Tag: Howey

Is a Note a Security?

In the post-Dodd-Frank world of securities regulation, the definition of a security remains important when looking at funding options and regulatory regimes. Kickstarter works from the securities law perspective because it’s not selling securities. It’s helping project mangers sell products or receive contributions, with no expectation of an a profits interest in the underlying project. Equity crowdfunding platforms will need to wait for new SEC regulations to be enacted before they go live.

I’ve spent most of my time looking at securities from the perspective of equity because that it where I spend my working time. Of course, debt instruments can also be securities. Section 3(a)(10) of the Securities Exchange Act of 1934 explicitly includes “notes” in the definition of a security, but does not include loans. Recently, the influential Delaware Chancery Court took a look at some promissory notes and found that some were securities and some were loans. ( Francis Pileggi highlighted this case in his Delaware Commercial & Commercial Litigation Blog.)

The case involves several promissory notes, each with different terms and attributes, issued by ION. A shareholder of ION, Fletcher International, Ltd., claimed that the issuance of the notes was a violation of the terms of the contractual rights that governed the terms of ION’s preferred stock that required ION to obtain Fletcher’s approval before issuing any securities. Fletcher claims that the promissory notes were “securities”.

The Delaware court sets the standard of review using the the four-factor formula set forth by the United States Supreme Court in Reves v. Ernst & Young (.pdf). That decision limits the Howey four part analysis of securities to “investment contracts”, Instead, it creates a new framework to determining if a note is a “note” under section 3(a)(10), and therefore a security. This is the Family Resemblance test.

This test came from another decision that gave a list of 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.

The Reves decision states that this list needed more guidance. The Court starts from the position that “all notes are presumptively securities”.  Then you need to need analyze whether the note fits into one of those exceptions through a four part test.

First, we examine the transaction to assess the motivations that would prompt a reasonable seller and buyer to enter into it. If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a “security.” If the note is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash-flow difficulties, or to advance some other commercial or consumer purpose, on the other hand, the note is less sensibly described as a “security.” .

Second, we examine the “plan of distribution” of the instrument, to determine whether it is an instrument in which there is “common trading  for speculation or investment”.

Third, we examine the reasonable expectations of the investing public: The Court will consider instruments to be “securities” on the basis of such public expectations, even where an economic analysis of the circumstances of the particular transaction might suggest that the instruments are not “securities” as used in that transaction. […]

Finally, we examine whether 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.

You need to look at an instrument to see if it bears a “family resemblance” to one of the enumerated instruments. Under this test, the presumption can be rebutted if the note bears a strong resemblance to one of the enumerated types of notes.

I scratch my head with a bit of confusion with the Reves test. The Delaware Court shares that confusion:  “Multi-factor tests can sometimes make the mind glaze over, and obscure their own fundamental purposes. Some of the less-than-logically-compelling case law under Reves illustrates that danger.” (In my mind there is even more confusion in the mix given the trading activity of residential mortgages. They were readily traded around during the overabundant years of the real estate boom.)

The essence of the Reves analysis is to determine whether the note in question is more like an investment or, more like a commercial loan or consumer loan transaction. “If the note in question looks more like a corporate bond, debenture, or other instrument the value of which rises and falls with the success of the issuer’s business, has a term of several years, and is easily traded, then that presumption will not be rebutted, because the note will not bear a strong resemblance to any of the notes listed in Reves for the basic reason that such a note is easily characterized as an investment, and thus a
security.”

Going back to the Delaware case, the court found one of the notes to be a security. The determination seems to pivot mostly on the length of the loan: four years. Another factor was that the note had a securities legend with references to a security. So it looked like a paper security/bond instead of a promissory note.

In the end, this case does little to help me clarify my thoughts about typical private equity and real estate fund note holdings. I suppose if the note has securities legends, that will tip it more towards the category of securities than a typical vanilla promissory note.

