Article by Dennis S. Corgill
Disappointed purchasers or sellers of investments often pursue causes of action under federal securities laws. Causes of action under the federal statutes are available, however, only if the subject matter of the transaction comes within the statutory definition of a “security.” The federal definition of a security does not describe the character of an investment that is a security but, instead, lists numerous investment instruments that are securities. The federal statutes also contain provisions that exempt limited classes of investment instruments that otherwise would give rise to federal jurisdiction.
An investment instrument's enumeration in the laundry-list definition of a security does not necessarily determine whether the securities laws will apply. When enacting the federal securities laws, Congress sought “to eliminate serious abuses in a largely unregulated securities market.” Courts have recognized that transactions in a securities market may not always bear a label enumerated in the statutory definition. Thus, some courts, citing the broad remedial purposes of the securities laws, have included investment transactions that are not enumerated. These courts have relied on the statutory category of “investment contracts” as a means to extend the reach of the securities laws to transactions not otherwise specifically enumerated.
Nor do the securities laws automatically apply simply because an investment instrument bears a label enumerated in the laundry-list definition. When enacting the securities laws, Congress did not intend to “creat e a general federal cause of action for fraud” by, in effect, supplanting the common law in markets other than the securities markets. Following this rationale, courts recognize that the label on an investment instrument does not necessarily identify a transaction as made on a securities market and have excluded some transactions specifically enumerated on the list. These courts have relied on statutory language stating that definitions apply “unless the context otherwise requires” as a means to exclude these transactions.
Courts have commonly grappled with the issue of defining a security when the subject matter of the transaction is a loan. When a loan is extended, the form of the obligation typically is a note-one of the specific investment instruments enumerated on the list of securities. Not all notes are securities, however. For example, courts agree that consumer and commercial loans are not among the kinds of notes that should be subject to the securities laws. In these and other cases where the initial characterization of the transaction as a security is challenged, courts look beyond the form of the investment instrument to examine the character of the investment and the economic realities underlying the transaction. Many courts, for example, exclude consumer and commercial loans by reasoning that those loans were not extended for investment purposes.
To resolve the issue of what is a security under an economic realities analysis, some courts take the approach that one characteristic of a security, if not the dispositive one, is that a security is an investment at risk or an investment in risk capital. The Supreme Court, for example, has often accounted for risk when distinguishing a security from other types of investments, and the Court recently named risk as one of four factors that should be used to determine whether a note is a security. In addition, at least two circuits have mandated a “risk capital” test to identify all securities.
Using the concept of “risk” as a test to identify investments that are securities suggests that economic analysis can guide the application of the statutory definition of a security. Economic analysis has examined “risk” in several contexts, most notably in the study of probability and statistics. Nevertheless, current references to risk in the case law do not follow an economic definition of risk. Judicial opinions seemingly adopt a common language notion of risk that arguably applies to all investments, regardless of whether an investment was made in a transaction in a securities market. In fact, economic analysis confirms that any investment in any market is at risk and that judicial interpretations of risk distinguish neither the fact of risk nor the degree of riskiness.
This Article argues that the economic concept of “risk” can be employed to distinguish investments that are securities from those that are not. Part II presents two economic analyses of risk and uses these analyses to compare a share of common stock, the most typical of securities, with loans extended for consumer or commercial purposes, which are not securities. One analysis is taken from the standard statistical presentation of expected values and central measures of tendency that describe the probability of deviating from the expected value. The other is taken from a simplified Bayesian decision game in which risk is minimized by calculating conditional probabilities from available information. Neither approach provides an adequate basis for distinguishing a security as an investment at risk because a consumer or commercial loan, which is not a security, can exhibit the same risk characteristics as stock.
Part III turns to the judicial tests that attempt to distinguish a security as an investment at risk or an investment in risk capital. Courts purport to account for risk in different ways. For example, risk is implicitly included in at least one test devised for a specific investment instrument that is enumerated on the list. Risk also is explicitly included as one factor in a multi-factor analysis of another specific instrument on the list. And, in some cases, risk is the dispositive criterion, most often analyzed in a multi-factor test. While these approaches bear resemblance to each other by virtue of their fact intensive analyses of investments, each fails to disclose, at least from an economic perspective, why a security, but not a consumer or commercial loan, is an investment at risk.
Finally, in Part IV, the Article suggests that the legal definition of a security does not turn on whether there is an investment at risk or, for that matter, whether the investment exhibits certain risk characteristics. Rather, the distinctions actually made by courts appear to turn on who has an opportunity to affect or structure risk by prescribing how the investment will be repaid. For example, in the most typical of securities, a share of common stock, the entity receiving the investment-the issuer-has the ex ante opportunity to structure risk by reserving the right to declare dividends. By contrast, in the typical consumer or commercial loan, the investor-the lender-has the ex ante opportunity to structure risk by setting the interest to be paid on the principal.
The analysis proposed in Part IV does not focus on the label of an investment instrument or the inevitable fact that all investments are at risk. Rather, the proposed analysis focuses on the ways that investors in securities markets account for risk. Put in economic terms, to the extent that risk defines a security, the issue is who constructs and controls the play of a Bayesian decision game in which risk is structured by altering conditional probabilities of expected values. While this and other factors in the proposed definition may not always resolve whether an investment is a security, the proposed definition should help to guide the application of risk analysis where risk is relevant.
About the Author
Dennis S. Corgill. Assistant Professor of Law, Widener University School of Law. B.A., 1973, Standford University; M.A., 1977, University of Chicago; J.D., 1982, Yale University.
Citation
67 Tul. L. Rev. 861 (1993)