What is a Security?
Article Date: Thursday, November 04, 2010
Written By: Allan C. J. Russ
Businesses often need capital. One way to raise capital is by selling securities to investors. The definition of “security” is broader than many people may think. Determining whether you are working with a matter that involves a “security” is important because, if you are, compliance with the federal and state securities laws, including the registration and anti-fraud provisions, is required.
Generally speaking, when the product being sold is a “security,” it must be registered or be eligible to claim an exemption from registration. The persons who offer and sell securities in North Carolina must also be properly registered to engage in that business activity. Furthermore, the securities laws require full disclosure of all material facts regarding the issuer of the securities so that an investor has all the necessary information that he or she needs to make a fully informed investment decision.
Failure to comply with the North Carolina Securities Act (Chapter 78A of the North Carolina General Statutes, the “Securities Act”) can result in administrative, civil, or criminal actions against non-compliant individuals and entities. This failure also results in a transaction that, for your client, is vulnerable to attack.
“Security” is defined in N.C.G.S. §78A-2(11) and includes the following popular instruments:
any note; stock; bond; evidence of indebtedness; participation in any profit-sharing agreement; investment contract; participation in an oil, gas, or mining title or lease; and a viatical settlement contract.
This article is focused on one of the products mentioned above; the “investment contract.”
An “investment contract” is considered to be a “catch-all” for the definition of security. That is, if the product is not a note, stock, bond, evidence of indebtedness, etc., then one would need to look at the product and the way it is marketed and sold to determine if it meets the definition of an “investment contract.”
There are at least two recognized “tests” to determine whether a product is an “investment contract” under the Securities Act and those tests are found in the administrative rules. The first test is derived from the seminal case S.E.C. v. W.J. Howey Co., 328 U.S. 293 (1946) and it is known simply as the “Howey” test. The second test is known as the ‘Hawaii Market Center” test as it is derived from the case State v. Hawaii Market Center, Inc., 485 P.2d. 105 (1971).
Both tests are found in Title 18, Chapter 6A of the North Carolina Administrative Code, Rule .1104(8). The first test in Rule .1104(8), in keeping with the Howey test, provides that an “investment contract” includes (1) any investment in (2) a common enterprise (3) with the expectation of profit (4) to be derived through the essential managerial efforts of someone other than the investor.
The second alternative formula found in Rule .1104(8) (the “Hawaii Market Center” test) provides that an “investment contract” includes an investment by which (1) an offeree furnishes initial value to an offeror, and (2) a portion of this initial value is subjected to the risks of the enterprise, and (3) the furnishing of this initial value is induced by the offeror’s promises or representations which give rise to a reasonable understanding that a valuable benefit of some kind over and above the initial value will accrue to the offeree as a result of the operation of the enterprise, and (4) the offeree does not receive the right to exercise practical and actual control over the managerial decisions of the enterprise.
With respect to the Howey test found in Rule .1104(8), the first element of an “investment of money” has been defined by case law very broadly to include virtually every contribution of capital, services, or otherwise. Courts will look to whether the investor subjected herself to financial loss by committing assets to the enterprise.
With respect to the “common enterprise” element of the Howey test, “common enterprise” refers to the relationship between and among the promoter and the investors. Courts across the country are divided as to whether “horizontal commonality” or “vertical commonality” is required.
Horizontal commonality occurs when there is a pooling of money into a common fund that is then used to fund the enterprise. All people who have money in the “pool” are sharing the risk of loss and the hope of profits. These people are said to be involved in a common enterprise if they are in a jurisdiction that adopts the “horizontal commonality” position.
North Carolina is a jurisdiction that has adopted the “vertical commonality” version of a “common enterprise.” The “vertical commonality” test has at least two forms; the “broad” form and the “narrow or strict” form.
Under North Carolina’s Rule .1104(8)(a), “common enterprise” means an enterprise in which the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment or of a third party. This test for “common enterprise” is known as the “broad vertical commonality” test. For federal securities laws purposes, however, “strict vertical commonality” involving showing that investor’s profits are directly related to promoter’s profits should be shown; “broad vertical commonality,” under which fortunes of investor need be linked only to efforts of promoter, is not sufficient. See SEC v. Pinckney, 923 F. Supp. 76 (1996).
The element of “expectation of profit” occurs when a person expects that their investment will produce a profit. For example, profits can come through capital appreciation or a participation in earnings.
The fourth element of the Howey test, “to be derived solely from the efforts of others,” requires an examination into the level of control retained by the investor. Courts will examine the investor’s involvement in the day-to-day operations or management decisions of the business enterprise to determine whether the investment depends solely on the efforts of others. Here, the courts are more interested in substance over form.
Essentially, one can easily condense the four elements of the Howey case into a neat rule of thumb. That is, if you have a “passive investment” made by an investor into some kind of enterprise, you are dealing with a matter that involves a “security.”
With respect to the Hawaii Market Center test for an “investment contract”, the Hawaii Market Center test is a combination of the Howey test with “risk capital” concepts added: if an investor puts his capital at risk of loss in order to finance an enterprise, with an expectation of a benefit, then the investment opportunity being offered is a “security.”
Again, these two tests for defining what is an “investment contract” under the Securities Act, and therefore a “security,” are critical because they help you determine whether a “security” is involved and whether the registration and anti-fraud provisions of the Securities Act apply to the particular transaction.
The Securities Division of the Department of the Secretary of State has seen a recent increase in people wishing to buy and sell distressed properties, either for the purpose of buying and managing the properties or simply “flipping” the properties after improving the property in some manner. Often, these persons seek capital contributions from investors to help them in purchasing or rehabilitating the properties in question.
These business activities could subject a client to find herself offering and selling securities in the form of an “investment contract.” Additionally, the client may also be offering and selling to investors other securities in the form of an LLC interest or a promissory note.
These business opportunities, if they satisfy the definition of an “investment contract” or a “security” would require your client to (1) comply with the registration provisions of the Securities Act and (2) ensure that they are providing all material information about the enterprise to investors.
If you should have any questions about whether or not you are involved in a transaction where a security is being offered or sold, please do not hesitate to contact the Securities Division to talk about compliance with the securities laws. The Securities Division’s telephone number is (919) 733-3924 and our e-mail address is email@example.com .
Russ is the Deputy Director of the Securities Division of the office of the North Carolina Secretary of State.
Views and opinions expressed in articles published herein are the authors' only and are not to be attributed to this newsletter, the section, or the NCBA unless expressly stated. Authors are responsible for the accuracy of all citations and quotations.