§15.3 - Specific Applications of the Definition of Security to Real Estate Transactions

• Jurisdiction: Washington

§15.3SPECIFIC APPLICATIONS OF THE DEFINITION OF SECURITY TO REAL ESTATE TRANSACTIONS

This section discusses specific types of real estate transactions that may be classified as involving the sale of securities.

(1) Sales of lots

If a purchaser buys a lot to occupy it or develop it, the transaction does not constitute an investment contract under the federal securities laws. See S.E.C. v. W.J. Howey Co., 328 U.S. 293, 300, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946). Even if the seller promises the development of amenities, if the benefit to the purchaser is largely in his or her own use and enjoyment of the property, the requisite expectation of profit is missing. See United Hous. Found., Inc. v. Forman, 421 U.S. 837, 857, 95 S.Ct. 2051, 44 L.Ed.2d 621 (1975). If, however, the purchaser is induced to buy a lot as an investment, with the expectation that the property will increase in value because of the seller's activities in developing and managing the property, then the transaction may involve a security. Compare Aldrich v. McCulloch Props., Inc., 627 F.2d 1036 (10th Cir. 1980), and S.E.C. v. Diversified Indus., Inc., 465 F.Supp. 104 (D.D.C. 1979), with Westchester Corp. v. Peat, Marwick, Mitchell & Co., 626 F.2d 1212 (5th Cir. 1980), De Luz Ranchos Inv., Ltd. v. Coldwell Banker & Co., 608 F.2d 1297 (9th Cir. 1979), and Lopez v. Richards, 594 F.Supp. 488 (S.D.Miss. 1984). See also S.E.C. Release No. 33-5347 FED. SEC. L. REP. (CCH) ¶1,049 (Jan. 4, 1973).

Similarly, if a purchaser is induced to buy a fractional and undivided interest in real estate, the transaction will involve a security if all elements of the Howey test are satisfied. See S.E.C. v. Fed. Shopping Way, Inc., 433 F.2d 148 (9th Cir. 1970) (per curiam); Cook v. Farrell, [1975-1976 TRANSFER BINDER] FED. SEC. L. REP. (CCH) ¶95,337 (N.D.Ga. 1975); In re Los Angeles Land & Invs., Ltd., 282 F.Supp. 448 (D. Haw. 1968), aff'd, 447 F.2d 1366 (1971).

(2) Home mortgage notes and commercial real estate loans

Although both the federal and state securities statutes include within the definition of "security" any "note," courts have for some time recognized that notes vary widely in their characteristics and some notes should not be deemed to be securities, including notes secured by a home mortgage. In Reves v. Ernst & Young, 494 U.S. 56, 110 S.Ct. 945, 108 L.Ed.2d 47 (1990), the U.S. Supreme Court adopted the following "family resemblance" test for determining if a note is a security:

A note is presumed to be a "security," and that presumption may be rebutted only by a showing that the note bears a strong resemblance (in terms of the four factors we have identified) to one of the enumerated categories of instrument. If an instrument is not sufficiently similar to an item on the list, the decision whether another category should be added is to be made by examining the same factors.

Id. at 67.

The list of excluded notes cited by the Court in Reves refers to the list created by the Second Circuit Court of Appeals in Exchange National Bank v. Touche Ross & Co., 544 F.2d 1126, 1138 (2d Cir. 1976), modified sub nom. Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930 (2d Cir.), cert. denied, 469 U.S. 884 (1984), and Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930 (2d Cir.), cert. denied, 469 U.S. 884 (1984), and includes the

note delivered in consumer financing, the note secured by a mortgage on a home, the short-term note secured by a lien on a small business or some of its assets, the note evidencing a "character" loan to a bank customer, short-term notes secured by an assignment of accounts receivable, or a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized) [and] notes evidencing loans by commercial banks for current operations.

Reves, 494 U.S. at 65. The Court adopted the following four standards to determine whether an item bears the requisite resemblance and should be added to the list: (1) examine the motivations that would prompt a reasonable seller and purchaser to enter into the transactions; (2) examine the plan of distribution; (3) examine the reasonable expectations of the investing public; and (4) examine whether some other factor, such as the existence of a regulatory scheme, significantly reduces the risk of the instrument rendering application of the securities laws unnecessary. Id. at 66-67.

It should be noted that in Reves, the Court specifically rejected the use of the investment contract approach (S.E.C. v. W.J. Howey, 328 U.S. 293) and the risk capital approach (see, e.g., Amfac Mortgage Corp. v. Ariz. Mall of Tempe, Inc., 583 F.2d 426 (9th Cir. 1978)) to determine if a note is a security. Reves, 494 U.S. at 64.

Although an individual home mortgage note or a note and deed of trust secured by commercial real estate is not a security, a collection of such notes and mortgages, or participations in them, will typically constitute a security when sold to the investing public. See Los Angeles Trust Deed & Mortgage Exch. v. S.E.C., 285 F.2d 162 (9th Cir. 1960)...