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  3. What is an Investment Contract under Securities Law

What is an Investment Contract under Securities Law

3. What qualifies as an “investment contract”?

The broadest category of a business interest constituting a security is an “investment contract”. Courts have developed a number of tests to determine what constitutes an investment contract. The most influential is the “Howey test”. The elements for determining whether a business interest constitutes an investment contract (and thereby a security) are as follows:

•    an investment of money,

⁃    Note: To invest money means to provide any sort of value to the company in exchange for a beneficial interest in or ownership of the company. The investment does not have to be cash or currency.

⁃    Example: I receive an ownership interest (10% ownership) in your business activity in exchange for my contribution of a pickup truck for use in the business.

•    in a common enterprise,

⁃    Note: A common enterprise is any form of concerted business activity. The enterprise does not have to be a registered business entity.

⁃    Example: A common enterprise may include a default entity form, such as a general partnership.

•    with the expectation of profits, and

⁃    Note: The expectation of profits is a very broad notion. An individual can invest in the enterprise with the purpose of directly or indirectly deriving profits. This may include the objective of taking advantage of any tax benefits associated with the investment.

⁃    Example: I invest in ABC, LLC. The LLC will have losses this year and for the next couple of years. I am not actively involved in the business. As such, I will be able to offset the passive losses against the active profits I have in a separate investment. This will reduce my tax liability. Eventually, I expect ABC, LLC to produce a profit.

•    derived solely from the efforts of others.

⁃    Note: Derived solely from the efforts of others means that the investor does not actively take part in the business activity. She may be able to offer limited guidance to the business managers, but she does not take part in the active affairs of the business. This provision seems to eliminate investments in games of chance that do not involve a business activity or a concerted activity with someone else.

⁃    Example: I am interested in providing money to Alice’s design services business. I may offer some guidance to Alice in how to run the business, but I do not take part in any of Alice’s business operations. It is Alice’s efforts and not my personal activity that constitute the business (such as in a sole proprietorship or general partnership).
Each element of this test requires considerable analysis. Courts have interpreted each element to add a great deal of specificity and complexity to the individual factors.

•    Discussion: Why do you think the definition of an investment contract has been interpreted so broadly? What would be the potential effect of a narrow interpretation?

•    Practice Question: Ralph is an avid gambler. He loves to wager money on any type of sporting event or game of chance. He puts his money in a pool to purchase lottery tickets under the understanding that everyone will split any winnings. Is this an investment contract? Why or why not? Does it change your analysis if Ralph and the other investors depend upon Carter to manage the funds, purchase and hold the tickets, collect any winnings, and distribute those funds to any investors? Why?

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