Definition of a Security: The Investment Contract (Part I)

This article is the second in an occasional series on the definition of a “security.”  As I explained previously, when a financial instrument qualifies as a “security,” it becomes subject to an extensive apparatus of securities regulation.  The most notable of this group are the Securities Act of 1933 and the Securities Exchange Act of 1934 (collectively, the “Securities Acts” or the “Acts”).  This article will analyze “investment contracts,” one of several instruments the Acts identify as a security.  Courts determine whether an instrument is an investment contract by using the Howey Test (or the “Test”), which the US Supreme Court established in the 1946 case, SEC v. Howey.  The Test defines “investment contract” as an investment of money, in a common enterprise, with an expectation of profits achieved through the efforts of others.  Though most courts frame this as three elements, it functions as four.  In Part I below, I will examine the first two elements: (1) an investment of money and (2) the common enterprise.  Part II will examine the remaining two elements.  It will arrive at a later date. 


It is well established that federal securities laws only apply to the purchase or sale of “securities.”[1]  Within that sphere, Congress intended the Acts to be expansive, the goal being to protect investors from the “countless and variable” financial schemes others may use to defraud them.  So to that end, the Acts’ definition of “security” is broad,[2]encompassing

any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, . . . investment contract, voting-trust certificate, . . . any interest or instrument commonly known as a security, or any certificate of interest or participation in, . . . or right to subscribe to or purchase, any of the foregoing.[3]

The broad definition is meant to catch both obvious securities (like stocks and bonds), as well as less traditional schemes that may lack “the formal attributes of a security.” [4]    

Among the more flexible instruments specified in the Acts’ definition is the “investment contract.” Courts have viewed “investment contract” as somewhat of a catchall term – one meant to cover “novel, uncommon or irregular devices.”[5]  Still, while including it in the definition, the Acts provide little concrete guidance as to what qualifies as an “investment contract.”  Thus, as might be expected, investors and the SEC have tried to fit a diverse collection of schemes within the term’s boundaries.  This has left the courts with the job of defining an “investment contract” and identifying situations where it applies.


The definition of an investment contract dates back almost eighty years, to the 1946 Supreme Court case, SEC v. Howey.  As the Court formally established there, any “scheme [involving] an investment of money in a common enterprise with profits to come solely from the efforts of others” is an investment contract.[6]  Since Howey, case law has segmented the original definition into three elements: (1) an investment of money, (2) in a common enterprise, and (3) with an expectation of profits that are derived solely from the efforts of others.[7]  These form the Howey Test.

While expressed as three elements, in practice, the Test functions as four.  This is because the third element consists of two distinct requirements – an expectation of profits and profits derived “solely from the efforts of others” – each of which courts analyze separately.[8]  So in effect, the Test’s third element is only “an expectation of profits,” which precedes the fourth element: profits derived “solely from the efforts of others.”[9] 

I will address the Test as four elements – the first two examined below and the last two examined in Part II of this article.   


Investment of money

In most cases, this element is not controversial.[10]  After all, typically, determining whether money has been contributed to an enterprise will be a black-and-white issue. 

To the extent analysis is required, an “investment of money” occurs when the would-be investor commits assets to the enterprise in such a manner as to risk financial loss.[11] [12] This rule is broad, and Courts enforce it literally.  For example, in Rubera, the Ninth Circuit found an investment of money where investors bought pay telephones from the defendants, who the investors then hired to service the phones and collect whatever revenue the phones generated.[13]  With little analysis, the Court was able to classify the scheme as an “investment of money.”  First, the investors committed assets by purchasing the phones and hiring the defendants.[14]  Second, they also assumed the risk their individual phones would not make a profit and defendants’ entire scheme would fail.[15]  In short, the investor committed assets (money) and assumed the risk of loss (if the operation failed).  So there was an investment of money.

Despite the rule’s breadth, its reach is not unlimited.  For one, the investment must come from the actual investors in question. In Daniel, a trucker brought a securities fraud claim under both Acts after being denied benefits from his employer’s pension plan.[16]  Under the plan, the employer, but not the trucker, committed a certain amount of money each week to a common pension fund.[17]  The amount was calculated by taking a fixed sum and multiplying it by the number of “man-weeks” the employees worked.[18]  In relevant part, the plaintiff argued that these monthly contributions satisfied the “investment of money” requirement.[19]  The US Supreme Court disagreed.  As the Court noted, the monthly contributions did not come from the employees and, only in the most attenuated sense, were they made on the employees’ behalf.  Rather, the man-week formula served only as a means for the employer to track its obligation to the common fund.[20]  In short, nothing about the contributions indicated they came from the employee.  Consequently, the employee made no investment of money.

But again, Daniel is an outlier.[21]  Most plaintiffs demonstrate an investment of money.    

