Definition of "Security"
Now that you know who counts as a "person," the next question is: what counts as a "security"? This is arguably the most important definition in the entire Uniform Securities Act (USA). If something is not a security, the Act does not apply to it.
The Statutory Definition
- A security means any note; stock; treasury stock; 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; certificate of interest or participation in an oil, gas, or mining title or lease; or, in general, any interest or instrument commonly known as a "security"
- Also includes 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 definition is modeled on Section 2(1) of the Securities Act of 1933 and is intentionally broad
Key principles:
- Catch-all provision: The phrase "any interest or instrument commonly known as a security" prevents people from avoiding regulation by simply calling a security by another name
- Substance over form: Courts and regulators look at the economic reality of a transaction, not just the label attached to it
- Federal case law applies: Because the USA definition mirrors the federal Securities Act of 1933, federal court decisions (including the Howey Test) are used to interpret the state definition
Exam Tip: Gotchas
- The definition of "security" is much broader than stocks and bonds. The catch-all phrase "any interest or instrument commonly known as a security" means the label does not matter; the economic reality does.
The Howey Test
When a financial arrangement does not look like a traditional security (stock, bond, etc.), regulators apply the Howey Test to determine whether it qualifies as an investment contract, and therefore a security.
The test comes from the Supreme Court case Securities and Exchange Commission (SEC) v. W.J. Howey Co. (328 U.S. 293, 1946), where the SEC argued that interests in an orange grove operation were securities.
The Four Prongs
All four prongs must be met for something to qualify as a security:
| Prong | Requirement | Example |
|---|---|---|
| 1. Investment of money | A person invests money or something of value | Paying cash to buy a stake in a venture |
| 2. Common enterprise | The investment is pooled with others in a shared venture | Multiple investors fund the same orange grove |
| 3. Expectation of profits | The investor expects to earn a return | Anticipating a share of the profits from citrus sales |
| 4. Derived from efforts of others | Profits depend primarily on the work of a third party | A management company tends the groves and markets the fruit |
Think of it this way: Someone asks you to invest money in their orange grove. You will not pick any oranges yourself; a management company handles everything. You are just writing a check and waiting for profits. That checks all four Howey boxes: your money, pooled with other investors, expecting profits, from someone else's work. It is an investment contract, and therefore a security.
How the Howey Test Works in Practice
- The test is flexible; it allows regulators to classify unconventional investments as securities (e.g., interests in whiskey warehouses, crypto-mining schemes, timeshare investments)
- The word "solely" in the original opinion has been loosened by later courts. Profits need to come "primarily" or "substantially" from the efforts of others, not exclusively.
- The test applies whenever the instrument is not a traditional security but may still be an investment contract
When the Howey Test Fails
If any one of the four prongs is missing, the arrangement is not an investment contract:
- No investment of money: Receiving something for free does not create a security
- No common enterprise: An investor acting entirely alone, with no pooling, may not meet prong 2
- No expectation of profits: Buying something purely for personal use (a house to live in) is not a security
- No reliance on others' efforts: A person who buys and personally operates a business is not purchasing a security (the profits come from their own efforts)
Exam Tip: Gotchas
- All FOUR Howey prongs must be satisfied. If the investor actively manages the venture (prong 4 fails), it is NOT an investment contract. This is the most commonly tested prong.
- "Efforts of others" does not mean zero effort by the investor. Courts have relaxed the original "solely" language to "primarily" the efforts of others.
Notes as Securities
- A note (a written promise to pay) is presumed to be a security under the USA
- The presumption can be rebutted if the note resembles a type that is NOT typically a security:
- A personal loan between friends
- A short-term consumer note
- A note secured by a home mortgage
- A short-term note secured by an assignment of accounts receivable
- If the note has characteristics of an investment (long-term, marketed to investors, traded on a secondary market), the presumption holds
Think of it this way: If you lend your neighbor $500 and they sign a promissory note, that is just a personal loan. But if a company issues notes to hundreds of investors promising a return, those notes look and act like securities, and regulators will treat them that way.
Exam Tip: Gotchas
- Not all notes are securities. A note is presumed to be a security, but that presumption can be rebutted. Short-term consumer notes, personal loans between friends, and home mortgage notes are NOT securities.