Category: What is a Security?

Is a Cow a Security?

If the investment is a “security”, you have to comply with the Securities and Exchange Commission regulations. The seminal case is Howey, where a sponsor was selling interests in an orange grove in Florida. The sponsor was not just selling the small land parcels with orange trees on them, but also his management, harvesting and sale of the oranges. It’s more like buying shares in Tropicana, so the investment scheme was considered an “investment contract” that fell within the definition of a security.

The SEC just filed a case against Agridime. The company allowed you to make money raising cattle. Seems like an interesting idea, support farmers and make money. Maybe you even get some meat from your own cow as part of the profit? (Not sure if that was a feature.) Of course, raising cattle takes a lot of work so why not have Agrdime do the work for you.

Investors never get delivery of the cattle and investors relied on Agridime to do all the work. That sounds a lot like the orange groves in Howey. If so, that makes the cattle contract a security and triggers the many securities regulations.

One of those regulations is that you can’t engage in the general solicitation of investors. Agridime advertised its cattle contracts on its own public website and on Facebook. Those are clear violations of the securities laws.

Agridime offered a guaranteed 15-20% yearly profits. “We know it sounds too good to be true.”  

Yes, it was too good to be true according to the SEC. In the SEC complaint, the SEC alleges that the business was not profitable enough to pay those “guaranteed” returns. Agridime started using new investor money to pay returns to existing investors, instead of using the money on new cattle. It became a Ponzi scheme.

Before the SEC stepped in, North Dakota and Arizona had brought cases against Agridime to stop selling unregistered securities in their states. At least in Arizona, Agridime is taking the position that is a “registered and bonded livestock broker and marketing agency” under jurisdiction of the United States Department of Agriculture.

Now I’m scratching my head and wondering if the USDA has jurisdiction on cattle capital. Sure enough there are some regulations around custodial accounts and the payment of funds under the Packers and Stockyards Act of 1921.

I’m grabbing a bucket of popcorn to see how this one turns out.

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The One with the Stoner Cats

With the onset of the crypto winter, the Securities and Exchange Commission is continuing to bring cases against crypto companies. The latest is against a funding model for animated series: Stoner Cats. The producers wanted to try finding a crypto method to fund the production.

It started off as Kickstarter mixed with Non-Fungible Tokens. The tokens were digital pictures of the animated characters on the production. I think that’s okay and the tokens would not likely to be securities. You initially buy the NFT from producer to be able to watch the series. That’s like buying a movie ticket. That funds the production of the series.

Then the producers added in a royalty feature. When the NFT is traded from the initial buyer to secondary user, the producers take a 2.5% fee that gets passed to the actors and producers. I still that’s okay and doesn’t move the tokens into the treatment as a security.

Under the Howey test, it’s clearly a pooled investment and it’s success is clearly due to the efforts of the production team. The question is there an expectation of profits required by the third prong of the Howey test?

The cash flow from re-sale fee goes to the producers, not the token holders. So, the expectation of profits does not flow directly from the success of the production.

The SEC focused on the potential increase in value of the tokens.

“[I]t led investors to expect profits from their entrepreneurial and managerial efforts, because a successful web series could cause the resale value of the Stoner Cats NFTs to rise in the secondary market.” …

“Investors were also told that “the more successful the show, the more successful your NFT” will be.”

There are plenty of securities offerings that investors look to an increase in value and not to a payment of dividends. Those equity offerings still offer investors a residual claim on the business, even if they don’t get cash flow.

The SEC seems to hang it’s charges on the marketing efforts of the producers that the NFTs could increase in value if there is demand for the series. But of course that is part of the pitch to token holders and the whole NFT eco-system. Buy these tokens and they will increase in value. NFTs occupy this space between commodities and securities.

There is probably an interesting legal analysis and this could be an interesting court case. However, the producers settled with the SEC, agreed to return funds and destroy the NFTs.

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Kirschner Update: Leveraged Loans are Not Securities

The Second Circuit put the leveraged loan market at ease and ruled that those notes are not securities. The Court had asked the Securities and Exchange Commission to offer its opinion on whether they were securities and the SEC declined to do so.

