On its website, the Atlanta Opera includes an Opera 101 area designed to explain opera to the uninitiated. The site boldly proclaims, "Opera is a dramatic story told through song" It’s true that when most people think of opera, they imagine a huge lengthy spectacle with elaborate sets and costumes and people dancing and singing in a foreign language with orchestra accompaniment.
But “grand opera” is but one type of opera. The Opera 101 site notes that Bel Canto Opera focuses on music. And there is Opera Buffa, which is comic opera sung in Italian. Similar to Opera Buffa are operettas, such as those written by Gilbert and Sullivan. Operettas are light, amusing, and usually shorter than grand opera.
Opera also isn’t always what one might expect. In 1922, George Gershwin and Buddy DeSylva’s Blue Monday, a one-act "Jazz Opera," first was performed. Nearly a century later, in 2021, the Metropolitan Opera performed its first work by a Black composer – Fire Shut Up in My Bones, by jazz trumpeter Terence Blanchard.
In the 1960s, rock bands created a new genre – Rock Opera. Nirvana tried its hand at Rock Opera in 1967, but The Who's 1969 album, Tommy, is commonly thought to be the first Rock Opera. Pink Floyd’s 1979 album, The Wall, is also a rock opera, as is Andrew Lloyd Webber’s and Tim Rice’s Jesus Christ Superstar, which opened on Broadway in 1971.
Just as there are different types of operas, there are different types of securities subject to Securities and Exchange Commission (SEC) regulation. And like opera, securities aren’t always what one might expect. It's not surprising that notes, stock, bonds, debentures, and options are securities. Security-based swaps, evidences of indebtedness, collateral-trust certificates, voting-trust certificates, and certificates of deposit are also securities. And “investment contracts” also are securities.
Investment contract has become a “catch-all” term that brings diverse categories of investments – many of which may seem to have nothing to do with securities law – under the SEC’s jurisdiction. For example, when a start-up raises funds from friends and family, it frequently is selling securities. And many real estate sponsors, investors, and professionals are surprised to learn that their real estate investments are governed by securities laws. This article discusses when an investment is (and is not) an investment contract governed by securities laws.
The SEC Regulations the Sale of Orange Groves
In 1946, the Supreme Court held in SEC v. W.J. Howey Co. that the sale of the Florida orange groves with an optional management agreement is an “investment contract.” Investment contracts are a catch-all category in the definition of “security” in the federal securities laws. The Court’s Howey test to decide if an investment is a security remains in effect today:
1. There is an investment of money (or other assets).
2. The investment is in a common enterprise (generally, this means pooling of assets).
3. There is an expectation of a profit.
4. The profit comes from the efforts of a promoter or a third party.
Pay Phones, ATMs, Fine Art Collections, and Real Estate Investments Are Securities
Under the Howey test, Courts have found a diverse group of financial ventures to be investment contracts. For example, whiskey warehouse receipts, commercial real estate funds, payphones and ATMs with placement contracts, interests in a lumber mill, fine art collections, and timeshare arrangements all can be investment contracts.
An enterprise need not be profitable to be an investment contract. The Howey test looks at the intention when investing, not whether the investment makes money. So, a poor investment that loses money can still be an investment contract.
Further, the expectation of a profit refers to any financial benefit. For example, an enterprise expecting a loss to provide tax benefits to the investor can be an investment contract.
Not all Investments are Investment Contracts
Many people believe that every investment is an investment contract. Not so – some investments in a common enterprise aren’t investment contracts.
In United Housing Foundation, Inc. v. Forman, the Supreme Court held that investments in a cooperative housing project were NOT investment contracts despite investors expecting a profit. The Supreme Court noted that the investors’ primary motivation for buying into the housing cooperative was to obtain housing. That they might also expect a profit didn’t convert their acquisition of housing into an investment contract.
Other types of real estate investments won't be investment contracts. For example, a group of siblings who buy a vacation home to use during the summer but hire a property manager to rent the home when they aren’t using it aren’t investing in a security. Their primary purpose for investing is to obtain a vacation property.