Common enterprise

Courts recognize two forms of commonality: horizontal and vertical.  To be a common enterprise, a scheme must exhibit at least one of them – although the requisite form varies from court to court.    

Each form of commonality arises from a different relationship between the investor and the other parties in the enterprise.  Horizontal commonality exists when the investors in an enterprise pool their assets and agree to share any profits or risks stemming therefrom.[22]  Put another way, a scheme with horizontal commonality is “common to a group of investors.”[23]  Vertical commonality means the investors’ fortunes are tied to the promoter’s success, rather than to the fortunes of their fellow investors.[24]  In other words, a scheme with vertical commonality is common to the promoter and the investor.[25]

The circuits are split, or more accurately, entangled, over which form of commonality should prevail.  Some circuits favor horizontal, some prefer vertical, and still others use both.   Specifically, the First, Sixth and Seventh Circuits only consider horizontal commonality.[26]  For the Fifth and Eleventh, vertical is the exclusive standard.[27]  The Second, Third and Fourth Circuit, as well as the D.C. Circuit, have established horizontal commonality as a viable benchmark.  But they have not ruled on whether vertical commonality also qualifies. [28]  The Ninth Circuit has made that determination, finding that both horizontal and vertical commonality support a “common enterprise.”[29]  Again, the circuits are entangled more than split.

But the takeaway is that different rules and requirements will govern the common enterprise element, depending on where the lawsuit is filed.

Horizontal Commonality

Though not always expressed as such, horizontal commonality breaks into two necessary elements: (1) the pooling of assets (“pooling”); and (2) the sharing of profits and risks (“sharing”).[30]  Each is straightforward, which makes horizontal commonality a bright-line test.[31]

Hocking serves as a good example of both elements.  Earlier, the district court had granted summary judgment to the defendants on the grounds that Hocking failed to show a common enterprise and, thus, could not establish the instrument in question was a security. The SEC appealed to the Ninth Circuit. 

According to the record, Hocking bought a condominium in Hawaii and, subsequently, entered into a rental pool agreement (the “RPA”) with owners of other units in the same resort.[32]  Under the RPA’s terms, the unit owners granted the Hotel Corporation of the Pacific (“HCP”) the exclusive right to rent their condominiums.[33]  It was then HCP’s job to rent as many of the units as possible.  Income from the rented units was then pooled and distributed to the RPA participants pro rata.  Each participant received his or her pro rata share regardless of whether his or her individual unit was rented.[34]

Here, the elements of horizontal commonality were easy to spot.  First, the owners’ rental income all flowed into a common and undifferentiated pool.  As such, the investors pooled their assets.[35]  Second, from the pool, each took his or her proportional share.  In other words, they shared the profits and risks.[36] Consequently, the Ninth Circuit held that the evidence on the record could support horizontal commonality and reversed the district court’s summary judgment ruling. [37]

Hocking is not much of an aberration, as for the most part, each element tracks the ordinary usage of their relevant terms.

First, “pooling” happens when multiple actors combine their money in a common location, like a single account.[38]  The promoters then use the funds from the pool for the purported benefit of all investors.  Examples include SG, Ltd – where investor funds were piled into a single account, which would settle online transactions – Infinity Group – where funds were combined into an investment fund, which the promoters claimed would create “highly-leveraged investment power” and, consequently, generate substantial returns for investors – and Banner Fund – where contributions from small investors were pooled into a single fund, which would supposedly allow them to participate in deals that required “large capital outlays.”[39]

Second, on the “sharing” element, the law is mildly unsettled.  The question is whether “sharing” must include the pro-rata distribution of profits and risks.  At least the Third Circuit holds that it must.  Other circuits differ, concluding pro-rata distribution is not a requirement.  Nonetheless, these courts still treat it as a sufficient condition – enough to establish sharing.    

Regardless, typically, plaintiffs’ push to demonstrate “sharing” rests on the argument that returns were allocated pro rata.  So even if, technically, pro-rata distribution is not a requirement, it often functions as one.

When the issue does arise, the analysis is basic:  If the investors’ percentages of the investment match their percentage of the return, the distribution is pro rata.[40]

Certain arrangements can make this more obvious.  Good examples are cases where an enterprise delineates shares, stock or “capital units” for each investor.  In these kinds of cases, investors’ pro-rata return is directly proportional to the number of shares or capital units each of them owns.  And, in turn, the number of shares is directly proportional to their investments.[41]  So at each stage, the pro-rata nature of the enterprise is transparent.    

