What is a security and why does it matter?

If something falls within the definition of a security under applicable law, it will be governed by extensive rules and regulations that can be quite complex and expensive to comply with.

The definition of a security can be quite broad!

Securities Definition under Federal Law

The Howey Test

Over the years, many schemes for raising capital have been devised in attempts to avoid application of the securities laws. These schemes have been analyzed by the courts to determine whether they are “investment contracts,” and therefore “securities” under the federal definition.

The leading case on the definition of an investment contract is the U.S. Supreme Court case, SEC v. W.J. Howey Co. Under the Howey test, an investment contract is “a contract, transaction or scheme whereby a person invests his money in a common enterprise[1] and is led to expect profits solely from the efforts of the promoter or a third party.”

The “investment of money” prong of the Howey test requires that the investor commit his or her assets to the enterprise in such a manner as to subject the investor to financial loss.

The focus of the inquiry is on what the purchasers were offered or promised. “The test [for determining whether an instrument is a security] . . . is what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.”

The U.S. Supreme Court has defined “profits” as “either capital appreciation resulting from the development of the initial investment . . . or a participation in earnings resulting from the use of investors’ funds.” The promised return may be fixed or variable and may be marketed as low-risk or “guaranteed.”

The Howey Court noted that its definition of a security “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”

The courts have rejected attempts to narrow the definition of a security. As one opinion put it, “[I]n searching for the meaning and scope of the word ‘security’ . . . form should be disregarded for substance and the emphasis should be on economic reality.”

Courts have frequently examined the promotional materials associated with an instrument in determining whether it is a security.  If the materials promise things like great returns or guaranteed income, the court will almost certainly find the instrument to be a security, and therefore subject to federal securities regulations.

When the Investor’s Primary Motivation is Consumption

In United Housing Foundation v. Forman, residents of a cooperative housing project sued the developer, for, among other things, sale of unregistered securities (shares in the cooperative). To be able to rent an apartment, a prospective resident was required to buy 18 shares of stock for each room desired at $25 per share. Residents also paid monthly rent.

The Court in Forman noted that even though the instruments in question are called stock and the word “stock” is included in the definition of a security, the economic realities of the transaction are what need to be considered in light of the purposes of the securities laws.  The court stated, “In holding that the name given to an instrument is not dispositive, we do not suggest that the name is wholly irrelevant to the decision whether it is a security. There may be occasions when the use of a traditional name such as ‘stocks’ or ‘bonds’ will lead a purchaser justifiably to assume that the federal securities laws apply.  This would clearly be the case when the underlying transaction embodies some of the significant characteristics typically associated with the named instrument.”

The court reasoned that “people who intend to acquire only a residential apartment in a state-subsidized cooperative, for their personal use, are not likely to believe that, in reality they are purchasing investment securities simply because the transaction is evidenced by something called a share of stock. . . .  [T]he inducement to purchase was solely to acquire subsidized low-cost living space; it was not to invest for profit.”

Importantly, the court concluded that “when a purchaser is motivated by a desire to use or consume the item purchased . . . the securities laws do not apply.”

The Forman case was very important for cooperatives and similar enterprises throughout the country. It clarified that the purchase of a membership in a cooperative, when the purchaser was motivated by a desire to use the goods and services of the cooperative, would not be considered a security. As we shall see, however, many states have rejected the Forman reasoning.

Notes – the Family Resemblance Test

How does a court determine whether a note is a security? Federal courts apply the “family resemblance test:”

First, we examine the transaction to assess the motivations that would prompt a reasonable seller and buyer to enter into it.  If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a ‘security.’  If the note is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash-flow difficulties, or to advance some other commercial or consumer purpose, on the other hand, the note is less sensibly described as a ‘security.’

Second, we examine the ‘plan of distribution’ of the instrument to determine whether it is an instrument in which there is ‘common trading for speculation or investment,’

Third, we examine the reasonable expectations of the investing public: The Court will consider instruments to be ‘securities’ on the basis of such public expectations, even where an economic analysis of the circumstances of the particular transaction might suggest that the instruments are not ‘securities’ as used in that transaction.

Finally, we examine whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.

To summarize,

  1. If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a “security.”
  2. If there is a plan to distribute the notes for trading and investment, the notes are likely to be considered securities.
  3. If investors reasonably expect that the notes will be treated as securities, the courts are more likely to do so.
  4. If some other regulatory scheme reduces the risk of the note, the courts are likely to find the application of the securities laws unnecessary.