The Second Circuit followed the four factors of the Reeves “family resemblance” test.

1) “[T]he motivations that would prompt a reasonable seller and buyer to enter into” the transaction;
2) “[T]he plan of distribution of the instrument”;
3) “[T]he reasonable expectations of the investing public”; and
4) “[W]hether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.”

The court found that the company and the note purchasers had different motivations. The company was entering into a commercial transaction. The note purchasers may have been motivated for investment.

Even though there ended up being lots of note purchasers, the distribution was controlled and not made available to the general public.

The court found that the note purchasers should have expected the notes to be treated as loans and not investments in the company.

Finally, the court found that there was some regulatory guidance and the loans were secured by a perfected interest in the company’s assets.

The court found that the notes had a family resemblance to loans issued by banks for commercial purposes. Therefore they are not securities.

The result of the decision is that the note purchasers can’t bring fraud claims under the state securities laws, which would have given them an additional remedy. In end, it was a lot of worrying, with no change in the law. It does stand as a reminder to focus on structuring loan transactions and documents to make sure you hit the points of the Reeves test.

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Are Syndicated Loans Securities?

Notes are securities and loans are not securities. Simple enough. Except, our financial system doesn’t operate in such a black and white manner. Syndicated loans kind of fall in the middle.

Your traditional loan is a single lender who holds and controls the debt. Notes and bonds get issued into a more fungible format to more than one investor, with control centralized with a trustee or loan administrator. There are lots of different structures on the notes and bond side of the spectrum.

Syndicated loans involve a group of lenders. Typically it’s a smaller group of lenders and they have some amount of control, collectively, over the administration of the loan.

There a fight in the Second Circuit in Kirschner v. JP Morgan Chase Bank on whether a particular syndicated loan issuance was a security. There is enough uncertainty that the court asked the Securities and Exchange Commission to offer its opinion. A few days ago, the SEC declined to do so.

While we are used to a discussion of the Howey test when talking about securities, it’s important to note that it is focused on the definition of an “investment contract.” There is a whole other line of cases on the “loan” versus “note” definition lead by the Reves v. Ernst & Young case which established the “family resemblance test.”

The analysis is whether the note in question is like any of these notes that are not securities:

  1. the note delivered in consumer financing,
  2. the note secured by a mortgage on a home,
  3. the short term note secured by a lien on a small business or some of its assets,
  4. the note evidencing a ‘character’ loan to a bank customer,
  5. short-term notes secured by an assignment of accounts receivable, or
  6. a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized [… and]
  7. notes evidencing loans by commercial banks for current operations.

In determining whether the note in question has a family resemblance to one of the seven, there are four factors to consider:

  1. The motivation of seller and buyer – If the seller’s motivation is to raise money for his/her business and the buyer’s motivation is to earn profits, then the note is likely a security.  Even if the note is not necessarily characteristic of a security, if the investor reasonably expected that they were buying a security, and would be protected by the accompanying securities laws, then its more likely to be a security.
  2. The plan of distribution of the note – If the note instrument is being offered and sold to a broad segment or the general public for investment purposes, it is a security.
  3. The reasonable expectations of the investing public – If the investors think that the securities laws and their anti-fraud provisions apply to the note, then it’s more likely to be a security.
  4. Alternative regulatory regime – Is there another regulatory scheme, like banking regulation, that applies to the note, then its less likely to be a security.

The case as hand involves a $1.775 billion syndicated loan to Millennium Laboratories. As you might expect, Millennium defaulted. The loan participants are suing the loan syndicator to try get some additional recovery. The district court ruled that the syndicated loan interests were not securities and the loan participants appealed to the Second Circuit.

As mentioned above, the Second Circuit is mulling over the appeal and asked the SEC to opine on the treatment of this loan syndication. The SEC’s failure to say that the syndicated loan interests are not securities has created a bit of a panic in the syndicate loan markets.

