In 1959, some enterprising developers bought land in Marin County to develop a country club. To pay for some of the costs of building the club, they sold charter memberships in the club. The members would not share in the profits or ownership of the club but would have the right to use club facilities. Under the federal definition, these memberships would not be securities because the members joined the club to get the benefits of membership, not for a financial return. But the California Supreme Court, in a landmark case called Silver Hills Country Club v. Sobieski,[22]found that these memberships were securities.
The court formulated a new test for whether something is a security, called the risk capital test, which considers:
• Whether funds are being raised for a business venture or enterprise;
• Whether the transaction is offered indiscriminately to the public at large;
• Whether the investors are substantially powerless to effect [sic] the success of the enterprise; and
• Whether the investor’s money is substantially at risk because it is inadequately secured.
In Sobieski, the court held that the sale of membership to a country club was a security because it fell under the purview of the regulatory intent of the California securities act.[23] On that point, the court held that courts have to look through form to substance to protect the public from schemes to attract “risk capital,” which it found in this case.[24] The court found that the investors were risking their capital in expectation of receiving the benefits of club membership, which was in the control of the issuers of the membership.[25] Notably, the court stated the “act extends even to transactions where capital is placed without expectation of any material benefits.”[26]
Since Sobieski, the risk capital test has been applied by courts, with each case emphasizing different components of the test. The test is stated broadly as condemning a transaction that involves raising “funds for a business venture or enterprise; an indiscriminate offering to the public at large where the persons solicited are selected at random; a passive position on the part of the investor; and the conduct of the enterprise by the issuer with other people’s money.”[27] Most generally, the risk capital test “focuses retrospectively on what the investor stands to lose rather than prospectively on what he expects to gain.”[28]
The broad formulation of the risk capital test emphasizes that the test eliminates the profit requirement of the federal Howey test.[29] “The risk capital test has two major advantages when contrasted with the federal test. First, it does not define a benefit as narrowly as the federal test defines a profit. The benefit need not be a material benefit.”[30]
A couple of examples of fundraising schemes that were not found to be securities under the risk capital test might help clarify the test. First, inMoreland v. Department of Corporations, the court found that the sale of gold ore and a contract to refine the ore was not a security under the risk capital test even though “the promotional materials given to the public by appellant included the following statement: ‘The reason for selling the gold at this price is to raise the capital for a new milling and refinery plant.’”[31] The Department of Corporations argued that the intended use of the proceeds demonstrated by this statement satisfied the requirement under the risk capital test that the funds “be used for a business venture or enterprise.”[32] The court disagreed, stating,
Superficially, this may be so since the construction of a mill and refinery is essential to the conduct of appellant’s intended mining, milling and refining operations. However, it is equally true that every purchaser of a product from a seller, who reinvests the proceeds of the sale in his business operations, contributes to a seller’s business capital. Notwithstanding, such a contribution is an investment in the purchased product and not a contribution of risk capital to a business enterprise within the normal scope of securities regulation.[33]
In Hamilton Jewelers v. Department of Corporations, the court held that the following offering did not constitute a security under the risk capital test:
Hamilton Jewelers invites you to invest in a ONE CARAT DIAMOND for only $500, and if anytime [sic] within a three year period you elect to return the Stone, Hamilton will return to you the full purchase price plus 5% interest calculated daily from the date of purchase. A diamond investment of $500 will return $578.81 in cash at the end of a three year period.
The court reasoned that even though the offer to pay interest on an investment would normally fall within the definition of a security, in this case the investor’s capital was not at risk because the investor had a diamond worth at least $500. The court stated, “[t]he customer, being adequately secured, would have placed no ‘risk capital’ with Hamilton; and, therefore, the transaction would not come within the regulatory purpose of the Corporate Securities Law even though 5 percent interest might ultimately be paid to the customer.”[34]
The risk capital test has been adopted in some form in 16 jurisdictions (in addition to California):[35]
• By the Supreme Court of Hawaii (1971);
• By the Supreme Court of Arkansas (1987);
• By the District Court of Guam (Appellate Division, 1981);
• By the Court of Appeals of Ohio (10th District, 1975);
• By the Supreme Court of Oregon (1976);
• By statute in Alaska, Georgia, Michigan, North Dakota, Oklahoma, and Washington;
• Through regulatory rule in Illinois, New Mexico, North Carolina, Wisconsin, and Wyoming.
For example, Washington’s statutory definition of a security includes “investment of money or other consideration in the risk capital of a venture with the expectation of some valuable benefit to the investor where the investor does not receive the right to exercise practical and actual control over the managerial decisions of the venture.”[36]
The Hawaii Supreme Court devised a test that is a combination of the Howey test and the risk capital test established in Sobieski. This test states that an investment contract (and security) is formed when
(1) An offeree furnishes initial value to an offeror, and
(2) A portion of this initial value is subjected to the risks of the enterprise, and
(3) The furnishing of the initial value is induced by the offeror’s promises or representations which give rise to a reasonable understanding that a valuable benefit of some kind, over and above the initial value, will accrue to the offeree as a result of the operation of the enterprise, and
(4) The offeree does not receive the right to exercise practical and actual control over the managerial decisions of the enterprise.[37]
The Hawaii test softens the harsh application of the risk capital test by specifying that the benefit has to be “over and above the initial value” and “as a result of the operation of the enterprise.”[38]
Some jurisdictions have applied the risk capital test less broadly. For example,
• In Hacker v. Goldberg,[39] the court found that a sale of membership was not a security where “no financial profit or income could be derived under the charter.”[40]
• In Creasy Corp. v. Enz Bros. Co.,[41] the court held that the state securities law was not enacted to protect against the sale of membership that would render a service available to them with no rights to the capital or profits of the company.[42]
• The New York Court of Appeals held that the sale of membership in recreational campgrounds is not a security where members acquire no legal interests in the company, no right to their business, any share of income, or any right to participate in management.[43] Rather than a financial interest, the court found that members acquired membership solely for their own personal enjoyment and not for resale or profit.[44]The court stated that the Howey test is the test of choice in New York; however, it also acknowledged the use of the risk capital test.[45] The court found application of the risk capital test irrelevant because the memberships were being sold for an established business instead of to raise capital for a new enterprise.[46] On this basis, the court failed to consider whether or not the risk capital test would be a useful addition to theHowey test in New York.[47]
• In Dunwoody Country Club of Atlanta, Inc. v. Fortson,[48] the court found that an investment in exchange for a membership certificate and use rights to social and recreational facilities was not the type of investment that the Securities Act meant to protect. Because the country club in question was a nonprofit organization, the court distinguished the present case from Sobieski.[49]
Even states that do not exclusively employ the risk capital test acknowledge its utility.[50]
There is some degree of judicial uncertainty regarding how the risk capital test should be applied.[51] In particular, California Appellate Courts, following the California Supreme Court, have avoided establishing an “all-inclusive formula” to test the facts of every case.[52] More specifically, the California Court of Appeals found that “[t]he ‘risk capital’ test is […] not applicable in all situations,” even though the parameters of its application are left unexplained.[53]
The only cases in which California courts find something not to be a security are those where the investments are sufficiently collateralized and/or where the investors are actively involved in the venture. For instance, in Reiswig, the court held that a CD-with-bonus package was not a security under the risk capital test, in part, because the CDs were FDIC insured, and there was therefore no substantial risk.[54]
Generally, courts in states that apply the risk capital test will use both the Howey test and the risk capital test to determine whether something is a security. If an instrument meets the definition under either test, the court will conclude that it is a security. States that do not apply the risk capital test will generally apply the Howey test only.
