Today I will begin talking about the definition of a security as an investment contract and the landmark U.S. Supreme Court case of SEC v. W.J. Howey Co. the result of which has become commonly known as the “Howey Test.”
Under the Howey Test, whether an investment instrument is a security requires a substance-over-form analysis. Clearly a “stock” or “bond” is a security, but an investment contract can take many different forms and its underlying character may not be as easily recognizable. The Howey Test defines an investment contract as follows:
… an investment contract for purposes of the Securities Act means 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…. Such a definition…permits the fulfillment of the statutory purpose of compelling full and fair disclosure relative to the issuance of the many types of instruments that in our commercial world fall within the ordinary concept of a security…. It 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.
To further break down the analysis, Howey established a four-part test. In particular:
The first factor – requires an investment of money and has been expanded by subsequent cases to include any form of consideration with value;
The second factor is “In a common enterprise” –The majority of federal courts define a common enterprise as having “horizontal commonality,” which involves the pooling of money or assets from multiple investors with the sharing in the profits and risk in some proportion.
Another group of federal courts define a common enterprise as involving “vertical commonality,” which focuses on the relationship of the parties and whether one is relying on the efforts of the other. If a commonality of enterprise is found, regardless of the form it has taken, this factor in the test will be satisfied.
The third factor is “With an expectation of profits” – Profits can either be in the form of capital appreciation, cash return on investment or other earnings (including dividends or interest). Profits for purposes of the Howey Test refers particularly to a return to the investor and not necessarily the success of the enterprise as a whole. A Ponzi scheme clearly involves a security, even though the enterprise itself is designed to be a failure. The analysis turns on a finding that the investor is motivated by a return on his investment.
The fourth factor is the requirement that the potential profit be derived solely from the efforts of the promoters or third parties or in other words that it be a passive investment for the investor.