What Is a “Security” Under the Securities Act (And Why Does It Matter)?

Every sale of a security must be either (i) registered with the US Securities and Exchange Commission (the “SEC”) or (ii) exempt from registration. Sell a security without registration or an exemption and you’ll be in big trouble with the SEC.

This fundamental rule applies to all kinds of securities offerings, from the sale of LP interests in a small limited partnership to the issue of bonds by a multinational corporation.

But what is a security subject to SEC regulation? Stocks? Notes? Shares of an orange grove? Here, you’ll find out. 

The Securities Act Definition of a “Security”  

The SEC sets the rules for what counts as a security subject to its regulation. The official definition of a security is in the Securities Act of 1933. 

Are you ready for it? Hold your nose and take a deep breath.

Or just skip it — up to you.

The term “security” means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

There we go. Article over. 

…Ok. Fine. Perhaps we need to dig a little deeper. 

The Howey Test for Determining If Something Is a Security

When I was a wee lad in law school, we read SEC v. Howey Co., 328 U.S. 293, 328 (1946) to learn what counts as an SEC-regulated security. 

The Facts

In Howey, a promoter sold interests in orange groves to out-of-state investors. The interests were paired with a mandatory service contract. According to the contract, the promoter kept possession of the land and merely gave the investor a percentage of the profits from the orange crop. 

So, at the end of the day, all the investors were getting was a share of the income. As the court said, investors had “no right to specific fruit.” No orange juice. No zest from the peel. No smell of fresh citrus at sunrise. Just cash flow. 

Is this a security? 

The Test

The Howey court developed the following four-pronged test to determine if something is a security: 

A security is “a contract, transaction or scheme whereby a person invests his [or her!] money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.”

Let’s break it out: 

1. Investment of money: The purchaser must have invested money (or other assets).
2. Expectation of profits: The purchaser expects a profit from the investment. Buying something primarily for consumption (like a primary residence or a car) doesn’t count. 
3. Common enterprise: Courts have different definitions of “commonality” but it usually means (i) the investor is pooling money with other investors or (ii) there is a commonality of interest between the investor and the seller/promoter of the securities. 
4. Reliance on the efforts of third parties: The investor is relying on the efforts of others to generate the returns. If the profits are based on the investor’s own work, it’s unlikely to be a security. 

Also, according to the last part of Howey’s holding, a share certificate (or some other piece of paper) isn’t necessary for something to count as a security. 

The Result 

In the Howey case, there was (1 and 2) an investment with the expectation of profits — the buyers paid money for a financial return, not the oranges.

The investors and the seller shared the income from the sale of the oranges, so they were engaged in a (3) common enterprise.

Finally, the investors were (4) relying on the promoter to run the orange grove business. They weren’t rolling up their sleeves and planting seeds on their own (or whatever happens at orange groves). 

So, the interests were securities. 

Default Rules for What Counts as a Security 

Luckily, we don’t have to whip out the Howey test or read the nightmare-inducing Securities Act definition of a “security” every time we want to determine if something is a security. Case law and statutes provide default rules for various financial instruments. 

Things That Are Usually Securities 

• Stocks
• Corporate bonds
• Passive interests in LLCs
• Interests in limited partnerships 

Things That Are Usually Not Securities 

• Commercial paper 
• Government bonds
• Certificates of deposit
• Active interests in LLCs 
• Individually-owned real estate 
• Interests in general partnerships 

Are Notes Securities?

The term “note” can refer to a broad range of financial instruments, some of which are securities and others which aren’t. 

The Reves Test

In Reves v. Ernst & Young, 494 U.S. 56 (1990), the court started with the presumption that a note is a security, and then laid out a four-factor test: 

1. Motivation of the transaction. Financing and investment transactions are more likely to be securities, while notes entered into for cash flow and business purposes are less likely to be securities. 
2. Plan of distribution. Notes with a wide circulation and liquid market are more likely to be securities, while one-to-one illiquid notes are less likely to be securities. 
3. Societal expectation. Does the general public think the investment is a security? 
4. Existing regulation. Is the note already regulated by a government entity other than the SEC? Examples could be regulations for banking, commodities, etc. 

So, while a corporate bond-like instrument merely called a “note” would likely be a security, many notes aren’t. 

Notes That Aren’t Securities 

The following financial instruments typically won’t be considered securities subject to SEC regulation: 

• Personal loans 
• Mortgage loans
• Commercial financing (for a car, toaster, etc.) 
• Notes evidencing accounts payable/receivable 
• A short-term note secured by a lien on a business

Context Matters! — 30-Unit Apartment Example

It’s important to note (no pun intended…sorry) that the structure of the transaction is critical when determining whether something is a security. 

For example, let’s take a 30-unit apartment complex and run through some scenarios. 

Not a Security…

• You buy the apartment in your personal name with cash. 
• You buy the apartment through your single-member LLC with bank financing (neither the apartment nor the mortgage note are securities).
• You buy the apartment through a general partnership between your sister and yourself.

Yes a Security! 

• You form a limited partnership to buy the apartment. You sell limited partnership interests to passive investors who want a share of the profits. The LP interests are securities! You need to either (i) register the LP interests with the SEC or (ii) find an exemption from registration. 

What to Do If You Think You’re Selling Securities 

If it turns out you’re selling securities after all, don’t panic. A large proportion of securities transactions are exempt from registration with the SEC because they don’t involve a “public offering” or target only “accredited investors.” I’ll cover these exemptions — like Section 4(a)(2) and Regulation D — in future articles. 

If you’re thinking of buying or selling securities but need some guidance through the maze of US securities laws, feel free to reach out for help.