Definition Of A Security

Tuesday, March 22, 2005

Thomas Sherrard, Sherrard & Roe, Nashville, TN, http://

Better Business Management & Planning Practices

Definition Of A Security Still An Open, Evolving Question

Abstracted from: What Is A Security­Revisited
By: Thomas Sherrard Sherrard & Roe, Nashville, TN
Review of Securities & Commodities Regulation - Vol. 37, No. 18, Pgs. 227-234

Overview:
Surveys federal case law applying the definition of a security to novel financial arrangements. Observes that the definition is fluid and still evolving.

Still an unsettled question.
Recent cases indicate that the definition of a security­which determines what financial arrangements the federal securities laws govern­remains an open, fluid question, according to attorney Thomas Sherrard. As first defined by the US Supreme Court in SEC v. W.J. Howey (1946), a security is an investment contract through which investors put money into a common enterprise whose profits derive solely from other individuals’ efforts. A significant recent Supreme Court case, SEC v. Edwards (2004), concerns the sale of pay telephones. The seller then leased back the phones and managed them, while the purchasers played no role in daily business operations but were to enjoy a guaranteed, fixed return (which the seller proved unable to pay). The Court held on several grounds that this arrangement is a security: Howey applies equally to promises of fixed and variable returns; investments marketed as low-risk, such as those guaranteeing a fixed return, appeal strongly to investors who are vulnerable to fraud; and the guaranteed return came solely through others’ efforts.

Limited liability entities.
The Supreme Court, notes the author, has not decided the difficult question of whether Howey’s definition of a security encompasses membership interests in limited liability entities, which combine features of corporations, partnerships, and limited partnerships. The Supreme Court, since Howey, has eliminated the word "solely" from its restatement of the Howey definition. Noting that, the Fourth Circuit has stated it will look not to the entity’s form but to its economic reality. Therefore, membership interests are securities if the investors lack "meaningful control." The Fourth Circuit held in Robinson v. Glynn (2003) that the interests at issue were not securities, because, far from being passive, the investor had held management positions, appointed other managers, and wielded substantial power under the operating agreement.

Promissory notes.
Two 2002 Ninth Circuit cases, McNabb v. SEC and SEC v. Wallenbrock, follow the Supreme Court’s decision in Reves v. Ernst & Young (1990). The author explains that the Supreme Court created a rebuttable presumption in Reves: promissory notes are securities unless they resemble the notes in judicially devised classes of financial instruments that are clearly not securities. The Ninth Circuit observed that the lenders in both cases could reasonably regard themselves as having made an investment. In one case, the borrower used the money to reorganize a business; in the second, the borrowers sold notes­with a guaranteed return and apparently fictitious collateralization­to over 1,000 persons in 25 or more states.

Synthetic options and viatical settlements.
The Second Circuit has deemed synthetic options, which imitate the economic effect of physically trading actual shares and options, to be securities. This decision appears to be correct, the author finds, since the definition of a security in 1934 Act Section 3(a)(10) covers synthetic options and since a contrary decision could result in abuse. Two courts examined viatical settlements, under which an investor purchases the right to receive the benefits (minus administrative costs) of a terminally ill person’s life-insurance policy at a deep discount that depends on the person’s life expectancy. The DC Circuit held that viatical settlements are not securities under Howey, because the investors’ profits result principally from the insureds’ deaths rather than from the honest promoters’ post-sale efforts, which included creating a secondary market. The financial arrangements were similar in a case in the Northern District of Texas, but evidence there showed that the promoters were guilty of misrepresentation and misappropriation. The court reached the opposite result.

Abstracted from Review of Securities & Commodities Regulation, published by Standard & Poor’s, 55 Water Street, New York, NY 10041.

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