An “Investment Contract” is a “Security”

Why is the term "investment contract" which appears in the definition of "security" in the federal Securities Act of 1933, the federal Securities Exchange Act of 1934, and the Texas Securities Act corporate stock so important? Corporate stock is a "security" of course — that’s clear on the face of the statutory definitions. Bonds and debentures? Yes, for the same reason. [Because the securities laws elevate substance over form, in some very unusual circumstances an instrument denominated “stock” may not be treated as a security for purposes of the securities laws where it in economic reality is utterly lacking in the attributes of typical corporate stock; but because the statute says “stock” is a security, anyone contending that an instrument labeled “stock” is not a security faces a very heavy burden of proof to establish otherwise.]

What about a limited partner interest in a limited partnership? A member interest in a limited liability company? Or even a general partner interest in a general partnership or joint venture? Other than the TSA (where a limited partner interest is included in the statutory definition of “security”), neither of these common forms of equity ownership is among the list of instruments within the statutory definitions of “securities.” Yet, there is a nearly conclusive presumption that LP interests are “securities” under federal and state securities laws; a presumption that member interests are; and a possibility that general partner interests may be (although presumably they are not).

Why? The reason lies primarily in another type of “security” listed in the definitions sections of the statutes: “investment contract”.

Back in 1981, the 5th Circuit Court of Appeals (which includes Texas) considered in Williamson v Tucker whether joint venture interests may be securities and concluded that under certain narrow circumstances, the answer is yes. The analytical tool for making that determination was first announced in a 1946 opinion by the US Supreme Court in Howey, where the court described what the term “investment contract” means (important, since the statutes do not define the term):

1. An investment of money
2. In a common enterprise
3. With an expectation of profit
4. Solely from the efforts of others

Whether a transaction involves the first and third elements is usually obvious. As the 5th Circuit observed, the “solely” standard in the fourth element should be read flexibly and not literally, and in Williamson the court adopted “a more realistic test, whether the efforts made by those other than the investor are … those essential managerial efforts which affect the failure or success of the enterprise.” In subsequent decisions, the 5th Circuit (unlike some other US Circuit Courts) extended the term “common enterprise” in the second element to include “vertical commonality” between a single investor and the promoter as well as “horizontal commonality” among multiple investors.

In Wiliamson, the 5th Circuit concluded that an investor claiming his general partnership interest is an “investment contract” has a difficult burden to overcome because as a general partner, the investor normally “retains substantial control over his investment and an ability to protect himself from the managing partner or hired manager.” But the investor might prevail

[if he can ] demonstrate that, in spite of the partnership form which the investment took, he was so dependent on the promoter or on a third party that he was in fact unable to exercise meaningful partnership powers.

It is the Howey test (as modified) which, in Texas, the 5th Circuit and most of the US, is the appropriate test against which to measure whether a limited partner interest, member interest, or general partner interest is a “security.”

AND to measure whether another investment transaction — regardless of its form — in substance involves the first three elements of Howey and a dependence upon the efforts of others sufficient to satisfy the fourth element.

That is why — along with more conventional forms of investment vehicles like partnerships and LLCs — the individual who transfers cash or other property to acquire an ownership interest in, a consulting agreement regarding, a nominally commercial contract concerning, or another contractual arrangement involving, fruit trees, a hog raising program, a thoroughbred horse syndication, viatical agreements, cemetery lots, a livestock breeding program, whiskey, rabbits, public pay phones, recording agreements or almost any other tangible or intangible property, may become the holder of an “investment contract” and entitled to the protections afforded investors under federal and state securities laws.

And also why the counterparty to whom he transfers that money may find himself or itself on the opposite side (read “subject to criminal or civil liability”) of the same laws.

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