After their conversation yesterday on securities, Greg asked everyone, except Cleo, to do a bit of research on their own about the “Howey test” that the US Supreme Court used to define an investment contract, which in return will define securities. Today they come together at the dinner table again to present and trade their findings besides eating.
Greg: So, what did you guys find on the Howey Test? Who wants to tell us the background story behind the Howey Test?
Lily: Let me try it. According to the piece I’ve read, a Florida-based Howey Company sold land with citrus groves to buyers. They then asked the buyers to lease their land back to them, so they could grow and sell the citrus and split the money with the landowners.
Kimberly: I smell something strange. Why can’t Howey just use the land they own to grow and sell citrus? What’s the point of selling the land and then leasing back?
Lily: I wondered about the same. There must be something beneficial from doing the leaseback deal, most likely the company thought they did not have to register the transaction with SEC, and that was where their legal troubles started.
Jason: Wait! What is SEC?
Lily: Its full name spelt out is U.S. Securities and Exchange Commission. It’s a government agency in charge of regulating the securities markets and protecting investors. Right, dad?
Greg: You got it. It’s created 1934 by the Securities Act of 1933 and Securities Exchange Act of 1934, the two milestone laws in securities. Just remember this: Much of the securities rules and regulations didn’t exist until after the Great Depression in 1920s and early 1930s. They are the lessons learned by this country from the crisis.
Lily: Yeah, so in 1946, the SEC sued Howey because it believed the citrus deal qualified as an investment contract and therefore, Howey should have registered with SEC. The case went all the way to the U.S. Supreme Court.
Emily: I’m surprised that the Supreme Court agreed to hear it. To me it’s a small case.
Greg: Well, the Supreme Court in 1946 was not the Supreme Court today. What is important then is different from what is important now. It all changes by time.
Lily: After the court hearing it was decided that Howey should register with the SEC because the citrus business was an investment contract. The four conditions listed by the Supreme Court ruling then became one of the most famous case laws of this country.
Kimberly: I find it interesting that the whole definition of securities hinges on this single test. Mom was right when she called this Howey test “Almighty” yesterday.
Emily: That’s because the ruling of the Supreme Court was rich, containing four elements if I remember correctly.
Kimberly: You are right, I have written these elements down: The first is investment of money; the next is into a common enterprise; then investors must have expected profits and finally the profit is solely generated by efforts of others, not by the investors.
Greg: Since you’ve written it down, could you try to summarize the Howey Test for us?
Kimberly: It’s easy given the order I put the four elements down: Howey test says someone must invests money to a common enterprise or a company for the purpose of receiving profits that are solely generated from others’ efforts and time. If all four conditions are met, you have an investment contract and that defines a security.
Greg: Sounds good to me! Did anyone have questions?
Emily: I do! I have a friend whose dad invested in a farm — not with money but with a tractor he inherited from his father. Would that count as investment?
Greg: It would. “Invest money” has been later expanded to “invest asset” or valued resources. There is a catch, though, and not every book or article mentions it: Everyone will accept money, but not everyone will accept a tractor, depending on what the common enterprise needs. The investor would have to find out before investing.
Kimberly: What exactly is a “common enterprise?” We don’t hear that term often.
Lily: From what I searched, that term has never been precisely defined. Most federal courts defined it as “horizontal,” meaning several investors pooling their money or assets together to invest in a project. A common enterprise is similar to a “shared project” in that sense. But other courts have different definitions.
Greg: I think it is important to keep in mind that the SEC was created to tighten the control and regulations of securities, cleaning up the mess left by the Great Depression. With that in mind, the Supreme Court cared more about substance than form in its ruling.
Emily: What do you mean “substance over form?”
Greg: Let’s use the Howey example, the leaseback deal that the Howey Company did with the landowners in Florida. There was never a stock or bond issued by the company. Would that count as investment contract? We all know now that the Supreme Court said “Yes.” The landowners were investing their assets in the Howey Company, and therefore must register with the SEC.
Joy: Yeah, speaking of substance over form, I found this other legal test called the “Forman test.” It’s quite interesting because it tells us what a security is not, even though the transactions involved names like “stocks” or “shares.”
Emily: Really, that’s interesting. Tell us more about it please!
Joy: You guys can Google it yourself by using “the Forman Test of securities.” But the basic story was that this nonprofit organization called United Housing Foundation developed some low-cost, government subsidized housing units and asked that anybody wanted to rent an apartment must buy eighteen shares of stock first. The shares were not transferrable — remember dad said ownership liquidity for securities, that anyone can buy or sell any number of shares at any time? Well, this one did not have any liquidity, and shareholders had no voting rights, either. When they leave the housing unit they must sell the shares back to the nonprofit organization at the original price they bought.
Emily: How did the Supreme Court hear the case? I mean what happened that triggered Supreme Court hearing?
Joy: Like most legal battles, this one started when private interests were threatened. The nonprofits decided to raise the price for the units and 57 residents decided to file a lawsuit against the nonprofit. Interestingly, instead of accusing the nonprofit for simply raising price, these residents argued that the nonprofit violated the securities laws by issuing unregistered stock. The nonprofit argued back that the stocks it issued were not securities. That’s what the Supreme Court had to decide.
Kimberly: What’s the verdict of the Court?
