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Regulated Instruments - Module 2 of 5

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Module 2-Regulated Instruments


            For some, the term “securities” conjures images of a bustling exchange, where hurried traders in colorful jackets shout out orders. Perhaps the term reminds others of brokers and financial advisers suggesting an investment in a particular company’s stocks or bonds. Without question, these scenarios involve transactions that are the subject of securities regulation. 

Securities regulation, however, covers a much more expansive realm of instruments. For example, a local grocery store that is owned in equal parts by two sisters may involve “securities” owned by each. A loan to a friend to start a business, with the promise of a return once the business becomes profitable, may also be considered a “security.” A website that allows entrepreneurs to seek investments from strangers is almost certainly running a marketplace for securities. Even the sale of a gas station from one owner to the next can be a securities transaction.[1]

In this module, we will examine which instruments are subject to securities regulation. First, we’ll look at why the definition of “security” is important to investors, issuers, brokers, investment advisers and others in the financial markets. Second, we will examine some widely-recognized securities and their common features. Third, we will explore the definition of “security” in the Securities Act of 1933. Next, we’ll explore standards adopted by the courts to determine whether an investment is, in fact, a security. Finally, we will examine a handful of investment scenarios to determine whether they are securities.


Defining “Security” 

            Investors need to know whether their investments are “securities” so that they can avail themselves of the protections under federal securities laws, most notably the antifraud provisions in the 1933 Securities Act and the 1934 Exchange Act.

            On the other side of the transaction, issuers that make investment instruments available for sale and those selling or recommending these investments, such as brokers and financial advisers, must know when securities laws apply. If the investment is a “security,” it has to be registered with the Securities and Exchange Commission, unless an exemption applies.[2] If it is not registered and an exemption does not apply, the issuer can be liable for any losses the investor suffers--even if the losses were not attributable to any misrepresentations.  Moreover, even if an exemption from registration applies, all securities are subject to the antifraud provisions of the 1933 Securities Act and 1934 Exchange Act.[3] 

There are multiple types of “traditional securities” to which the federal securities laws indisputably apply. These include stocks, options and bonds.


            Stocks are the most commonly recognized security, and the Securities Act specifically enumerates “stock” as a form of “security.” In the investment world, stock is defined as the ownership of a corporation typically divided into shares and whose interests are represented by transferable certificates of ownership.[4] Although stocks may be divided into classes with respect to voting rights and dividends, a stock always involves an element of “ownership.” Most common stocks entitle the investor to dividends, which are portions of the company’s profits that are distributed to the shareholders. 

Equity Options 

            The Securities Act includes “calls” and “puts” in the definition of “security.” Although these equity options do not convey a direct ownership interest, they give the owner a right to acquire or sell an ownership interest. 

A call is an option that confers upon the buyer the right to buy the underlying security, usually for an agreed-upon price, within an agreed-upon timeframe. The seller of the call option has the obligation to sell the underlying stock to the buyer at the specified price any time within the given timeframe. As the value of the underlying stock rises, the value of the call option rises. Conversely, as the value of the underlying stock falls, the value of the call option falls. Note that if the call expires when the stock’s value is not higher than the option price, it becomes worthless. As such, options are considered high-risk investments.

A put confers upon the buyer the right to sell the underlying security, also at an agreed-upon price within an agreed-upon timeframe. The seller of the put option has the obligation to buy the underlying stock from option holder at the specified price. As the value of the underlying stock rises, the value of the put option falls. Conversely, as the value of the underlying stock falls, the put option’s value rises.[5]

Because puts and calls, and other derivative instruments, move in tandem with the price of their underlying securities, federal securities laws protect the investors of these instruments. 


            The Securities Act classifies bonds as securities. A bond investor gives the company a sum of money, referred to as the principal. In return, the company makes periodic interest payments to the investor over the term of the bond and returns the principal at the end of the bond term. Alternatively, the company may simply pay a lump sum of principal and interest when the bond’s term expires or when the holder chooses to cash out. Bonds involve an element of ownership. The investor gives the company money and expects a rate of return. The company’s success makes it more likely that the interest and principal payments will be made. If the company goes bankrupt, for example, the bond may never be repaid and may become worthless. In this sense, the bondholder has a vested interest in the success of the company.[6] 

            Stocks, equity options and bonds share certain features. First, the investor pays a sum of money in the transaction. Second, the investor is hoping to make a profit from the investment. Third, there is a separate enterprise- the company- whose success or failure dictates the success or failure of the investment.


Additional Securities under the 1933 Act 

            An analysis of whether an instrument is a “security” must begin with the definition that Congress adopted in the Securities Act.[7] The definition, which is broad and goes far beyond “stocks” and “bonds,” includes: 

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… transferable share, investment contract, voting-trust certificate, certificate of deposit for a security…, put, call, straddle, option… or, in general, any interest or instrument commonly known as a ‘security’, or any certificate of interest or participation in.. or right to subscribe to or purchase any of the foregoing.[8]

The 1934 Act features a similar definition.[9] These definitions include generic terms like “evidence of indebtedness,” “participation in any profit-sharing agreement,” as well as a catch-all phrase, “investment contract.” These broad definitions of “securities” are attributable to several factors. 

