Opinion ID: 1060352
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Heading Rank: 5

Heading: The Definition of an Investment Contract

Text: We begin our analysis with the language of the Tennessee Securities Act of 1980, which defines the term security as follows: (12) `Security' means any note, stock, treasury stock, bond, 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, voting-trust certificate, certificate of deposit for a security, certificate of interest or participation in an oil, gas, or mining title or lease or in payments out of production under such a title or lease; 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. Tenn.Code Ann. § 48-2-102(12) (1995) (emphasis added). This definition is substantially identical to definitions contained in the federal Securities Act of 1933 and the federal Securities Exchange Act of 1934. See Securities Act of 1933, 15 U.S.C. § 77b(1) (2002); Securities Exchange Act of 1934, 15 U.S.C. § 78c(a)(10) (2002). While the statute makes plain that an investment contract is a security, the statute does not define the term investment contract. The Commissioner argues that the Court of Appeals' decision rejecting Brewer and applying Howey-Forman conflicts with the fundamental purpose of Tennessee's securities laws, which is to protect investors. As support for this claim, the Commissioner relies upon this Court's decision in DeWees v. State, 216 Tenn. 104, 390 S.W.2d 241, 242 (1965), directing that securities laws are remedial statutes that must be liberally construed to protect investors from fraud. A brief review of the development, history, and purpose of state securities laws is necessary to place this issue in context. Securities regulation first developed as state law. State securities statutes, or blue sky laws, were this country's sole means of regulating securities for more than two decades, until the federal government enacted the Securities Act of 1933 and the Securities Exchange Act of 1934. [1] In creating the federal securities regulation laws, Congress has specifically refused to preempt state blue sky laws. See 15 U.S.C. § 77r (2002). Thus, both state and federal laws now regulate the marketing and sales of securities. One reason for this dual system of securities regulation is that the state and federal laws were adopted to serve different purposes. Like Tennessee, states enacted securities regulation to protect investors. See 1980 Tenn. Pub. Acts, ch. 866, § 25 (stating that the securities laws are intended to protect investors); see also, e.g., Carder v. Burrow, 327 Ark. 545, 940 S.W.2d 429 (1997); People v. Figueroa, 41 Cal.3d 714, 224 Cal.Rptr. 719, 715 P.2d 680, 695 (1986); Rosenthal v. Dean Witter Reynolds, 908 P.2d 1095, 1105 (Colo.1995); Skurnick v. Ainsworth, 591 So.2d 904, 906 (Fla.1991); Ratliffe v. Hartsfield Co., 181 Ga. 663, 184 S.E. 324, 327 (1935); State v. Hawaii Market, 52 Haw. 642, 485 P.2d 105, 109 (1971); State v. Coin Wholesalers, Inc., 311 Minn. 346, 250 N.W.2d 583, 588 (1976). Federal securities regulations, on the other hand, were enacted to serve the broader purpose of protecting the integrity of the increasingly nationalized market. See 15 U.S.C. § 78b (2002); Robert B. Thompson, The Measure of Recovery Under Rule 10b-5: A Restitution Alternative to Tort Damages, 37 Vand. L.Rev. 349, 393 (1984) (quoting Shapiro v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 495 F.2d 228, 236-37 (2d Cir.1974)). The different, but complementary, purposes served by the dual system of securities regulation is further reflected in the differing treatment of the term investment contract by state and federal courts. The term was first used by state legislatures and first construed by state courts. Seeking to afford maximum protection to investors, state courts, like the Minnesota Supreme Court, [2] construed the term broadly in accordance with its commonly understood meaning. Twenty-six years later, the United States Supreme Court defined investment contract as it applied to the Securities Exchange Act of 1933 in SEC v. W.J. Howey Co., 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946). Under Howey, an investment contract means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party. Id. at 298-99, 66 S.Ct. 1100 (emphasis added). This definition was criticized as being too rigid, particularly its requirement that profits be derived solely from the efforts of the promoter or a third party. [3] In 1971, the Hawaii Supreme Court became one of the first state courts to openly reject the Howey test and formulate a more flexible test for determining which transactions constitute an investment contract under its state securities laws. [4] See State v. Hawaii Market, 52 Haw. 642, 485 P.2d 105 (1971). The Hawaii Market test requires proof of the following