A security is a form of ownership in an entity. While some believe that in order for an instrument to qualify, it must be traded on a market, the legal definition of a security is much broader. The definition is important, because if the instrument is a security, then the federal and state securities laws apply to the purchase and sale of that instrument.
The securities acts provide similar definitions of the term:
The Securities Act Definition of a Security
Section 2(a)(1) of the Securities Act of 1933 defines a security 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.”
The Exchange Act Definition of a Security
Section 3(a)(10) of the Securities Exchange Act of 1934 has the following definition:
“any note, stock, treasury stock, security future, security-based swap, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, 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 instrument commonly known as a “security”; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but 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.”
The Howey Test
The leading Supreme Court case provides a full analysis of the definition. Boiling that analysis down to a sentence, a security is “an investment of money in a common enterprise with profits to come solely from the efforts of others; and, if that test be satisfied, it is immaterial whether the enterprise is speculative or nonspeculative, or whether there is a sale of property with or without intrinsic value”. SEC v. Howey Co., 328 U.S. 293 (1946)
Equity Securities
An equity security represents ownership interest held by shareholders in an entity (a company, partnership, or trust), which includes shares of both common and preferred stock. Equity securities are what we think of when we think of “owning stock.”
Holders of equity securities are typically not entitled to regular payments—although equity securities often do pay dividends—but they are able to profit from capital gains when they sell the securities.
Debt Securities
A debt security represents borrowed money that must be repaid, with terms that state the size of the loan, interest rate, and other terms and conditions. Debt securities, which include government and corporate bonds, certificates of deposit (CDs), and collateralized securities (such as CDOs and CMOs), generally entitle their holder to the regular payment of interest and repayment of principal (regardless of the issuer’s performance), along with any other stipulated contractual rights (which do not include voting rights).
Debt securities, such as bonds, are usually issued for a fixed term at the end of which they can be redeemed by the issuer. Debt securities can be secured (backed by collateral) or unsecured. If secured, they may be contractually prioritized over other unsecured, subordinated debt in the case of bankruptcy.
Hybrid Securities
Hybrid securities, as the name suggests, combine some of the characteristics of both debt and equity securities. Examples of hybrid securities include equity warrants (options issued by the company itself that give shareholders the right to purchase stock within a certain time frame and at a specific price), convertible bonds (bonds that can be converted into shares of common stock in the issuing company), and preference shares(company stocks whose payments of interest, dividends, or other returns of capital can be prioritized over those of other stockholders).
Options
Options are a financial instrument that offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying security. Unlike futures, the holder is not required to buy or sell the asset if they decide against it. Each contract will have a specific expiration date by which the holder must exercise their option. The stated price on an option is known as the strike price. Options are typically bought and sold through online or retail brokers.
The most common option contract is the call option. A call is a contract that gives the buyer the right to buy the underlying security at a specific price on a specific date. Puts are contracts that give the buyer the right to sell the underlying security at a specific price on a specific date.
For American options, the strike price is the price at which the option is written. The price is set by the market at the time the option is written. European options can be exercised any time before the expiration date of the option, but only on the expiration date or the exercise date. Exercising the option means utilizing the right to buy or sell the underlying security.
American options can be exercised any time before the expiration date of the option, while European options can only be exercised on the expiration date or the exercise date. Exercising means utilizing the right to buy or sell the underlying security.
Derivatives
Financial instruments such as derivatives, bonds, and other securities are known as derivatives because their prices are based on the price of an underlying asset Financial contracts have been developed based on currencies, energy prices, and interest rates, in addition to traditional assets such as stocks, bonds, and commodities.
Derivatives are often used in hedging, which involves reducing the risk of adverse changes in prices, especially for large transactions. Futures contracts are an example of a derivative product based on a currency and are traded by investors and speculators to speculate on the value of a currency.
Derivatives can also be used with interest-rate products. Interest rate derivatives are most often used to hedge against interest rate risk. Interest rate risk can occur when a change in interest rates causes the value of the underlying asset’s price to change.
Derivatives are complex products, and can in some instances have a high degree of risk. Options, discussed above, are a form of a derivative. Other derivatives are Currency Futures, Future Contracts, Forward Contracts, and Swaps.
Regulation of Securities
In the United States, the U.S. Securities and Exchange Commission (SEC) regulates the public offer and sale of securities. Public offerings, sales, and trades of U.S. securities must be registered and filed with the state securities departments.
While each state has its own securities laws and regulations, there are differences in those regulations, and some states are more aggressive than others in enforcement. Their rules and regulations are known as Blue Sky Laws.
SECLaw.com maintains a list of the state securities commissioners and their websites and contact information.
Securities Exchanges
Publicly traded securities are listed on stock exchanges. Issuers make applications to the exchanges, and upon approval, their securities are “listed” and available to the investing public to buy or sell.
These exchanges, the most notable being the New York Stock Exchange, help create a liquid and regulated market. Currently, there are seven major exchanges, plus others, which registered with the SEC, including the NYSE, the NASDAQ Stock Market, the Chicago Board Options Exchange, and five regional exchanges. The SEC publishes a list of the registered securities exchanges.
Mark J. Astarita, Esq. is a securities lawyer who represents investors, financial professionals and firms in litigation, arbitration and regulatory matters across the country. He is a partner in the national securities law firm of Sallah Astarita & Cox, LLC and can be reached by email at mja@sallahlaw.com or by phone at 212-509-6544.
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