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

The following is Part II of my article on investment contracts.  It will analyze the final two elements of the Howey Test: The expectation of profit and profit derived from the efforts of others. Part I can be found here.

Expectation of profits

As confirmed by the Supreme Court, the definition of “profit” is broad and general: “Simply a financial return on…investments.”[1]  The wide net serves the Acts’ goal of catching as many fraudulent schemes as possible – even those that may be unique or irregular.[2]

Going a step further, the “expectation of profit” hinges on the purpose of the transaction:  financial return or consumption.[3]  So where the plaintiff contributed money to an enterprise with the hope of achieving a financial return, he or she expected a profit.[4]  Conversely, if the plaintiff spent money to purchase a good he or she meant to consume, profit was not the motive.[5]

Here, Joiner and Forman – two Supreme Court cases that fell on either side of this divide – are instructive.[6]   In Joiner, the defendants sold assignments of leases, covering land upon which they were drilling for oil.[7]  Defendants’ advertising literature used their drilling operation as the leases’ main selling point.  That is, the literature highlighted the leaseholds’ oil-producing potential and the defendants’ drilling operation.[8] 

Largely based on these materials, the Supreme Court held that the investors bought into the defendants’ scheme expecting profits.[9]  Indeed, as the Court found, the defendants were not selling leases alone.  Rather, they were selling leases and the possible benefits of the drilling operation taking place on the corresponding land.  Thus, an economic interest in the drilling became the instrument’s defining characteristic and the source of its value.[10]  As such, the venture was an investment, and the purchasers had an expectation of profit. 

Notably, the Court also speculated that, if the advertising literature had “omitted the economic inducements of the proposed and promised exploration well,” the analysis may have cut the other way.[11]  After all, this scenario would have left the purchasers to develop the land themselves.  So they could not have expected any of the economic benefits stemming from defendants’ drilling operation.

This hypothetical commodity – a naked real estate interest, detached from any further economic venture – more closely resembles the interest in Forman.  There, would-be tenants purchased shares in a nonprofit housing cooperative that owned and managed an apartment building in New York City.[12]  The purchasers all wanted to live in the building, which they could only do if they bought the shares.[13] 

The co-op’s advertising bulletin emphasized different features than the advertising literature in Joiner.  Whereas the Joiner literature touted the economic activity occurring on the leaseholds, the co-op’s bulletin promoted the advantages of living in the building.  These included the tenants’ equal control of the building’s operations and the “community atmosphere.”[14] The bulletin also notified purchasers that, when they moved out of the building, they would need to offer their shares back to the co-op at the price they paid for them.  Relying on the bulletin, the Court concluded tenants purchased shares in the co-op to secure “living quarters for personal use” and not “making investments for profit.”[15]  On this basis, the enterprise fell outside the Acts’ definition of a security.[16]

At a general level, Joiner and Forman are similar in that each involved the purchase of real estate interests.  But they diverge when the subject turns to how the real estate was used.  In Joiner, the buyers were purchasing the leaseholds for the oil revenue the defendants’ efforts might extract from the land.  They did not intend to live on the land or even use it to conduct their own drilling operations.  Plainly, they were drawn to the prospect of a financial return from the drilling.  The leaseholds were incidental.  By contrast, in Forman, the buyers’ principal motivation was to live on the properties in question. The shares were merely incidental to that pursuit.[17] 

All told, the purchasers in Joiner made an investment in the drilling project, hoping it would yield a profit.  This was deemed an investment contract.  The purchasers in Forman lived in the apartments they bought, despite the low probability of a return.  This was not an investment contract.  In short, the investment-consumption rule prevailed.

Efforts of others

The most important factor is control

To be an investment contract, the venture’s anticipated profits must derive “solely from the efforts of others.”[18]  That said, courts do not give the term “solely” literal effect.  Instead, the promoter or third party’s efforts may support an investment contract if they are merely a significant influence on the venture’s profits, as opposed to the sole factor. 

But how much influence must the venture owe to the efforts of others? 