We’ll keep an eye out for this decision.

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Ripple is Sometimes a Security (?)

The big challenge with crypto is how it fits into regulatory schemes that were drafted almost a century a go. Add in the politically driven split between the regulation of commodities by the CFTC and the regulation of securities by the SEC and you get a mess. Slap in the variable structures used by crypto issuers when selling crypto tokens and you get a tangled mess.

This challenge just got messier with the recent decision in the case of the Securities and Exchange Commission v Ripple Labs.

The definition of a “security” includes an “investment contract.” The meaning behind that term was established in the 1946 case of the SEC v. W.J. Howey. The decision created a three prong test:

(1) invests his money (2) in a common enterprise and (3) is led to expect profits solely from the efforts of the promoter or a third party.

Bitcoin largely falls outside the definition. You don’t expect a dividend on Bitcoin. You’re investing for the rise in price alone. There is no meaningful company behind it trying to find a way to make a profit. Bitcoin is more like a commodity.

Some will argue a currency. But currencies are used as a store of value to buy things. I don’t think Bitcoin is being used to buy many legal goods.

Ripple Labs comes along and sells the XRP token to generate cash to build out the Ripple platforms, some of which will use the XRP token. The facts are a bit murky about whether the XRP coin holders would get some of the profit from the Ripple platforms.

The court looked first at the past sales of XRP tokens directly to institutional buyers and decisively finds that the XRP tokens are securities. “When the value of XRP rose, all Institutional Buyers profited in proportion to their XRP holdings.” (page 18)

For some weird reason, the court then finds that indirect sales and sales on exchanges are not investment contracts. Since they were blind bid/ask transactions, the buyers didn’t know if the money was going to Ripple or to a secondary seller.

So institutional buyers get more protection than retail buyers under the court’s reasoning. That seems to be the opposite approach of the protective regulatory approach of the SEC.

That also seems weird in the reality of exchanges for “securities.” An investment would be a security if it’s bought directly from the issuer and possibly not a security if it’s purchased from a secondary seller.

Under the court’s decision, crypto is looking very good. Sales of “investment contracts” to institutional investors can rely on the private placement regime. Sales to retail investors through an exchange would not be an investment contract.

Weird result. The product’s status as a security is dependent on how it’s sold. Doesn’t sound right to me. I assume the SEC will appeal this result. I think this will just be a temporary win for Crypto.

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Can a Supercomputer Be a Security?

Accept at face value that Profit Connect is not a scam. That is a stretch given the purported high returns, coupled with a money back guarantee.

• 15% to 20% Fixed APR
• High-Net-Worth 30% APR
• APR is Locked-In
• 100% Money Back Guarantee

No such thing as high returns with no risk. Of course, if the returns are that good, why would the sponsor let you invest.

After going through the mumbo-jumbo on the website, I got to an interesting take on the investment structure.

“A Profit Connect Wealth Builder is not an Investment, it is a purchase of Supercomputer time (usage) and the use of an App that pays you money, for blockchain calculations delivered to a client. The blockchain client is found, managed and supported by Profit Connect. The Wealth Builder Depositor simply places a deposit for seat time and the App makes them money every month, giving you total peace of mind. All Wealth Builder APR percentages are Guaranteed and All Wealth Builders have a Lifetime Money Back Guarantee.”

They are making some claim that you are merely renting computer time. I make the logical leap that the firm is taking the position that you are not buying securities from Profit-Connect and the firm is not selling you securities. That could be true. Renting computer time to you run Bitcoin mining is probably not a security by itself.

The Securities and Exchange Commission doesn’t spend much time on this point in the complaint.

100. The investments were part of a common enterprise because both investors and Profit Connect were to make money through Profit Connect’s investments, because Profit Connect pooled all investor funds into one bank account (the Profit Connect Investor Account), and because Profit Connect used some of those funds to make payments to investors.

101. Profit Connect investors were passive investors with no involvement in Profit Connect’s investment activity.

102. Investors relied entirely on the efforts of Profit Connect, which claimed that investor money would be invested in sectors determined by Profit Connect’s proprietary “supercomputer.”

