What Is a Security? The Answer Matters for Businesses and Investors

Whether you are a business raising capital or an investor buying securities, understanding the definition of a security is important...

Every offer and sale of a security is required to be registered with the Securities and Exchange Commission (SEC), unless subject to an exemption from registration under the Securities Act of 1933.  So, whether you are a business raising capital or an investor buying securities, understanding the definition of a security is important.

The Basic Definition

Under Section 2(a)(1) of the Securities Act, the term “security” is defined as:

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.

Because the definition largely provides a list rather than describing the characteristics that distinguish securities from non-securities, the courts have provided further guidance regarding whether a particular instrument should be characterized as a security subject to the federal securities laws. 

Howey Test

In SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the U.S. Supreme Court addressed when investment schemes should be considered “investment contracts,” and therefore “securities” under the Securities Act. The Court defined “investment contract” as a contract, transaction or scheme in which (i) a person invests money in a common enterprise, (ii) with the expectation of profits, (iii) solely from the efforts of the promoter or a third party.  According to the Court, this definition 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 Howey test is one of the most widely used tests for determining what qualifies as a security. While the decision dates back decades and has been further fine-tuned by the courts, it has proven to be applicable to a wide range of instruments. 

Security Should Be Interpreted Broadly

In Tcherepnin v. Knight, 389 U.S. 332 (1967), the Supreme Court emphasized that the term “security” as it is used in the Exchange Act, should be broadly construed. In support, the Court stated that it was “guided by the familiar canon of statutory construction that remedial legislation should be construed broadly to effectuate its purposes,” concluding that the Exchange Act quite clearly falls into the category of remedial legislation.

“One of its central purposes is to protect investors through the requirement of full disclosure by issuers of securities, and the definition of security in §3(a)(10) necessarily determines the classes of investments and investors which will receive the Act’s protections,” the Court wrote. “Finally, we are reminded that, in searching for the meaning and scope of the word ‘security’ in the Act, form should be disregarded for substance and the emphasis should be on economic reality.”

The case supports the SEC’s position that the term “security” should be interpreted broadly to protect the expectations of investors.

Substance Over Form

In United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975), the Supreme Court clarified that the name used to describe the transaction is not always the last word, citing the substance over form doctrine. The Court found that although the word “stock” was used in reference to the instruments at issue in the case (shares in a cooperative housing project), it was the economic realities behind the transaction, not the instrument’s label, that invoke the protection of our federal securities laws since securities transactions are economic by nature.

“In holding that the name given to an instrument is not dispositive, we do not suggest that the name is wholly irrelevant to the decision whether it is a security. There may be occasions when the use of a traditional name such as ‘stocks’ or ‘bonds’ will lead a purchaser justifiably to assume that the federal securities laws apply,” the Court further explained. “This would clearly be the case when the underlying transaction embodies some of the significant characteristics typically associated with the named instrument.”

The takeaway for businesses is that courts will look at the substance of the transaction rather than simply the name you give it. Investors should always do so as well.

Classifying Digital Assets As Securities

As we have discussed in prior articles, the laws governing digital assets have been slow to evolve. The SEC has taken a proactive role in trying to keep pace, with the goal of both reducing regulatory uncertainty and protecting investors.

In prior guidance and enforcement actions involving the offer and sale of coins and tokens, the SEC has made it clear a digital asset may fall within the definition of a security under the U.S. federal securities laws, depending on what rights it purports to convey and how it is offered and sold. Not surprisingly, the SEC has faced pushback from issuers of digital assets. As in the past, it will likely be up to the courts to further clarify the definition of security.

If you have questions, please contact us

If you have any questions or if you would like to discuss the matter further, please contact me, Kenneth Oh, or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.