The Basics
Security is a small word with a broad meaning. It encompasses, among a host of other investment vehicles and instruments, stocks, treasury stock, notes, debentures, evidence of indebtedness, interests in oil and gas wells and mineral rights, limited liability company interests, limited partnership interests, options, puts, calls, and rights convertible into securities. Whether something is a security is based on the definition of security in the Securities Act of 1933. In addition to some of the specific instruments and vehicles listed above, it also includes those things that may be considered an “investment contract.” An investment contract is a catchall term defined in the Securities Act of 1933, which was created to include any possible future types of securities that were unforeseeable at the time the Securities Act of 1933 was drafted. As we shall see in the article, the term Investment contract is important in helping decipher what is and what is not a security. 
Let’s decipher the term “Securities”
We mentioned that security is a broad term. The easiest way to explain what a security is by giving some examples. The most obvious example we’ll start with is anything that you see publicly traded on the stock exchange market. Let’s say someone wants to purchase stock in a public company. The stock being traded is the security.
There’s more to securities than just Public Offerings.
Most people associate securities with public offerings, which is right. However, public securities offerings are a very small portion of the securities market. There is a much larger world behind this term, especially in the private market. There can also be a very thin line separating what is and what is not a security, and knowing this term is important for the small, medium, and large-sized business owner, the partner in a joint venture, or any other form of the possible issuer. This thin line comes in part from the “investment contract” securities definition. How do you determine whether something is an investment contract?
The Howey Test
The Howe Test is a legal test that determines whether something is an investment contract. Courts created this legal formula when it became apparent that the definition of securities, on its face, was not enough to make it clear exactly what the term security includes. Although the Howey test was formulated to determine if something was an investment contract, it is also useful in explaining what all securities are because it encompasses all securities’ qualities. We’ve explained the elements of the test. “An ‘investment contract’ exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” – Securities and Exchange Commission Read more about the SEC’s Framework for “Investment Contracts” here.
Expectation of Profits
According to the Howey test, the most basic aspect of an investment contract, and securities, in general, is that there be some expectation of profits. This is generally pretty easy to see, and it does not matter whether the expectation of profits is based on a fixed or variable return. In many of the securities transactions we work on, the returns are a certain percentage of proceeds or profits for a specified period of time. Usually, this period of time is quarterly or per annum. However, this can also be phrased as a fixed return, say $3300 per annum for each of five years. The bottom line is that the determination of whether there is an expectation of profits does not depend on whether the investor only receives the return based upon the success of the business or whether the return varies over time. It is dependent on whether there is a profit expectation at all.
Common Enterprise
When something is considered a security, that means all the investors providing the funds are engaged in a common enterprise, and their funds are being pooled together. Pooling together funds is more straightforward than it sounds. Saying you are pooling together funds really means you are taking funds from more than one person and combining them to invest the money into one business, venture, or idea. There are hard money lenders in the private market that do pool together private funds obtained from lenders and those who do not pool these funds. We have hard money lender clients whose entire business is based around finding private lenders to loan to real estate borrowers at attractive interest rates. These private lenders are either pooled together in a fund that a hard money lender manages or are structured loans where each private lender funds a single loan. Pooling investor funds together is definitely a security and requires compliance with regulations requiring proper disclosures and registration or an exemption. However, the Howey test does not pass, if each private lender funds only one loan. This is the case because there is no pooling of investor funds. There may be mortgage and lending regulations that apply, but there are no worries concerning regulations specifically applied to securities.
Based on the Efforts of a Third Party
There are asset managers that use securities to fund their ventures. We have clients who seek out private money from investors. Then the private money is pooled together in a fund to support the purchase and remodel of multi-family complexes, to later sell the multi-family complexes off for profit. This is not only a security because of the pooled together funds, as previously explained, but also because the return is based upon a third party’s efforts. How so? Because the investor does not: These decisions are made by the asset managers, their employees, and those they contract work out to. A similar situation exists with our clients who start or purchase their own businesses and similarly pool together private money to support and operate their businesses. They pool together the private money and then use the funds to manage the investor’s investment (the business). The investors take little to no part unless they are also part of the management.
Not every private money investing amounts to a security
On the flip side, not every private money investment, pooled or not, is a security. On top of seeking out private money from outside investors, many of our clients invest their own money into their businesses or joint ventures. Additionally, the individual owners may, in fact, be pooling their money together to invest these funds. This is not a security and is not subject to the securities laws. The reason being their investment is, in fact, based on their own efforts. We have clients who purchase and start businesses who invest their own money into the project but still retain control over important aspects like who gets what fees, what the business will consist of, who they will hire, making agreements with third parties, and other various aspects of developing, purchasing and running the business, that is central to the management of their investment.
Types of Securities
Now that we already know how to determine what a security is, we can delve into securities types. The two general categories of securities are: 1. Equities 2. Debts However, some securities have elements of both equities and debts.
Equities
When you buy equity security, you are buying into the company. In other words, you get ownership interest. Legal entities (companies, trusts, and partnerships) offer equity securities in terms of shares. People with equity securities do not make regular payments. However, they gain from their investment through dividends from annual profits realized by the entity. Another perk of these securities is that you can exercise some control over the company by exercising voting rights, which you automatically get after investing.
Debt Securities
When an entity requires money, it can acquire loans (debts securitized as tradable assets) from investors, but payback with interest. A debt securities’ issued for a fixed term. Entitling an investor to regular payments. Eventually, after the expiration of the term, an investor should have recovered their principal amount and interest due. Debt securities can be secure or unsecured. There are also some special types (hybrid) of securities with both equity and debt securities characteristics. Commonly known as hybrid securities. An example is equity warrants, preference shares, and convertible bonds.
Bottom Line
Security is a term that includes a multitude of different investment vehicles and instruments. It may require taking a closer look at the transaction, the management structure, and the benefit of the investment to determine whether you’re working with a security. However, making the wrong determination has big consequences. How? Specific securities laws come into play, ranging from registration to disclosure requirements if an issuer is selling a security. Failure to abide by them will have consequences. You will be required to have proper documentation, which requires compliance with complex securities laws if you are working with securities. We work with clients to determine if what they want to sell is, in fact, a security. And if it is, we help with the process of setting up a plan that works best for their situation. As well as guide them through the maze of securities regulations. Call us toll-free at 844-4DODSON or schedule a free consultation regarding any securities matters.