One follow-up from the Reves analysis of a note. In SEC v. Edwards, 540 U.S. 389 (2004), the Supreme Court held that a note that falls outside the family resemblance test as a “note” could still qualify as an “investment contract” under the Howey test.

Sources:

Image of the Sears, Roebuck bond is by SpreeTom

http://www.delawarelitigation.com/author/francispileggi/

Is it a Security?

In my ongoing quest to distinguish what’s a security and what’s not a security, a new case came down from Missouri on the topic. Disgruntled purchasers of condominiums at the Branson Landing Hilton Promenade Boutique Hotel felt they got a bad deal and sued the seller/issuer to get their money back: Obester v. Boutique Hotel (.pdf)

The owners claim the seller/issuer represented that the condominiums would be rented out and they would receive a portion of the profits, generating substantial revenue. I assume the investment did not turn out to be a financial windfall. According to the claim, the hotel rented its inventory of unsold units at a discounted rate.

Fee simple ownership of the “bricks and mortar” of real estate is not a securities transaction. “The offer of real estate as such, without any collateral arrangements with the seller or others, does not involve the offer of a security.” As you move further away from that model, you move closer and closer to the ownership a security than the ownership of real estate. The line between the two is not a bright line.

As with the Hard Rock San Diego case still working its way through the federal courts in California, combining the sale of real estate with a management agreement starts making the real estate look like a security.

In the Boutique Hotel case, the court goes back to the Howey case and uses a four part test to determine if there is an investment contract, where there is

  1. an investment of money,
  2. a common enterprise,
  3. a reasonable expectation of profits, and
  4. a reliance on the entrepreneurial or managerial efforts of others.

The court draws a distinction between a vertical commonality and a horizontal commonality to create a common enterprise. Vertical looks at the relationship between the seller and the purchaser. Horizontal focuses on the pooling of interests among investors. It’s an interesting way to look at the analysis, but it ends up not being decisive to the court.

What kills the securities claim is that the owners were not required to participate in the rental program. An owner could chose to not rent out its condominium or rent it out on its own. That means the business arrangement did not have a reliance on the entrepreneurial or managerial efforts of others.

That distinguishes the arrangement from the one being contested in the Salameh / Hard Rock San Diego case. San Diego restricted the rental program to the one run by the seller/issuer. Under San Diego zoning, the units had to be sold for non-residential use and be managed as part of the hotel.

These cases do little to help me decide when an interest in a manager-managed limited liability company is a security. But it’s clear that there is still a big gray space between what is a security and what is not a security.

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When is Real Estate a Security?

Fee simple ownership of the “bricks and mortar” of real estate is not a securities transaction. “The offer of real estate as such, without any collateral arrangements with the seller or others, does not involve the offer of a security.” As you move further away from that model, you move closer and closer to the ownership a security than the ownership of real estate. The line between the two is not a bright line. One of the latest cases to address the difference is Salameh v. Tarsadia Hotels 2011 U.S. Dist. LEXIS 30375, on appeal to the Ninth Circuit.

One of the seminal cases is SEC v. W.J. Howey Co., 328 U.S. 293 (1946). That case involved an offering of units of a citrus grove development, coupled with a contract for cultivating, marketing, and remitting the net proceeds to the investor. They held that it was an offering of an “investment contract” within the meaning of that term as used in the provision of § 2(1) of the Securities Act of 1933 defining “security” as including any “investment contract,” and was therefore subject to the registration requirements of the Securities Act.

Even though decades have passed, the line is bit a clearer, but still muddy as the Salameh case illustrates. The developer of the Hard Rock Hotel in San Diego used a condominium- hotel ownership structure to help provide capital.  The purchase/investment turned out to be a bad one, so they sued the developer.

Their claim was that a series of documents, including the Purchase Contract, the Unit Maintenance and Operations Agreement, and the Rental Management Agreement turned the ownership into a “security” and not the mere ownership of real estate. Since the securities were not registered, they could seek rescission. In this case, the ownership and control issues were not just split into separate documents, some of the documents were entered into at significantly different times.

