Substance, Not Form, Determines What Constitutes a “Security”

Ninth Circuit Issues Reminder That Substance, Not Form, Determines What Constitutes a “Security”

A common misconception is that the securities laws apply only to investments traditionally thought of as securities, such as publicly traded stocks and bonds. This is not the case. In addition to those well-understood categories of securities, the securities laws also apply to “investment contracts,” an expansive term that covers any contract or scheme by which someone invests money in an enterprise with the expectation of profits from a third party’s efforts. This means that the label put on an investment is legally irrelevant: persons soliciting funds from third parties cannot avoid the securities laws by calling a security something else.

A recent decision by the Ninth Circuit Court of Appeals is a useful reminder of this rule – and the serious consequences of ignoring it. The defendant in S.E.C. v. Schooler, No. 16-55167, 2018 WL 4608227 (9th Cir. Sept. 26, 2018) purchased parcels of land, then sold to third parties (often at several times the price he originally paid for the land) “general partnership interests” in entities that held the real property. Interests in general partnerships are typically not securities, because in a true general partnership, each partner is responsible for managing the enterprise, and thus there is no expectation of profits from the efforts of others.

In S.E.C. v. Schooler, however, the Securities and Exchange Commission established that the “general partnership” label was illusory because Schooler exercised “near total control” over the investment scheme. The investment, in other words, was more akin to a limited partnership, in which limited partners are passive investors and control is vested in a general partner. Accordingly, the federal securities laws applied to the defendant’s investment scheme, as a result of which the defendant was found to have violated the registration requirements of the U.S. Securities Act and various antifraud provisions of the federal securities laws.

S.E.C. v. Schooler highlights the breadth and flexibility of the federal securities laws. Courts and the S.E.C. can and will “look through” the legal form and other superficial features of an investment scheme to determine its true substance. If they conclude that an investment is a security, and that those offering it to third parties have not complied with the securities laws, the consequences are potentially severe and include:

• A right of rescission in favor of investors – in other words, an automatic “put right” that allows investors to recover the money they invested up to a year after the date of the violation;
• Damages awards, in some cases including attorneys’ fees and punitive damages, in civil actions brought by plaintiffs;
• Fines and disgorgement orders in actions brought by the S.E.C.; and
• In especially severe cases, criminal penalties.

It is therefore critical that anyone seeking to raise capital understand how securities laws apply to their contemplated deal.

If you need assistance structuring an investment vehicle or otherwise complying with the securities laws, or if you believe someone has obtained funds from you in violation of those laws, the experienced professionals at Capobianco Law Offices can help.