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Transcript

Introduction to SEC v. Howey and Why It Matters

The story we’re going to go through today goes to the heart of whether what you’re working on right now is a security and something that needs to be registered with the SEC, or come under an exemption or be part of a blue sky law. Or if it’s something else, just a contract. Today, we’re going to talk about the case of SEC versus Howey.

As a syndication attorney and attorney that works on private equity funds, my favorite case of all time has to be SEC vs. Howey. This is the fundamental case that talks about whether something is a security or is not. So I thought it would be helpful for you to go through that case, what happened and what that decision is. And then out of that, you can extract what you’re working on and apply it and see, does this make sense? And is what I’m working on right now a security or not?

The Howey Orange Grove Business Model

So let’s go through it. A long, long time ago, in the 1930s and early 1940s, there was a company named Howey, and Howey Corporation did one thing and it did it very well. They would buy 500 acres of land. And out of that 500 acres of land, they would cut it up into strips but not all the way. So they would cut about half of it into strips, and then the other half they would leave for themselves. Now these strips had on them 48 orange trees.

They also owned a resort. In this resort, guests would come from around the country, not only from Florida, but most of their guests would come from other states. So the guests would come and they would see pamphlets as part of the thing saying “come visit the beautiful orange trees.” These orange trees just happened to be the ones located on these strips.

The Investor Sales Pitch and Promised Returns

So they’d come and visit and then they would begin the sales pitch. The sales pitch went something like this:

“Dear Mr. Investor, you see how beautiful this place is. We’ve got orange trees, and you know how much money we make from those orange trees. We make a lot of money. That’s how we can afford to have a beautiful resort like the one you’re staying in. Do you like your steak? Sure you do. Now as part of your stay, you also get to see this. But you know, we have a special right now that we would like you to be part of our business.

You see, we’ve got these orange trees that we’ve divided up into special strips. And as part of that we’re offering to sell you a beautiful piece of that tract of land with 48 trees you can buy. Now most of our people buy about five of these strips, but you could buy more, you can buy as many as you like.”

“What you’ll get is full title. We’re not going to own anything to do with this land. This is your land where you can make just as much money as we make selling oranges. Now I understand you’re from out of state. But as the deal goes, we just so happen to be experts at farming oranges. As you can see, the orange trees are all in bloom, everything’s going very nicely. So what we’re willing to do is this: we will take a lease on your property. This is supposed to be a lease. We’ll take a lease on that property for 10 years. And as part of that lease, we’re going to pay you money because you own the land, right? And so we’re going to pay you for the right to use your land but we’re also going to pay you part of the profits. Does that sound like a good deal?”

“Now what kind of returns are we talking about? I’m sure you’ve seen many other hotels, on Facebook and things like that offering similar packages. Well, right now we’re not offering a preferred return, but we are offering an IRR of 20%. Sounds pretty good and slick. How safe is it? You own title to the land, all you need to do is buy the land. And we’re going to enter into this contract in order to do the servicing of that land.”

Expansion of the Offering and SEC Scrutiny

So that’s the sales pitch that these investors would hear. And they would get people to invest in this. And people would come from around the state. And so as this became more and more successful for Howey, they also decided that the resort was only doing so well, that maybe they should also just send regular mail out. And so they’d send regular mail and they’d either invite them to the resort, or they’d invite them to this and they’d tell people about this great investment opportunity.

Now that all sounds well and good, right? Sounds like a simple transaction. Well, the SEC didn’t agree. The SEC said, “Hey, hold on a minute, you guys, Howey, this is a security what you’re doing here. And that as a security, it’s just not going to work. You need to either register it or you need to come under some exemption.” Now Rule 506 Reg D did not exist at this point. But there were other exemptions that were occasionally used.

Howey needed to get their act together. Howey said no, this isn’t a security at all. We don’t need to do that. And so it went to court.

Lower Court Rulings and the Appeal

And ultimately it found its way up to the Circuit Court of Appeals. So that’s the second level. So it went to federal court first and then it went up to the Court of Appeals, and the Court of Appeals looked at this closely, and they said, “You know what? We think Howey’s right. We don’t think that this is a securities contract, that this is an investment contract.”

The law is this: an investment contract is a security. But we don’t think this is an investment contract. Why? Well, for two reasons. We don’t think this is an investment contract, first of all, because it’s not speculative. The investors are buying the land. Right. So that’s not speculative. They’re getting that land. There’s nothing speculative about it.

And the second problem with it being a security is this: the sale itself had value. So it was the sale of the land that Howey was selling. And certainly the sale of land isn’t a security. Right?

The Supreme Court Defines the Howey Test

Well, so this case went all the way up to the Supreme Court. And the Supreme Court took a look at it, and they saw where it said investment contract. And that’s what was really the question, what exactly is an investment contract.

Now also, as a side note, I put some other of what is a security here, just because I think it’s interesting: promissory notes, stock, treasury stock, bonds, certificates of interest, participation and profit sharing agreement.

But let’s go back to what the Supreme Court was saying. And the Supreme Court looked at this and said, “You know what, let’s put that aside, I think there should be a four-part test.”

That four-part test should look like this: that any time that there is an investment of money in a common enterprise, with the expectation of profit, which is based on the effort of others, that’s an investment contract, and that is a security by the Securities Act of 1933.

Applying the Four Elements of the Howey Test

So was there an investment of money? Yes, there was an investment of money in the land, because the people who bought this land didn’t have a choice on how it would actually be practical to service that land.

Number two: Was there a common enterprise? Absolutely. This was orange farming.

Number three: the expectation of profit. Nobody buys a strip of orange grove land without expecting to make money.

And number four, it’s based on the effort of others. Howey was doing all the work—leasing the land, farming the oranges, and distributing profits.

So this was the core element of why the Supreme Court said, “Howey, this is an investment contract… this is a security.”

Applying the Howey Test to Modern Deals

Now let’s go back to what you’re working on. You have to ask yourself, does it fit into those categories? Does it meet the definition of an investment contract?

Was there a contribution of money in a common enterprise with the expectation of profit based on the work of another—meaning you, the syndicator, or the fund manager?

Because there are other things too that also constitute a security, such as notes and promissory notes, as long as there’s an investment going in with the expectation of profit.

So when people say, “We’re just taking loans from friends and family,” that doesn’t necessarily exempt it. The only loans that are really exempt are loans from banks. Loans from individuals can be securities if they meet the Howey Test.

Likewise, participation in any profit-sharing agreement, as long as that profit sharing relies on investors being passive, is a security which must either be registered with the SEC or fall under an exemption like Regulation D.

And it doesn’t matter whether it’s written down or not. What matters is what’s in the investor’s head. Does the investor believe they are passive? Or are they actually passive? Either one can make it a security.

Why the Howey Test Still Controls Securities Law

So I hope that helps. This is the big test in all of securities, the Howey Test, super famous, because it outlines those four elements that are present in any security. While there has been new case law over the years, it has largely clarified the boundaries—not replaced the test. These four pillars are still the foundation.

My name is Tilden Moschetti. I am a syndication securities attorney with the Moschetti Syndication Law Group. Now if we can help you in your offering and your security offering, please don’t hesitate to give us a call. We can go through whatever you’re working on and determine with you whether or not it’s a security, and whether it makes sense that it is—or in some cases, that it isn’t.