Securities Law, Small Law Firms

What Is This 'Security' Of Which You Speak?

How can you explain to a client why the securities laws apply to their scheme to finance their venture?

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big data analytics moneyFor most of my life, I had no idea what a security was.  Normal people know the terms “stocks” and “bonds,” but outside of finance and law, “security” is something you buy a lock for.  Back in the 1500s, when Europe experienced rapid economic expansion and many of the concepts in commerce that we have today originated, “security” meant “collateral.”  Your hus would be held as security for a loan.  Eventually, the term expanded to mean anything that evidenced a debt, then it was used to refer to equity as well, and then gradually the term attained its current meaning.

Which is what exactly?

Happily for the bank accounts of securities lawyers, the regs, at least in the U.S., don’t really say.  The definition that is given in the Securities Act of 1933 is simply a list of items that should be considered a security, such as “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness,” and so on and so forth.  This is not particularly useful, unless you’re a securities attorney and have a car payment coming up.

Enter our third branch of government.  Every now and then a court does its job.

In the case of SEC v. W.J. Howey Co. (U.S. 1946), which involved citrus groves owned by Mr. Howey which he would sell to investors who would then lease the land to Howey’s service company to farm the land, the Supreme Court gave us the “Howey Test.”  The court defined “investment contract” as “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.”  “Investment contract” was already included in the 1933 Act’s long string of items identified as securities, so now this definition is generally regarded as the Howey Test for whether something is a security.

Though “common enterprise” occasionally comes into play, the last part of the definition is the important part.  The expected profits are to come solely from the efforts of a third party.  This is why when a client is putting his or her own money into a company, or is controlling the action of a venture, the securities laws are not triggered.  But when a person is purchasing something and then sitting back and relying on others for a return on that something, it’s time to apply the Howey Test.

Let’s look at a couple of examples.  Take baseball cards.  If I buy a Bryce Harper baseball card, aren’t I relying on Bryce Harper to continue putting up good numbers so that one day I can sell the card on eBay at a profit?  Well, yes, but a baseball card is not a “contract, transaction or scheme.”  Not a security.

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What if I loan twenty dollars to my neighbor’s kid to build a lemonade stand, and I make the kid promise to pay me back out of the sales of lemonade at LIBOR + 300 basis points?  Even if there’s nothing in writing, that’s a security.

This comes up a fair amount in the cryptocurrency space.  Is a cryptocurrency a security?  For a cryptocurrency as widely used as Bitcoin, it’s obviously not a security, since the item is so widely disseminated that it can’t be said to controlled by a single party.  But what about when a cryptocurrency is first starting out?  At launch, it has to be under the control of someone, and the early purchasers are clearly hoping for an appreciation in value.  In that situation, it’s a closer call.

Knowing the Howey Test is most useful when explaining to a client why the securities laws apply to their scheme to finance their venture.  In general, if you’re trying to argue to a regulator that something is not a security, you’re in a bad spot, like if you’re denying having an affair by parsing out the true definition of “sex” (or “is,” for that matter).  Normally in that situation, you need to have a backup argument that the item was exempt from registration (or that it wasn’t me).

Gary J. Ross is a partner at Ross & Shulga PLLC, which he co-founded in 2017 after running his own firm for four years and after several years in Biglaw and the federal government. Gary handles corporate and securities law matters for venture capital funds, startups, and other large and small businesses, as well as investors in each. You can reach Gary by email at Gary@RSglobal.law.

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