Court Looks to Relationship of Parties to Determine Existence of Investment Contract

In a case decided June 11, 2008, the Second Circuit has added clarification to the Supreme Court’s definition of an “investment contract” as explained in SEC v. J.W. Howey, Co., 328 U.S. 293 (1946). In U.S. v. Leonard, the court determined that courts should analyze the investment relationship beyond the formal terms of an agreement to see whether the reality was one of significant investor control.

In Leonard, a jury convicted the defendants of securities fraud and conspiracy to commit securities and mail fraud for marketing investment interests in film companies. Among the challenged to the convictions, defendants argued that the financial vehicles at issue were not in fact securities and therefore the sales could not subject them to conviction for securities fraud related offenses.

The defendants sold investment units in limited liability companies at $10,000 per unit. The monies raised were to finance the production of motion pictures. When defendants sold an investment unit, they received a commission of either 42% or 45% depending on which production they had sold. The offering memorandum did not disclose the size of the commissions. To the contrary, the offering materials could have led a potential investor to conclude that there was a maximum sales commission of 20% per unit.

In Howey, the Supreme Court included in the definition of “investment contract” that the investment be “in a common enterprise and [the investor] is led to expect profits solely from the efforts of the promoter or a third party.” The defendants argued that the investment units at issue did not meet the definition of an “investment contract” because the investors did not expect profits solely from the efforts of the promoters.

The Second Circuit rejected the defendants’ argument. The court made a distinction between a passive investor and an investor with a significant expectation of exercising control. Moreover, the court said that determination of the nature of an investment in a limited liability corporation required a case by case analysis into the economic realities of the transaction.

While, in Leonard, the offering materials on their face appeared to indicate that investor involvement was not a passive investment, the court rejected this superficial impression. It held that the investors “played an extremely passive role in the management and operation of the companies.” Evidence at trial proved that the overwhelming majority of the investors did not participate actively in the management of the companies and that a reasonable jury could conclude that there was no expectation of investor control. This and other factors permitted the jury to conclude that the statements of investor control in the offering materials were illusory.

Thus, the court has reinforced the importance of analyzing substance over form. Offering documents should accurately portray actual relationship between investor and promoter. If the relationship is not that of an active investor, documents that misrepresent the relationship will fail to remove the transaction from the purview of the securities laws and regulations. Moreover, such inaccurate offering materials could instead provide significant evidence of an intent to evade the securities statutes.

About Richard Serafini

Welcome to my blog. I am an attorney and practice in the area of corporate trial work. Areas of particular emphasis are white collar defense, securities litigation, health care litigation, internal investigations, RICO, and financial litigation. I will be posting interesting developments in my areas of interest. I hope that you find this blog helpful and informative.