While courts have not always used the same phrasing, the answer boils down to control – as in, who exerts “meaningful” control over the venture.[19]  If it is the “others,” this necessarily makes the enterprise dependent on their efforts.  So the enterprise meets the Howey Test’s final element. Conversely, meaningful investor control may signal that it was the investor’s efforts that drove the success of the enterprise.[20]  And this would leave little room for significant influence from the promoter or third party.

So, again, speaking generally, the relative levels of control determine whether the others’ efforts are enough to support an investment contract.

Control depends on the “economic reality”

Courts weigh control based on how the scheme operates in practice – often termed the “economic reality.”  This goes beyond the distribution of control in the written documents. 

Specifically, the written documents may grant investors control over certain matters, which circumstances prevent them from exercising.  In these cases, the investors’ control, as expressed in the written documents, is “illusory.”[21]   

Bailey is a good example.  There, the Fourth Circuit examined a crossbreed program for cattle.  If successful, the program would yield “superior” cattle, which investors could then sell at a premium.[22] According to the program’s written agreements, investors could choose the embryos subjected to the crossbreed and, thereafter, manage the cattle’s treatment.[23]  But despite these nominal powers, the investors lacked the knowledge and experience to select the right embryos or monitor the treatment.  This left them no alternative but to cede those powers to the promoters.[24]  Further, even if an investor could run the program, he or she would not have enough cattle to do it without using other investors’ cattle.  As such, the program required coordination between investors, a job best run through a single entity like the promoter.[25]  Or put another way, no investor, regardless of his or her expertise, could have run the crossbreed on his or her own. Effectively, these issues neutered the powers granted to investors in writing and left the program’s results dependent on the “efforts of others.” [26] 

The economic reality varies based on the facts

Control and, by extension, the “efforts of others” issue are case-specific determinations.  At one end of the factual spectrum are cases where the investor holds total (or almost total) control over the enterprise.  In Robinson, for example, the investor held managerial authority over most aspects of the company in question and ultimate control over many of its financial decisions.   So investor control was significant, and the enterprise was a non-security.  On the other end are cases where the promoter or third party enjoys “sole” control.   These include SG, where the defendants controlled all aspects of a virtual stock exchange that promised investors a 10% return, and Unique Financial Concepts, where the defendants had “sole discretion” to use investor funds.[27]   

Between the two poles, the issue comes back to which side has more control: the investor or the “other.”  This leaves courts to weigh each side’s relative strength.  In Albanese, the promoter was a company that sold and serviced payphones.  True to that mission, it organized an enterprise whereby it sold payphones to investors, who then contracted to have the promoter service those phones.  On one hand, the written agreements between the parties granted investors the power to choose their phones’ locations.[28]  But on the other, they could only pick sites from a list arranged by the promoter.[29]  In addition, the promoter performed most of the services needed on the phones.[30]  Namely, the promoter determined the phones’ possible locations, contracted with the entities that controlled those locations, serviced the machines, and accounted for the profits.  By comparison, the Eleventh Circuit deemed the investors’ power “insubstantial.”[31]  So ultimately, the Court ruled that the limited power to select the phone’s locations was not nearly enough to overcome the more robust authority left to the promoter.[32]

In Banner Fund, Banner Fund’s principals solicited investments from “low-income” individuals, on the promise they would invest the money through an “arbitrage” strategy.[33]  They also offered a recruitment program, whereby existing investors could recruit new ones and receive 20% of the profits those investors earned from the fund.[34]  The DC Circuit found Banner Fund’s advertising literature was enough to demonstrate its profits stemmed from the “efforts of others.”  Indeed, the literature claimed only Banner Fund’s principals would manage the investors’ funds.[35]  Moreover, the recruitment program did not change the result, as the return from recruiting new investors – 20% of their revenue from Banner Fund – also depended on the promoters.[36]

At bottom, control is a fact-intensive issue that will shift depending on the power relationships in a given case.  The written agreements may grant an accurate view of these relationships.  But in some cases, other facts may overrun the agreements’ terms and make them irrelevant.  In short, the control analysis is flexible – a quality that allows it to serve the Acts’ goal of catching the “countless and variable” schemes used to defraud investors.