Joy: Well, like dad was saying, substance over form. The Court basically agreed with the nonprofit and declared that just because it called its shares “stock” did not automatically make it an investment contract. The Court said something like when the transaction was motivated by consumption rather than investment for profit, the securities laws do not apply.
Lily: In other words, it is not how people call it, but what is really going on between investors and companies that matters.
Greg: Yeah. Some people get really creative with playing the names game just so they don’t have to register with SEC. It’s understandable because, let’s face it, it’s no fun to do the paperwork with government. Not just the paperwork but they must disclose all the crucial financial information to the public, like quarterly financial reports.
Joy: The Forman test was a big deal because it says you must separate consumption from investment.
Greg: Not all states agreed with the Forman test, though, despite the Supreme Court ruling.
Emily: Oh, really? Can states disagree with the Supreme Court?
Greg: Sure, there are federal laws and state laws, and if they disagree, your case will depend on which state you live or do business with.
Emily: Could you give us an example?
Greg: Yeah, I did my homework last night and found that there was one historical case right here in the Bay Area, in Marin County to be accurate. In 1959, let me quote this website, “some enterprising developers bought land in Marin County to develop a country club. To pay for some of the costs of building the club, they sold charter memberships in the club. The members would not share in the profits or ownership of the club but would have the right to use club facilities.”
Kimberly: Let me see if I could put it in plain English: Some Marin County real estate developers needed money to build a country club. So they announced that anyone investing in money would receive a membership to use the club, not an ownership of the club.
Greg: That’s it, you did a good job in translation!
Kimberly: That to me is another “consumption but not investment” case like the Forman test says.
Greg: Exactly. By federal definition the membership would not count as securities because investors only get the right to use, not the right to own the club. But the California Supreme Court disagreed and came up with a new test called “Risk capital test.” It said even if investors only got the right to use, they invested money in a risky business that could not guarantee the consumption right in the future.
Emily: Very interesting! So cases like that will be counted as securities and must register with the state of California.
Greg: Yup.
Kimberly: That says a lot because almost all investment of money involves risks, and few if any enterprise would guarantee the return of profit.
Greg: It did say a lot. Instead of profits in the future, it looked backward to risk involved when investors wrote checks to business. The California Supreme Court apparently wanted to protect the public from risky investment schemes with uncertain or risky results.
Emily: Dad, I would like to return to Howey test. Why did the Supreme Court asked for having someone else’s time and efforts to qualify for a security? Why can’t it allow investors to take control of the company and be the managers?
Joy: I have been thinking of the same question myself, and I think I have an answer: Separating investors from company managers helps the company grow and reach a scale.
Emily: Are you saying a security is not like a family business? You know, like mom and dad do everything themselves: investing their own money, working together to control everything in business.
Joy: That’s a good way of saying it.
Kimberly: I have a simpler explanation: Just think about borrowing money from a friend. If you own a business and wanted to borrow money from your friend, would you like to have that friend manipulate or manage your business, just because s/he lends you money? Of course not.
Joy: An excellent point. It reminds us that all laws are based on common sense.
Lily: I think the other reason is efficiency: Many investors know nothing about a particular business, and they may not be interested in it, but they are the ones with the money. Why not invest the capital and let someone else run the business. Everyone is happy and gets to do what they do best.
Joy: Another good point! I want to clarify one point about family business: At first they do everything by themselves but later when they grow bigger, they will hire someone else for managing the business. Some family businesses may also need more capital to grow. If they decide to go to public for funds, they turn themselves into the securities market.
Emily: If a family business stays private and never issues stocks and never lists itself on the stock market, would it qualify as a security?
Joy: It’s funny you asked. I came across this notion of “private securities” earlier. Apparently securities include both public and private types. It’s just that most securities we know are public.
Emily: So how the private securities differ from public?
Joy: A privately owned security does not issue any stock to the public. It is also not required to register with the SEC and do all the disclosures like public securities must. Of course, its downside is not to be able to sell stocks to the general public, only to accredited investors.
Emily: Who are the accredited investors?
Joy: I did some follow-up research and found that an accredited investor may be an individual or an entity like an organization, a firm, a bank, an insurance firm. Basically they are financially sophisticated, like a stockbroker or a licensed financial advisor, or with so much money that they do not need the protection by SEC.
Kimberly: I heard about accredited investors before. My school once invited a startup founder to speak to us and he mentioned that they prefer to get private funds from accredited investors, not through IPO …
Jason: What’s IPO?
Kimberly: It stands for Initial Public Offering, to raise capital from the public for new companies. The startup will sell shares of their stock to everyone who wants to buy. Of course, it’s public, so SEC will be involved. The speaker said they didn’t want to go through all the regulations and paperwork, so they chose to go private.
Joy: Speaking of startups, did you hear the term “Unicorn?” That’s a term used in the venture capital industry to describe a privately held startup company with a value of at least $1 billion.
Jason: Could you give me some examples of Unicorn?
Joy: This one I am sure you have heard: ByteDance, who owns TikTok, and SpaceX by Elon Musk.
Jason: Oh yeah! Let me check their valuation. Oh, ByteDance is valued at $140 billion, and SpaceX is at $100+ billion. By the way, how do they know the value of a startup?
Greg: The key is to separate two values: Intrinsic versus market. A startup is about to enter the market but not yet, so we don’t know its market value. But experts can come up with an estimated intrinsic value based on future earnings or some other company attribute unrelated to the market price of a security.
(At this point the dinner table conversation ends.)