Security (Investment)

A security is a financial instrument or arrangement that falls within the definition in the federal securities laws, and therefore within the registration, disclosure and antifraud rules those laws impose. Section 2(a)(1) of the Securities Act of 1933, at 15 U.S.C. 77b(a)(1), gives the definition by enumeration and then by two catch-alls. It provides that, "unless the context otherwise requires", the term 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", options and index products, "or, in general, any interest or instrument commonly known as a 'security'."

The word carries several unrelated meanings elsewhere and this page covers only the investment sense. It has nothing to do with Social Security, which is a federal benefits program, with a security deposit paid to a landlord, or with information security. In the investment sense the plural, "securities", is also used as a mass noun for the whole category, as in "securities regulation".

Two features of the definition explain almost everything that follows from it. The first is that it is functional rather than formal: Congress listed instruments but did not stop at instruments, adding "investment contract" and "any interest or instrument commonly known as a 'security'" so that the statute would reach arrangements nobody had thought of yet. The second is the opening qualifier, "unless the context otherwise requires", which means the definition is not mechanical even on its own terms.

The Supreme Court supplied the operative test for the catch-all in SEC v. W. J. Howey Co. in 1946. The case concerned tracts of a Florida citrus grove sold to out-of-state buyers together with a service contract under which the seller cultivated and marketed the crop and paid each buyer a share of the proceeds. The Court held that this was an investment contract, and therefore a security, even though what changed hands on paper was land. Its reasoning is the durable part: the term had been "broadly construed by state courts so as to afford the investing public a full measure of protection", and "form was disregarded for substance and emphasis was placed upon economic reality."

The Court's own formulation is worth reading twice: "an investment contract for purposes of the Securities Act means 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, 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." It restated the test more compactly at the end: "the test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others." Whether a particular arrangement satisfies it is decided on the facts of that arrangement, not on its label.

The consequences of the classification are the reason it is fought over. If an arrangement is a security, then offering or selling it requires a registration statement unless an exemption applies, and registration means audited financial statements and a prospectus. The antifraud provisions attach, which is what gives the SEC and private plaintiffs a cause of action for misstatements. The people selling it generally have to be registered as brokers or work for a firm that is. State blue-sky laws add a further layer. If it is not a security, none of that follows from the federal securities laws, though other law may of course apply.

The Securities Act's definition is not the only one. The Securities Exchange Act of 1934 has its own, at 15 U.S.C. 78c(a)(10), which tracks the 1933 Act closely but is not identical: it omits "evidence of indebtedness", it does not include the oil, gas and mineral-rights item in the same terms, and it ends with an express exclusion, providing that the term "shall not include currency or any note, draft, bill of exchange, or banker's acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited." That nine-month carve-out is why short-term commercial paper is generally discussed outside the securities framework. When a source says something "is a security", the useful follow-up question is: under which statute, and for what purpose.

In practice the analysis runs in two steps. First, is the thing on one of the enumerated lists, such as stock or a bond? If so, the question is usually over. If not, the second step is the Howey analysis: was there an investment of money, into a common enterprise, with an expectation of profits derived from the efforts of others?

A hypothetical illustration of the second step. An organizer raises money to build a vending-machine route. Twenty-five people each contribute $10,000, a total of $250,000. The organizer buys and places the machines, stocks them, services them and keeps the books; the contributors do nothing but wait, and each is promised a proportional share of the profits. The agreement is titled a "partnership interest" and the word "security" appears nowhere in it.

Run the test. Money was invested. It went into a single common enterprise whose fortunes the contributors share. The profits are expected to come from the organizer's efforts rather than the contributors'. On Howey's reasoning that is an investment contract and therefore a security, and the title on the document is exactly the kind of formality the Court said should be disregarded in favor of economic reality.

Change one fact and the answer can change. If each of the twenty-five bought and ran their own machines, kept their own revenue, and merely used the organizer as a supplier, there is no common enterprise and no reliance on another's efforts, and the analysis comes out differently. This is why the question is decided arrangement by arrangement rather than by product category.

Why the breadth of the definition matters to investors

• It means the protections travel with the economic substance of a deal rather than with its paperwork, so relabeling an offering does not escape them.
• Registration or an exemption is required before a security is offered, which is what forces disclosure of what an investor is actually buying.
• The antifraud provisions reach anything within the definition, which is the basis for most enforcement in this area.
• Securities held at a member brokerage carry a distinct failure-of-the-firm protection, covered on our page for the Securities Investor Protection Corporation.

The limits and the friction

• Breadth is bought at the cost of certainty: whether a novel arrangement is a security is often unresolved until a court or the SEC says so.
• Two federal statutes define the term differently, and state law adds a third layer, so a single answer to "is it a security" may not exist.
• Being a security says nothing about whether an investment is sound. A registered offering can lose all of its value, and registration is not approval.
• Something outside the definition is not thereby unregulated, and something inside it is not thereby safe.