Investor lacks necessary expertise to control the enterprise

To a substantial degree, the “efforts of others” standard is nebulous.  Nonetheless, certain types of cases can introduce more structure.  A notable example is those where the venture requires specific expertise.

In these cases, to operate successfully, the enterprise may require a specific skill set the “other” has but the investor does not.  For two reasons, these schemes are more likely to depend on the “efforts of others.”

First, the promoter or third party’s expertise becomes part of the total package of benefits the investor purchases – as essential to the enterprise as the commodity or financial product being transacted.[37]  In Glen-Arden, the Second Circuit explained this point with an instructive comparison.  The Glen-Arden defendants sold warehouse receipts that established the holder’s ownership of specific casks of Scotch whiskey.[38]  While each receipt matched a designated cask, purchasers did not possess the whiskey itself.  Instead, their goal was to sell the receipt for a profit.[39]   

The defendants offered to run the entire operation for the purchasers.  This meant they selected each cask, stored the whiskey, and sold the receipt when the time arrived.[40]  The defendants later argued these services did not form an investment contract because the purchasers merely bought a commodity.  To them, this was no different than trading wheat or grain futures, neither of which trigger the Acts.[41] 

But the Second Circuit saw a distinction between defendants’ scheme and trading commodity futures.  Unlike futures buyers, the receipt purchasers relied on the defendants to select specific casks.  In turn, the right casks would be more valuable when the purchasers resold their receipts.[42]  By contrast, futures traders do not request a particular bushel of wheat or bucket of grain.[43]  Their success depends on the price of those commodities in general.  So all told, the receipt purchasers needed expertise in selecting the casks in a way futures traders do not when they purchase commodities. 

Relying in part on this distinction, the Court held that receipt purchasers were buying more than the receipts.  They were also buying the defendants’ “expertise in selecting the type and quality of Scotch whiskey and casks” and, at a later date, finding a buyer for the receipt.[44]  These services formed a “package deal.”[45]  And thus, the enterprise was an investment contract.[46]

This distinction between the hypothetical futures trader and the purchasers in Glen-Arden highlights the role expertise can play in the “efforts of others” analysis.  In both instances, the purchasers are buying the right to a commodity, which they will trade, rather than  consume.  But because the hypothetical trader gains nothing from purchasing one version of the commodity instead of another, he or she does not need an expert for this step.  So he or she does not purchase the efforts of any others.  The Glen-Arden purchasers, however, did need to pick the right whiskey.  So along with the receipts themselves, they bought the promoters’ expertise – aka, the efforts of another party. In short, the need for expertise meant the scheme could not succeed without the efforts of others.

Second, if the necessary skills are beyond the investors, it follows that they could not have controlled the enterprise.  Take the crossbreed program in Bailey.  Originally, the district court ruled the investors had too much control over the enterprise to be dependent on the “efforts of others.”[47]  This conclusion rested on the contracts the investors signed, which gave them the power to select the embryos and direct the cattle’s maintenance.[48] 

But the Fourth Circuit believed the district court clung too tightly to the rights expressed in the contracts, without considering whether the investors had actual control over the enterprise.[49]  In finding such control absent, the Court highlighted the investors’ lack of expertise in selecting the right embryos and maintaining the cattle.  So they could not have controlled the enterprise because they did not have the ability to control the enterprise.[50]  Given that, the Fourth Circuit held that the scheme was an investment contract.[51] 

Also keep in mind a critical nuance in the expertise principle: It does not apply to a situation simply because the investor lacks expertise.  It applies where the lack of expertise indicates the investor cannot control the enterprise.[52] 

Going back to Bailey, the Court speculated that, if the program had merely involved the slaughter and sale of cattle, the investors may well have had the ability to control it.[53]  All were experienced businesspeople, and they could sell the cattle.  Further, to the extent they lacked experience raising the cattle, they could have directed the process while leaning on others to perform the day-to-day operations.[54]  But the program at issue required expertise in choosing the right embryos and crossbreeding.  The plaintiffs could not summon these qualities or gain them from another source.[55]  So out of necessity, they were dependent on the efforts of others.[56]

