The Definition of a Security

Question 1

What type of interests are securities in a corporation?

Answer 1

Security: Common and preferred shares

Question 2

What type of interests are securities in a limited partnership?

Answer 2

Security: Limited partner interest if person takes no active role, Not Security: General partner interest

Question 3

What type of interests are securities in a limited liability corporation?

Answer 3

Security: Passive member interest, Not Security: Active member interest

Question 4

What type of interests are securities in a partnership (joint venture)?

Answer 4

Security: Passive partner interest, Not Security: Active partner interest

Question 5

Risk Capital Test

Answer 5

Mainly used in conjunction with state blue sky law to determine if a contract is a security. Focuses on the extent to which the investor’s initial outlay is subject to t he risks of the enterprise, risks over which the investor had NO managerial control.

Question 6

Howey Test

Answer 6

Defined investment contract as: 1) a person investing money 2) in a common enterpise 3) with an expectation of profits 4) solely from the efforts of others. Court applies substance over form.

Question 7

Securities Act §2(a)(1) and Exchange Act §3(a)(10)

Answer 7

2 Tier Definition of a Security. Financial Instruments - Stocks, Bonds, Debentures, Notes, Transferable Shares. Catchalls - Investment Contracts, Interest in Profit-Sharing Agreements, Evidences of Indebtedness.

Question 8

What are courts concerned about in investment contract cases?

Answer 8

Courts are concerned about fraud, not injury.

Question 9

What is the remedy for violation of §5 where security is an investment contract?

Answer 9

§12(a)(1), but this is only a remedy for purchasers.

Question 10

What is vertical commonality?

Answer 10

Important when considering whether the common enterprise prong of the Howey test. Emphasizes the relationship between the investors and promoter. Principle inquiry is whether the activities of the promoter are the controlling factor in the success or failure of the investment. Can exist without ppoling of investor funds or interests. Can exist with a single investor.

Question 11

What is broad vertical commonality?

Answer 11

Requires only a connection between the efforts of the promoter and collective successes or losses of the investors. 9Th & 11th Cir.

Question 12

What is strict vertical commonality?

Answer 12

Requires a direct relationship between the success of the promoter and that of the investors. Promoters and investors must share the risk of the venture. 2nd Cir.

Question 13

What is horizontal commonality?

Answer 13

Requires pooling of investors’ funds and usually a pro rata distribution of profits or losses among investors. Requires multiple investors. 3Rd & 7th Cir.

Question 14

United Housing Foundation v. Forman – Co-op City shares to occupy apartment in public housing

Answer 14

Substance over form. The name of the transaction is not dispositive for the determination of whether or not it is a security. Stocks typically 1) provide dividends, 2) are negotiable 3) confer voting rights. Stock purchased for consumption instead of investment purposes is usually not a security.

Question 15

Marine Bank v. Weaver – Pledged a CD as a security to guarantee a loan

Answer 15

CD as Securities – CD does not qualify as a security. Already subject to a comprehensive set of regulations governing the bank industry.

Question 16

Landreth Timber Co. v. Landreth – Purchased stock of a timber mill

Answer 16

Stock as Securities – A sale of shares of stock will be covered by the securities law, despite stockholder’s role in managing the corporation. Sale of assets are not a security. Distinguished Howey to be applicable only to investment contracts.

Question 17

Reves v. Ernst & Young

Answer 17

Notes as Securities – Every note is presumed to be a security. This presumption is rebuttable by applying the family resemblance test.

Question 18

Family Resemblance Test

Answer 18

To determine whether a note is a security: 1) Assess the motivations of the seller and buyer. Must be for investment, not commercial or consumer. 2) Examine the plan of distribution 3) Consider the investor’s expectations 4) Consider the existence of another regulatory scheme reducing the risk of the investment.

Question 19

Securities Act §3(a)(10)

Answer 19

A note that is due within 9 months is not a security. Demand notes have no maturity date and therefore cannot use the exclusion.

Question 20

What is the treatment of notes with a maturity of less than 9 months under the Securities and the Exchange Act?

Answer 20

Under the ‘34 Act, these notes are not securities. Under the ‘33 Act, there is an exemption.