If you’ve read our blog at all, you know that we are constantly harping about securities!  I have been asked many times whether something that someone is offering is a security.  This post offers some guidance.

A security is defined under federal law as

“any note, stock, treasury stock, security future, 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.” 15 U.S.C. 77b(a)(1).

The leading case on the definition of a security is federal Supreme Court case SEC v. W.J. Howey Co. (1946).  Under the Howey test, a security is “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”

In Howey, the “scheme” in question was the sale of land containing fruit trees as well as “service contracts” to cultivate and market the crops, with an allocation of the net profits going to the purchaser.

The Howey Court noted that its definition of a security “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”

The ninth circuit court of appeals distilled Howey’s definition into a three-part test: “(1) an investment of money (2) in a common enterprise (3) with an expectation of profits produced by the efforts of others.” SEC v. Rubera (2003).

The courts have rejected attempts to narrow the definition of a security.  As one opinion put it, “[I]n searching for the meaning and scope of the word ‘security’ . . . form should be disregarded for substance and the emphasis should be on economic reality.”

The “investment of money” prong of the Howey test “requires that the investor ‘commit his assets to the enterprise in such a manner as to subject himself to financial loss.’”

The focus of the inquiry is on what the purchasers were offered or promised.  “The test [for determining whether an instrument is a security] . . . is what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.”

What does it mean to create an expectation of profits?  The Supreme Court defined profits as “either capital appreciation resulting from the development of the initial investment . . . or a participation in earnings resulting from the use of investors’ funds.”

The promised return may be fixed or variable and may be marketed as low-risk or “guaranteed.”

Courts have frequently examined the promotional materials associated with an instrument in determining whether it is a security.  If the materials promise things like great returns or guaranteed income, the court will almost certainly find the instrument to be a security, and therefore subject to federal securities regulations.

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