First, the Securities Act was meant to prevent the recurrence of the fraudulent schemes of the 1920’s. Congress wanted to stay one step ahead of those who could devise other investment schemes that fall outside the ambit of traditional stocks and bonds. As the Supreme Court put it, “Congress painted with a broad brush. It recognized the virtually limitless scope of human ingenuity, especially in the creation of 'countless and variable schemes devised by those who seek to use the money of others on the promise of profits.’”[10] 

Second, as capital markets have matured, they’ve become more sophisticated. For instance, not all companies are “corporations” that issue stock. Indeed, not even all publicly traded securities are stocks. During the twentieth century, myriads of new business forms emerged. These included the limited partnership and the LLC. Membership interests in these entities are also forms of ownership. As a result, their membership interests are also forms of “securities.

Third, in the latter part of the Twentieth Century, exotic financial products designed to help companies and investors manage their risks and hedge exposure to different financial situations emerged. For that reason, instruments such as the “securities-based swap” and “index of securities” have been added to the definition of “security.”

            Finally, the definition of “security” in the Securities Act includes the phrase, “unless the context otherwise requires” which permits exclusion of some enumerated instruments if characterizing them as securities does not make sense when considering the facts. An easy example is a “note” that a customer signs promising to repay the bank for a car loan. The bank is theoretically investing in the customer and hoping to make a profit (interest) on the loan, but the bank is not obtaining an ownership interest in the customer or any “enterprise.” Thus, context would dictate that the note should not be considered a “security.” 

            That an instrument has a title traditionally used for a security does not necessarily make it a security. For example, the Supreme Court has held that a unit of “stock” in a residential housing cooperative is not a security if the primary reason residents purchase the so-called “stock” is not for investment, but rather to gain the right to live in the housing complex.[11]


Promissory Notes as Securities

Promissory notes provide excellent examples of the case-by-case approach that is necessary to determine whether the instrument is a security. Recall that “note” is the first instrument listed in the definition of securities in the Securities Act of 1933.[12] However, because the name alone is not dispositive, not all “notes” are “securities.”

The determination of whether a note is a security involves a three-step process called the “Family Resemblance Test.”[13].

The first step is to determine the term of the note. Second Circuit case law has indicated that if the term is longer than nine months, then it is presumed to be a security.[14] 

The second step is to determine whether the note is the type that the federal courts have already determined are not securities. 

These include notes:

·         delivered in consumer financing or secured by a mortgage on a home;

·         secured by a lien on a small business or some of its assets;

·         evidencing a character loan to a bank customer;

·          that are short term and secured by the assignment of accounts receivable; and

·         evidencing commercial bank loans that the borrower uses to fund current operations.[15] 

If the note does not fit into one of these categories, then it may be a security, depending on a four-factor analysis. 

First, what were the motivations of both the seller and the buyer? If the issuer of the note is motivated to raise capital for its business, and the investor is motivated to earn profits from the note, then it is likely a security. Second, how is the note being sold and what is the plan of distribution? If the note is being offered to the public at large (as opposed to a limited number of potential investors), it is likely to be deemed a security. Third, what are the reasonable expectations of the investing public? If investors reasonably expected that the federal securities laws and accompanying antifraud provisions applied to the note, it will likely be considered a security. Fourth, is there an alternative federal regulatory scheme that protects the buyers of the notes? If not, then the note is likely to be considered a security.[16] Note that you don’t need all four factors pointing toward the instrument being a “security.” Rather, the determination can be made based on one or two factors that strongly point in the security direction, even if other factors point against it. 

In Reves v. Ernst & Young, the noteholders of a farmers’ co-op filed a lawsuit against the co-op’s accounting firm, Ernst & Young, alleging that Ernst & Young knowingly created fraudulent financial statements and audit reports for the co-op.[17] The Supreme Court had to determine whether promissory notes sold by an agricultural cooperative were “securities” for purposes of assigning liability to Ernst & Young. It held that the promissory notes were securities because the notes were not within a category determined by the courts to not be a security. With respect to the analysis factors, the company sold the notes to raise money for its general business operations and investors purchased them to earn profits in the form of interest on the notes. The notes were offered to 23,000 potential investors. They were marketed as “investments” suggesting that the investing public reasonably believed the federal securities laws would apply. Finally, there was no other federal regulatory scheme that applied to the notes.[18]


Investment Contracts as Securities 

            The use of the term “investment contract” in the Securities Act definition of “security” is a catchall for novel securities that are masquerading as common commercial instruments. Although not defined in the federal securities laws, the term “investment contract” has been broadly construed to afford the investing public a full measure of protection under the securities laws. 

