Do Joint Ventures Require Securities Law Compliance?
You will not find the analysis to determine whether or not a joint venture is considered a “security” within the 145-word definition of 15 U.S. Code § 77b. The Securities Exchange Act takes a broad approach to violations. This enables regulators to prosecute any type of business entity engaged in the unlawful sale of securities. Securities business models, such as real estate syndications, are frequently posed as joint ventures, and if properly structured can successfully comply with securities law standards.
How to Test for a Security
The Supreme Court has applied several tests to determine what is considered a security. In 1946, the landmark decision in SEC v. W. J. Howey Co. set a precedent still true today. The Court points out that what came to be known as the “Howey Test” is intended to disregard form for substance and emphasizes economic reality. The Howey Test is commonly broken down into four elements: 1) an investment of money; 2) in a common enterprise; 3) with the expectation of profit, and 4) profits come from the efforts of a promoter or third party.
Applying the Howey Test to a joint venture structure necessarily focuses on the last element; “profits come from the efforts of a promoter or third party.” The analysis seeks those persons or entities who have supplied investment capital to the business and examines who carries out the governing duties within the joint venture. If in fact a third party or manager is actually in control, then any investment funds are considered securities and those who sold them are accountable.
Modern Application of Howey
In 2017, the Eastern District of Texas in SEC v. Mieka Energy Corporation determined the defendant/manager’s sale of joint venture interests constituted the unregistered sale of securities in violation of the law. Factually, the defendant/manager held the sole final authority to bind the company while capital investors faced limited situations to remove the defendant/manager, who imposed several barriers to do so. Here the court expounds upon the final element of the Howey Test to determine whether investors expected to “depend on the efforts of others” in a purported general partnership or joint venture.
Per the court’s order in Meika, any of the following would fulfill the last element of the Howey Test regarding the efforts of the manager or third parties: 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.
Whether or not a joint venture requires securities compliance depends on the nature of the deal. Just about anything can fall into the definition of a security, the improper sale of which is charged as a felony. The definition of “sale” alone is the length of this article. Securities laws are designed to be encompassing in order to afford a full measure of protection to the public, and ignorance of the law is not a legal defense. If you ever consider entering into any type of business arrangement comprised of pooled private money, carefully consider the application of securities laws and do not hesitate to seek professional legal counsel.