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

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§ 1A:4.2 BROKER-DEALER REGULATION Other circuit courts have held that a “common enterprise” exists by virtue of “vertical commonality,” which focuses on the relationship between the promoter and the body of investors. 250 In this approach, an investor’s fortunes are tied to the promoter’s success rather than to the fortunes of his or her fellow investors. 251 The approach focuses on the community of interest between the individual investor and the manager of the enterprise. 252 In vertical commonality, the investors’ fortunes need not rise and fall together, and a pro rata sharing of profits and losses is not required. 253 It is also not necessary that the funds of investors be pooled. 254 The doctrine of “vertical commonality” as developed by various courts has two variants: “broad vertical commonality” and “narrow vertical commonality” (or “strict vertical commonality”). “Broad vertical commonality” requires that the fortunes of the investors be linked only to the expertise or efforts of the promoter. 255 The promoter’s efforts impact the individual investors collectively, and the promoter does not share in the returns or risks of each investor. In contrast, “narrow vertical commonality” requires that the investors’ fortunes be “interwoven with and dependent upon the efforts and success of those seeking the investment or of third parties.” 256 Under this approach, the promoter shares in the returns of the investors. 257 The various judicial circuits are divided regarding whether horizontal or vertical commonality is required (and, in the latter case, whether the broad or narrow variety is required) to satisfy the Howey common enterprise requirement. 250. Revak, 18 F.3d 81 (discussing SEC v. Koscot Interplanetary, Inc., 497 F.2d 473, 479 (5th Cir. 1974)). 251. SEC v. SG Ltd., 265 F.3d 42, 49 (1st Cir. 2001); SEC v. Unique Fin. Concepts, Inc., 196 F.3d 1195 (11th Cir. 1999). 252. See, e.g., Long v. Shultz Cattle Co., 881 F.2d 129 (5th Cir. 1989). 253. Revak, 18 F.3d 81. 254. SEC v. Goldfield Deep Mines Co., 758 F.2d 459 (9th Cir. 1985). 255. SEC v. SG Ltd., 265 F.3d 42, 49 (1st Cir. 2001); Revak, 18 F.3d 81; Long, 881 F.2d 1 (citing SEC v. Continental Commodities Corp., 497 F.2d 516, 522 (5th Cir. 1974)); Koscot Interplanetary, 497 F.2d at 478–79. 256. SEC v. Glenn W. Turner Enters., 474 F.2d 476, 482 n.7 (9th Cir. 1973), cert. denied, 414 U.S. 821 (1973) (internal citations omitted). 257. SEC v. R. G. Reynolds Enters., Inc., 952 F.2d 1125 (9th Cir. 1991) (vertical commonality may be established by showing that the fortunes of the investors are linked with those of the promoters; the fact that Reynolds made his management fee based on a percentage of the profits was sufficient to show vertical commonality); Brodt v. Bache & Co., 595 F.2d 459 (9th Cir. 1978) (merely furnishing investment counsel to another for a commission, even when done by way of a discretionary commodities account, does not amount to a “common enterprise”; since there is no direct correlation on either the success or failure side, the court held that there was no common enterprise between Bache and Brodt). 1A–58
What Is a Broker-Dealer? § 1A:4.2 [D] Expectation of Profits Under the Howey test, profits can be either capital appreciation resulting from the development of the initial investment, or a participation in earnings resulting from the use of investors’ funds. 258 Profits are income or return that investors seek on their investment, not the profits of the scheme in which they invest. 259 Profits include, for example, dividends, other periodic payments, or the increased value of the investment. 260 Tax deductions, government subsidies, and welfare benefits, on the other hand, are not “profits” for purposes of the securities laws, since they do not derive from the efforts of third parties. 261 The analysis should not distinguish between promises of fixed returns and promises of variable returns for purposes of the test. 262 The determining factor under this prong of the Howey test is that the investor is “attracted solely by the prospects of a return” on his investment. 263 The investor may not have been motivated by a desire to use or consume the item purchased. 264 In determining whether an investor was “attracted or led” by the expectation of profits, courts look 258. United Hous. Found., Inc. v. Forman, 421 U.S. 837, 852 (1975), reh’g denied, 423 U.S. 884 (1975); for an example of profits as capital appreciation resulting from the development of the initial investment, see SEC v. Joiner, 320 U.S. 344 (1943) (sale of oil leases conditioned on promoters’ agreement to drill exploratory well); for an example of profits as a participation in earnings resulting from the use of investors’ funds, see Tcherepnin v. Knight, 389 U.S. 332 (1967) (dividends on the investment based on savings and loan association’s profits). 259. SEC v. Edwards, 540 U.S. 389, 394 (2004). 260. Id. 261. United Hous. Found., 421 U.S. 837. 262. Because, in both cases, the investing public is attracted by representations of investment income. Moreover, as the Court has noted, investments pitched as low risk (such as those offering a “guaranteed” fixed return) are particularly attractive to individuals more vulnerable to investment fraud, including older and less sophisticated investors. Edwards, 540 U.S. at 390. 263. SEC v. W.J. Howey Co., 328 U.S. 293 (1946); United Hous. Found., 421 U.S. 837. 264. See W.J. Howey Co., 328 U.S. at 300 (the Court found that the investors had no desire to occupy the land or to develop it themselves, and they were attracted solely by the prospects of a return on their investment; if the purchasers wanted to occupy the land or to develop it themselves, the securities laws would not apply); see also United Hous. Found., 421 U.S. at 852–54 (1975) (the Court concluded that sale of shares in a housing cooperative did not give rise to a securities transaction where the investors were attracted solely by the prospect of acquiring a place to live, and not by financial returns on their investments; when a purchaser is motivated by a desire to use or consume the item purchased, the securities laws do not apply). On July 22, 2010, the SEC staff released a report on the life (Broker-Dealer Reg., Rel. #9, 9/10) 1A–59
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What is a Broker-Dealer? - Davis Polk & Wardwell

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