Is Your Business Transaction a Security under the Securities Laws


Investment Contracts: Is Your Business Transaction a Security?

Many seemingly ordinary business transactions that may appear to not involve securities actually trigger the application of Arizona securities law because they qualify as investment contracts.

Please note that, while this article accurately describes applicable law on the subject covered at the time of its writing, the law continues to develop with the passage of time. Accordingly, before relying upon this article, care should be taken to verify that the law described herein has not changed.

I. Arizona’s Broad and Flexible Definition of a Security.

The Arizona Securities Act (A.R.S. § 44-1801, et seq.) sets forth Arizona’s securities laws. The legislature has directed that the Arizona Securities “Act ‘shall not be given a narrow or restricted interpretation or construction, but shall be liberally construed as a remedial measure in order not to defeat the purpose thereof.'” Siporin v. Carrington, 200 Ariz. 95, 103, 23 P.3d 92, 100 (Ct. App. 2001). Such a broad and liberal interpretation and construction satisfies the “intent and purpose of this Act [which] is for the protection of the public, the preservation of fair and equitable business practices, the suppression of fraudulent or deceptive practices in the sale or purchase of securities, and the prosecution of persons engaged in fraudulent or deceptive practices in the sale or purchase of securities.” 1951 Ariz. Sess. Laws ch. 18, § 20. See also Rose v. Dobras, 128 Ariz. 209, 212, 624 P.2d 887, 890 (Ct. App. 1981) (“securities laws were designed to protect the public from speculative and fraudulent schemes of promoters”).

In accordance with that liberal construction and interpretation and its remedial purpose, the Arizona Securities Act broadly defines a “security” to include an investment contract as follows:
[A]ny note, stock, treasury stock, bond, commodity investment contract, commodity option, 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, viatical or life settlement investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas or other mineral rights, real property investment contract 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.
A.R.S. § 44-1801(26) (emphasis added).

This “definition of a security ’embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.'” Siporin, 200 Ariz. at 101, 23 P.3d at 96 (quoting Nutek Info. Sys., Inc. v. Ariz. Corp. Comm’n, 194 Ariz. 104, 108, 977 P.2d 826, 830 (Ct. App. 1998)). See also MacCollum v. Perkinson, 185 Ariz. 179, 185-86, 913 P.2d 1097, 1103-04 (Ct. App. 1996) (“The definition of security for purposes of the registration statute is broad,” and “even broader” for purposes of the securities fraud statute as it even includes exempt securities). “The supreme court has consistently construed the definition of ‘security’ liberally. In searching for the meaning and scope of this term, form should be disregarded for substances and the emphasis should be on economic reality.” Rose, 128 Ariz. at 212, 624 P.2d at 890 (citing Tcherepnin v. Knight, 389 U.S. 332, 336 (1967)).

Therefore, like the Arizona Securities Act in general, Arizona courts are to “give a liberal construction to the term ‘security,'” and look to substance over form. Siporin, 200 Ariz. at 101, 23 P.3d at 96 (citing Rose, 128 Ariz. at 212, 624 P.2d at 890).

II. Investment Contracts under the Howey Test.

Although the statutory definition of a security specifically includes an “investment contract,” that term is not defined by A.R.S. § 44-1801(26) or any other provision of the Arizona Securities Act. Since Arizona’s statutory definition of a security is “patterned after” and “virtually identical” to the federal statutory definition of a security, Arizona courts “look to federal interpretations of securities law for guidance.” Daggett v. Jackie Fine Arts, Inc., 152 Ariz. 559, 565, 733 P.2d 1142, 1148 (Ct. App. 1986).

In doing so, the Arizona Court of Appeals Arizona adopted the U.S. Supreme Court’s three-part Howey test to determine whether a particular transaction is an investment contract. Rose, 128 Ariz. at 211, 624 P.2d at 889. Since then, “Arizona courts have repeatedly applied the Howey test in resolving ‘investment contract’ issues in Arizona Securities Act litigation.” Siporin, 200 Ariz. at 101, 23 P.3d at 96.

Under the Howey test, an investment contract is defined as any transaction in which: (1) an individual is led to invest money; (2) in a common enterprise; (3) with an expectation of profits solely from the efforts of others. S.E.C. v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946). If the Howey test is satisfied, it is immaterial whether the enterprise is speculative or promotional in character, or whether the tangible interest that is sold has intrinsic value independent of the success of the enterprise as a whole. Id. at 301.

Courts use an objective standard when applying the Howey test, and characterize the transaction at the time when it transpired. Daggett, 152 Ariz. at 565, 733 P.2d at 1148. See also Warfield v. Alaniz, 569 F.3d 1015, 1021 (9th Cir. 2009) (focusing “inquiry on what the purchasers were offered or promised. Under Howey, courts conduct an objective inquiry into the character of the instrument or transaction offered based on what the purchasers were ‘led to expect.'”). “Therefore, what actually occurred, or in speculation what could have occurred, following the transaction is immaterial.” Daggett, 152 Ariz. at 565, 733 P.2d at 1148. Moreover, the Arizona Court of Appeals has held that “[s]ubstance controls over form when determining whether a financial arrangement constitutes an investment contract.” Siporin, 200 Ariz. at 101, 23 P.3d at 96. See also Nutek, 194 Ariz. at 108, 977 P.2d at 830 (“substance controls over form”).

