Episode 63 – Are You Creating a Security? The Howey Test Knows: A Look At SEC vs. Howey

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?

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.

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.”

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. So 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.

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?

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. And we’ll talk about those in just a minute.

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.” And 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.

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. Right. So they bought the land.

Number two: Was there a common enterprise? Absolutely. This was orange farming. I mean, you know, these people were all coming together in order to farm oranges to make money, which is number three, the expectation of profit. Now nobody goes and just buys a strip of land in the middle of Florida without there being some expectation of profit, because why would you buy a strip of Orange Grove in the middle of nowhere, just to say you own one, right? You’re expecting to make money.

And number four, it’s based on the effort of others. Here Howey was doing all the work, they were leasing it, and then they would do all the work on the actual farming, and then they’d share in the profits.

So this was the core element of why it became why the Supreme Court said, “Howey, this is an investment contract, Howey you did wrong, this is a security.”

Now let’s go back to what to this note one more time. So when we take a look at what you are working on, you have to ask yourself, does it fit into those categories? So does it meet? Is it an investment contract? Was there a contribution of money and investment of money in a common enterprise with the expectation of profit based on the work of another meaning you the syndicator, probably is that person or the fund manager is that? Are those elements there?

Because there are other things too, that also constitute a security such as notes, a promissory note, as long as there’s an investment going in with the expectation, it may be a security. Now, not all notes are securities, but the ones that I hear about all the time, are securities, and that’s where they get a bunch of people together, they say, “Hey, we’re gonna borrow $5,000 or $5 million, in order to get our business off the ground, and we’re gonna raise it from friends and family.”

So that doesn’t qualify does it? We’re just gonna pay them simple interest, we just are taking loans from everybody. Well, the only loans that are exempt from this are really loans from banks. A loan from other people is a security as long as it meets those tests, as long as it’s an investment of money. So I’m giving you this money in order for your business, within a common enterprise, your business with the expectation of profit, I’m expecting to get that money back plus interest, and relying on the work of another meaning you. I’m expecting you to do your business so that you can afford to pay me back. Right, that is a security.

Likewise, this participation in any profit sharing agreement, as long as that profit sharing agreement is relying on the investor taking a passive role. That 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. As I’ve said in other videos, what matters is what’s in the investor’s head. Does the investor believe that they have a passive role? Or do they actually have a passive role? Either one of those is fine to make it automatically a security.

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. It’s the very clear rule, which helps us to find it. Now, of course, there’s been new case law, but the new case law has just helped let us know what the boundaries are. Those are still the main four pillars in any test to see whether or not it is a security.

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, we can talk about whether it makes sense that it is or in some cases it doesn’t. Because sometimes I’ve had people call me and at the end of the day, I don’t think it’s a security and neither should they. So if we can be of help to you in doing that exploration, we’d be happy to do it.