To me the Profit Connect supercomputer is like the Howey orange grove. Renting supercomputer time is analogous to renting an orange grove. But if you package that resource into someone else doing all the work with no input from you, it looks a more like a security. I can rent supercomputer time and mine bitcoins. I take the risk of valuation fluctuations, utility costs, and success rate. Profit Connect is purporting to do all that for me. I give them money, do no work, I’m not allowed to do any work, and they give me more money back. Yeah, that does sound like a security.

It seems unlikely that the Profit Connect supercomputer is a real thing. One of the firm’s principals had been previously convicted of securities fraud. The SEC alleges that the firm had no operating revenue. All of the money coming in came from “investors.” Most of the money was paid out to solicitors and to the sponsors for personal use.

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The One with the Missing Solar Generators

Jeff and Paulette Carpoff had what sounds like a great idea to me: mobile solar generator units. These are solar generators that would be mounted on trailers that could provide emergency power to cellphone towers and lighting at sporting events. Plus there were generous federal tax credits due to the solar nature of the generators.

I’m willing to hand over a check just hearing the idea. Others agreed and gave Carpoff almost $1 billion in investments to create over 17,000 of the generators.

“A million dollars isn’t cool. You know what’s cool? A billion dollars.”

Sean Parker – The Social Network

What’s not cool is that the Carpoffs only had about 6,571 of the generators.

The conspirators pulled off their scheme by selling solar generators that did not exist to investors, making it appear that solar generators existed in locations that they did not, creating false financial statements, and obtaining false lease contracts, among other efforts to conceal the fraud. 

There is a “What is a Security?” twist to the charges. Some of the fake generator investments were structured as sale-leaseback arrangements. The investors paid to purchase generators from DC Solutions, while simultaneously leasing them to DC Distribution. DC Distribution would then sub-lease the Generators to end-users. The investors would profit from the investments due to tax credits, depreciation on the generators, and lease payments. If the purchase of the generator is tied to the lease and exclusive, then there is a line of cases finding that to be an investment contract. Just like the orange grove in Howey. However a bulk of the investments were made to a fund, pooling money for a bulk purchase and lease of generators.

As interesting as I may find this topic in the charges, the conspirators are going to jail and probably have less interest in the arcane corners or securities law.

I’m going to assume that the Carpoffs started the business with good intentions. They did create thousands of these generators and leased at least some of those for legitimate purposes. They seem to have made at least $18 million in revenue. It seems that the business just did not scale. They could find enough end users to satisfy the investment demand.

As with many Ponzi schemes, they weren’t willing to be honest with their investors about the failure and engaged in false and misleading. There was much more money to be made in collect cash from investors than from leasing the generators.

As with any good fraud fraud charges they list out the extravagant items bought by the fraudsters. This comes up short on the itemization.

  • 150 cars
  • dozens of properties
  • 1978 Firebird previously owned by actor Burt Reynolds
  • a minor-league professional baseball team
  • share in a jet service
  • Nascar sponsorship

Jeff and Paulette Carpoff are scheduled to be sentenced by U.S. District Judge John A. Mendez on May 19. Jeff Carpoff faces a maximum statutory penalty of 30 years in prison. Paulette Carpoff faces a maximum statutory penalty of 15 years in prison. The actual sentences, however, will be determined at the discretion of the court after consideration of any applicable statutory factors and the Federal Sentencing Guidelines, which take into account a number of variables.

Four defendants have previously pleaded guilty to federal criminal charges related to the fraud scheme since October. Joseph W. Bayliss, 44, of Martinez, and Ronald J. Roach, of Walnut Creek, each pleaded guilty to related charges on Oct. 22, 2019. Robert A. Karmann, 53, of Clayton, pleaded guilty to related charges on Dec. 17, 2019. Ryan Guidry, 53, of Pleasant Hill, pleaded guilty to related charges on Jan. 14, 2020. A seventh co-conspirator is scheduled to plead guilty on Feb. 11. The investigation into the fraud remains ongoing.

