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

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)
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