four elements for an investment contract to be present: (1) An offeree furnishes initial value to an offeror, and (2) a portion of this initial value is subjected to the risks of the enterprise, and (3) the furnishing of the initial value is induced by the offeror's promises or representations which give rise to a reasonable understanding that a valuable benefit of some kind, over and above the initial value, will accrue to the offeree as a result of the operation of the enterprise, and (4) the offeree does not receive the right to exercise practical and actual control over the managerial decisions of the enterprise. Id. at 109. The Hawaii Supreme Court utilized the concepts from risk capital theory, stating that the subjection of the investor's money to the risks of an enterprise over which he exerts no managerial control is the basic economic reality of a security transaction. Id. A few years after the Hawaii Market decision, the United States Supreme Court revisited the test adopted in Howey. Responding to the criticism of Howey, the Court in Forman emphasized that in determining whether a particular transaction is an investment contract and thus a security, the focus must be on the substancethe economic realities of the transactionrather than the names that may have been employed by the parties. United Hous. Found., Inc. v. Forman, 421 U.S. 837, 851-52, 95 S.Ct. 2051, 44 L.Ed.2d 621 (1975). To this end, the Court stated that [t]he touchstone is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. Id. at 852, 95 S.Ct. 2051. Thus, the  Howey-Forman  test emerged as the new, more flexible federal test for what constitutes a security. Against this backdrop, in 1996, the Tennessee Court of Criminal Appeals elected to employ the Hawaii Market test to determine whether the transaction in question was an investment contract under Tennessee law. See Brewer, 932 S.W.2d at 14. In support of its decision, the Brewer court noted that, as of 1996, seventeen jurisdictions had adopted the Hawaii Market test. See id. at 13 n. 13. Furthermore, Brewer highlighted the similarities between the two tests as follows: The first prong of the Hawaii Market test is nothing more than the investment concept of the Howey-Forman test. The second prong adopts the concept of risk capital, whereas Howey-Forman focuses on the existence of a common venture, i.e., vertical or horizontal commonality. The third prong of Hawaii Market utilizes the more liberal concept of the expectation to receive a benefit instead of the slightly more restrictive concept of profits found in Howey-Forman. Lastly, the fourth prong makes explicit, in layman's terms, the Howey-Forman principle that the investor exercises no managerial control. Id. at 13-14. In adopting the Hawaii Market test, the Brewer court noted that DeWees mandated liberal construction of securities laws to protect the public and that the Hawaii Market test better serves the remedial purpose of Tennessee's securities laws by embracing not only obvious and commonplace investment schemes, but also `the countless and variable schemes devised by those who seek the money of others on the promise of profits.' Id. at 14 (quoting Howey, 328 U.S. at 299, 66 S.Ct. 1100). Additionally, the Brewer court deemed the Hawaii Market test superior in providing detailed statements of its elements in layman's terms, which promotes the proper administration of justice by the jury. Id. In this case, the test adopted in Brewer was applied by the administrative law judge, the Commissioner, and the chancery court. However, the Court of Appeals adopted the Howey-Forman test used by the Sixth Circuit in Cooper v. King, No. 96-5361, 114 F.2d 1186, 1997 WL 243424, at  (6th Cir. May 9, 1997), an unpublished case involving the sale of pay telephones in the same manner and under the same terms as in the present case. [5] After careful consideration, we conclude the Court of Appeals erred in adopting the Howey-Forman test. The appropriate test for defining an investment contract under Tennessee law is the Hawaii Market test adopted in Brewer . First, the General Assembly has stated that the Tennessee Securities Act of 1980 should be interpreted to effectuate its general purpose to protect investors and to coordinate the interpretation and administration of this Act with related federal and state regulation. 