Security: An Overview
Security refers to a broad type of investments with risks that are regulated under securities law. Securities exist in numerous forms including: notes, stocks, treasury stocks, bonds, and certificates of interest or participation in profit sharing agreements. Securities law exists because of unique informational needs of investors. Securities are not inherently valuable; their worth comes only from the claims they entitle their owner to make upon the assets and earnings of the issuer or the voting power that accompanies such claims. The value of securities depends on the issuer's financial condition, products and markets, management, and the competitive and regulatory climate. Securities laws and regulations aim at ensuring that investors receive accurate and necessary information regarding the type and value of the interest under consideration for purchase. (For more information on securities law generally, see securities).
Scope of Securities
Much of the litigation related to securities involves defining what does and does not constitute a security subject to the requirements of securities law. In deciding what is a security, securities law focuses on the substantive elements of investor expectations and nature of the investment rather than form. The primary definitions from the Securities Act of 1933 and the Securities Exchange Act of 1934 similarly define securities as specific instruments such as a “note, stock, treasury stock, security future, security-based swap, bond, debenture” and any instruments that fall into broad categories like “investment contracts” or “any interest or instrument commonly known as a “security”” (see 15 U.S.C. § 77b). Some types of securities like stocks are per se securities under the Acts, but other types of instruments like swaps require further analysis to determine whether they fall under the Act.
Courts have come up with different tests and factors to consider when deciding whether an instrument falls under the statutory definitions of securities. The Supreme Court defined investment contracts to be any instrument: “[1] where a person invests his money [2] in a common enterprise and [3] is led to expect profits [4] solely from the efforts of the promoter or a third party” (SEC v. W. J. Howey Co. et al., 328 U.S. 293 (1946)). A lot of litigation has surfaced interpreting the four prongs of this case. For example, in interpreting whether the investment meets the fourth prong (referred to as the managerial prong), courts have differed on the test to be used. Some courts have followed the 9th Circuit test emphasizing “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise” (SEC v. Glenn W. Turner Enterprises Inc., 474 F.2d 476, 482 (9th Cir. 1973)). Investors can retain minor control in the investments and still meet the fourth prong (see SEC v. Unique Financial Concepts, 196 F.3d 1195, 1201–1202 (11th Cir.1999)). In interpreting the profit requirement, much litigation has surrounded the test to be used, and courts have distinguished an expected profit from an investment versus a consumed benefit that resembles a security (see United Housing Foundation, Inc. v. Forma, 421 U.S.C. 837 (1975)(finding that ‘stock’ in a housing co-op was for consumeristic needs rather than a real investment purpose)). Generally, the more an instrument or agreement creates the expectations of potential profit by investors or the average person, the more likely a court will find that an instrument falls under the broad definitions of securities.
Many instruments may or may not fall under the definition of security depending on the context in which they arise. Generally, commodities and futures do not fall under securities and are covered by the Commodities Exchange Act and regulated by the Commodity Futures Trading Commission (CFTC). However, some futures and swaps that are based on individual securities or security indexes fall under securities regulation too (see 15 U.S.C. § 78c(a)(68)). Most types of partnerships do not fall under the category of securities, but most limited partner interests will as long as they retain limited control over the partnership. A more modern debate exists over whether cryptocurrency and other digital currencies constitute a security; the SEC and courts have held that cryptocurrencies can be a security under the Hawley test depending on the way the assets are used (see SEC v. Ripple Labs, Inc., New York Southern District Court (October 3, 2023), 2023 U.S. Dist.).
Some types of instruments that would otherwise qualify as a security have been expressly exempted from the definition including some offered by local governments and municipalities, bank trust funds, and charitable entities (see 15 U.S.C. § 77c).
[Last updated in October of 2023 by the Wex Definitions Team]
