Chapter 2 - § 2.1 • WHAT IS A SECURITY?

• Jurisdiction: Colorado

§ 2.1 • WHAT IS A SECURITY?

§ 2.1.1—The Statutory Definitions

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. The term is defined in § 2(a)(1) of the 1933 Act as follows:

Unless 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.

The definition of a security under § 3(a)(10) of the 1934 Act is worded slightly differently, but the U.S. Supreme Court has held that Congress intended it to be substantially the same as the 1933 Act definition.¹ The question whether an instrument is a security for the purposes of the 1933 Act or the 1934 Act is generally considered a mixed question of fact and law as discussed in the following sections.

In all cases, it is important to note the definitional requirement that the items listed in the definition of securities ("any note, stock, treasury stock . . .") are subject to the definitional predicate: "Unless the context otherwise requires." In the "note" context and as explained in § 2.3, evidences of indebtedness (including notes) are not always securities.² As discussed in § 2.1.4,³ not even all shares of corporate stock are "securities" where the context suggests otherwise.

§ 2.1.2—Investment Contracts — General

The phrase "investment contract" frequently appears in judicial decisions as a synonym for "security." In the 1946 case of SEC v. W. J. Howey & Co.,⁴ 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 principal, 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.⁵

It has been argued that the phrase "investment contract" is only meant to apply to investment vehicles not included in the enumeration of instruments defined to be a security by the statutes. In other cases, it has been argued that even some instruments that are defined to be a "security" (such as stock or evidences of indebtedness in certain cases) should not be considered to be a security because they lack the additional attributes of an investment.

§ 2.1.3—Investment Contracts — Common Enterprise

An issue in determining whether a security is involved is the "common enterprise" element of Howey. Generally, either horizontal commonality or vertical commonality is required.

"Vertical commonality" occurs where the promoter and the investor are participating in the business together, such as with a condominium purchase by the investor together with a rental pool arrangement. In Revak v. SEC Realty Corp.,⁶ the court held that "broad vertical commonality" is not sufficient to satisfy the Howey common enterprise requirement. According to the Second Circuit, "broad vertical commonality" requires that the fortunes of the investors are linked only to the efforts of the promoter. "Strict vertical commonality," on the other hand, requires that the fortunes of the investors be tied to the fortunes of the promoter.

"Horizontal commonality" occurs where investors pool their assets in return for a pro rata share of the profits.⁷

A large number of people do not have to be involved to have a "common enterprise." In Vale Natural Gas America Corp. v. Carrollton Resources 1990 Ltd.,⁸ the court found that a common enterprise could exist where one person invested in oil wells and shared the profits with one promoter. The federal...