This nuance explains why the Fourth Circuit reached a different conclusion in Robinson than it did in Bailey.  In Robinson, the plaintiff, James Robinson, invested $15M in GeoPhone, a telecommunications company based on signal processing technology known as CAMA.[57]  Defendant Thomas Glynn induced Robinson’s investment by showing him CAMA’s allegedly successful field test results.[58]  With his investment, Robinson obtained significant control of GeoPhone.  Most notably, the company put him on its board of managers and executive committee, which, together, held all managerial authority.  GeoPhone also named Robinson its treasurer, allowed him to appoint two additional directors, and granted him final approval over any additional debt the company wanted to assume.[59] 

Robinson later learned that the field test results Glynn showed him were fake.  Upon this discovery, Robinson sued Glynn under the Securities Act, alleging his contributions to GeoPhone formed an investment contract.  Addressing the “efforts of others” issue, Robinson argued that he did not have the technical skills to understand the CAMA system.  So he had to rely on others to direct GeoPhone.

But the Fourth Circuit concluded that, despite his inexperience with CAMA, Robinson still held sufficient control over GeoPhone and, therefore, his investment.  Indeed, Robinson’s board and executive committee seats allowed him to direct GeoPhone’s decisions.  Further, his meager technical background did not impede him from exercising those managerial powers.  For example, he reviewed financial records and status reports, rejected certain proposed spending, and offered his input on matters ranging from GeoPhone’s technological licenses to its marketability.[60]  As for CAMA, the Court noted that Robinson could hire experts to cover any gaps in his knowledge.[61]  This still left him to manage the company, which he had the skills to do.[62] 

The enterprise in Bailey was different in that, for one, those investors needed particular expertise to control their investment.  And without that expertise, they had to rely almost entirely on the promoters.  As such, the promoters were left to perform the enterprise’s core functions: choosing the right embryos, organizing the cattle and crossbreeding the embryos.  These skills, which only they held, would determine the scheme’s success.  In short, unlike Robinson, the hole in the Bailey investors’ expertise pointed to a larger inability to control their investment.


As noted in Part I, the Acts’ use the term “investment contract” as a catchall – meant to encompass fraudulent schemes involving instruments that function like a security but do not fit the definition’s other examples.  For better or worse, this makes the definition tough to pin down.  It also means the Acts are not as susceptible to loopholes or technicalities that blunt its application.  So any solid analysis of the “investment contract” definition must be grounded in a thorough understanding of the relevant case law – especially each case’s facts. 

For more information on the legal services Terry Brennan can offer financial professionals, please visit the “Meet Terry Brennan” and “Practice Areas” sections of this website.

[1] SEC v. Edwards, 540 U.S. 389, 396 (2004), quoting United Housing Foundation v. Forman, 421 U.S. 837, 853 (1975)

[2] See e.g., Edwards, 540 U.S. at 394

[3] See e.g., SEC v. Infinity Group, 212 F.3d 180, 188 (3rd Cir. 2000)(Emphasis added); SEC v. Life Partners, 87 F.3d 536, 543 (DC Cir. 1996)

[4] Id.

[5] Forman, 421 U.S. at 852-853;Infinity Group, 212 F.3d at 187; See Life Partners, 87 F.3d at 543 (“The Court’s general principle we think, is only that the expected profits must, in conformity with ordinary usage, be in the form of a financial return on the investment, not in the form of consumption.”).

[6] It bears mentioning that Joiner preceded Howey by three years.  Nonetheless, the case was decided on similar principles.  SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 349 (1943)

[7] Id. at 345-346

[8] Id. at 348-349

[9] Id. at 349

[10] Id. at 349 (“It is clear that an economic interest in this well-drilling undertaking was what brought into being the instruments that defendants were selling and gave to the instruments most of their value and all of their lure.”)