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Is a Ranch a Security?

Thomas M. Maney had a 1000-acre parcel of undeveloped, vacant, desert land in Kern County, California. He decided to find other interested in owning part of it and helping with the development decisions. He split it into 4000 undivided, fractional ownership interests. So far, that’s just a time-share and not a security.

Then Silver Saddle required buyers to contribute $500 of additional funds for each quarter share into a pooled fund for further development of the property. According to the complaint filed by the State of California Department of Business Oversight:

“Investors were told that the capital contributions of $500.00, $1,000.00 or $2,000.00 made to the Capital Improvement Fund would appreciate in value and that the investors would later use the funds to develop the 1,020 acres of undeveloped land into viable commercial and industrial properties.”

That sounds less like a real estate purchase and more like a pooled fund of capital with the purpose of generating a return.

As for control, purchasers could vote on how to spend the money in the Capital Improvement Fund. But only full-unit holders could vote. Half-share and quarter-share owners could not vote. Plus, the ranch’s board of directors made all of the management decisions. The board was controlled Mr. Maney. The owners were effectively relying on others to manage the money.

Pooled funds, relying on the work of others to earn a return puts it into the definition of “investment contract” and therefore a security.

Of course, there were other problems with the sales of interests at Silver Saddle. The DBO accused Maney of diverting funds for personal use, using high-pressure sales tactics, promising a lack of risk and high returns, and failing to disclose a past history of unlawful real estate sales.

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When Is a Note Not A Security?

I had to scratch my head for a moment when reading the case against Jan Atlas. The SEC accused the lawyer of issuing legal opinions in which he falsified or omitted important facts in connection with an unregistered, fraudulent offering.

“At the time he drafted the May 17 opinion letter, Atlas knew that certain facts stated in the letter on which he was basing his opinion were false, and that he was omitting from the letter other facts inconsistent with his opinion. For example, the letter based its conclusions in large part on statements that 1 Global was offering and selling nine-month notes, and only to sophisticated investors. “

“Nine-months”? What did that have to with the analysis?

Clearly, I have spent too much time looking at the Howey test and less with the statutes.

Promissory notes are presumptively considered to be securities and are listed as securities under the Securities Act § 2(a)(1). However, Section 3(a)(3) has a specially exemption for certain notes:

Any note, draft, bill of exchange, or banker’s acceptance which arises out of a current transaction or the proceeds of which have been or are to be used for current transactions, and which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited

There is that “nine months” reference. I don’t remember running into this exemption before.

In the case of Mr. Atlas, the SEC accused him of knowing that the notes subject to his opinion has an automatic renewal option. That would remove them from that exemption.

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Can Cattle Be a Security?

The Security and Exchange Commission filed a complaint alleges that Mark Ray, a Denver resident, was the mastermind of a scheme for the purported purchase and immediate resale of large numbers of cattle. I don’t recall cattle showing up in the definition of a “security.”

The first part of the scheme is labeled a Ponzi scheme in the complaint. Mr. Ray told investors they were investing in wholesale, commercial cattle trades. They were often told the specifics about the cattle and which ranch the they were located. The SEC contacted the ranches and confirmed they had not engaged in any cattle trading with Mr. Ray.

Mr. Ray had no cattle to support his supposed investments. He used later investors’ money to repay prior investors. Classic Ponzi scheme.

Big Hat, No Cattle.

Mr. Ray later got more sophisticated and sold promissory notes to investors that were supposed to be used in cattle trading. It’s hard to argue that those notes are not securities

The direct investments in cattle are not clearly securities. Mr. Ray settled with the SEC so we won’t see the argument.

The SEC broadly states that the agreement called for the investor to make an investment of money with the expectation of profit. The investors relied on Mr. Ray’s purported skill and knowledge to generate profits. Many of the investors knew little of the industry.

The SEC made the classic Howey test argument about the nature of the transactions. It was good enough for Mr. Ray’s lawyers to agree to settlement, rather than fight the SEC.

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