Securities Markets

1. Securities Market: Concept of
Securities
Dr. Rajesh Kumar

2.  Capitalism is based on two important ideas, Freedom and sanctity of
contract . This Idea has created partnership, company and other
incorporated entities .
 Features are added from time to time to ensure its smooth growth .
 It was felt that the existence and growth depend mainly on capability to
raise , maintain and utilize the capital. i.e. Corporate finance
 Public offer of securities is the main source of raising the capital
 Segregation of ownership , management and trading is important to build
the trust among the shareholders and investors.
 Concept of securities was evolved to built trust between the investor and
the company
 Institution of brokers emerged followed by stock exchanges
Background

3.  1285: Prosecution against unlicensed brokers
 1697 : Bubble mania – France and UK started bursting of
bubbles through bubble act . Use of false or irregular character
& taking of subscription – Penalties and forfeitures
 Repealed in 1825
 1844 : Prospectus requirements introduced under company law
 1867 : contents of prospectus was identified
 1890 : Director’s liability act – Modify common law as applied in
Derry v Peek (Corporate directors and promoters were
imposed civil liability for untrue statement , so that the proof of
scinter can be diluted)
 1900: Affirmative Disclosure based regulations and negative
injunction against fraud
Common Law Development

4.  Disclosure regime: Corporate giants and super giants did not
abide, leading to ruled related to increase public and
institutional shareholding
 Ownership of control : Majority, minority and control by the
management
 problem of dummy director – corporate governance,
segregation of role of director and managers
 Limitation of common Law : Civil Recovery, stock exchanges as
private club, Family run corporation
 Securities regulation –role – Competition, efficiency, capital
formation and investor protection
 Registration of securities, Disclosure, Antifraud provision and
regulation of intermediaries
Contd.

5.  Stock Market crash in 1929 followed by long depression and securities
law in US
 Preventive laws would not work, requires stern enforcement of penal
laws, efficiency based disclosure ,
 Investors are not in position to understand financial statements
 Disclosures should be aimed at preventing fraudulent transaction, civil
liability different from common law and criminal liability
 Periodic reports , corporate governance, rights of minorities
 Efficient market theory : Sufficient incentive to disclose , supplied
voluntarily
 Other theory- full disclosure will reduce the firms abilities, higher
securities prices ( role of research analyst), appreciation rights
Contd.

6.  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, meaning and types

7.  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
Securities

8.  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
Case Laws

9.  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.

10.  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.
Contd.

11.  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.
Case

12.  Jackson is a 15-year old athlete who shows great promise. His
parents are intrigued by the idea of monetizing his future so
that he could have current income based on his future
prospects. To this end, they propose to sell to investors
interests in Jackson’s future income. They are still working on a
formula, but the idea is that for a $100,000 investment today
the investor would be entitled to a specified percentage of all
Jackson’s future earnings (including income from
endorsements). Is this arrangement an investment contract?
Does the existence of multiple investors affect your analysis?
What if Jackson is part of a pool of promising athletes, with
investors purchasing undivided interests in a portion of the
income stream generated by the athletes?
Contd.

13.  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.

14.  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.

15.  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.

16.  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.

17.  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.

18.  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.

19.  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?
Contd.

20.  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)
Crypto currencies, ICOs, and
Securities

21. 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.
Contd.

22.  Williamson v. Tucker , It was observed that
 A general partnership or joint venture interest can be designated a
security if the investor can establish . . that
 (1) an agreement among the parties leaves so little power in the
hands of the partner or venturer that the arrangement in fact
distributes power as would a limited partnership; or
 (2) the partner or venturer is so inexperienced and unknowledgeable
in business affairs that he is incapable of intelligently exercising his
partnership or venture powers; or
 (3) the partner or venturer is so dependent on some unique
entrepreneurial or managerial ability of the promoter or manager
that he cannot replace the manager of the enterprise or otherwise
exercise meaningful partnership or venture powers.
Partnership or Joint venture Interest
as Securities

23.  United states v Leonard Case ;
 [Dickau and Silverstein] each operated an independent sales office
(“ISO”) selling interests in companies formed to finance the
production and distribution of motion pictures. Dickau’s ISO sold
interests in Little Giant, LLC, an entity created to produce the film
Carlo’s Wake. The ISOs solicited investments in Little Giant and
Heritage over the phone, calling potential investors to generate
interest in the film projects. The film’s promoters would then mail
potential investors offering materials, including a brochure, operating
agreement, subscription agreement, risk disclosure sheet, and
instruction sheet. If the potential investor decided to participate in
the investment, he or she would send the subscription agreement,
along with a check, directly to the film’s promoters.
Contd.

24.  When an ISO succeeded in selling an interest in Little Giant or
Heritage, it would receive a commission. . . . Dickau’s company
sold a combined total of $520,000 worth of Little Giant and
Heritage units and retained $210,376 in commissions.
Silverstein’s company sold $90,000 in interests in Heritage,
pocketing $32,939 in commissions.
 The government charged Dickau with four counts of securities
and mail fraud . All counts centered around the failure to
disclose accurately the sales commission that the ISOs would
be taking on the investment units.
 In appeal, they took the plea that it is not securities.
Contd.

25.  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
Real estate offerings

26.  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
Securities

27.  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;
Types of securities

28.  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
Securities

29.  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
Not Securities/CIS