[11] Id. at 348

[12] Forman, 421 U.S. at 842

[13] Id.

[14] Id. at 853

[15] Id.

[16] Id. at 859-860

[17] Forman, 421 U.S. at 857

[18] Revak v. SEC Realty Corp., 18 F. 3d 81, 88 (2nd Cir. 1994); Steinhardt Group Inc. v. Citicorp, 126 F.3d 144, 151 (3d Cir.1997);Infinity Group, 212 F.3d at 188; See SEC v. SG, Ltd., 265 F.3d 42, 46 (1st Cir. 2001)

[19] Courts’ different phrasings all circle back to control. See Life Partners, 87 F.3d at 545 (Rejecting an investment contract where none of the promoter’s services affected the investors’ rate of return); See SEC v. RG Reynolds, 952 F.2d 1125, 1131 (9th Cir. 1991)(The “efforts of others” prong is met when “the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.”); SEC v. Banner Fund, 211 F.3d 602, 615 (DC Cir. 2000)(“Purely ministerial or clerical efforts” do not help satisfy the “efforts of others” element.); SEC v. Mutual Benefits, 408 F.3d 737, 743 (11th Cir. 2005) (Profits must be derived “predominantly” from the efforts of others.); SEC v. Rubera, 350 F.3d 1084, 1092 (9th Cir. 2003)(Finding the “efforts of others” prong met, in part, because the promoter’s efforts were “crucial to the profitability of the investment”)

[20] See Albanese v. Florida National Bank of Orlando, 823 F.2d 408, 410 (11th Cir. 1987)

[21] See Albanese, 823 F.2d at 412; See also Bailey v. JWK Properties, 904 F.2d 918, 923-924 (4th Cir. 1990)

[22] Id. at 919

[23] Id.

[24] Id. at 924-925

[25] Id. at 924

[26] See Albanese v. Florida National Bank of Orlando, 823 F.2d 408, 412 (11th Cir. 1987)

[27] SG, Ltd., 265 F.3d at 55; Unique Financial Concepts, 196 F.3d 1195, 1201 (11th Cir. 1999)

[28] Technically, there were three agreements, all of which granted the investors some influence over the machines’ locations.  Albanese, 823 F.2d at 410

[29] Technically, the investors could request a site that was not on the list.  But practically, they would still have to rely on the promoter to find the site and arrange for the placement.  Id. at 412

[30] Id.

[31] Id.

[32] Id.

[33] Banner Fund, 211 F.3d at 606

[34] Id.

[35] Id. at 615

[36] Id.

[37] See also Joiner, 320 U.S. at 349 (“It is clear that an economic interest in this well-drilling undertaking was what brought into being the instruments that defendants were selling and gave to the instruments most of their value and all of their lure.”)

[38] Glen-Arden v. Costantino, 493 F.2d 1027, 1031 (2nd Cir. 1974)

[39] Id. at 1034-1035

[40] Id. at 1033

[41] Id.

[42] Id. at 1035

[43] Id. (“It is not as if [the whiskey receipt buyers] were buying simply X carloads of wheat or barley, a commitment to sell which could be supplied by the furnishing of any other carload of wheat or barley.”)

[44] Id.

[45] Id.

[46] Id. at 1035-1036

[47] Bailey, 904 F.2d at 920-921

[48] Id. at 921-922

[49] Id. at 923-924

[50] Id. at 924

[51] Id. at 925

[52] See Robinson v. Glynn, 349 F.3d 166, 171-172 (1st Cir. 2003)

[53] Bailey, 904 F.2d at 923-924

[54] Id.

[55] Id.

[56] This reasoning has governed other cases where an investor purchases a product but cedes operation of it to the seller.  See Albanese, 823 F.2d at 412;SEC v. Alpha Telecom, 187 F. Supp. 2d 1250, 1260(D. Or. 2002)            

[57] CAMA stood for Convolutional Ambiguity Multiple Access.  Robinson, 349 F.2d at 168

[58] Id.

[59] Id. at 170-171

[60] Id.

[61] Id. at 171

[62] Id.

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