Definition of “Security”
I. What is a “Security”?
A. Under Section 2(a)(1) of the Securities Act of 1933, “unless the context
otherwi requires,” the term “curity” includes
any note, stock, treasury stock, curity 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 curity, fractional undivided interest in oil, gas, or other mineral
rights, any put, call, straddle, option, or privilege on any curity,
certificate of deposit, or group or index of curities (including any
interest therein or bad on the value thereof), or any put, call,
straddle, option, or privilege entered into on a national curities
exchange relating to foreign currency, or, in general, any interest or
instrument commonly known as a “curity”, 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
purcha, any of the foregoing.
B. As the Supreme Court stated in Marine Bank v. Weaver, 455 U.S. 551,
(1982), construing the virtually identical definition of “curity” under the
Securities Exchange Act of 1934, the definition is “quite broad” and meant
to include “the many types of instruments that in our commercial world fall
within the ordinary concept of a curity,” including “stocks and bonds,
along with the countless and variable schemes devid by tho who ek
the u of the money of others on the promi of profits.” Weaver, 455
U.S. at 555.
C. Thus the federal curities laws define “curity” in both specific (any
“stock,” “bond,” “note,” “debenture,” etc.) and general (e.g., any
“investment contract” or “instrument commonly known as a ‘curity’”)
terms.
D. The Supreme Court has suggested that “instrument commonly known as a
curity” and “investment contract” have the same meaning for purpos
of the Securities Act and the Exchange Act. United Housing Foundation,
Inc. v. Forman, 421 U.S. 837, 852.
II. Interpreting the Statutory Definition of a Security
Contracts
A. Investment
1. SEC v. W.J. Howey Co.
328 U.S. 293 (1946)
The Howey Company, a Florida corporation that sold small tracts of
land in a citrus grove to 42 purchars, many of whom were patrons
of a nearby resort hotel. While investing in the enterpri for profit,
the purchars, for the most part, lacked the knowledge, skill, and
equipment necessary for the care and cultivation of citrus trees. And
while the purchars were free to rvice the tracts themlves, or
contract with a number of companies to rvice the tracts for them,
the sales contract stresd the superiority of a Howey-related rvice
company, Howey-in-the-Hills Service, Inc. (“HITH”), which
purchars of 85 percent of the acreage cho to rvice their tracts.
The rvice contracts granted HITH full and complete posssion of
the acreage. Individual purchars had no right of entry to market
the crop, but shared in the profits of the enterpri, which amounted
to 20 percent in the 1943-44 growing ason.
The Howey Company did not register the interests in the enterpri
as curities. The SEC brought an action to enjoin the sale of the
citrus grove interests. Becau the interest at issue did not
constitute any of the specific, traditional kinds of curities
enumerated in Section 2(a)(1) of the Securities Act, the SEC argued
that the interests were “investment contracts.” Noting that the term
“investment contract” had not been defined by Congress but was
widely ud in state curities laws, the Supreme Court adopted the
definition ud by most state courts and held that an investment
contract is a curity under the Securities Act if investors purcha
with (1) an expectation of profits arising from (2) a common
enterpri that (3) depends “solely” for its success on the efforts of
others. Applying this test, the Court found that the interests in the
citrus grove sold by the Howey Company were “investment
contracts,” and thus curities, subject to the Securities Act.
a) expectation of profits
(1) United Housing Foundation, Inc. v. Forman
421 U.S. 837 (1975)
The issue in Forman was whether shares of stock entitling a purchar to lea an apartment in Co-op City a state-subsidized and -supervid nonprofit housing cooperative in New York City, were “curities” within the meaning of the Securities Act and the Exchange Act. The housing cooperative sold shares of stock to prospective tenants. The sole purpo of acquiring the shares was to enable the purchar to occupy an apartment in the cooperative. No voting rights attached to the shares, nor could they be transferred, pledged, or otherwi encumbered like traditional stock. If the tenant vacated the apartment, the cooperative could repurcha the shares at cost. In effect the shares reprented a recoverable deposit on the apartment.
After the housing cooperative raid rental charges, the residents sued the cooperative under Section
17(a) of the Securities Act, asrting that the cooperative fally reprented that it would bear all subquent cost increas. The Supreme Court held that the stock issued by the cooperative was not a “curity” becau the shares lacked the five most common features of stock: (1) the right to receive dividends contingent on an apportionment of profits; (2) negotiability; (3) the ability to be pledged or hypothecated; (4) voting rights in proportion to the number of shares owned; and (5) the ability to appreciate in value. Becau the purchars obtained the stock in order to acquire subsidized housing, not to invest for profit, the shares were not curities within the purview of the federal curities laws.
Thus Forman stands for the proposition that to determine whether a particular financial instrument is an investment contract, using the test the Court t out in Howey, the test is to be applied in light of “the substance—the economic realities of the transaction—rather than the names that may have been employed by the parties.” Forman, 421 U.S. at 851-52.
b) common enterpri
(1) horizontal vs. vertical commonality
Courts have split over whether investment in a
“common enterpri” requires horizontal commonality
between investors, or vertical commonality between a
promoter and an investor. Horizontal commonality
requires a pooling of investor contributions and
distribution of profits and loss on a pro-rata basis
among investors. See, e.g., Salcer v. Merrill, Lynch,
Pierce, Fenner & Smith, Inc., 682 F.2d 459 (3d Cir.
1983). Vertical commonality is less stringent, though
some courts require so-called “strict” vertical
commonality, insisting that there be a direct
relationship between the promoters’ financial success
and that of the investors (e, e.g., Mordaunt v.
Incomco, 686 F.2d 815 (9th Cir. 1982)), while others
allow for “broad” vertical commonality, requiring only
that “the fortunes of investors be tied to the fortune of
the promoter” (Revak v. SEC Realty Corp., 18 F.3d
81, 88 (2d Cir. 1994); e also SEC v. Professional
Associates, 731 F.2d 349, 354 (6th Cir. 1984)).
(2) horizontal commonality and the Internet
In SEC v. SG Ltd., 265 F.3d 42 (1st Cir. 2001), the
First Circuit held that “virtual shares” in an Internet
game were curities. The defendant operated
“StockGeneration,” a website where visitors could buy
“virtual shares” in “virtual companies” on a “virtual
stock exchange.” The website indicated that the
game would generate one “privileged company”
who shares would constantly increa in value by
10 percent each month. Participants had to pay real
money to buy shares, and if they referred new players
to the site, they would receive a percentage of the
new players’ payments (i.e., your typical “Ponzi” or
pyramid scheme). The SEC brought an enforcement
action against the defendant, claiming the virtual
shares were Howey-type investment contracts, which
the district court dismisd on grounds that the game
was a lottery and not a common enterpri. The First
Circuit reverd. It found the requisite “horizontal
commonality” in the pooling of participants’ funds (the
defendant had no other source of funds) to pay the