The types of notes that are not “securities” include

“the note delivered in consumer financing, the note secured by a mortgage on a home, the short-term note secured by a lien on a small business or some of its assets, the note evidencing a character loan to a bank customer, short-term notes secured by an assignment of accounts receivable, or a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized).”

Securities Definition under State Law

It is necessary to comply with both state and federal securities law. So, let’s say you want to raise money in Utah. You need to determine whether the instrument you are using is a security under federal law and under Utah law. It is possible that something that is not a security under federal law will be a security under state law.

The Risk Capital Test Used By a Minority of States

In 1959, some enterprising developers bought land in Marin County to develop a country club. To pay for some of the costs of building the club, they sold charter memberships in the club. The members would not share in the profits or ownership of the club but would have the right to use club facilities.

Under the federal definition, these memberships would not be securities because the members joined the club to get the benefits of membership, not for a financial return.

But the California Supreme Court, in a landmark case called Silver Hills Country Club v. Sobieski, found that these memberships were securities.

The court formulated a new test for whether something is a security, called the “risk capital test” which considers

  • whether funds are being raised for a business venture or enterprise;
  • whether the transaction is offered indiscriminately to the public at large;
  • whether the investors are substantially powerless to effect [sic] the success of the enterprise; and
  • whether the investor’s money is substantially at risk because it is inadequately secured.

In Sobieski, the court held that the sale of membership to a country club was a security because it fell under the purview of the regulatory intent of the corporate securities act. On that point, the court held that courts have to look through form to substance to protect the public from schemes to attract “risk capital,” which it found in this case. The court found that the investors were risking their capital in expectation or receiving the benefits of club membership, which was in the control of the issuers of the membership. Notably, the court stated the “act extends even to transactions where capital is placed without expectation of any material benefits.”

The risk capital test is stated broadly as condemning a transaction that involves raising “funds for a business venture or enterprise; an indiscriminate offering to the public at large where the persons solicited are selected at random; a passive position on the part of the investor; and the conduct of the enterprise by the issuer with other people’s money.” The risk-capital test “focuses retrospectively on what the investor stands to lose rather than prospectively on what he expects to gain.”

The risk-capital test has been adopted in some form in sixteen jurisdictions (in addition to California):

  • by the Supreme Court of Hawai’i (1971)
  • by the Supreme Court of Arkansas (1987)
  • by the District Court of Guam (Appellate Division, 1981)
  • by the Court of Appeals of Ohio (10th District, 1975)
  • by the Supreme Court of Oregon (1976).
  • by statute in Alaska, Georgia, Michigan, North Dakota, Oklahoma, and Washington.
  • through regulatory rule in Illinois, New Mexico, North Carolina, Wisconsin, and Wyoming.

There is some degree of judicial uncertainty regarding how the risk capital test should be applied.[2] In particular, California Appellate Courts, following the California Supreme Court, have avoided establishing an “all-inclusive formula” to test the facts of every case. More specifically, the California Court of Appeals found that “[t]he ‘risk capital’ test is . . . not applicable in all situations,” even though the parameters of its application are left unexplained.

The only cases in which California courts find something not to be a security is those where the investments are sufficiently collateralized and/or where the investors are actively involved in the venture.

Generally courts in states that apply the risk capital test will use both the Howey test and the risk capital test to determine whether something is a security. If an instrument meets the definition under either test, the court will conclude that it is a security.

The Rest of the States

States that do not apply the risk capital test will generally apply the Howey test only.


[1] “A common enterprise is a venture ‘in which the “fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment . . . .”’  It is not necessary that the funds of investors are pooled; what must be shown is that the fortunes of the investors are linked with those of the promoters, thereby establishing the requisite element of vertical commonality. Thus, a common enterprise exists if a direct correlation has been established between success or failure of [the promoter’s] efforts and success or failure of the investment.”  Securities and Exchange Commission v. Eurobond Exchange, Ltd., 13 F.3d 1334 (9th Cir., 1994)

[2] See McLish v. Harris Farms, Inc., 507 F. Supp. 1075, 1086 (E.D. Cal. 1980): “One can read hundreds, indeed, literally thousands of pages of commentary since the announcement of the Silver Hills case . . . as well as study intently the decisions of the California Appellate Courts since Silver Hills, and still not be able to state with any degree of certainty as to whether or not it was the purpose of the California Supreme Court to supplant the expectations of profit test with the risk of loss test, or merely to supplement the expectations of profit test with another test where . . . the purposes of the securities act would not be served because of the transactional bias contained in the expectations of profits test.”