Chapter 2

• Jurisdiction: United States

Chapter 2 What Is a Security?

The definition of a "security" began as a matter of state, not federal, law. Today, however, most states look to the federal laws, not their own, for the definition. In fact, the Uniform Securities Act basically duplicates federal standards. Unfortunately, there is no widely accepted definition of a "security" under federal law.¹

In Marine Bank v. Weaver, 455 U.S. 551 (1982), the Supreme Court wrote that the definition of "security" is "quite broad" and is meant to include "the many types of instruments that, in our commercial world, fall within the ordinary concept of a security." In other words, the definition of a "security" as the term is used in the federal securities laws includes, but is not limited to, the statutory definitions that Congress has provided. There are two lists of examples of securities in the federal securities laws; they are helpful but not sufficient. They are not definitional, only examples.

Statutes and Rules

Securities Act of 1933. Section 2(a)(1) contains a list of examples of what constitutes a "security." In general, it is a very broad term.

Securities Exchange Act of 1934. Section 3(a)(10) also contains a nearly identical list, with a few minor wrinkles.

But these lists are not exhaustive or even always applicable. For example, Section 2(a)(1) of the 1933 Act defines "security" as, among other things, "any note, stock . . . transferable share [and] investment contract. . . ." It goes on to include in the definition "any interest or instrument commonly known as a 'security' . . ." but the statute explicitly exempts any definition of a security if "the context otherwise requires." So much for a bright-line test.

One of the types of "security" listed in both the 1933 Act and the 1934 Act is an "investment contract." However, there is no other definition in the statutes. In the leading—and still valid—test first set forth in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (the so-called Howey in the Hills case), the Supreme Court established a four-part test for determining what constituted an "investment contract" under the statutes: The transaction must be one in which (1) a person invests money, (2) in a common enterprise, and (3) is led to expect profits, (4) solely from the efforts of others. The ostensible purpose of the Howey test was to look at the economic realities of the transaction, but that is often hard to discern. In Howey itself, the Supreme Court, rejecting the decisions of the lower courts, held that an investment contract in which a purchaser bought a row of forty-eight citrus trees that were cultivated, harvested, and marketed by an affiliate of the seller, constituted a security. However, the court took a literal approach and declined the opportunity to consider the policy implications in determining what constituted a "security." Rather, it used the term "investment contract" to apply to novel schemes whenever they were encountered. For example, the sale of earthworms and the sale of "participations" in a pyramid scheme for distributing cosmetics both meet the definition of an "investment contract." The Howey court wrote that an investment contract "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."

Why do we care about the definition of a "security"? There are several reasons:

• first and foremost, the federal securities laws only apply to transactions in "securities";
• the key provisions of the 1934 Securities Exchange Act, Section 10(b) and Rule 10b-5, only apply to transactions "in connection with the purchase or sale of a security";
• under most circumstances, most offerings of "securities" require registration with the SEC; and
• statutory disclosure rules apply to "securities."

In most cases, the issue turns on what is an "investment contract," a term used in both statutes and that formed the basis of the Howey decision. Note that although that term is used in both statutes as a part of the definition of a "security," there is no other definition of an "investment contract" in the securities laws. Post-Howey decisions have adopted a flexible, even expansive, interpretation of the four-part Howey test. The common law test looks at substance, not form, in order to define an "investment contract." It seems to be a legal term without any commercial significance.

In Marine Bank v. Weaver, 455 U.S. 551 (1982), the court considered the "if context otherwise requires" portion of the definition of security in the Exchange Act. At issue were certificates of deposit and the Supreme Court took note of the fact that such instruments were already extensively regulated by banking laws, especially those on depositor insurance. The court held that neither a certificate of deposit nor an agreement given as consideration for pledging the certificate to guarantee a bank loan was a security under the federal securities laws. "Congress, in enacting the securities laws, did not intend to provide a broad federal remedy for all fraud."

The Elements of the Howey Test Explained

A Person Invests His Money. In International Brotherhood of Teamsters v. Daniel, 439 U.S. 551 (1979), an employer-funded, fixed-benefit pension plan in which employees make no direct contribution and their participation is compulsory is not a security. There were two reasons: the plan's benefits were fixed and depended not so much on the investment returns as on the employee becoming eligible, and the ERISA statute already regulated such plans, making securities law protection less important.

In a Common Enterprise. In SEC v. SG Ltd., 265 F.3d 42 (1st Cir. 2001), the court found a security when an offshore company created an online investment game that allowed players to buy a "virtual investment" and earn "virtual returns" that depended on the promoters and players luring other players into the game. The U.S. Court of Appeals for the First Circuit held that it was irrelevant that the enterprise was called a "game"; the question was whether it met the Howey test, and it did. There was horizontal commonality because the assets were pooled from many investors who all shared in the profits and risks, and there was vertical commonality because the investors' fortunes were tied to the success of the promoter, not the fellow investors. The court's decision was based on the horizontal commonality, largely because of the pooling.

Is Led to Expect Profits. In United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975), a nonprofit co-op was created for low-income families who purchased shares of stock that allowed them to lease apartments. The tenants sued claiming false and material misrepresentations after the prices of the apartments rose. The Second Circuit held that the "stock" was a security or an investment contract, but the Supreme Court...