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What is a “Security”?

What is a “Security”?. Investment Contract. The Howey Test. THRESHOLD: contract, transaction or scheme 1. INVEST MONEY 2. COMMON ENTERPRISE 3. EXPECTATION OF PROFITS 4. EFFORTS OF ANOTHER. Investment Contract. LAND SALES CONTRACT. Investors. FRED. SERVICE CONTRACT.

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What is a “Security”?

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  1. What is a “Security”?

  2. Investment Contract • The Howey Test THRESHOLD:contract, transaction or scheme 1. INVEST MONEY 2. COMMON ENTERPRISE 3. EXPECTATION OF PROFITS 4. EFFORTS OF ANOTHER

  3. Investment Contract LAND SALESCONTRACT Investors FRED SERVICECONTRACT • Back to Howey Inc. W.J. Howey Co. Howey-in-the-Hills Service Inc. COMMONENTERPRISE?

  4. Investment Contract • Common Enterprise 1. HORIZONTAL COMMONALITY return to a group of investors are pooled and are correlated with one another 2. VERTICAL COMMONALITY promoter’s efforts affect the individual investors collectively a. BROAD – promoter not at risk b. NARROW – promoter takes on risk

  5. Investment Contract • Common Enterprise – Horizontal Commonality -15% +10% +10% -15% -15% +10% +10% -15%

  6. Investment Contract • Common Enterprise – Vertical Commonality +10% -5% +15% +10%

  7. Investment Contract 20 – 30%referral fee • SEC v. SG Ltd. stockgeneration.com

  8. Investment Contract • In Honor of Charles K. Ponzi

  9. Investment Contract If SG Ltd takes in $1 million then how much does it owe the investors over time? $9.5 trillion $1 million $3.2 million $9.9 million . . . Year 0 Year 12 Year 1 Year 2

  10. Investment Contract HORIZONTAL? VERTICALBROAD? NARROW? • SEC v. SG Ltd. THE HOWEY TEST Threshold: Ponzi scheme 1. INVEST MONEY? 2. COMMON ENTERPRISE? 3. EXPECTATION OF PROFITS? 4. EFFORTS OF ANOTHER?

  11. Investment Contract HORIZONTAL? VERTICALBROAD? NARROW? • SEC v. SG Ltd. THE HOWEY TEST Threshold: Ponzi scheme 1. INVEST MONEY? 2. COMMON ENTERPRISE? 3. EXPECTATION OF PROFITS? 4. EFFORTS OF ANOTHER?

  12. Investment Contract • SEC v. SG Ltd. • 1. Do you think stockgeneration.com was a game or an investment? • it is possible to be both • Does it matter what the participants in stockgeneration.com thought?

  13. Investment Contract • SEC v. SG Ltd. • You gamble all your money on 32 red. You lose. You feel defrauded because the casino said “everyone goes home a winner.” • Is the gamble a security transaction? • invest money? • common enterprise? • expectation of profits? • efforts of another?

  14. Investment Contract • SEC v. SG Ltd. 2. Which formulation of commonality do you think best serves the purposes of the securities laws?

  15. Investment Contract • SEC v. SG Ltd. Scenario A A cosmetics company sells “distributor rights” for $100,000 each. Existing distributors earn a $20,000 return for each new person they refer to become a distributor. The cosmetics company hosts a Las Vegas convention and gives existing distributors a script to attract new distributors.

  16. Investment Contract • SEC v. SG Ltd. Scenario B Individual owners of condos turn to a leasing company to help lease their apartments. The leasing company takes care of advertising, renting, collecting rent, and maintenance. The leasing company is paid a fixed annual rate.

  17. Investment Contract • Recognizing Scams • Asks for Money Up Front • Promises Abnormal Returns • Uses High Pressure Sales Tactics • Testimonials from Big Winners (Euphoria) • Person to person pressure (Only one left; want to be nice to me?) • Targets vulnerable marks (older; less savvy) • Depends on a Continuing Flow of New Investors • (a/k/a Suckers) • Enlists initial investors in attracting new investors

  18. Investment Contract • Recognizing Scams • Promoter Characteristics • Very Personable • “He doesn’t look like a con artist!” • History of Scams • Wants a Quick Exit • Odd Technical Systems of Organization • Odd Use of Language in Contracts

  19. Investment Contract • The Howey Test THRESHOLD:contract, transaction or scheme 1. INVEST MONEY 2. COMMON ENTERPRISE 3. EXPECTATION OF PROFITS 4. EFFORTS OF ANOTHER

  20. Investment Contract • Expectation of Profits • SECURITIES TRANSACTIONS • – key characteristics • - information asymmetries • - collective action problems • - “closeness” to public capital markets • - tendency of investors to get “greedy” • - lack of another, comparable regulatory regime

  21. Investment Contract $25 / share INVESTORS / TENANTS RIVERBAYCORPORATION stock one room (per 18 shares) STOCK? CO-OPCITY • United Housing Foundation, Inc. v. Forman INVESTMENTCONTRACT?

  22. Investment Contract • United Housing Foundation, Inc. v. Forman 1. Does the Co-Op share or an IBM share better fit the traditional characteristics of “stock”? Does all stock have the same characteristics? RIVERBAY IBM NO NO NO NO Dividend – Profit Transferable Voting Rights Appreciable Value YES YES YES YES

  23. Investment Contract • United Housing Foundation, Inc. v. Forman 1. Would the following changes make the Riverbay “stock” a security? - stock is transferable? - voting rights attach to stock? - tenants / investors can capture appreciation gains? - dividends based on profits from the community center stores? - all of the above?

  24. Investment Contract • United Housing Foundation, Inc. v. Forman • 2. Why does the Court also find that the Co-op shares are not investment contracts? • - invest money? • - common enterprise? • - expectation of profits? • - efforts of another?

  25. Investment Contract • United Housing Foundation, Inc. v. Forman • 3. Should courts use the Howey test to determine whether the stock of particular companies counts as a security? • - “form should be disregarded for substance and the emphasis should be on economic reality”

  26. Investment Contract • United Housing Foundation, Inc. v. Forman • 4. What if the Court held that anything labeled “stock” fell within the definition of a security? • - avoid securities regulatory scheme by not labeling instrument “stock”

  27. Investment Contract ~$7,000 • SEC v. Edwards Investor ETSPayphones site lease $82 / month 14% annualreturn leaseback and management agreement buy back agreement

  28. Investment Contract • SEC v. Edwards • 1. Was the Court’s conclusion that a guaranteed return did not exclude a financial instrument from the definition of a security consistent with the emphasis on risk reduction in earlier cases? • - representations of low-risk areharmful to the unsophisticated investor • this was really a high risk investment inneed of securities regulatory protections

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