Vertical Commonality

Unlike horizontal commonality, which focuses on the links between investors, vertical commonality targets the link between each investor and the promoter.[42]  Vertical commonality itself can appear in two forms: (1) strict vertical commonality and (2) broad vertical commonality.  For strict vertical commonality, the fortunes of the investor and the promoter must be intertwined and dependent on the promoter’s efforts.[43]  In contrast, broad vertical commonality requires only that the investor’s fortunes be tied to the promoter’s efforts.[44] 

Strict Vertical Commonality.  In schemes with strict vertical commonality, the investor’s fortunes are “tied to the fortunes of the promoter.”[45]  Thus, both fortunes “rise and fall” together.[46] 

In practice, this limits strict vertical commonality to schemes where the promoter’s and investor’s fortunes depend on the same factors and cannot go in opposite directions.

Two hypothetical commission-based arrangements help illustrate the point.[47]  In the first, an investor puts his or her assets under the management of an investment advisor.[48]  Each quarter, the advisor takes a commission equal to 5% of the investor’s assets that remain under management. 

This scenario does not equate to strict vertical commonality.[49]  The advisor’s fortunes are the commissions.  Those depend only on the total value of the assets under management at the time the commission is extracted.  The value may have dropped – or worse, dropped due to the advisor’s poor investment choices.[50]  Nonetheless, the advisor would still earn a commission (albeit a lower one than if the assets’ value went up).  The investor, however, would earn nothing if the value went down.[51]  Consequently, the fortunes of the investor and the advisor do not depend on the same factors.  And so those fortunes are neither intertwined nor dependent on the advisor’s success.      

In the second scenario, an advisor raises funds from qualified investors for a specific enterprise.  The enterprise is relatively simple:  The advisor will combine the investors’ funds and invest them in various financial instruments.[52]  For these services, the advisor will earn a commission equal to 10% of any profits generated from the investments.[53]  The remainder of the profits will go to the investors. 

This is strict vertical commonality.[54]  The advisor only makes a commission if his investments result in profits.  The investors’ position is the same.  The assets’ value determines whether they make or lose money.  So like the advisor, they would see no gains unless the enterprise, through the advisor’s efforts, succeeded.

At bottom, strict vertical commonality requires investor interests that cannot diverge from the promoter’s interests.  Any potential daylight between the two puts the concept out of reach.  In that sense, strict vertical commonality is, well, strict.  

Broad Vertical Commonality.  Among federal courts, support for broad vertical commonality is not broad.  Indeed, only the Fifth and Eleventh Circuits have found it sufficient to demonstrate a common enterprise.[55]  The other circuits either ignore the concept or explicitly reject its use.[56] 

For their part, the Fifth and Eleventh Circuits use broad vertical commonality because they believe it conforms to the policy rationales underlying the Securities Acts – namely, broad disclosure.[57]  Indeed, broad vertical commonality extends the Acts’ coverage farther than the horizontal or strict vertical approaches because it does not require the investor to have a common financial interest with any other party.  As such, it can pull many different contractual arrangements into the Acts’ sphere and, in the process, mandate their disclosure.  

But for other circuits, broad vertical commonality only repeats the “efforts of others” principle in the fourth prong and, thus, offers the Test nothing.[58]  At the very least, the former is true.[59]  Broad vertical commonality only requires a link between the investor’s fortunes and the promoter’s efforts.  This sounds like the fourth element: profits derived solely from the efforts of others.  The concepts are, therefore, repetitive, and applying broad vertical commonality would render one of the Test’s elements superfluous.  This helps explain why most courts are reluctant to use it.

[1] Steinhardt Group Inc. v. Citicorp, 126 F.3d 144, 150 (3d Cir.1997);SEC v. Infinity Group, 212 F.3d 180, 186 (3rd Cir. 2000); SEC v. Rubera, 350 F.3d 1084, 1089 (9th Cir. 2003)

[2] Masel v. Villarreal, 924 F.3d 734, 743 (5th Cir. 2019)

[3] 15 U.S.C. § 78c(a)(10); 15 U.S.C. § 77b(a)(1)

[4] SEC v. Arcturus, 928 F.3d 400, 409 (5th Cir. 2019), quoting Youmans v. Simon, 791 F.2d 341, 345 (5th Cir. 1986); SEC v. SG, Ltd., 265 F.3d 42, 46 (1st Cir. 2001)(“Congress intended these sweeping definitions, set forth in an appendix hereto, to encompass a wide array of financial instruments, ranging from well-established investment vehicles (e.g., stocks and bonds) to much more arcane arrangements.”), citing SEC v. Joiner, 320 U.S. 344, 351 (1943)

[5] SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 351 (1943); SEC v. Mutual Benefits, 408 F.3d 737, 742 (11th Cir. 2005) (Referring to “investment contract” as a “catch-all term”)

[6] SEC v. WJ Howey Co., 328 US 293, 301 (1946)

[7] See e.g., SG, Ltd., 265 F.3d at 46; Foxfield Villa Associates v.  Robben, 967 F.3d 1082, 1090 (10th Cir. 2020)

[8] See Warfield v. Alaniz, 569 F.3d 1015, 1020, n. 6 (9th Cir. 2009); See also Great Rivers Coop. of Se. Iowa v. Farmland Industries, 198 F.3d 685, 700 (8th Cir. 1999)

[9] See Warfield, 569 F.3d at 1020

[10] See Hocking v. Dubois, 885 F.2d 1449, 1455 (9th Cir. 1989)

[11] Rubera, 350 F.3d at 1090; Warfield, 569 F.3d at 1021; SEC v. Comcoa, 855 F.Supp. 1258, 1260 (MD Fla 1994)

[12] There need not be an actual loss, only the risk of one.  Rubera, 350 F.3d at 1093

[13] Id. at 1087

[14] Id. at 1090

[15] Id.

