Securities Market: Concept of

Securities
Dr. Rajesh Kumar
 Background
* The concept of securities emerged before the
concept of company
* The company was given the power to issue the
securities
* The development of stock exchanges and
securities regulations helped the growth of
securities
* Technology has further accelerated the growth of
securities
 Securities, meaning and types
* In U.S. it includes a commonly known document traded for speculation and
investment
* According to sec-2(1) of the Securities Act of 1933 the term “Security” means
any note, stock, treasury stock, security future, security-based swap, bond,
debenture, evidence of indebtedness, certificate of interest or participation in
any profit-sharing agreement, collateral-trust certificate, pre organization
certificate or subscription, transferable share, investment contract, voting-trust
certificate, certificate of deposit for a security, fractional undivided interest in
oil, gas, or other mineral rights, any put, call, straddle, option, or privilege, on
any security, certificate of deposit, or group or index of securities(including
any interest therein or based on the value thereof), or any put, call, straddle,
option, or privilege entered into on a national securities exchange relating to
foreign currency, 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.
 Securities
* Sec 2h of SCRA : “securities” include—
* (i) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities
of a like nature in or of any incorporated company or other body corporate; derivative;
(ib) units or any other instrument issued by any collective investment scheme to the
investors in such schemes;] ic)security receipt as defined in clause (zg) of section 2 of the
Securitisation and Reconstruction of Financial Assets and Enforcement of Security
Interest Act, 2002;] [(id) units or any other such instrument issued to the investors under
and mutual fund scheme;] (ii) Government securities; (iia) such other instruments as may
be declared by the Central Government to be securities; and (iii) rights or interest in
securities;
* A Collective investment scheme is any scheme or arrangement, which satisfies the
conditions, referred to in sub-section (2) of section 11AA of the SEBI Act. Any
scheme or arrangement made or offered by any company under which the
contributions, or payments made by the investors, are pooled and utilized with a view
to receive profits, income, produce or property, and is managed on behalf of the
investors is a CIS. Investors do not have day to day control over the management and
operation of such scheme or arrangement
 Case Laws
* SEC v Howey Co.
* an offering of units of a citrus grove development coupled with a
contract for cultivating, marketing and remitting the net proceeds to the
investor.
* Each prospective customer is offered both a land sales contract and a
service contract, after having been told that it is not feasible to invest in
a grove unless service arrangements are made. While the purchaser is
free to make arrangements with other service companies, the superiority
of Howey-in-the-Hills Service, Inc.,is stressed.
* Under the test developed in Howey, a contract, transaction, or scheme
is an investment contract if “a person (1) invests his money (2) in a
common enterprise and (3) is led to expect profits (4) solely from the
efforts of the promoter or a third party
 Contd.
* In Howey, it was held as securities. But what is return was not in
the form of profit but in the form of other benefits like use or
enjoyment of underlying assets.
* United Housing Foundation, Inc. v. Forman , 421 U.S. 837 (1975)
* The issue in these cases is whether shares of stock entitling a
purchaser to lease an apartment in Co-op City, a state subsidized
and supervised nonprofit housing cooperative, are “securities.”
* Held not securities despite of term used shares and stocks as not
for investemnt.
 Contd.
* Whether the definition of securities is subject to Howey test?
* 4th test : profit must come primarily and substantially through the efforts
of third party.
* Economic reality of the complete package : form over the substance
* However, In the case of Landreth Timber Co. v. Landreth, it was held
that when stock has a normal attribute of stock , then this interpretation
is not applicable.
* Relevance of profit : Football team shareholding without any profit , but
having seat licences and ticketing rights not securities even though they
may be transferred for profit under limited circumstances, presumably
in part because purchasers represented they made purchases to attend
events and enjoy benefits rather than in anticipation of selling for
profits.
 Case
* SEC v. Joiner case, Joyner Co. owns a large tract of land. They sent letters to
public, offering to sell surrounding land . Joyner claimed that the company
was going to drill for oil on their land and that if oil was found the purchasers
would earn a lot of money. Joiner claimed that the land was in the heart of the
most oil producing land in Texas, and that all the purchasers had to do was
buy the land and they would get the benefits (passive investment).
* The SEC alleged securities fraud, claiming the oil interest was a security and
an investment contract. Joyner claimed he was just selling land. It was held as
covered under the definition of securities as sale of investment contract is
involved.
* The court of U.S. defined an investment contract as a flexible principle and
said that 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 third party.
 Contd.
