What is a Broker-Dealer? - Davis Polk & Wardwell

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§ 1A:4.2 BROKER-DEALER REGULATION 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 instrument commonly known as a “security”; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker’s acceptance 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. 240 It was Congress’ intent to define “security” in general terms so as to include within the definition the many types of instruments that in the commercial world fall within the ordinary concept of a “security,” 241 and courts have interpreted the definition of “security” broadly. 242 In determining whether an instrument is a security, courts will look at the economic reality and focus on the substance rather than form. 243 The Dodd-Frank Act, signed into law on July 21, 2010, adds “security-based swaps” to the definition of “security” in section 3(a)(10) of the Exchange Act. “Security-based swaps” are discussed further in infra section 1A:4.4. § 1A:4.2 Case Law on “Investment Contracts” [A] Generally The term “investment contract” is the residual category in the definition that captures securities that do not fall within other categories. Although not defined in the securities laws, it refers to an interest that is not a conventional security like “stock” or “bond,” but has the essential properties of a security and is treated as one for purposes of the securities laws. 244 It is a descriptive term capable of adaptation to meet many different types of investment schemes. 245 There is a considerable body of case law on whether a given arrangement is an investment contract when it does not fall under the definition of other more commonly known securities. In the leading 240. Exchange Act § 3(a)(10). 241. H.R. REP. NO. 85, at 11 (1933). 242. See Reves v. Ernst & Young, 494 U.S. 56 (1990); SEC v. Edwards, 540 U.S. 389 (2004). 243. See Tcherepnin v. Knight, 389 U.S. 332 (1967); SEC v. W.J. Howey Co., 328 U.S. 293 (1946); Reves, 494 U.S. 56. 244. SEC v. Lauer, 52 F.3d 667 (7th Cir. 1995). 245. See SEC v. W.J. Howey Co., 328 U.S. 293 (May 27, 1946), reh’g denied, 329 U.S. 819 (Oct. 14, 1946); SEC v. Joiner Leasing Corp., 320 U.S. 344 (Nov. 22, 1943). 1A–56
What Is a Broker-Dealer? § 1A:4.2 case, SEC v. W.J. Howey Co., the U.S. Supreme Court defined an “investment contract” as “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.” 246 The definition establishes a four-part test in determining whether a particular scheme is an investment contract. Specifically, the test requires that there is: (i) an investment of money; (ii) in a common enterprise; (iii) with an expectation of profits; (iv) which are derived solely from the efforts of the promoter. [B] Investment of Money The investment does not have to be in the form of “money,” but it can be any form of consideration in return for a separable financial interest with the characteristics of a security. 247 [C] Common Enterprise There is a split in authority among the federal circuit courts regarding what constitutes a “common enterprise.” A majority of the circuit courts require or recognize a showing of “horizontal commonality” which involves the pooling of assets from multiple investors in such a manner that all share in the profits and risks of the enterprise. 248 In horizontal commonality, the fortunes of each investor depend upon the profitability of the enterprise as a whole. 249 246. W.J. Howey Co., 328 U.S. at 298–99. 247. Int’l Bhd. Teamsters v. Daniel, 439 U.S. 551, 559 (1979). 248. The First, Second, Third, Fourth, Sixth, Seventh and D.C. Circuits have recognized “horizontal commonality” as satisfying the requirement of “common enterprise.” See, e.g., SEC v. SG Ltd., 265 F.3d 42 (1st Cir. 2001); Revak v. SEC Realty Corp., 18 F.3d 81 (2d Cir. 1994); SEC v. The Infinity Group Co., 212 F.3d 180, 188 (3rd Cir. 2000), cert. denied, 532 U.S. 905 (2001); Teague v. Bakker, 35 F.3d 978 n.8 (4th Cir. 1994); Newmyer v. Philatelic Leasing, Ltd., 888 F.2d 385 (6th Cir. 1989); Union Planters Nat’l Bank of Memphis v. Commercial Credit Bus. Loans, Inc., 651 F.2d 1174 (6 Cir. 1981), cert. denied, 454 U.S. 1124 (1981); Cooper v. King, 114 F.3d 1186 (6th Cir. 1997); SEC v. Lauer, 52 F.3d 667, 670 (7th Cir. 1995); Wals v. Fox Hills Dev. Corp., 24 F.3d 1016 (7th Cir. 1994); SEC v. Banner Fund Int’l, 211 F.3d 602 (D.C. Cir. 2000); SEC v. Life Partners, Inc., 87 F.3d 536, 543 (1996), reh’g denied, 102 F.3d 587 (D.C. Cir. 1996). 249. Revak, 18 F.3d 81 (citing Hart v. Pulte Homes of Michigan Corp., 735 F.2d 1001 (6th Cir. 1984) (horizontal commonality ties the fortunes of each investor in a pool of investors to the success of the overall venture; a finding of horizontal commonality requires a sharing or pooling of funds)). (Broker-Dealer Reg., Rel. #9, 9/10) 1A–57
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