The issues are not that new. The Securities and Exchange Commission noted the problem as far back as 1973 when it issued Release No. 33-5347 which had guidelines on the applicability of federal securities laws to the sales of condominiums and units of real estate development.

The investors/purchaser lost the court case.  The court The case is now under appeal and there are numerous other issues involved in the case so we may not any new insight on when an investment in real estate becomes an investment in a security.

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What is a Security? Is Real Estate a Security?


Previously, I went through the analysis that a fund manager is considered an investment adviser. But left open the question of “what is a security?” That’s a key question for fund managers with alternative investments, like real estate.

The Investment Advisers Act gives a very broad definition of a security:

any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security (including a certificate of deposit) or on any group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guaranty of, or warrant or right to subscribe to or purchase any of the foregoing. [202(a)(18)]

What’s missing from that definition is hard assets (collectibles, like baseball cards), futures contracts relating to commodities (but not future contracts relating to securities), and real estate (but not shares in real estate companies).

Pure bricks and mortar are not securities. So private equity funds that invest directly in hard real estate assets are not giving advice regarding securities.  As you start adding additional levels of ownership and holding companies, things get a bit grayer as you have more and more organizational boxes between the fund and the real estate.

One of the early seminal Supreme Court cases on the definition of a security involved a real estate deal. In 1946, SEC v W.J. Howey Co. (328 U.S. 293) involved an offering of units of a citrus grove development, coupled with a contract for cultivating, marketing, and remitting the net proceeds to the investor. They held that it was an offering of an “investment contract” within the meaning of that term as used in the provision of § 2(1) of the Securities Act of 1933 defining “security” as including any “investment contract,” and was therefore subject to the registration requirements of the Act.

For purposes of the Securities Act, an investment contract (undefined by the Act) means a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.

There are three components:

  1. expectation of profits
  2. a common enterprise
  3. depends “solely” for its success on the efforts of others.

So passive investments, where investors do not have any decision-making power are securities. Investments made by the principals who are actively involved in the management of the enterprise are not securities. Of course, that leaves a whole lot of business arrangement in between.

Shares of stock in a corporation do not have enough involvement to get them out of the characterization of securities. Most real estate is owned in partnership or partnership-like entities to take advantage of some favorable tax treatment.  There is an expectation of profits and it’s going to be a common enterprise. That leaves the “success on the efforts of others” as the key test for investment entities.

Traditionally, limited partnership interests are generally securities because limited partners rely on the general partners to manage the partnership. Since Delaware and other states have given limited partners to have more power in the management of the partnership and still retain their liability shield, the analysis has gotten harder.

For a general partnership, those interests are generally not securities because they fail to satisfy the “solely from the efforts of others” part of the test. Usually all general partners have decision making power with respect to the affairs of the partnership.

Limited liability company interests are tougher to make a general statement. If the LLC is member-managed, then each member is involved in management of the enterprise  and therefore their interests would generally not be securities. On the other hand, if the LLC is manager-managed, then members are may be just passive investors, and their LLC interests are more likely to be securities.

When it comes to real estate joint ventures, the managing interest is not going to be a security. The non-managing interest is more likely to be a security.

Notes, debt, and debt-to-own interests are likely to be considered securities. You can see notes listed right in the definition of securities. Given the continuing distress in the real estate debt markets, many fund managers are looking at buying distressed debt instead of pure bricks and mortar. That’s going to push them into the role of giving “advice about securities” and force them to look at registration as an investment adviser.

Deal structure may influence the analysis. It’s common in some jurisdictions to structure the transaction as a sale of interests in the owner of the real estate instead of a sale of the asset itself. That transaction structure could be viewed as a sale of securities, instead of a sale of real estate.

Image of Glass office building in downtown Los Angeles is by Ricardo Diaz