1980 Tenn. Pub. Acts, ch. 866, § 25. As noted by the Brewer court, the Hawaii Market test better serves the remedial purpose of Tennessee's securities laws by embracing not only obvious and commonplace investment schemes, but also `the countless and variable schemes devised by those who seek the money of others on the promise of profits.' Brewer, 932 S.W.2d at 14 (quoting Howey, 328 U.S. at 299, 66 S.Ct. 1100). As previously explained, state and federal regulations serve different purposes. While the federal test is tailored to federal law, the Hawaii Market test adopted in Brewer is more in keeping with the public policy espoused by this Court in DeWees because it presents a more flexible definition of investment contract. King argues that the Howey-Forman test advances the second stated purpose of the 1980 Actuniformity and coordination with state and federal regulation. See 1980 Tenn. Pub. Acts, ch. 866, § 25. In support of this argument, King emphasizes that the Howey-Forman test has been adopted by a majority of jurisdictions and that the ample case law from other jurisdictions applying the Howey-Forman test to various transactions provides notice to investors and brokers of the types of transactions that qualify as investment contracts under Tennessee law. We disagree. While the General Assembly clearly intended for Tennessee's securities laws to operate harmoniously with federal and other state securities regulations, adopting the Howey-Forman test does not accomplish this result because this test is not consistently applied among the states or the federal circuits. The primary area of disagreement surrounds the Howey-Forman test's second element: a common enterprise. Three bases for commonality are recognized by the federal courts. The strictest test is that of horizontal commonality, requiring the pooling of assets in which the fortunes of the individual investors are inextricably intertwined by contractual and financial arrangement. See Union Planters Nat'l Bank v. Commercial Credit Bus. Loans, Inc., 651 F.2d 1174, 1183 (6th Cir.1981). The other test, vertical commonality, has two variants. Narrow vertical commonality requires that the investors' fortunes be interwoven with and dependent upon the efforts and success of those seeking the investment of third parties. SEC v. Glenn W. Turner Enters., 474 F.2d 476, 482 n. 7 (9th Cir.1973). Broad vertical commonality, on the other hand, only requires that the well-being of the investors be dependent on the promoter's experience. See SEC v. SG Ltd., 265 F.3d 42, 49 (1st Cir.2001). The United States Supreme Court has not adopted a test for the common enterprise element of the Howey-Forman test, and the circuits are split on this issue. Both the Sixth and Seventh Circuits require a showing of horizontal commonality to satisfy the common enterprise element. See, e.g., Curran v. Merrill Lynch, Pierce, Fenner & Smith, 622 F.2d 216, 222, 224 (6th Cir.1980); Wals v. Fox Hills Dev. Corp., 24 F.3d 1016, 1018 (7th Cir.1994). Four other circuits have adopted horizontal commonality, but have yet to rule on whether vertical commonality also would be acceptable. See SEC v. Infinity Group Co., 212 F.3d 180, 187 n. 9 (3d Cir.2000), cert. denied, 532 U.S. 905, 121 S.Ct. 1228, 149 L.Ed.2d 138 (2001); SEC v. Life Partners, Inc., 87 F.3d 536, 544 (D.C.Cir.1996); Teague v. Bakker, 35 F.3d 978, 986 n. 8 (4th Cir.1994); Revak v. SEC Realty Co., 18 F.3d 81, 88 (2d Cir.1994)(rejecting broad vertical commonality). Thus, the Howey-Forman test is not applied consistently among the circuits. Moreover, despite its adherence to horizontal commonality, the Sixth Circuit has not been consistent in its interpretation of the pooling of funds requirement. [6] In addition, states within the Sixth CircuitOhio, Kentucky, and Michiganhave varying approaches to defining an investment contract. The Ohio Court of Appeals has adopted the Hawaii Market test. See State v. George, 50 Ohio App.2d 297, 362 N.E.2d 1223 (1975). The Kentucky Court of Appeals has adopted the Howey-Forman definition, as has the Michigan Court of Appeals. See Scholarship Counselors, Inc. v. Waddle, 507 S.W.2d 138 (Ky.1974); Rzepka v. Michael, 171 Mich.App. 748, 431 N.W.2d 441 (1988). However, a Michigan statute defines security by using the language of the Hawaii Market test. See Mich. Comp. Laws § 451.801(1) (2002). Given the federal and state courts' varying interpretations of Howey-Forman, King's assertion that its adoption will advance uniformity and predictability has a hollow ring. We reiterate and reaffirm our statement in DeWees , that securities laws are remedial in character, designed to prevent frauds and impositions upon the public, and consequently should be liberally construed to effectuate the purpose of the acts. 390 S.W.2d at 242. Since the Tennessee Securities Act of 1980 was enacted with the goal of protecting investors, this Court's primary concern is with the investors of this state. This Court also believes that the danger in adopting the stricter Howey-Forman test for investment contract is that it allows unscrupulous promoters to circumvent the law. Thus, we find that the Hawaii Market test as adopted in Brewer is the test better suited to protect investors.