* Common Enterprise and Profits Solely from the Efforts of Others
* Securities and Exchange Commission v. Edwards, 540 U.S. 389 (2004)
* [ETS Payphones, Inc.] sold payphones to the public via independent
* distributors. The payphones were offered packaged with a site lease, a
5-year leaseback and management agreement, and a buyback
agreement. All but a tiny fraction of purchasers chose this package,
although other management options were offered. The purchase price
for the payphone packages was approximately $7,000. Under the
leaseback and management agreement, purchasers received $82 per
month, a 14% annual return. Purchasers were not involved in the
day-to-day operation of the payphones they owned.
* It was held as securities ( Fixed return v Variable return)
 Contd.
* Meaning of common enterprise : Element of vertical commonality v Horizontal
commonality , connection between the effort of promoter and success and loss of
the investor
* In SEC v. Lauer, only one investor left , it was held by the court that scheme is
more important than horizontal commonality.
* SG Trading Company maintains a web site allowing individuals to play a game
called “Stock Generation.” The lure of this game is easy money, or as is stated on
the web site, “Would you like your money to double each month? Then welcome
to the Virtual Stock Exchange SG.” The game allows participants to purchase
shares in 11 different “virtual companies” listed on the web site’s virtual stock
exchange. Although the companies are fantasy companies that exist only in
cyberspace, participants invest real money in this game. SG arbitrarily sets the
purchase and sale prices of each of the virtual companies (adjusted biweekly) and
guarantees that investors can buy or sell any quantity of shares at the posted prices.
Invested funds are pooled in a single account used to settle participants’ online
transactions. SG believes that the system will work as long as the base of investors
continues to grow. To ensure that condition, SG promises to pay Stock Generation
participants who recruit new participants bonuses equal to 20 percent of the new
recruits’ payments.
 Contd.
* SG also promises that the share price for one “privileged
company” will continuously rise and that investors in that
company will enjoy a 10 percent per month return. To make sure
that this happens, SG pledges that it will allocate a portion of its
profits derived from its web site operations to a special reserve
fund designed to support the price of the privileged company’s
shares.
* Does this game involve an investment contract?
 Contd.
* SEC v. Life Partners, Inc., 87 F.3d 536 (D.C. Cir. 1996),which dealt with
vertical settlements whereby investors acquire an interest in the life insurance
policy of a terminally ill person (typically an AIDS patient). The purchase is at a
discount to the face value of the policy and provides the insured individual with
immediate cash and the investor with a return measured by the difference
between the discounted purchase price of the interest and the death benefit later
collected. Life Partners, Inc., acted as an intermediary in arranging the
transactions. Most of its efforts occurred prior to the point the investments
actually were made. Following the investments, Life Partners’ efforts were
substantially reduced and related primarily to monitoring the status of the
insured and attending to the details of the insurance policies (i.e., making sure
premiums are paid when due and overseeing the disbursement of funds).
* The court concluded the arrangements did not involve investment contracts
because the major “efforts of others” (i.e., Life Partners) occurred before
purchasers made their investments
 Contd.
* Belmont Reid needs funds to develop its gold mines. It offers to sell
gold, in the form of coins, directly to investors. The coins are sold in
sets of 12. The price is at a substantial discount to the world market
price of gold at the time of the offering. Delivery of the coins will be in
the future, and purchasers are advised that the gold required to mint the
coins has not yet been extracted. In the event the world market price of
gold declines to a level below the prepayment price, Belmont Reid
promises to refund the difference to the purchasers. To secure both its
guarantee and its performance, Belmont Reid puts the deed to one of its
mines in a trust account.
* Is Belmont Reid selling a security? Does your answer depend upon
whether the sales are made during a period in which the price of gold is
rising?
 Contd.
* McSushi Inc. has been formed to develop Japanese fast food restaurants.
Its initial capitalization is very small, and the plan is to raise funds to
promote the concept and gain public recognition by selling franchises to
operate specific restaurants. For an investment of $35,000 plus a
percentage of the gross receipts,
* McSushi will train franchisees in the preparation of Japanese food,
provide equipment needed in the restaurants, engage in extensive
advertising to promote the McSushi label, and supervise the restaurants
to ensure quality control and uniformity of operation. Both food and
uniforms must be purchased from McSushi.
* The franchisees are expected to work as on-site managers. They may,
however, establish menu prices and engage in local promotions. Are
these franchises securities?
 Contd.
* A car racing club organises auto races notably one big annual
racing event. A share of stock in club is must to participate in car
racing. Transfer of shares depends on physical fitness of purchaser
for racing. Failure to participate in racing may lead to redemption
of stock. Shareholders elect the board, which is the decision
making body. Shareholders are also entitled to dividend and
money is coming from racing, advertisement and endorsement.
* Is stock a securities?
 Crypto currencies, ICOs, and
Securities
* Consider Howey’s common enterprise requirement. Horizontal commonality
may be satisfied because the networks receive funding from a pool of
investors. But the vertical commonality analysis is less clear.
