Chapter 14 - § 14.2 • DEFINITION OF A SECURITY
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§ 14.2.1—General
Federal Statutory Definition
The term "security" is fundamental to the application of the 1933 Act, the 1934 Act, and the other laws regulating the offer and sale of and transactions in securities.14 Unless a transaction involves the offer or sale of a security, the securities laws do not apply. The 1933 Act defines "security" as follows:
[U]nless the context otherwise requires— (1). The term "security" means 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, 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
The definition of a security under § 3(a)(10) the 1934 Act is worded slightly differently, but the Supreme Court has held that Congress intended it to be substantially the same as the 1933 Act definition. Courts have long held the question of whether an instrument is a security is a question of fact, not a question of law.16
Investment Contracts and Common Enterprises
The definitions include the term "investment contract" within the list of items that are a security "[u]nless the context otherwise requires." The courts and practitioners frequently use the term "investment contract" as a synonym for "security." In the 1946 case of SEC v. W. J. Howey Co.,17 the Supreme Court defined an "investment contract" as:
[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. . . . It embodies a flexible rather than a static principle, one that is 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.
The "common enterprise" element of Howey's definition of "security" generally requires either horizontal commonality or vertical commonality to be present.
"Vertical commonality" occurs where the promoter and the investor are participating in a business together. For example, in Hocking v. DuBois,18 the Ninth Circuit held that there was an offer of a security in a transaction where the promoter was offering a condominium for sale together with a rental pool arrangement. In a later case, however, Salameh v. Tarsadia Hotel,19 the Ninth Circuit affirmed the dismissal of the plaintiff's lawsuit, agreeing with the district court that a security was not involved in the sale of a condominium when the rental contracts were not included in the original transaction but were executed eight to 15 months after the condominium purchase. The court concluded that "the economic reality as we see it is that these two transactions were distinct."20
"Horizontal commonality" occurs where investors pool their assets in return for a pro rata share of the profits.21 This is a basis for finding the existence of a "security" in Ponzi schemes, discussed below.22
A finding of "common enterprise" does not require that a large number of investors be involved. In Vale Natural Gas America Corp. v. Carrollton Resources 1990, Ltd.,23 the court found that a common enterprise could exist where one person invested in oil wells and shared the profits with one promoter.
Another issue important to determining whether an investment contract exists is whether the anticipated profits result "solely from the efforts of others." The courts have not interpreted this phrase literally but have stated that the critical inquiry is "whether the efforts made by those other than the investor are the undeniably significant ones."24 SEC v. Glenn W. Turner Enterprises, Inc.25 and SEC v. Koscot Interplanetary, Inc.26 both involved pyramid or "Ponzi" schemes where investors solicited subsequent investors to keep the scheme in effect. The courts found that a security was involved in both cases notwithstanding the need for the investors' efforts because the courts found that the promoter's efforts (and not the investors' efforts) were "those essential managerial efforts which affect the failure or success of the enterprise."27
Definitional Analysis
Generally, the courts apply a strict definitional analysis: If § 2(a)(1) specifically refers to an instrument and if the instrument has any investment characteristics, it will be found to be a security. However, the seminal case and two SEC staff positions found "common stock" not to be a security even though the term is specifically included within the § 2(a)(1) definition "unless the context otherwise requires."
In United Housing Foundation, Inc. v. Forman,28 the U.S. Supreme Court determined that shares entitling the holders to an apartment in a housing project did not have the normal incidents of a security, and, even though the instruments were referred to as "stock," they were not securities. In that case, the shares were not transferable and there was no possibility of appreciation in value.
The staff of the SEC's Division of Corporation Finance applied Forman in a number of no action letters, including the following two from 1994 and 2014:
• In Independent Stationers, Inc.29 the applicant requesting the no action letter was a cooperative that wanted to sell common stock and Class A shares to its members. The staff noted that: (1) neither the common stock nor the Class A shares possessed the usual characteristics of a security; (2) neither would appreciate in value; (3) the common stock would provide members only with membership interests operated on a cooperative basis; and (4) the Class A shares would possess only a right to notice of allocation of dividends.
• In Entheos Audiology Cooperative, Inc.,30 the cooperative intended to issue Class A and Class B common stock to members in exchange for capital contributions. The shares would not be transferable, each cooperative member would have a single vote, they would not be entitled to dividends based on the number of shares owned (although they would be entitled to patronage rebates), and the shares would never appreciate in value but would be redeemable for a price at or below the amount of the original consideration paid. In addition, upon withdrawal of a member, the cooperative might issue "withdrawal notes" reflecting the amount due to the member for redemption of its shares. Citing United Housing Foundation, Inc. v. Forman31 and a number of other cases, counsel to the cooperative opined, and the SEC staff agreed, that the shares and withdrawal notes did not have the characteristics of an investment and therefore were not "securities" as defined in § 2(a)(1) of the 1933 Act.32
§ 14.2.2—The Williamson Presumption and Economic Realities
Generally
Interests in LLCs, general partnerships, LLPs, limited partnerships, and LLLPs are not included in the list of "securities" in either 1933 Act § 2(a)(1) or 1934 Act § 3(a)(10). These interests are also not described as "securities" in most state laws. Generally, therefore, issuers that are LLCs, general partnerships, LLPs, limited partnerships, or LLLPs and their advisors must apply the "investment contract" analysis to determine whether the interests being offered are securities subject to federal or state registration requirements.
Because of the "efforts of others" requirements as set forth in the Howey test, interests in manager-managed LLCs will likely be considered to be securities under state and federal law. Similarly, limited partnership interests in limited partnerships and LLLPs where the operations of the entities are dependent on the general partners will likely be considered securities for the purposes of state and federal law. In both cases in the normal situation, members of the manager-managed LLC and limited partners of the LP or LLLP are dependent on the managers or the general partners for their profits.
Member-managed LLCs, general partnerships, and LLPs are subject to a different analysis, which depends (in the first instance) on whether the non-managing members and general partners, even though they have the right to manage, actually have the knowledge and ability to do so.
The Williamson Presumption
For a long period of legal history, practitioners thought that general partnership interests and similar investments could not be securities since each general partner had the same right to manage the business as each other general partner. Thus any dependence by a general partner on another general partner was voluntary and not an indication that the general partner was relying on the efforts of others.
That said, in the 1970s promoters began to develop schemes that were designed to avoid the application of the securities laws rather than gather together general partners with equal management capabilities. This trend continued into the 2000s.
General partnership interests and joint venture interests may be "securities" if the investors do not have the ability or the opportunity to meaningfully participate in the management of the business. The seminal case in this field is Williamson v. Tucker,33 where the court held that the determination as to whether a general partnership was an investment contract and therefore a security under Howey is to be...
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