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 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.
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.
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 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:
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.
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.
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.
The term “note” can refer to a broad range of financial instruments, some of which are securities and others which aren’t.
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:
So, while a corporate bond-like instrument merely called a “note” would likely be a security, many notes aren’t.
The following financial instruments typically won’t be considered securities subject to SEC regulation:
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.
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.
Great break down and great news. Just to clarify – This means that I can ask and advertise for private lenders all day long without any fear because I will be buying property in my own name or in the name of my individually owned LLC. Is this correct?
Michael Bjorn Huseby says:Hi Jesse, You’re right that you can advertise for private lenders, but the reason is that the loan itself likely isn’t a security, and therefore isn’t subject to SEC regulation. This would be especially true if the note is secured by real estate (though an unsecured note is still unlikely to be a security). Let me know if you have any more questions. Thanks!
Michael
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