Each of the three prongs of the Howey test are discussed in turn below.

A. Investment of money. The first prong, whether one invested money, is a rather straightforward inquiry. An “‘investment of money’ means only that the investor must commit his assets to the enterprise in such a manner as to subject himself to financial loss.” Hector v. Wiens, 533 F.2d 429, 432 (9th Cir. 1976). See also Warfield, 569 F.3d at 1023 (since purchasers “committed their assets in return for promised financial gain, the transactions involved satisfy the ‘investment of money’ prong”).

B. Common enterprise. The second prong, a “common enterprise is one in which the fortunes of the investor are interwoven with and dependent upon the efforts and successes of those seeking the investment or of third parties.” Sullivan v. Metro Prods., Inc., 150 Ariz. 573, 576, 724 P.2d 1242, 1245 (Ct. App. 1986) (quoting S.E.C. v. Glenn W. Turner Enters., Inc., 474 F.2d 476, 482 n.7 (9th Cir. 1973)).

Two tests determine the existence of a common enterprise: (1) the horizontal commonality test, which requires the pooling of investor funds collectively managed by a promoter or third party; and (2) the vertical commonality test, which requires a positive correlation between the success of the investor and the success of the promoter without requiring a pooling of funds. Daggett, 152 Ariz. at 565, 733 P.2d at 1148.

In Arizona, satisfying either the horizontal commonality test or the vertical commonality test is sufficient to meet the requirements of the second prong of the Howey test; the pooling of funds is not strictly required. Id. at 566, 733 P.2d at 1149. See also Vairo v. Clayden, 153 Ariz. 13, 17, 734 P.2d 110, 114 (Ct. App. 1987).

Where the promoter’s interest does not end after the transaction is consummated, because, for example, the promoter’s success depends on the investor’s success, or the promoter is otherwise inextricably interested in the success or failure of the transaction, vertical commonality exists. Daggett, 152 Ariz. at 566, 733 P.2d at 1149.

Finally, a promoter cannot “unilaterally change the character of the transaction by merely assigning away its interest.” Id. at 566, 733 P.2d at 1149. Such an assignment is “incidental” to the promoter’s interest in the investor’s success and does not affect the transaction between the promoter and investor. Id. at 566, 733 P.2d at 1149.

C. Expectation of profits solely from efforts of others. For the third prong, expectation of profits solely from the efforts of others, profits are defined “as simply financial returns on investments,” “income or return,” including dividends, periodic payments or increased value of investment, and “either capital appreciation resulting from the development of the initial investment or a participation in earnings resulting from the use of investors’ funds.” Warfield, 569 F.3d at 1023-24 (quoting United Housing Found. v. Forman, 421 U.S. 837, 852-53 (1975)).

Even if profits exist, they must be derived solely from the efforts of others. Howey, 328 U.S. at 299. However, “the word ‘solely’ in the Howey test is not to be read as a literal limitation on the definition.” Sullivan, 150 Ariz. at 577, 724 P.2d at 1246 (quoting Turner, 474 F.2d at 482). See also Rose, 128 Ariz. at 212, 624 P.2d at 890 (interpreting this third prong “in a flexible and remedial fashion,” noting that its “strict interpretation” has been criticized). Instead, courts “adopt a more realistic test, whether 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. The emphasis in determining whether an investment is a security is on economic reality.” Sullivan, 150 Ariz. at 577, 724 P.2d at 1246 (quoting Turner, 474 F.2d at 482).

Important economic realities of the transaction include the promotional emphasis, contractual materials, and investor’s motivation and ability to exercise control over the investment. See Daggett, 152 Ariz. at 566-67, 733 P.2d at 1149-50; Vairo, 153 Ariz. at 17-18, 734 P.2d at 114-15. “When the investor is relative uninformed and then turns over his money to others, essentially depending upon their representations and their honesty and skill in managing it, the transaction is generally considered to be an investment contract. Rose, 128 Ariz. at 213, 624 P.2d at 891 (quoting S.E.C. v. Heritage Trust Co., 402 F. Supp. 744, 749 (D. Ariz. 1975)). Thus, investment contracts typically exist when transactions are offered without regard to the investors’ background, knowledge, skill, experience or sophistication, because they are basically passive investors. See, e.g., Nutek, 194 Ariz. at 111, 977 P.2d at 833; Daggett, 152 Ariz. at 566-68, 733 P.2d at 1149-51; Sullivan, 150 Ariz. at 577, 724 P.2d at 1246.

Moreover, “it is not necessary . . . that the efforts be those of the promoter.” Daggett, 152 Ariz. at 566, 733 P.2d at 1149. The “efforts of others” test is satisfied when “the typical investor would accept third party efforts.” Id. at 566, 733 P.3d at 1149. See also Rose, 128 Ariz. at 212, 624 P.2d at 890 (holding “efforts of others” prong is satisfied when significant managerial efforts are arranged by party selling the investment).

