Both the Securities Act of 1933 and the California Corporate Securities Law of 1968 provide similar, but not the same, definitions of a "security". See Making A List Of Securities And Checking It Twice. Although these lists are expansive, courts continue to explain why some items on the lists are not securities and why some financial arrangements are securities even though they are not on the lists. A recent ruling by U.S. District Court Judge Roger T. Benitez addresses the latter situation.
Gallagher v. Roberts, 2017 U.S. Dist. LEXIS 57714 (S.D. Cal. Apr. 11, 2017), the defendant offered the plaintiff in a 25% interest in to be formed entity for cash consideration of $250,000. The entity would acquire real property in Panama. When the escrow closed, the plaintiff would receive a return of 100% of her investment and have a 25% interest in the entity. When the money was not returned after some years had passed, the plaintiff sued under both the Securities Act and the CSL, which claims the defendants moved to dismiss under Rule 12(b)(6) of the Federal Rules of Civil Procedure.
In ruling on the defendants' motion, Judge Benitez correctly observed that the plaintiff's securities law claims require that there be a "security". He then analyzed the plaintiff's allegations in light of the U.S. Supreme Court's definition of an "investment contract" in SEC v. Howey, 328 U.S. 293, 66 S. Ct. 1100, 90 L. Ed. 1244 (1946) ("whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others"). Applying Howey, Judge Benitez ruled that the plaintiffs had failed to allege adequately the existence of a security:
Given this offer, it is questionable whether Plaintiff made an "investment of money" for which she expected "profits." The investment of money prong "requires that the investor commit his assets to the enterprise in such a manner as to subject himself to financial loss." Warfield [v. Alaniz], 569 F.3d 1015, 569 F.3d at 1021 (internal citations omitted). Plaintiff appears to have not subjected herself to financial loss because Roberts [the defendant] promised that she would receive her $250,000 back shortly after the property was purchased.
As to an expectation of profits, "by profits, [the Supreme Court] has meant either capital appreciation resulting from the development of the initial investment . . . or a participation in earnings resulting from the use of investors' funds." Id. at 1023 (internal citation omitted). Here, the Gallaghers would receive a 25% interest in an entity that owned the land, but Plaintiff fails to allege what Roberts said the entity would do with the land. It appears that, after the Gallaghers made their "investment," Roberts attempted to develop the land. (Compl. ¶ 21.) However, the Complaint fails to allege that this was Plaintiff's understanding at the time of the offer and sale of the alleged security. Indeed, the Complaint suggests that Roberts and the Gallaghers may have intended to resell the Panama Property. (Id., Introduction.) Courts have held that the profits element is not satisfied when profits are expected from appreciation in the value of property to be reaped upon resale, as opposed to the result of development of the land. See Harman v. Harper, 914 F.2d 262 (9th Cir. 1990).
It is important to note that Judge Benitez did not rule that the investment was not a security. Rather, he ruled that the plaintiff had failed to allege adequately that the investment was a security. In granting the defendants' motion to dismiss, Judge Benitez granted the plaintiff leave to file an amended complaint. Thus, it remains to be seen whether plaintiff will fix the deficiencies in its initial complaint.
From a broader perspective, the case is emblematic of the sometimes blurry line between a securities and real estate transaction. It also evidences judicial reluctance to view "one off" transactions as securities transactions. See Court Finds Promissory Notes Are Not Securities.