In Securities and Exchange Commission v. W.J. Howey Co., “the SEC filed suit against the W. J. Howey Co. and Howey-in-the-Hills Service, Inc. alleging that a program offering to sell units of a citrus grove development by way of warranty deed transfer, paired with a contract for ‘cultivating, marketing and remitting the net proceeds to the investor’ qualified as a security in the form of an investment contract under the 1933 Act.”[19] The Court determined that interests in a citrus grove evidenced by a land deed and a service contract were investment contracts. In exchange for their investments, each investor received an interest in a small tract of the citrus grove and a service contract through which the company promised to grow and harvest fruit on the tract, pool it with fruit from other tracts and pay investors returns on their investments, which was estimated to average 10% annually over 10 years. The Supreme Court held that the elements of an investment contract were there because the investors were investing money in the citrus grove’s pooled fruit and were promised profits from the sale of the fruit.[20]

For an instrument to be considered an investment contract, four elements must be satisfied:

·         there must be an investment of money or other property;

·         the investment must be in a common enterprise;

·         the investor must expect to earn profits; and

·         the profits must be expected to come primarily from the efforts of others who are operating or aiding the common enterprise.[21]

            In United Housing Foundation, Inc. v. Forman,[22] the Supreme Court determined that an interest in a high-rise residential housing cooperative in New York was not an investment contract. To obtain the right to live in the building, residents had to buy 18 shares of “stock” at $25 per share for each room in the apartment. Although the residents invested money in exchange for an interest in a housing cooperative, they were attracted “solely by the prospect of acquiring a place to live, and not by financial returns on their investments.” There is no “investment contract” where the investor is “purchasing a commodity for personal consumption or living quarters for personal use” rather than investing money “in the hope of receiving profits from the efforts of others.”[23]

            More recently, the Securities and Exchange Commission applied the investment contract test to virtual currencies offered and sold by an enterprise called “The DAO.”[24]  Thousands of investors paid The DAO with a virtual currency called “Ether” in exchange for DAO Tokens. The DAO Tokens granted the holders voting and ownership rights that would yield profits in the form of additional Ether. The DAO used the money to invest in other projects. 

When a dispute arose as to whether The DAO violated securities laws, the SEC held that DAO Tokens were, in fact, investment contracts. The buyers invested virtual currency in a common enterprise, The DAO. They expected profits to be generated from various projects proposed by The DAO. Finally, The DAO’s founders oversaw its operations and their managerial efforts were critical to the success of the common enterprise and return on the investments.

In our next module, we’ll differentiate public from non-public offerings and will learn more about government securities.


[1] Landreth Timber Co. v. Landreth, 471 U.S. 681, 685-86 (1985).

[2] David M Love & John S. Gillies, “What Constitutes a Security and Requirements Relating to the Offer and Sales of Securities and Exemptions From Registration Associated Therewith,” American Bar Association (April 2017),https://www.americanbar.org/publications/blt/2017/04/06_loev.html.

[3] Frequently Asked Questions About Exempt Offerings,” U.S. Securities and Exchange Commission, https://www.sec.gov/smallbusiness/exemptofferings/faq (last visited Sept. 22, 2018).

[4]Stock,” Meriam-Webster Dictionary, https://www.merriam-webster.com/dictionary/stock (last visited Sept. 22, 2018).

[5] Options: Calls and Puts,” Investopedia, https://www.investopedia.com/exam-guide/cfa-level-1/derivatives/options-calls-puts.asp (last visited Sept. 22, 2018).

[6] Bond,” Investopedia, https://www.investopedia.com/terms/b/bond.asp (last visited Sept. 22, 2018).

[7] Landreth Timber Co. v. Landreth, 471 U.S. 681, 685-86 (1985).

[8] 15 U.S.C. 77b(a)(1) (emphasis added).

[9] 15 U.S.C. 78c(a)(10).

[10] Reves v. Ernst & Young, 494 U.S. 56, 61-62 (1990).

[11] United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 851 (1975).

[12] 15 U.S.C. 77b(a).

[13] Reves v. Ernst & Young, 494 U.S. 56, 64 (1990).

[14] Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930, 936-37 (2d Cir. 1983).

[15] Id. at 937.

[16] Reves, 494 U.S. at 66-67.

[18] Reves v. Ernst & Young, 494 U.S. 56, 67-69 (1990).

[20] S.E.C.v. W.J. Howey Co., 328 U.S. 293, 299-300 (1946).

[21] Id. at 301.

[22] United Housing Foundation, Inc.v. Forman, 421 U.S. 837 (1975).

[23] Id. at 858.

[24] “Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO,” Securities and Exchange Commission, (July 25, 2017), https://www.sec.gov/litigation/investreport/34-81207.pdf