Legal Corner part 2: What is a Security? and in the P2P Lending World Why Do We Care?

In part 1, I introduced the P2P Lending Expert legal eagle, Jonathan Wilson, who is going to discuss legal implications and ongoing cases in the securities world and how they affect peer to peer lending, and especially how they affect the little guy like us. Again, my commentary is in parentheses.

On to the Howey case....

It was the mid-1940s and, in the prosperity that resulted from the end of World War II, speculation in Florida real estate (and especially Florida orange groves) was booming.  One company, W.J. Howey & Co., owned large tracts of land in Florida and pursued a business that involved selling customers a one-acre tract of land in a Florida orange grove along with a “service contract” in which Howey promised to harvest oranges from the land and remit the profits to the property owner.  In essence, Howey made a business out of selling to customers not just a piece of a Florida orange grove but the opportunity to realize the profit that could be obtained from harvesting oranges from the grove.

(Stu here. This is a very common type of investment still today, just not here in the US. Many countries, especially those in South America and Africa that have a heavy agricultural presence in their economy offer this type of investment)

The SEC sued W.J. Howey & Co., arguing that the combination of the land sale alongside of a service contract for the harvesting of oranges amounted to an “investment contract.”  As we’ll discuss next week, federal securities laws make it illegal to sell any security that is not either “registered” or “exempt.”   W.J. Howey & Co. didn’t believe it was selling securities and had not taken any of the legal steps required to either register its sale of securities or cause that sale to be exempt.  W.J. Howey & Co., won a dismissal of the case in the federal trial court and in the Fifth Circuit Court of Appeals and the SEC obtained a writ of certiorari to have the case reviewed by the U.S. Supreme Court.

In front of the Supreme Court, the SEC prevailed as the Supreme Court found that the arrangement was an investment contract and sent the case back to the lower court.  In the “money quote” Justice Murphy wrote:

In other words, an investment contract for purposes of the Securities Act 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.

(Note here that had they only sold the real estate for the buyer to do whatever they wanted with it, it would not have been a security but the tying in of the service contract is what made it a security in the eyes of the Court)

While the Howey case dealt with the question of whether an arrangement was an “investment contract” it has come to stand for the definition of whether something is a “security.”  In essence, if the arrangement includes “a transaction’ in which “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” then the arrangement is a security.

Because of the ruling in Howey, most transactions in the P2P lending space involving transactions in securities and, as we’ll see in my next post, that makes all the difference.

(The investment contract itself or a piece of a contract in a common enterprise, like when we buy $100 out of a $5000 loan is why peer to peer loans are classified as a security)

About the author

Stu Stu Lustman, the author of this post, is a Credit Analyst by trade trying to bring Commercial Credit Analysis techniques to the world of Peer to Peer Lending. Check me out on Twitter, LinkedIn and Google+

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