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Securities Fraud

According to the Supreme Court, a security “means any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, or, in general, any interest or instrument commonly known as a ‘security,’ or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”

Florida courts have accepted and applied this definition. Since the term “stock” has not been specifically defined by the Florida or Federal courts, courts equate stock to an “investment contract” in order to analyze whether the stock qualifies as a security requiring registration with the SEC.

The Supreme Court set out a three-pronged test to define an investment contract in SEC v. W.J. Howey Co. In Howey, the SEC sued a company by the name of Howey-in-the-Hills Service, Inc. (located in Florida) that was offering half of its citrus acreage to the public to help the company finance additional development. The Company required, as part of its land sales contract, that buyers also buy a service contract to cultivate the land. Buyers did not have to use Howey-in-the-Hills Service, Inc. as their service provider, but the company stressed whole superiority.

The SEC’s claim against Howey-in-the-Hills Service, Inc. was that the company was involved in the sale of unregistered and nonexempt securities and was therefore in violation of the Securities Act. The Supreme Court was thus presented with the issue of whether the combination of the land sales, service contracts, and warranty deed sold by Howey-in-the-Hills Service, Inc. could, together, “constitute an investment contract within the meaning of the Securities Act.”

The Supreme Court set out a three-pronged test to define an investment contract in SEC v. W.J. Howey Co. In Howey, the SEC sued a company by the name of Howey-in-the-Hills Service, Inc. (located in Florida) that was offering half of its citrus acreage to the public to help the company finance additional development. The Company required, as part of its land sales contract, that buyers also buy a service contract to cultivate the land. Buyers did not have to use Howey-in-the-Hills Service, Inc. as their service provider, but the company stressed whole superiority.

The SEC’s claim against Howey-in-the-Hills Service, Inc. was that the company was involved in the sale of unregistered and nonexempt securities and was therefore in violation of the Securities Act. The Supreme Court was thus presented with the issue of whether the combination of the land sales, service contracts, and warranty deed sold by Howey-in-the-Hills Service, Inc. could, together, “constitute an investment contract within the meaning of the Securities Act.”

The Supreme Court held that “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.” The Court explained that under this definition, the combination of contracts Howey-in-the-Hills Service, Inc. was selling qualified as investment contracts and thus were subject to SEC regulation. Courts have now divided this definition into parts for easier analysis.

Thus, in order to qualify as an investment contract that must be registered as a security with the SEC, the following three elements are required:

  1. An investment of money
  2. Sharing a common enterprise
  3. Profits derived from the efforts of others

Allegations of securities fraud can be complicated and require detailed and sophisticated analysis of the facts and the law. Anyone facing potential allegations of securities fraud by state or federal prosecutors, state administrative agencies, or the Securities and Exchange Commission (S.E.C.) should seek legal advice from experienced and competent counsel immediately.

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