“The theoretical possibility that an investor would refuse the efforts of others is not fatal to a determination that profits are to be earned from third party efforts. The focus is on whether the typical investor would accept third party efforts.” Daggett, 152 Ariz. at 567, 733 P.2d at 1150 In other words, although the investor “was not strictly obligated to rely on the efforts of others, economic reality would require just that,” and satisfy the third prong of the Howey test. Id. at 567, 733 P.2d at 1150.

Finally, “pre-investment entrepreneurial or managerial activities may satisfy the third prong of the Howey test under appropriate circumstances.” Siporin, 200 Ariz. at 103, 23 P.3d at 98. “The timing of the managerial effort and the investor involvement are not the only considerations. They are, however, significant considerations when determining if the purchase is entitled to the protection of the Arizona Securities Act.” Id. at 104, 23 P.3d at 99.

This third prong of the Howey test is a “key factor” in determining whether a transaction constitutes an investment contract. Rose, 128 Ariz. at 213, 624 P.2d at 891. See also Daggett, 152 Ariz. at 565, 733 P.2d at 1148 (recognizing “decisions in most of the cases turn on the satisfaction of the third prong”).

In short, when a transaction meets all three prongs of the Howey test — investment of money in a common enterprises with an expectation of profits solely from the efforts of others — it is an investment contract, and therefore it is a security pursuant to the statutory definition set forth in A.R.S. § 44-1801(26). The offeror must then comply with all other securities law requirements, including registering the security under A.R.S. § 44-1841 or qualifying for an exemption or exception from registration pursuant to A.R.S. § 44-1843, et seq., and registering itself to sell the security under A.R.S. § 44-1842.

III. Types of Investment Contracts.

Investment contracts involve a wide variety of transactions, and not just what one would normally consider an investment, such as a stock or bond.

For example, Arizona courts have found investment contracts involving the sale and management of orchards, video production and distribution services, art purchase agreements, marketing membership interests, and viatical settlement agreements. See, e.g., Siporin, 200 Ariz. at 104, 23 P.3d at 99; Nutek, 194 Ariz. at 113, 977 P.2d at 835; Daggett, 152 Ariz. at 568, 733 P.2d at 1151; Sullivan, 150 Ariz. at 577, 724 P.2d at 1246; Rose, 128 Ariz. at 213, 624 P.2d at 891.

The Arizona Corporation Commission Securities Division, which oversees the purchase and sale of securities in Arizona and enforces the Arizona Securities Act, has found investment contracts involving the development of mineral resources, oil, gas and water wells, fractional interests in oil and gas mineral rights, gold, silver and gravel mining operations, mining enterprises, real estate development and investment programs, automobile sale-lease-back programs, restaurant equipment sale-lease-back programs, equipment leasing programs, silver coin purchase-and-sale programs, strategic metals, tax lien certificates, money voucher machine programs, promissory notes, viatical settlements, government securities, profit sharing certificates, joint venture agreements, warranties and liens, limited liability company membership interests, limited partnership interests, general partnership interests, independent distributorships, and sales of wireless cable television licenses.

What these transactions have in common is that they all essentially amount to a “profit-seeking business venture.” Howey, 328 U.S. at 300..

IV. Investment Contract Is a Question of Law.

“Whether an investment qualifies as a ‘security’ under the Arizona Securities Act is a question of law,” generally for the judge to determine rather than a jury. Siporin, 200 Ariz. at 100, 23 P.3d at 95. See also Nutek, 194 Ariz. at 107, 977 P.2d at 829; Vairo, 153 Ariz. at 18, 734 P.2d at 115; Daggett, 152 Ariz. at 564, 733 P.2d at 1147.

Therefore, Arizona courts commonly decide whether an investment is a security on summary judgment. See, e.g., Siporin, 200 Ariz. at 100-04, 23 P.3d at 96-99 (“conclud[ing] as a matter of law that viatical settlement agreements sold by [defendant] . . . constitute investment contracts. Accordingly, their sale constitutes the sale of ‘securities’ pursuant to A.R.S. section 44-1801[26]” and directing trial court to enter judgment in favor of plaintiffs on securities violations claims that plaintiffs were sold unregistered securities by unregistered dealers); Daggett, 152 Ariz. at 565-68, 733 P.2d at 1148-51 (finding art purchase agreement was “investment contract security unexempt from Arizona securities laws,” and therefore affirming trial court’s summary judgment); Sullivan, 150 Ariz. at 575-77, 724 P.2d at 1244-1246 (holding parties’ video production and distribution agreements were investment contracts and thus securities not exempt from registration, and hence upholding trial court’s finding on summary judgment). But see Vairo, 153 Ariz. at 17-18 734 P.2d at 114-15 (finding genuine issues of material fact on second and third prongs of Howey test precluded summary judgment on whether agreements for sale and distribution of videotapes amounted to investment contracts).

If you have questions regarding a possible securities law matter, or to arrange for a consultation concerning your legal matter, please contact Robert Mitchell at rdm@tblaw.com or at (602) 452-2730.
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