A security is a legal representation of ownership in a specific entity, and it serves as a financial instrument that embodies various rights and obligations. While some individuals hold the misconception that a security must be actively traded on a market to qualify as such, the legal definition of a security is more comprehensive and multifaceted. As we have seen in the “crypto as a security” argument as to whether they are financial securities, the definition bears substantial importance, are financial securities as it dictates whether federal and state securities laws are applicable.
In essence, the term “security” term security is defined broadly and extends beyond the confines of traditional stock and bond markets and there are many different types of securities. It encompasses a wide spectrum of instruments, including but not limited to stocks, bonds, derivatives, options, and investment contracts. These instruments are characterized by their role in representing ownership, debt, or participation in various investment endeavors, and they can take on diverse forms.
The regulatory scope of the term “security” is significant. If a financial instrument qualifies as a security, it becomes subject to the regulatory framework established by both federal and state securities laws as discussed below. These laws are designed to protect investors and ensure the integrity and transparency of financial markets. They impose obligations on issuers, brokers, and other market participants, demanding adherence to specific disclosure requirements and anti-fraud provisions. This regulatory oversight helps safeguard the interests of investors and maintains the overall stability of the financial system.
The broader legal definition of a security serves as a safeguard against attempts to evade regulatory scrutiny. In many cases, even innovative financial instruments and investment schemes can fall under the purview of securities laws if they fulfill the essential criteria of representing ownership, participation, or debt in an underlying entity. This expansive definition is a cornerstone of investor protection and market integrity, emphasizing the importance of adherence to established rules and regulations in the realm of finance.
The Howey Test
The leading Supreme Court case provides a full analysis of the definition and is the starting point of any analysis of whether an instrument is a security. The case is SEC v. Howey Co., 328 U.S. 293 (1946).
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)
The securities acts provide 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.”
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.
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, 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 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.
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.
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.
Need Help With a Securities Issue?
The partners at Sallah Astarita & Cox, LLC have over 100 years of combined experience in securities law and enforcement, as SEC Senior Staff Attorneys and Broker-Dealer Defense Attorneys. You can call or email them with questions at email@example.com or 212-509-6544.
Mark Astarita is a nationally recognized securities attorney, who represents investors, financial professionals and firms in securities litigation, arbitration and regulatory matters, including SEC and FINRA investigations and enforcement proceedings.
He is a partner in the national securities law firm Sallah Astarita & Cox, LLC, and the founder of The Securities Law Home Page - SECLaw.com, which was one of the first legal topic sites on the Internet. It went online in 1995 and is updated daily with news, commentary and securities law related links.