Likewise, three friends who jointly buy an apartment building and rent the entire building to tenants won’t be investing in a security if they self-manage the property, with each contributing effort to the project. The friends’ primary purpose in investing is to make a profit. But they are expecting that profit to come from their own hard work, rather than the efforts of others.
And investment into a common enterprise with an expectation of benefits that aren’t financial probably isn’t an investment contract. Suppose a running group collects money from members to rent an industrial space and buy treadmills so members have somewhere to run in the winter. If the members invest so they can maintain running skills despite snowy weather, their goal is fitness rather than financial benefits, and their investments might not be investment contracts.
Suppose on the other hand, the club encourages members to invest in the club’s treadmills to save money on a winter gym membership. Then, the members' motivation might be deemed financial, and the investments might be investment contracts.
When Are Small Business and Real Estate Investments are Investment Contracts?
Suppose three friends, an accountant, a real estate broker, and a construction contractor, put together a real estate investment. They believe that between them, they have the skills to identify a good real estate investment, supervise renovations, maintain financial records, and manage the real estate.
The investment requires $1.5M in equity, so each friend contributes $500,000. They buy the property, make renovations, increase revenues, and sell the property for a profit. During their ownership, the construction contractor supervises renovations and maintenance. The real estate broker identifies the property, manages the property, and arranges for the sale. And the accountant develops the financial plan, keeps the books, and oversees the tax returns.
This real estate investment has three of the four elements of an investment contract. The friends are 1) investing money, 2) into a common enterprise, 3) with the expectation of a profit. But since each friend contributes significantly to the success of the enterprise, the profit comes from their own efforts – not the efforts of others. This arrangement isn't an investment contract.
Let's change the facts a little. The same three friends participate in the same real estate investment, each with the same roles in its success. However, the friends only contribute $100,000 each into the enterprise this time. They go to friends and family to raise the remaining $1.2M in equity, promising those friends a share of the profits from the property in exchange for their investments.
The friends and family are passive investors depending on the three friends' efforts for a profit. Their investments are an investment contract and are subject to securities laws.
Compliance Requirements for Investment Contracts
So, what does it mean when an investment is subject to securities laws?
Registration or Exemption
Federal securities laws require that all securities offerings be registered with the SEC or exempt from registration. It's costly and time-consuming to file a registration statement with the SEC, so smaller investments usually are offered under an exemption from registration.
But the SEC isn't the only securities regulator. Each state has its own securities laws and regulators. And securities offerings also must either be qualified or exempt under state securities laws. That means the offering must comply with two sets of securities laws.
Two of the most popular federal exemptions are under Rule 506(b) and 506(c). The requirements to qualify for those exemptions are beyond the scope of this article, but they include restrictions on who can buy the securities. However, Rule 506 exemptions are popular because they preempt substantive state securities regulation, so there's only one set of securities laws to comply with. Most states require that the issuer file a notice after the sale of a Rule 506 offering in their state.
Securities laws also restrict who can sell securities. Generally, only licensed broker-dealers can be paid (or given something of value) for selling securities. So, if an investment is an investment contract, the issuer can’t pay an unlicensed individual a success fee for bringing investors into the deal.
Compensation includes giving anything of value. So, giving someone free shares of stock or another non-cash item of value for successfully finding investors for an offering isn’t allowed – unless the recipient is a licensed securities professional.
There are limited exceptions for funds raised by issuer principals. Still, compensation based on the successful recruitment of investors is risky.
Looking for Investment Contracts
Although not all investments are securities, most passive investments have the potential to be securities. That doesn’t mean that the investment can’t be sold to friends and family – just that the sales process, disclosure, and sales compensation must comply with securities laws. Therefore, before contacting their friends and family for investment in their latest business or real estate venture, everyone should consult with a securities attorney to evaluate whether they are selling securities and, if so, to ensure compliance with securities laws.
This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.