Investment Contract (Securities Law) - Explained
Using the Howey Test
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What is an Investment Contract?
An investment contract is a broad category of security under The Securities Act of 1933. The text for determine what is an investment contract is examined below.
Next Article: Major Federal Securities Laws Back to: SECURITIES LAW
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 Alices 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.
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?
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?
- Securities Law (Intro)
- What are Securities Laws?
- What is a Security?
- What qualifies as an Investment contract?
- What are the primary federal securities laws?
- What are the regulatory goals of security laws?
- What is the Securities and Exchange Commission?
- What is an Initial Public Offering?
- What is a Direct Public Offering?
- What is Crowdfunding?
- Securities Act of 1933
- What is an Offer to Sell securities?
- Who are the parties regulated in an offer to sell securities?
- What are the primary disclosure documents required in an offer to sell securities?
- Forward Looking
- Red Herring Prospectus (Securities) Definition
- Registration of Securities
- What is an issuer allowed to do at each stage of the registration process?
- How are issuers classified for purposes of the registration and offering process?
- What is an issuer allowed to do during the Pre-filing Period?
- What are the limitations on the issuer during the Post-filing, Waiting Period?
- What is an issuer allowed to do during the Post-Effective Period?
- What is an Emerging-Growth Company?
- What type of information must an issuer disclose?
- What laws govern the mechanics of disclosure in a securities offering?
- Deficiency Letter (Securities Law)
- Registration Exemptions Securities Act of 1933
- What are Exempt Securities and Exempt Transactions?
- What are Restricted Securities?
- Section 3(a)?
- Section 3(b)?
- What is a Rule 147 Exemption?
- What is a Section 4(a) Exemption?
- Section 4(a)(5)?
- What is a Regulation A Exemption?
- What are Regulation D Exemptions?
- What is a Rule 504 Exemption?
- What is a Rule 505 Exemption?
- What is a Rule 506(b) Exemption?
- What is a Rule 506(c) Exemption?
- What is Rule 502(d) and the Rule 144 Safe Harbor?
- Rule 144a
- What are the disclosure requirements for companies employing an exemption?
- What is the requirement to file Form D?
- What is the effect of failing to register an offering under Section 5?
- Liability Under the Securities and Exchange Act of 1933
- What is civil liability under Section 11 of the 33 Act?
- What is civil liability under Section 12 of the 33 Act?
- What are defenses available to charges under Sections 11 and 12?
- What is civil liability under Section 17 of the 33 Act?
- What is potential criminal liability under the 33 Act?
- The Security Exchange Act of 1934
- When must an issuer register pursuant to the 34 Act?
- What disclosures are required of reporting companies under the 34 Act?
- What is liability under Section 10(b) and Rule 10(b)(5)?
- What is insider trading under Rule 10(b)(5)?
- What damages are available under Section 10 and Rule 10(b)(5)?
- What is insider trading under Section 14 of the 34 Act?
- What is liability under Section 16 of the 34 Act?
- What is liability under Section 18 of the 34 Act?
- What is criminal liability under the 34 Act?
- Liability under the Securities Enforcement Remedies Act?
- Blue Sky Laws State Securities Laws
- What are Blue Sky Laws?
- When is an issuer required to comply with state securities laws?
- What are the registration requirements under state law?
- What is Coordinated Registration under state law?