[16] International Brotherhood of Teamsters, Chauffeurs, Warehousemen, and Helpers of America v. Daniel, 439 US 551, 554-555 (1979)

[17] Id. at 553-554

[18] Id. at 554

[19] Id. at 560-561

[20] Id.

[21] See Hocking, 885 F.2d at 1455

[22] SG, Ltd., 265 F.3d at 49-50

[23] Hocking, 839 F.2d at 1455; Infinity Group, 212 F.3d at 187, n. 8

[24] Revak v. SEC Realty Corp., 18 F. 3d 81, 87-88 (2nd Cir. 1994); SG, Ltd., 265 F.3d at 49

[25] Infinity Group, 212 F.3d at 187; See Maura K. Monaghan, An Uncommon State of Confusion: The Common Enterprise Element of Investment Contract Analysis, 63 Fordham L. Rev. 2135, 2157 (1995)

[26] SG, Ltd., 265 F.3d at 49-50

[27] SG, Ltd., 265 F.3d at 49-50

[28] Id.

[29] Id.

[30] SEC v. Banner Fund, 211 F.3d 602, 614-615 (DC Cir. 2000); See SG, Ltd., 265 F.3d at 50-51

[31] See Supra note 25 at 2154-2155

[32] Hocking, 839 F.2d at 1453

[33] Id. at 1453, n. 4

[34] Id.

[35] Id. at 1459

[36] Id.

[37] Id.

[38] See SG, Ltd., 265 F.3d at 50

[39] Id.; Infinity Group, 212 F.3d at 188; Banner Fund, 211 F.3d at 614-615

[40] See e.g., SG, Ltd., 265 F.3d at 51; Infinity Group, 212 F.3d at 188

[41] See SG, Ltd., 265 F.3d at 51 (Promoters guaranteed the same 10% return for each in a virtual company, meaning investors’ returns were “dependent upon the number of shares held.”); See Infinity Group, 212 F.3d at 188 (Each investor gained one capital unit for every $100 invested in the defendants’ trust and received dividends based on the number of capital units held.)

[42] See Supra note 25 at 2157

[43] Revak, 18 F.3d at 87-88;SG, Ltd., 265 F.3d at 49

[44] Revak, 18 F.3d at 87-88; SG, Ltd., 265 F.3d at 49

[45] Revak, 18 F.3d at 87-88; Telegram Group, 448 F.Supp.3d at 369; Marini v. Adamo, 812 F.Supp.2d 243, 256 (SDNY 2011)

[46] Id.

[47] See Supra note 25 at 2159

[48] See Meyer v. Thomas & McKinnon, 686 F.2d 818, 818-819 (9th Cir. 1982); See Mordaunt v. INCOMCO, 686 F.2d 815, 817 (9th Cir. 1982)

[49] This hypothetical scenario resembles the facts in Meyer v. Thomas & McKinnon, where a financial advisor earned a commission based off the investor’s assets under management.The Ninth Circuit held that this arrangement did not demonstrate strict vertical commonality, in part, because the advisor could earn commissions even if the investor’s account lost money. Meyer, 686 F.2d at 819

[50] See Id.; See also Mordaunt, 686 F.2d at 817

[51] See Meyer, 686 F.2d at 819; See also Mordaunt, 686 F.2d at 817

[52] See SEC v. RG Reynolds, 952 F.2d 1125, 1130-1131 (9th Cir. 1991)

[53] Id. at 1130-1131

[54] This hypothetical resembles the facts in SEC v. RG Reynolds, where a promoter solicited investments in specific ventures and promised to take a management fee from the resulting profits.  The Ninth Circuit ruled that the scheme did evidence strict vertical commonality because the promoter’s commissions depended upon the investor making money.  Id. at 1130-1131; See also SEC v. Goldfield Deep Mines Co. of Nevada, 758 F.2d 459, 463 (9th Cir. 1985)

[55] SG, Ltd., 265 F.3d at 49-50

[56] Id. (Collecting cases); See also Revak, 18 F.3d at 88

[57] See Supra note 25 at 2161            

[58] Revak, 18 F.3d at 88

[59] See Supra note 25 at 2161

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