For the Howey Test an enterprise is common if it is:
- Horizontal Commonality: Is about the relationship between co-investors. They either have pooled assets, recieve pro-rata distribution of profits, or otherwise tied together assets via the pooling of funds.
- Vertical Commanlity: Is about the relationship between the investor and the promoter/issuer. With the investors success tied to the efficacy or the profits of the issuer/promoter.
# A Common Enterprise:
One of the prongs of the US Howey Test, is that the entities must be involved in a “Common Enterprise”. This phrase presents unique challenge, as it is perhaps the least well defined component of the test.
In labor law in the US, where we most commonly see the phrase “Common Enterprise” we’re given our own three prong test as to what constitutes commonality. But, in securities law we’re left with split interpretations from various circuit courts.
In the 2004 case, “SEC v. Edwards”1 the courts had the opportunity to put to rest this ambiguity from split circuit opinions but instead chose not to. In part suggesting that commanality itself, may not be entirely clear, and have a flexible definition.
However, we can examine the types of “Common Enterprise” definitions that are put forward by each of the lower circuit courts.
In horizontal commonality, the legal analysis focuses on the relationship between each of the investors in an economic venture.
In “Revak v. SEC Realty Corp.”2 we were told that commonality is where investors profits are “tied to the success of the overall venture” and “usually involves the pro-rata distribution of profits”.
In “Hart v. Pulte Homes of Michigan Corp”3 and “Salcer v. Merrill Lync, Pierce, Fenner & Smith Inc”4 the courts expressly suggest that the “investment must be part of a pooled group of funds.”
And in “Milnarik v M-S Commodities”5 it is noted that “the success or failure of other contracts must have a direct impact on the profitability of plantiffs contracts.”
The case of “SEC v. ETS Payphones”6 a decision by the 11th Circuit goes as far to say: “most circuits that have considered the issue find it satisfied where a movant shows ‘horizontal commonality,’ that is the ‘pooling’ of investors’ funds as a result of which the individual investors share all the risks and benefits of the business enterprise.*”
As such, we can deem that “Horizontal Commonality” involves:
- The pooling of funds
- The pro-rata distribution of funds
- The sharing of both risk and rewards
The view of Horizontal Commonality is most often applied in the following Circuit Courts:
- DC Circuit
- First Circuit
- Second Circuit
- Third Circuit
- Fourth Circuit
- Sixth Circuit
- Seventh Circuit
Within the view of Vertical Commonality, we’re focused on the relationship between the investor and a promoter/issuer (that is someone who has either created/issued the asset, or is promoting the sale of the investment).
However, with in this view there are two different interpretations that look at this relationship differently, there is “Strict Vertical Commonality” (sometimes called “Narrow Vertical Commonality”) and the “Broad Vertical Commonality” - both interpretations appearing in different circuits.
Strict Vertical Commonality:
Within “Strict Vertical Commonality” we’re expressly looking at the financial relationship between the investor and the promoter/issuer.
In this narrow approach the question before the courts is are the “fortunes” of the investor and the promoter correlated.
In the case “SEC v. Eurobond Exchange LTD”7 the court put forth a definition that a “Common Enterprise” was “a venture in which the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment” they expressly noted that they did not require the pooling of investors funds to establish commonality, but instead that “a common enterprise exists if a direct correlation has been established between success or failure of (the promoter’s) efforts and success or failure of the investment.”
In the case “Long v. Shultz Cattle Co”8 it’s further noted that “fortunes of investors be tied to fortunes of the promoter. Losening how direct the relationship must be between the success of the investments but noting that they still must be tied together even if not directly correlated or proportional.
The application of the “Strict Vertical Commonality” lens is commonly only found in decisions from the Ninth Circuit.
Broad Vertical Commonality:
In the “Broad Vertical Commonality” perspective, we’re not focused on the financial relationship between the two parties but instead the expertise of the promoter.
A “Broad Vertical Commonality” is one in which the success of the enterprise and the investment is dependent on the promoters expertise and efforts to facilitate the return.
A defining case for this perspective is “SEC v. Glenn W Turner Enters Inc”9 in which it was defined by the court that commonality is established when an investors profits are “tied inextricably to the efficacy of the promoter” in the particular case the company Glenn Turner ran was paying participants to bring people to seminars in which Turner’s employees were closing a sale. Because the earnings of these participants were based on the efforts of the promoter and not their own efforts it was found to be a security.
In the case of “Villeneuve v. Advanced Bus Concepts Corp”10 this lens was further refined to note that “the fortunes of the investors need be linked only to the efforts of the promoter”.
This lens has been seen in decisions by both the Fifth Circuit and Elevent Circuit courts, but it throws into question some fundemental challenges if we consider it within the framework of the Howey Test.
The limits of the “Broad Vertical Commonality” have not been tested extensively and leave room for some thought experiments that present signifigant legal challenge.