The Securities Act of 1933 (the “Act”) provides a number of protections for investors. The purpose of the Act is to require issuers to provide financial or other significant information to investors when the issuer offers securities for public sale. The Act allows an investor to recover losses if the investor can show that the issuer did not fully or accurately disclose financial or significant information as required by the Act.
Many investors believe that the Act protects only securities that are traded on public markets like the New York Stock Exchange. While the Act does apply to these securities, the Act actually casts a far wider net of protection. Section 2(a)(1) of the Act defines a “security” in extremely broad terms. In fact, courts have noted that the definition extends much farther than it may seem at first glance. See Securities & Exch. Com. v. Starmont, 31 F. Supp. 264, 266 (E.D. Wa. 1940) (“The Securities Act of 1933 describes ‘security’  much more broadly than had been the previous interpretation of that term”).
Section 2(a)(1) contains a list of instruments that are per sesecurities. While this list houses a number of commonplace instruments, the list also contains generalized categories, such as “investment contracts.” This provides stronger protection for the public, but it also frequently ensnares many unknowing individuals in this strict regulatory framework. Investment contracts are some of the most common securities, yet few individuals know that the issued instrument might actually be a security under the Act.
In 1946, the Supreme Court of the United States decided Howey. In this case, the Court adopted a test to determine if an instrument is an investment contract—therefore a security. See SEC v. W. J. Howey Co., 328 U.S. 293, 66 S. Ct. 1100 (1946). In Howey, the SEC sued two related corporations. The Howey Company (the “Company”) owned large tracts of citrus farms in Florida, and the Howey-in-the-Hills Service (“Hills Service”) had operated a successful citrus harvesting business. The SEC alleged that the Company had sold non-exempt, unregistered securities in violation of the Act.
The Company planted around 500 acres of oranges annually. It would keep half of the groves itself and offer the other half for sale to the public “to help [it] finance additional development.” Id. at 295. Hills Service would develop the groves for the Company, including harvesting and marketing of crops. Id. When marketing the groves to investors, the Company would offer a land sale agreement and a service agreement to go with it. Id. The land sale agreement and warranty deed essentially allowed for profit participation across the grove as a whole. And each investor would be instructed that the land would be useless without a service agreement to manage the crops. Id. The Company allowed investors to make their own service arrangements, but 85% of the land sold by the Company had an agreement with Hills Service. Id. Thirty-one of forty-two investors purchased small amounts of land, only around 1.33 acres per investor on average.
On first glance, these are two legally separate entities and two legally separate contracts for each investor. But the Court focused on the economic reality of the contracts together. At that time, courts and states had defined investment contracts under the Act as “a contract or scheme for ‘the placing of capital or laying out of money in a way intended to secure income or profit from its employment.’” Id. at 298 (quoting State v. Gopher Tire & Rubber Co., 146 Minn. 52, 56, 177 N. W. 937, 938). The Supreme Court provided a more specific definition instead:
An investment contract for purposes of the Securities 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.
Id.298–299. The Court held that the case clearly involved investment contracts under this definition. Id. at 299. It noted that this was not merely the sale of land or a service contract, but instead more clearly resembled “an opportunity to contribute money and to share in the profits of a large citrus fruit enterprise managed and partly owned by respondents.” Id. In making this determination, the Court focused on the fact that many of the investors bought small tracts of land that would not turn profit absent a large common enterprise, and the investors solely depended on Hills Services to turn profit. Id. at 300.
This standard has come to be known as the Howey test. Courts still apply this same standard to transactions and instruments to determine whether the Act applies. Howey covers numerous instruments, the most common being the limited partnership interest (one of the most common ownership instruments). A limited partner invests money in a common enterprise solely from the efforts of the promoter or third-party, the general partner. Thus, Howeyis incredibly important because, under the Supreme Court’s standard, any sale of a limited partnership interest must meet an exception to the Act or be registered with the SEC—or those involved in its issuance risk suit from investors or the SEC.