USA President Franklin D. Roosevelt’s New Deal created the Securities and Exchange commission as part of the 1933 Act. It was designed to prevent business people from raising capital from the general public. Under the guise of consumer protection, the regulation made it illegal for entrepreneurs to advertise the offering of new shares in a company. Except to wealthy insiders—called accredited investors. The regulation relied upon a four-part test called ‘Howey’ to define which offers are considered securities.

Why is finding a good investment so difficult?

Well, if you’re a highly paid doctor or wealthy individual, perhaps one reason is because you’re too busy in your “day job” to search for new deals.  Indeed, the process of looking under rocks to find one worthy asset takes time and resource.

The second reason why it’s a challenge to find potentially higher yield investments is: they’re not well-publicized.  Due to decades of government regulation.

Here’s a helpful guide to protect you, in case you choose to grow your wealth with private equity investments; or in the event you decide to create your own venture.

A quick historical lesson on the rules of the game so you can Get Smarter Faster®.

It’s called the “Howey Test”.

First, I’ll share the inception.

Then, I’ll explain why it’s important.

To best understand this, let’s go back to the year 1933 when president Franklin D. Roosevelt created the SEC (aka, Securities and Exchange Commission).

The SEC was created in the 1933-34 Act as part of FDR’s “New Deal” program.

It was a consumer protection step designed to prevent promoters (aka, capital raisers) from advertising directly to the general public.

With the birth of the 1933-34 Act, entrepreneurs and business owners were required to file their offerings with the SEC, and gain government approval before advertising for investors.

There are two types of filings: a public offering, and a private offering.  Both of which require filing with the Securities and Exchange Commission.

(the legal fees that a promoter incurs for filing aren’t cheap, $20,000+.  Up to $1Million for some public offerings)

For businesses that wish to avoid public status and ongoing public reporting, the SEC set aside exemptions—or privileges—so promoters can offer shares to people in what’s called a “Private Placement.”

In Regulation D of the 1933 Act, the SEC created different categories of “private placements” which dictate how the private offerings are to be handled.

For example, there’s a Reg. D 506(b) offering, Reg. D 506(c) offering, Reg. A+ offerings, Reg. D 504 offerings and etc.  The key point to remember is that there are subtle nuances between each offering…

Things like “how many investors” are allowed in the investment fund, what forms of advertising are allowed, and the investor’s minimum “net worth” are all dictated by which type of private placement the promoter filed.

Have you noticed how there’s rarely any advertising to sell shares in an apartment building project? nor any Ad on t.v. to invest in a company before it gets widely known, or becomes public?

These could perhaps be higher return investment opportunities, but the general public is unaware of them because there’s rules on how advertising must be handled.

Charles Schwab can freely advertise their services; but a business owner cannot offer shares in a public or private investment (not without the appropriate government privilege).

With the JOBS ACT of 2012, however, certain advertising restrictions were lifted.  In some cases, like crowdfunding, promoters can advertise their investment offerings directly to the general public… so long as they file the proper SEC notice.

In other offerings, like a Red D. 506(c) offering for example, a promoter can generally advertise, so long as the promoter takes reasonable steps to verify that the purchasers of the offering are “accredited.”

Accredited Investors

Therefore, this leads us to the so-called “accredited investors” standard.

The SEC defines an “accredited investor” as:

  • certain institutions or any individual whose net worth is $1MM or more (not including your primary residence); or
  • if the individual earns more than $200K per year in each of the two most recent years ($300K/year if joint income with a spouse).

Basically, the regulation discriminates with private equity investments: only richer people and insiders allowed.

And now for the punch-line…

Howey Test

The Supreme Court created a test to determine if an investment offering was, in fact, a security.  If so, then the business promoter must obtain the proper government privilege.

(Note: another name for a “security” is called an “investment contract”)

There are 4 components to the Howey Test that the SEC looks at in order to determine if a business promoter has created a “security.”

Here are the four parts:

  1. an investment of money
  2. in a common enterprise
  3. with an expectation of profit
  4. by the efforts of a 3rd party (promoter)

Now here’s what each Howey Test part implies in plain English:

  • Investment of money: is there an investment of money by an investor?  If so, then check this box.
  • In a common enterprise: is there more than one investor investing in the enterprise?  If there’s 2 or more investors, then check this box.
  • With an expectation of profits: are the investors expecting to earn a profit by making the investment?  If so, then check this box as well.
  • By the efforts of a 3rd party: are the investors sharing in the decision making process? or is the promoter solely in control of all decisions on behalf of the business? If the investors are passive shareholders, which is often the case in a group investment, then check this box.

When ALL four (4) of these conditions are met, the SEC deems that a “security” has been created.  And the promoter of the enterprise must, therefore, file for an appropriate government privilege thru the SEC prior to selling any shares of stock.

For example, filing a legal paper called a “PPM” Private Placement Memorandum.

If you’re a person who happens to fit the definition of an accredited investor, or even if you’re not an accredited investor, be sure to consider these rules and verify that the promoter has filed, or will file, the appropriate government papers before you invest in a group investment.

Perhaps you’re interested in private equity investment—technology, healthcare or luxury real estate. To learn about private investments for wealthy people, contact us.

Legal disclaimer: The information contained here is for educational purposes. It does not recommend the purchase or sale of any security nor is it an offer to sell or a solicitation of an offer to buy any security. Any such offer will only be made in compliance with applicable state and federal securities laws pursuant to an offering memorandum and related offering documents which will be provided to qualified prospective investors upon request. Prospective investors should review a fund’s offering memorandum carefully, which includes important disclosures and risk factors associated with an investment in a fund.