* Pseudo currencies or commodities
* Munchee planned to sell $15 million in tokens, with the proceeds to be used to
fund its business and build the promised ecosystem. It never happened,
however, because the SEC issued a cease-and-desist order. See Securities Act
Release No. 10445 (Dec. 11, 2017). The order followed from its conclusion
that the tokens were investment contracts: “Purchasers would reasonably
believe they could profit by holding or trading MUN tokens, whether or not
they ever used the Munchee App or otherwise participated in the MUN
‘ecosystem,’ based on Munchee’s statements in its MUN White Paper and
other materials. Munchee primed purchasers’ reasonable expectations of profit
through statements on blogs, podcasts, and Facebook that talked about profits.
* Framework for “Investment Contract” Analysis of Digital Assets Strategic
Hub for Innovation and Financial Technology (FinHub) (2019)
 Contd.
TurnKey Jet, Inc. (TKJ) provides interstate air charter services. It proposes to launch a
Token membership program and develop a Token platform to facilitate Token sales for air
charter services via a private blockchain network (“Network”). Desiring to avoid financial
and regulatory issues with traditional payment methods utilizing wire transfers or credit
cards, TKJ proposes to allow consumers of their services to purchase Tokens via a private
blockchain network, which offers cost and speed efficiencies for both TKJ and its
customers. TKJ will sell Tokens at a fixed ratio of $1 for 1 token. Consumers interested in
chartering aircraft may purchase tokens through the blockchain network managed by TKJ.
TKJ will utilize smart contracts establishing that the Tokens are prepayment of the future
consumption of air charter services and there will be no return of principal or interest on the
monies that are prepaid. Further, TKJ will use the smart contracts to execute the
consideration for TKJ Token redemptions. When a Token enters circulation, TKJ
consumers may freely trade or exchange the Tokens in their possession with other
consumers enrolled in the Network. Since TKJ itself will continuously sell Tokens for $1
each, the market for tokens is likely to remain stable at around $1, rendering it unlikely that
anyone could sell tokens for a profit. Moreover, TKJ requires token purchasers to agree that
they are purchasing tokens solely for prepaid air charter services and not with the intention
of reselling for investment gains.
 Real estate offerings
* Generally not securities . However, substance over the form of
offerings is more important.
* Resort condominiums units may be considered as securities.
* Offered and sold managerial effort in renting by the promoter of
third party
* Offering of participation in a rental pool arrangement
* Arrangement where the purchaser is bound to offer his property
for rental service and receive a benefit by the effort of third party
 Securities
* Sec 2h of SCRA : “securities” include—
* (i) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities
of a like nature in or of any incorporated company or other body corporate; derivative;
(ib) units or any other instrument issued by any collective investment scheme to the
investors in such schemes;] ic)security receipt as defined in clause (zg) of section 2 of the
Securitisation and Reconstruction of Financial Assets and Enforcement of Security
Interest Act, 2002;] [(id) units or any other such instrument issued to the investors under
and mutual fund scheme;] (ii) Government securities; (iia) such other instruments as may
be declared by the Central Government to be securities; and (iii) rights or interest in
securities;
* A Collective investment scheme is any scheme or arrangement, which satisfies the
conditions, referred to in sub-section (2) of section 11AA of the SEBI Act. Any
scheme or arrangement made or offered by any company under which the
contributions, or payments made by the investors, are pooled and utilized with a view
to receive profits, income, produce or property, and is managed on behalf of the
investors is a CIS. Investors do not have day to day control over the management and
operation of such scheme or arrangement
 Types of securities
* General securities : includes shares, debentures, stocks bonds and
others securities
* Hybrid securities
* Derivatives : securities or contract which derives their value from
underlying assets. Sec (ac) Defines it as “derivative” includes—
* (A) a security derived from a debt instrument, share, loan, whether
secured or unsecured, risk instrument or contract for differences or
any other form of security;
* (B) a contract which derives its value from the prices, or index of
prices, of underlying securities;
 Securities
* Types of securities contract: spot delivery and future
contract
* Accordingly , a pension plan of an employee is not a
securities as no investment from the employee .
* It also require the element of common enterprise.
* CIS cases, plantation scheme, PACL cases and other
cases
* Electronic gold receipt
 Contd.
* Chit funds , A scheme offered by NBFC ,Insurance contract
* Pension Scheme , Deposits under companies act
* Deposits accepted by Nidhi Company
* ULIP case and Sahara India case
* Securities appreciation rights
* Unit trusts, Plantation schemes, Prize Debentures, Convertibles
* Commercial papers, Dabba Trading (Contract for differences) ,
Phantom stocks,