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

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§ 1A:4.3 BROKER-DEALER REGULATION at whether the promoter has induced prospective investors with proposed or promised profits. [E] Solely from the Efforts of the Promoter or a Third Party The Howey test requires that the profits of the investment be derived “solely from the efforts of the promoter or a third party.” The courts of appeals have uniformly declined to give literal meaning to the word “solely,” and have adopted liberal interpretations, emphasizing the economic reality of the transaction. 265 The interpretation by the Ninth Circuit has been widely cited and adopted by other circuit courts, and it requires that the efforts made by those other than the investor be “undeniably significant” ones and be “essential managerial efforts which affect the failure or success of the enterprise.” 266 § 1A:4.3 Case Law on “Notes” Under the definitions of “security” in the Exchange Act, “note” is listed as a specific category of “security.” Therefore, a note can be a security even if it does not meet the test for “investment contract.” 267 While the statutory definition of “security” includes “any note,” this is not interpreted literally. 268 “Note” is a relatively broad term that settlements market, which discusses the SEC staff ’s views regarding the status of life settlements as securities. Life Settlements Task Force, Report to the U.S. Securities and Exchange Commission (July 22, 2010), available at www.sec.gov/news/studies/2010/lifesettlements-report.pdf. 265. SEC v. SG Ltd., 265 F.3d 42, 55 (1st Cir. 2001); SEC v. Aqua-Sonic Prods. Corp., 687 F.2d 577 (2d Cir. 1982); Goodwin v. Elkins & Co., 730 F.2d 99, 103 (3d Cir. 1984), overruled on other grounds, Zosky v. Boyer, 856 F.2d 544 (1988); Rivanna Trawlers Unlimited v. Thompson Trawlers, Inc., 840 F.2d 236 (4th Cir. 1988); SEC v. Koscot, 497 F.2d 473 (5th Cir. 1974); SEC v. Professional Assocs., 731 F.2d 349 (6th Cir. 1984); Kim v. Cochenour, 687 F.2d 210 (7th Cir. 1982); Fargo Partners v. Dain Corp., 540 F.2d 912 (8th Cir. 1976); SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476 (9th Cir. 1973); McCown v. Caldwell, 527 F.2d 204 (10th Cir. 1975). 266. Glenn W. Turner Enters., 474 F.2d 476. Some circuits have adopted the Ninth Circuit’s interpretation, see SEC v. SG Ltd., supra, at 55; Turner Enters., 474 F.2d at 482, accord Rivanna Trawlers Unlimited, 840 F.2d at 240 n.4. 267. The fact that certain notes may not be “investment contracts” does not necessarily mean that they are not “notes” and thus not securities. See Reves v. Ernst & Young, 494 U.S. 56, 67 (1990). 268. Reves, 494 U.S. at 67. The name assigned to a transaction by the parties, although not dispositive, is relevant in determining security status. There may be associations when the use of a traditional name such as “stocks” or “bonds” will lead a purchaser justifiably to assume that the federal 1A–60
What Is a Broker-Dealer? § 1A:4.3 encompasses instruments with widely varying characteristics, depending on whether issued in consumer context or in some other investment context. 269 The U.S. Supreme Court, in Reves v. Ernst & Young, has adopted a specialized test—the “family resemblance” test—to determine whether a “note” is a security. 270 Whether a given note is or is not a “security” is a matter that requires specific analysis. Under the “family resemblance” test, courts presume that every “note” is a “security.” 271 This presumption may be rebutted only by a showing that the note bears a strong resemblance to one of the enumerated categories of instrument on a judicially developed list of exceptions from the rule. 272 If an instrument is not sufficiently similar to an item on the list, courts will decide whether another category should be added to the list. 273 The Supreme Court in Reves adopted the list created by the Second Circuit. 274 The Second Circuit’s list includes instruments commonly denominated “notes” that nonetheless fall outside of the “security” category, such as: (i) a note delivered in consumer financing; (ii) a note secured by a mortgage on a home; (iii) a short-term note secured by a lien on a small business or some of its assets; (iv) a note evidencing a character loan to a bank customer; (v) a short-term note secured by an assignment of accounts receivable; (vi) 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 securities laws apply. This would clearly be the case when the underlying transaction embodies some of the significant characteristics typically associated with the named instrument. See United Hous. Found., 421 U.S. 850. 269. See Landreth Timber Co. v. Landreth et al., 471 U.S. 681, 694 (1985). An investor cannot justifiably assume that a sale of a note is covered by the securities laws, because not all notes involve investments. See Reves, 494 U.S. 56. 270. Reves, 494 U.S. 56. 271. Id. 272. Id. If an instrument bearing the name “note” does not meet the family resemblance test, it can still be security if it meets the Howey test and falls under the category of “investment contract.” 273. Id. 274. Reves, 494 U.S. 56. (Broker-Dealer Reg., Rel. #9, 9/10) 1A–61
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