Opinion ID: 437476
Heading Depth: 1
Heading Rank: 2

Heading: History of the Sale-of-Business Doctrine

Text: 8 The 1933 and 1934 Securities Acts include within the definition of security a series of specific terms--e.g., note, stock, bond, and debenture--and thereafter employ a number of more general phrases--e.g., investment contract, any interest or instrument commonly known as a 'security.'  6 As early as 1943 the Supreme Court held that certain novel economic transactions were encompassed within these latter, more generic terms, even though not embraced by their more specific provisions like stock, bond, or note. See SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 348-55, 64 S.Ct. 120, 122-25, 88 L.Ed. 88 (1943) (holding that leasehold interests in property adjacent to exploratory oil wells were securities). The Court's leading opinion on this point, SEC v. W.J. Howey Co., 328 U.S. 293 (1946), held that agreements for the sale of a citrus crop coupled with optional service contracts were investment contracts. Howey propounded a definition of investment contract derived from descriptions widely employed in state blue sky laws: an investment contract, the Court held, is 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. at 1102-03. This definition came to be known as the Howey test and led many courts to classify a variety of novel economic schemes as investment contracts. 7 9 While the courts were giving the term investment contract a broad compass, the more specific term note was read narrowly, so as not to embrace every instrument comporting with the Acts' terms that is technically a note under state law. The first appellate holding that not every such note is a security under the federal Acts is this court's decision in Lino v. City Investing Co., 487 F.2d 689 (3d Cir.1973). 8 In Lino, this court held that a personal promissory note tendered as partial consideration for rights under a franchise agreement was not a note under the federal Acts. Id. at 693-96. Significantly, we did not apply the Howey test to the notes in question, as Part I of the opinion pointedly made clear by applying the Howey test to the franchise agreements themselves. Id. at 691-93. Rather, we examined the entire context of the note transaction, declining at that time to expound a 'test' ... that would aid in determining whether there has been a purchase or sale of securities when a personal promissory note is involved. Id. at 696 n. 15. 10 Following Lino 's lead, several courts strove to define the circumstances under which a note should be considered a security under the Securities Acts. The Fifth Circuit sought to determine whether a note comprised an investment. 9 The Ninth Circuit approached the problem on a slightly different tack, seeking to determine whether the lender supplies risk capital to the maker. 10 In a leading opinion written by Judge Friendly, the Second Circuit rejected both of these approaches. See Exchange National Bank of Chicago v. Touche Ross & Co., 544 F.2d 1126 (2d Cir.1976) (Friendly, J.). In part the Second Circuit feared that the investment and risk capital tests obliterated Congress' carefully drawn distinctions among those notes included within and excluded from the Acts. Congress took care to provide that any note arising out of a current transaction and having a maturity not exceeding nine months was excluded from the registration provisions, but included in the anti-fraud provisions, of the 1933 Act; 11 and that any note with a maturity not exceeding nine months was excluded from the 1934 Act. 12 As the Fifth Circuit candidly acknowledged, its investment test virtually writes [these distinctions] out of the law. McClure v. First National Bank of Lubbock, 497 F.2d 490, 494 (5th Cir.1974), cert. denied, 420 U.S. 930, 95 S.Ct. 1132, 43 L.Ed.2d 402 (1975). In addition, the Second Circuit expressed concern over the uncertainty that would inevitably follow from a weighing of factors without any instructions as to [their] relative weights. Exchange National Bank, 544 F.2d at 1137. In lieu of the investment and risk capital approaches, the Second Circuit enumerated a family of note transactions presumptively excluded from the Act--all concerning consumer financing or business financing of current costs--and held that other notes not bearing the family pedigree were presumptively securities under federal law. 13 11 There matters stood when late in 1976 the Seventh Circuit held that the Howey test for investment contract applies to determine whether a note is a security under the Acts. Emisco Industries, Inc. v. Pro's Inc., 543 F.2d 38, 39-40 (7th Cir.1976). The extension of Howey into the note arena was problematical. This application of Howey further obliterated the special statutory distinctions drawn by Congress among notes included in and excluded from the Acts, and injected into the note area the same uncertainty that pervades litigation over the inherently vague term investment contract. Moreover, the Seventh Circuit doctrine seemed to ignore some important statutory policies underlying the securities Acts. As the legislative history makes abundantly clear, 14 one such policy is the protection of investors; and to the extent that Howey maps the entire set of investors marked for protection--not an obviously correct assumption--then that policy may be satisfied. But a second policy of the Acts is, as we observe below, the protection of the marketability of certain instruments of commerce, whether or not purchased by investors under the Howey formula. Among the favored instruments, for example, is certain commercial paper. 15 Several commentators have perceptively remarked that an application of the investment or Howey  tests to these commercial instruments would undermine federal protection for many instruments most deserving of coverage. 16 12 Notwithstanding these concerns, in 1981 the Seventh Circuit extended the Howey or economic reality test to the purchase or sale of stock. Frederikson v. Poloway, 637 F.2d 1147 (7th Cir.), cert. denied, 451 U.S. 1017, 101 S.Ct. 3006, 69 L.Ed.2d 389 (1981). While the extension of the Howey test to the note area had been greeted with some concern, the further extension of that doctrine to the purchase or sale of stock sparked a considerable amount of alarm. 17 While the difficulties attending the simple extension of Howey to notes still applied, two other difficulties loomed even larger. 13 First, at least in the note area there is, as we held in Lino, some necessity for fine-tuning the definition of note to avoid sweeping within the coverage of section 10(b) of the 1934 Act every consumer and business loan financing current operational costs. But there is no such necessity in the stock area. Stock is a well-defined term, is not issued by consumers, and is not ordinarily employed by business to finance current transactions. While the importation of the Howey test into the note arena might be justified as an expedient--albeit an imperfect one--for limiting the definition of note, no such expedient seems necessary for the issue of stock. 14 Second, because the Howey test turns in part on whether the purchaser derives profits from the entrepreneurial or managerial efforts of others, see United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 852, 95 S.Ct. 2051, 2060, 44 L.Ed.2d 621 (1975), a central aspect of the test, when applied to stock, requires a determination whether the purchaser exercises a controlling share of the corporation. 18 A controlling share may be exercised with less than 100 percent stock ownership--indeed, at times with far less than 50 percent ownership. See Sutter v. Groen, 687 F.2d 197, 203 (7th Cir.1982). Thus an instrument might be transformed from a security into a non-security by virtue of a small increase in the number of shares traded. Instruments purchased by multiple investors might be securities as to some purchasers and non-securities as to others, or securities as to sellers but not as to purchasers. 19 Instruments might be securities if traded in a series of small transactions but non-securities if the same transaction is effectuated in a single sale. To many judges and lawyers with up to 50 years of experience with the securities laws, these seemed extraordinary consequences. 20 15 The case now before us illustrates just how far the extension of Howey from investment contract to note to stock may be taken. Ruefenacht is the purchaser of 50 percent of the stock of Continental. Had he purchased only 49 percent, Ruefenacht would presumably have lacked corporate control, rendering the instrument purchased (at least presumptively) a security. Had he purchased 51 percent, in contrast, the instrument would presumptively not have been a security. Both presumptions, of course--at least under the Seventh Circuit approach, see Sutter, 687 F.2d at 203--would have been subject to rebuttal. Because Ruefenacht purchased exactly 50 percent, a more sophisticated analysis would presumably be required--although just what that analysis should be is less than obvious. 16