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I’m going to take a wild guess here, but I’m willing to bet that no one reading this article wants to go to prison – pretty safe assumption, right?  If you read articles in this space very often, you’re probably aware that at KKOS Lawyers, we don’t practice criminal law.  Ok, then why in the world am I talking about the universal human desire to stay out of prison?  Well, one area we do practice in is helping our client’s raise money from investors – both for new ventures as well as for the expansion/growth of existing ones (i.e. securities law).  Believe it or not, this is an area where if you get it wrong, you could end up in Club Fed.

Federal law requires that anyone offering and/or selling non-exempt securities register those securities with the Securities and Exchange Commission (SEC) and makes it unlawful to offer or sell a security that has not been so registered.  So, if you want to raise money for your business (without going to prison), it’s probably a good idea to have a pretty decent handle on what exactly a security is.

Section 2(a)(1) of the Securities Act of 1933 defines the term “security” as:

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.

Ok, that definition is a bit mind-numbing, but keep in mind it was enacted into law by Congress and FDR in 1933, in response to the Stock Market Crash of 1929, and the Great Depression.  So, let’s talk about the fundamentals of what defines a security, as delineated by several Federal Court decisions. First, the U.S. Supreme Court has made clear that the definition of security is “quite broad” and meant to include “the many types of instruments that, in our commercial world, fall within the ordinary concept of a security.”

The part of the Section 2(a)(1) definition of a security that courts have looked at as essentially a “catch-all” for situations that they feel walk, talk and quack like a security, but that don’t easily fit into a listed category, is the “investment contract.” The leading case on the definition of an investment contract is Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946). Under the Howey test, an investment contract is “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.”

Breaking down the test a bit further, an investment is a security if:

  • There is an “investment of money”
  • In a “common enterprise”
  • With an “expectation of profits”
  • Solely “from the efforts of others”

Investment of Money

This part of the Howey test requires that the investor commit his or her assets to the enterprise in such a manner as to subject the investor to financial loss.  So, if the funds invested could possibly be lost, this prong of the test is met.

Common Enterprise

Courts have held that a common enterprise is a venture in which the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment.  It is not necessary that the funds of investors are pooled.  What must be shown is that the fortunes of the investors are linked with those of the promoters.  Thus, a common enterprise exists if a direct correlation can be established between success or failure of the promoter’s efforts and success or failure of the investment.  So, it’s not necessary that the investment be for a share of the company’s profits.  As long as the success of the investment depends on the success of the company where the investment is made, this prong of the test is met.

Expectation of Profits

The Howey Court has defined “profits” as either capital appreciation resulting from the development of the initial investment or a participation in earnings resulting from the use of investors’ funds.  So, basically, if the expectation and/or promise is that the investment will make the investor money, this prong of the test is met.

From the Efforts of Others

This prong of the test is often described as “material participation.”  If the investor merely makes a monetary investment in an enterprise and walks away without participating in the business in any other way, then this prong of the Howey test is met.  You can avoid meeting this part of the test if the investor is also really a “partner” (i.e. they bring something to the table other than money).  Maybe they have some expertise, know-how, or contacts that are used by the company to make a profit.  Maybe they materially participate is the company’s decision-making process.  If they don’t, then this prong of the test is met.

Think you’ve got a pretty good handle on all that?  Well, then chew on this – the Howey Court also noted that the definition of a security: “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.”  In other words, if you think you’ve got an idea that beats the system – you probably don’t.

Like I said – nobody wants to go to prison.  When it comes to raising capital in a way that keeps you on the right side of the bars, it’s essential to know whether what you are offering and selling really is a security.

When it comes to raising capital in a way that keeps you on the right side of the bars, it’s essential to know whether what you are offering and selling really is a security.