You Can't Cheat an Honest Man - James Walsh [34]
Some people are surprised that so many wealthy investors are drawn into these old-fashioned schemes. But they shouldn’t be surprised. For generations, bogus deals have been a staple of idiot sons from successful families who talk about doing business in vague terms besuccessful families who talk about doing business in vague terms be Q filings.
People who know investments—like people who know any business— talk about their interests in detail. They will welcome the chance to explain the mechanics of what they do, because they know there are no secret recipes for success.
But the 1980s and 1990s have generated armies of loosely-defined “investment advisers” and “financial planners.” Many of these have come out of the insurance industry—former agents looking for new markets. They can pose a considerable risk of promoting—knowingly or not—pyramids and Ponzi schemes.
Who is an Investment Adviser? In relevant part, the federal Investment Advisors Act provides that an investment adviser is:
[A]ny person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.
In defining the business standard for investment advisers, the SEC notes:
The giving of advice need not constitute the principal business activity or any particular portion of the business activities of a person in order for the person to be an investment advisor.... The giving of advice need only be done on such a basis that it constitutes a business activity occurring with some regularity.
Another important point: Federal securities law holds that anyone involved in a fraudulent scheme must understand that the scheme is fraudulent. (Bad investments made in good faith aren’t illegal.) Courts refer to this knowledge as scienter.
While all courts agree that a scienter requirement exists in securities fraud cases, “at least to the extent that something more than ordinary negligence is required,” they don’t all agree on a single standard. Some courts require “knowledge” while others require “general awareness that [a party’s] role was part of an overall activity that is improper.”
Perhaps the best summary of the standard for establishing scienter is that “[s]ome knowledge must be shown, but the exact level necessary for liability remains flexible and must be decided on a case-by-case basis.”
In this context, the surrounding circumstances and expectations of the people involved are critical.
One of the purposes of the Investment Advisors Act was to protect the public’s confidence in the financial markets. As one Senate Report warned: “Not only must the public be protected from the frauds and misrepresentations of unscrupulous tipsters and touts, but the bona fide investment adviser must be safeguarded against the stigma of...these individuals.”
The Investment Advisors Act sought to regulate “investment contracts,” which it described as any of a variety of investment devices and securities.
In its 1946 decision S.E.C. v. Howey, the U.S. Supreme Court set up a test for courts to use in determining whether an investment contract was, in essence, a security and therefore within the reach of the act. The court ruled that an investment contract is a transaction:
[W]hereby a person [1] invests his money in a [2] common enterprise and [3] is led to expect profits [4] solely from the efforts of [others].
In the more than 50 years that have passed since the Howey decision, federal courts have had little difficulty applying the first and third elements of the test. They’ve had more trouble applying the second (“common enterprise”) and fourth (“solely from the efforts of others”) elements.
The confusion has centered on whether so-called horizontal commonality between one investor with a pool of investors is required, or whether a vertical commonality between an investor and a promoter