The Howey Test Turns 64: Are the Courts Grading this Test on a Curve?
Hofstra University - Maurice A. Deane School of Law
August 27, 2010
Hofstra University Legal Studies Research Paper No. 10-28
Sixty-four years ago, the Supreme Court decided SEC v. W.J. Howey, crafting a definition for one form of security, known as an investment contract. The Supreme Court’s definition of investment contract in Howey is flexible, consistent with the Congressional approach to defining the broader concept of what constitutes a security. This choice of adopting a flexible definition for investment contract is not without cost, and raises the specter of inconsistent interpretation and/or application by the lower courts that threatens to undermine the utility of the Howey test itself as a trigger for investor protection. The intentional breadth and adaptability of the definition of investment contract necessarily leads to complex and fact-intensive judicial inquiries in the application thereof, and allows the possibility of inconsistent results between and among the various courts engaging in such inquiries, creating the possibility of similarly-situated litigants winding up with dissimilar outcomes.
Examples of these disparate outcomes are present in a number of industries, including the viatical settlement industry. Viatical settlements are a form of “asset-backed securities” under which purchasers buy the right to receive death benefits under life insurance policies from policyholders. These days, the very words “asset-backed security” may cause the public to recoil in horror, thinking of the sub-prime mortgage debacle and Bernard Madoff being led off in handcuffs while his devastated victims sob on the evening news. But not all asset-backed securities are problematic, and when undertaken legally and ethically, these interests can be solid investment vehicles, providing needed liquidity to the capital markets.
As the financial markets continue to grow and innovate, new forms of asset-backed securities will likely be created, and the potential for inconsistent treatment of similarly-situated investors in these asset-backed securities arguably increases, prompting the question explored herein of whether the definition of investment contract in the Howey test is too flexible to further the underlying legislative intent of the federal securities laws to protect investors through mandatory disclosure and anti-fraud liability. At present, investors and issuers can have no certainty as to the absolute parameters of the test or how any given court will articulate or interpret the definition of investment contract. The test has been burdened by judicially-imposed nuances, as judges try to give meaning to the Supreme Court’s words, and as a consequence, has triggered uneven applications.
This Article challenges the Howey test in light of today’s increasingly complicated and volatile securities markets, focusing on whether the underlying legislative goals of the federal securities laws are still met by the Howey test, as currently construed by the courts. The Article ultimately concludes that the benefits of the flexibility of the Howey test outweigh the costs in terms of dissimilar results for similar investments and that the uneven applications of the Howey test by courts should be considered necessary collateral damage acceptable in light of the significant protections still triggered by the Howey test.
Number of Pages in PDF File: 50
Keywords: Howey Test, Investment Contract, Definition of Security, Investor Protection
JEL Classification: K22
Date posted: August 28, 2010