3.2 Securities Act of 1933

• Library: Corporations and Partnerships in Virginia (Virginia CLE) (2016 Ed.)

3.2 SECURITIES ACT OF 1933

3.201 In General. The Securities Act is designated as an act "to provide full and fair disclosure of the character of securities [offered or] sold in interstate and foreign commerce and through the mails, and to prevent frauds in the sale thereof, and for other purposes." ⁴ It has two objectives: (i) to provide investors with financial material and other information concerning issues of securities offered in public distributions and (ii) to prohibit fraudulent sales of securities.

The major prohibitions are found in the following substantive provisions: (i) section 5 of the Securities Act, ⁵ which deals with disclosure in the form of a registration statement filed with the Securities and Exchange Commission (SEC) and (ii) sections 17 and 12(a)(2) of the Securities Act, ⁶ which relate to fraudulent interstate sales of securities. Section 17 prescribes

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criminal sanctions and enables the SEC to intervene through disciplinary proceedings by or through civil injunctive proceedings in federal court. Section 12 creates civil remedies for violation of the Securities Act.

Central to disclosure under the Securities Act is section 5, which requires that a registration statement be in effect before any offer or sale of a security can be made using the mails or interstate commerce. This applies unless the security is exempt under section 3 of the Securities Act ⁷ or unless the security is issued in a transaction exempt under section 4 of the Securities Act. ⁸ However, before the requirements of section 5 and the exemptions provided by sections 3 and 4 can be fully appreciated, the definitions contained in section 2 must be understood. Of principal importance are the definitions of the terms "security" and "sale."

3.202 Definition of Security. Section 2(1) of the Securities Act defines the term "security" to mean:

any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, pre-organization 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. ⁹

The statutory definition is quite broad and its scope is expanded even further through the judicial determination that, in light of legislative intent and the remedial nature of the statute, the term is construed liberally to

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embody a flexible, rather than static, principle capable of adaptation to meet the "countless and variable schemes devised by those who seek the use of the money of others on the promise of profits." ¹⁰

A. Instruments Evidencing a Security. Common and readily recognizable instruments such as corporate stock, bonds, debentures, voting-trust certificates, and government bonds are securities under the Securities Act. ¹¹ The term "security" is not, however, limited to such instruments. The courts consistently have held that Congress intended that the term should be sufficiently broad to include the many types of instruments that fall within the ordinary notion of "security." Moreover, "security" includes novel, uncommon, or irregular devices that are widely offered or that are dealt with in a manner that establishes their character in commerce as investment contracts. Therefore, whether an instrument or interest, irrespective of its form, constitutes a security within the meaning of the Securities Act cannot be determined by hard and fast rules. The substance of each transaction and the relationship between the purported issuer and the purported security holder must be examined in order to resolve the question properly.

The Supreme Court has stated, however, that where an interest is labelled "stock" and has all the characteristics of stock (such as the right to vote and the right to dividends), the interest is a "security" within the meaning of section 2(1) of the Securities Act, and there is no need to investigate further. ¹²

B. Test for Investment Contracts. The test commonly employed to determine if an instrument is a security by virtue of being an investment contract is "whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others." ¹³ Thus, a security may exist even where the enterprise's interests are not speculative or promotional in character or where fees to be received by the enterprise are not dependent upon the profitability of activities carried on in the investor's behalf.

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1. Investment of Money. This aspect of the test is usually a fairly straightforward analysis, although the term "money" is not synonymous with "currency." Any investment of value will meet the test. ¹⁴ However, the Supreme Court has ruled that an employee's noncontributory, compulsory pension plan did not involve an "investment" and no "security" existed. ¹⁵

2. Common Enterprise. Commonality may exist either where there is a pooling of interests among investors ("horizontal" commonality) or where the investor's success depends upon the efforts of the promoter ("vertical" commonality). ¹⁶

3. Profits Solely from the Efforts of Others. Litigation involving "pyramid distribution" schemes has broadened the definition of investment contract to include arrangements where investors provide some efforts, but where the essential managerial efforts affecting the success or failure of the enterprise are supplied by the recipient of the funds. ¹⁷

C. Debt Instruments. A note is presumed to be a security unless it bears a "family resemblance" to instruments that courts have found not to be securities for purposes of the Securities Act, such as notes in consumer financing. ¹⁸

D. Application to Noncorporate Enterprises. The concept of "investment contract" may be applicable to contracts or other arrangements purporting to represent an interest in a partnership or an association in which members invest in a common enterprise whose success lies in the hands of a manager or promoter. Membership in a general partnership where

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all the general partners possess such significant powers under the partnership agreement that the investment could not have been premised upon a reasonable expectation of profits being derived from the management efforts of others has been held not to be a security ¹⁹ except in very limited circumstances. ²⁰ The focus here is generally on the third part of the test discussed above: whether the partner was depending upon the efforts of others...