Definition of a Security: Risk Capital and Investment Contracts in Washington

Publication year1979


Definition Of A Security: Risk Capital And Investment Contracts In Washington

Michael E. Stevenson(fn*) John J. O'Leary III(fn**)

I. Introduction

After the Washington State Supreme Court recently held that Washington did not follow the "risk capital" concept of securities,(fn1) the legislature responded by unequivocally defining the term "security" to include risk capital.(fn2) In so doing, Washington became the seventh western state(fn3) to espouse the risk capital theory, which originated in the California courts(fn4) and has the endorsement of the Ninth Circuit Court of Appeals.(fn5) The theory developed in response to shortcomings in the federal interpretation of an "investment contract" security, particularly the requirements of investor nonparticipation and profit expectation."(fn6) Thus, the Washington Legislature expanded the applicability of the securities act to reach financing schemes that heretofore were unregulated. Despite the benefit to investors of broader protection, the risk capital theory is not without its critics.(fn7) It complicates existing law and requires flexibility in interpretation and application. To understand and apply the theory, it is desirable to review the evolution of the investment contract concept under the securities acts.(fn8) Viewing risk capital in the light of that evolution, one can more accurately predict the Washington courts' new answer to the old question, "What is a security?"

The purpose of this article is to guide practitioners and jurists in understanding this complex area of the law as applied in Washington. The most notable developments in the federal law dealing with investment contract securities, particularly as the Washington courts interpreted them, and the development of the risk capital theory in other jurisdictions are explored for the purpose of understanding what the Washington Legislature intended by its definition. To this end, this article examines the various elements of the new risk capital definition. The conclusion indicates areas in which the definition might apply and suggests practical steps a careful practitioner might follow in response to this new aspect of securities law in Washington.

II. History of the Federal Definition of Investment Contract

A. Pre-Howey Interpretations of "Security"

The first comprehensive attempt to define the term "security" was in the federal legislation enacted during the early 1930's. The Securities Act of 1933(fn9) and the Securities Exchange Act of 1934(fn10) defined "security" by use of nonexclusive lists of instruments commonly considered securities, such as stocks, bonds, and debentures. Although generally descriptive of securities, it was never clear how or why these instruments were securities or whether they were always securities. In addition, inclusion of the broader but less descriptive term "investment contract" complicated the lists.(fn11) Thus the task of defining exactly what Congress meant by the term "security" and, most importantly, by the term "investment contract," fell to the courts.

The United States Supreme Court's first opportunity to define the scope of the term "investment contract" as used in the Securities Act of 1933 came in SEC v. CM. Joiner Leasing Corp.(fn12) To finance the drilling of a test well on his Texas property, an oil promoter sold subleaseholds on several adjacent parcels. The subleases would greatly appreciate in value if the promoter struck oil in his test well. In this first encounter with the term "investment contract," the Court emphasized the functional and policy aspects of the transaction and looked to whether the scheme presented the abuses addressed by the securities acts. In finding the subleases to be securities, the Court did not define "investment contract," choosing rather to base its holding on the belief that Congress intended the securities acts to be flexible.(fn13) This substance-over-form approach allowed the Court to include within the scope of the securities laws any device that those laws were intended to reach, but placed the Court in the position of proceeding on -a case-by-case basis. No clear definition of an investment contract was apparent.

B. The Howey Test

Within three years of the Joiner decision, the Court, in SEC v. W.J. Howey Co.,(fn14) again addressed the scope of the term "investment contract." The W.J. Howey Co., a Florida corporation, was engaged in a program to sell interests in orange groves coupled with an optional service contract. Under the optional service contract, the seller's affiliate, the Howey-in-the-Hills Service Corporation, maintained and harvested the orange trees and shared the profits of the grove with the investor-purchasers. Most of the purchasers were nonresidents of Florida who lacked the knowledge, skill, and equipment necessary for the care and harvest of the trees, but who nevertheless were attracted to the scheme by the expectation of profits.

Determining that the sales scheme involved a security, the Court set down its now classic definition that a security is present whenever "the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others."(fn15) The test is usually broken down into four components:(fn16) (1) an investment of money (2) in a common enterprise (3) with an expectation of profits (4) to come solely from the efforts of others. The Court, while warning lower courts of the problems that might arise through a mechanistic application of this test, indicated that the test permitted "fulfillment of the statutory purpose of compelling full and fair disclosure."(fn17)

Subsequent federal cases have substantially refined the Howey test.(fn18) Some lower courts, ignoring the Court's admonition in Howey, have applied the test inflexibly.(fn19) Others have avoided dogmatic application of the test principally by expansive use of the term "profit" and by elimination of the fourth requirement that the profits come solely from the efforts of others.(fn20) Until 1975, the Court, although continuing to cite the Howey case as controlling,(fn21) did not reconsider the basic problems raised by the case or clarify the language it used. As a result, state and lower federal courts were left with the task of interpreting Howey.

C. The Forman Test

In 1975, United Housing Foundation v. Forman(fn22) reached the Supreme Court. The plaintiffs were residents of a New York low-cost housing cooperative. The housing project was built largely with funds procured under the New York Private Housing Finance Law, known as the Mitchell-Lama Act.(fn23) Under the act, the state of New York provided private developers with long-term, low-interest loans and special tax exemptions to build housing cooperatives to be operated on a nonprofit basis. United Housing Foundation, a nonprofit organization, financed construction of the project partly through sales of "stock" in the cooperative. To acquire an apartment, each prospective tenant had to purchase an amount of stock based upon the number of rooms acquired. The stock was severely restricted; there was no possibility of capital appreciation because stock could only be sold to current tenants and had to be tendered to the cooperative or an approved prospective tenant at cost. Further, the shares could not be pledged or encumbered and would descend, along with the apartment, only to a surviving spouse. The tenant plaintiffs sued United Housing Foundation after unanticipated construction costs caused the actual monthly rental charges to escalate over seventy percent above the projected rental charges.

The Forman Court held that the shares issued with the apartments were not securities either as stock or as investment contracts. The Court rejected the claim that there was an investment contract security because the transaction lacked a key element of the Howey test-expectation of profit. The Court indicated that a profit expectation sufficient to satisfy the Howey requirement may arise through capital appreciation, through participation in earnings, or perhaps income to be yielded on investment. However, the Court apparently rejected two of the three indicia of profit the Second Circuit Court of Appeals used to find a security-tax benefits and discounts-because the cooperative did not represent these benefits as profits, nor would the tenants obtain them through the efforts of the cooperative or third parties. The Court did admit that the circuit court's third indication of profit, income from commercial leases for the convenience facilities in the cooperative, "is the kind of profit traditionally associated with a security investment."(fn24) In this particular setting, however, the Court found this income "far too speculative and insubstantial to bring the entire transaction within the Securities Act."(fn25)

The Forman Court's cautious definition of profits places limits on the Howey test beyond which the Court cannot be expected to go without evidence of strong investment representations. The added requirement that a significant, realistic expectation of profit or income that will motivate investors to risk their capital, tends to exclude schemes that attract consumers rather than investors. Persons who purchase an interest with the intent of personal consumption do not at the same time, the Forman Court implied, expect to...

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