scheme was not a “security” because it offered a “fixed rate of return.” The Eleventh Circuit also held that the Howey test “that the return on the investment be ‘derived solely from the efforts of others’” did not apply because the investor had a contractual right to the $82 payment each month. 124 S.Ct. at 896, quoting ETS Payphones, supra, 300 F.3d at 1285. The Supreme Court reaffirmed Howey and held that “an investment scheme promising a fixed rate of return can be an ‘investment contract’ and thus a ‘security’ subject to the federal securities laws.” 124 S.Ct. at 898 – 899.

Some items that give their holders a right of use do not constitute securities. In United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 44 L.Ed.2d 621, 95 S.Ct. 2051 (1975), the Supreme Court found that “stock” entitling its holder to purchase an apartment from a cooperative was not a security because the purchasers were acquiring a right to purchase an apartment. The purchasers were not seeking the benefits accruing to investors. Rather, they were seeking the use of an apartment.

Ordinary commercial paper, even when described as a “note,” is not a security. In C.N.S. Enterprises, Inc. v. G. & G. Enterprises, Inc., 508 F.2d 1354 (7th Cir.), cert. denied, 96 S.Ct. 38 (1975), the court held that certain notes were not securities because the notes were ordinary commercial paper. The bank holding the notes was not acting as an investor or business partner. See also American Fletcher Mortgage Co. v. U.S. Steel Credit Corp., 635 F.2d 1247 (7th Cir. 1980), cert. denied, 101 S.Ct. 1982 (1981).

Bank certificates of deposit are not securities. Marine Bank v. Weaver, 455 U.S. 551, 71 L.Ed.2d 409, 102 S.Ct. 1220 (1982). In the Court’s view, because the banking laws amply protect investors in bank CDs, it is unnecessary to subject the issuer banks to liability under the antifraud provisions of the securities laws.

The sale of 100 percent of the outstanding stock of a company involves the sale of a security. Landreth Timber Co. v. Landreth, 471 U.S. 681, 85 L.Ed.2d 692, 105 S.Ct. 2297 (1985). In so holding, the Supreme Court expressed its view that the instrument involved was stock under the plain language of the statute.

A real estate contract may also be a security. In Adams v. Cavanagh Communities Corp., 847 F.Supp. 1390 (N.D.Ill. 1994), investors who had purchased Florida real estate interests on land sales contracts sued the developers for securities fraud. The court held that the land sales agreements were investment contracts. Moreover, since the installment contracts called for a repeated series of decisions to invest, each term payment was a separate offer and sale for determining the statute of limitations. Other courts have held that mortgage participations (Pollack v. Laidlaw Holdings, Inc., 27 F.3d 808 (2d Cir. 1994)) and joint venture interests purchased in reliance on the expertise of the venture’s manages to generate profits (Stone v. Kirk, 8 F.3d 1079 (6th Cir. 1993)) are securities.

Whether a contract or other economic right is a security essentially depends on whether the holder of the contract is acting as an investor who seeks financial benefits based on the work of a promoter or a third party.

The statute makes it clear that a promissory note or share of stock in a small closely held corporation is a security. 15 U.S.C. §77b(a)(1).

Edward X. Clinton, Jr.