Business Law Newsletter
| Publication year | 1982 |
| Pages | 1866 |
1982, July, Pg. 1866. Business Law Newsletter
Business lawyers often are faced with the issue of whether a particular transaction involves the offer or sale of a "security" as that term is defined in the federal securities laws.(fn1) If a transaction is determined to have involved a "security" and the transaction does not comply with the registration or exemption provisions of the Securities Act of 1933 ("Act"), this Act provides for numerous sanctions against the issuer, including criminal charges.(fn2) Therefore, it is crucial that a party seeking financing and his legal counsel determine if the transaction involves the offer or sale of a security. This column reviews some recent case developments in the definition of a "security."
After almost fifty years of judicial interpretation, the portion of the definition of a security which has become the broadest in scope is "investment contract." In 1946, the U.S. Supreme Court decided the landmark case of SEC v. W. J. Howey Co.,(fn3) in which it held that an investment contract was "a transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of a promoter or a third party."(fn4) This definition of investment contract has become known as "the Howey test" and has been applied by the federal courts in hundreds of cases since 1946 to determine whether transactions involve a security.
By 1973, the most litigated issue of the Howey test was whether the investor's profits from an investment must come entirely from the efforts of individuals other than the investor.(fn5) At that time, the Ninth Circuit Court of Appeals in SEC v. Glenn W. Turner Enterprises was asked to determine whether an investment contract existed in a pyramid franchise scheme which depended primarily on the efforts of the promoters for its success, but where the investor was also required to put forth time and effort into the project.(fn6)
The Ninth Circuit found an investment contract to be present, stating, "... in light of the remedial nature of the legislation, the statutory policy of affording broad protection to the public, and the Supreme Court's admonitions that the definition of securities should be a flexible one, the word 'solely' should not be read as a strict or literal limitation on the definition of an investment contract...." The Ninth Circuit adopted "... a more realistic test, whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise."(fn7)
This modification of the Howey test was expressly approved by the Supreme Court in United Housing Foundation, Inc. v. Forman, where it restated the Howey test of an investment contract as "an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others."(fn8) Most recently, in Marine Bank v. Weaver, the Supreme Court has held that an agreement whereby a party was given the right to share in a company's future profits in return for guaranteeing a bank loan was not an investment contract because the agreement was a "private transaction" where the investment offer was not made to the general public and the terms of the agreement were "negotiated one-on-one."(fn9)
An analysis of a few cases dealing with the investment contract issue and the business areas in which the issue can arise may prove helpful. Contracts which guarantee a profit on an investment or agree to repurchase an item for a price above the original sales price involve a security because the investor's potential profit is dependent on the efforts of a party who must repurchase the item.(fn10) Where the agreement calls for the repurchase only at the original price, the investor has no expectation of any profit from the repurchase obligation and, therefore, no security is involved.(fn11)
Franchise arrangements have been found not to involve an investment contract where the success or failure of each franchise is primarily dependent upon the efforts of the franchisee, not the franchisor.(fn12) However, where an individual invested in an arrangement with the franchisor to lease real estate to a restaurant franchise managed by the franchisee and the rent was based upon the gross revenues of the restaurant, an investment contract was found.(fn13) Livestock feedlot and breeding arrangements generally have been found to involve an investment contract where the expected profit to the investor is dependent upon the decisions and efforts of others as to buying, feeding, breeding and selling the...
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