Quick Answer
A security is broadly defined and includes any "investment contract" that meets all four prongs of the Howey test: money invested, in a common enterprise, expecting profits, from others' efforts. A federal covered security escapes state registration (states can still require notice filings and fees on most categories, except exchange-listed securities, and always keep antifraud power), and a non-issuer transaction is one where the proceeds go to the seller, not the issuer.
Before you can understand how securities are regulated, you need to know what qualifies as a security, and several related terms that appear throughout the Uniform Securities Act (USA).
Offer and Sale (USA Definitions)
These two terms define when securities regulation kicks in.
- Offer: Every attempt or offer to dispose of, or solicitation of an offer to buy, a security for value
- Sale: Every contract of sale of, contract to sell, or disposition of a security for value
- A security given as a bonus on a purchase (e.g., "buy this security, get shares of another free") is a sale, because the purchaser gave value for the whole package
- A purported gift of assessable stock (stock subject to a future call for payment) is treated as an offer and sale, since the recipient can be called on for value later
What does NOT count as an offer or sale:
- Bona fide pledges or loans (using securities as collateral)
- Stock dividends (if nothing of value is given by the shareholder)
- Stock splits
Exam Tip: Gotchas
- Not every "gift" or "bonus" is excluded. A bonus security tied to a purchase, or a gift of assessable stock, CAN be treated as a sale under the USA. An ordinary stock dividend where the shareholder gives nothing of value is excluded.
Security (USA Definitions)
The USA uses a broad definition of "security" that includes:
- Stocks, bonds, notes, debentures
- Investment contracts
- Certificates of interest or participation
- Voting trust certificates
- Limited partnership interests
- Variable annuities
- Collateral trust certificates, preorganization certificates, and many more
The Howey Test
The Supreme Court case SEC v. W.J. Howey Co. established a four-part test to determine whether an arrangement qualifies as an investment contract (and therefore a security). All four prongs must be met:
| Prong | Requirement |
|---|---|
| 1 | An investment of money (or other consideration) |
| 2 | In a common enterprise |
| 3 | With a reasonable expectation of profits |
| 4 | Derived primarily from the efforts of others |
Key principle: The Howey Test looks at the economic reality of the transaction, not what it's called. A "membership," "token," or "interest" can still be a security if all four prongs are met.
Think of it this way: If you give someone money, pool it with other investors, expect to profit, and rely on someone else to do the work, you have bought a security, regardless of what the seller calls it.
Exam Tip: Gotchas
- The Howey Test requires ALL four prongs. If any one is missing, the arrangement is not an investment contract; but it could still be a security under a different category (e.g., a stock, note, or bond), since "investment contract" is just one of many enumerated types of securities.
What Is NOT a Security
| Item | Why Not |
|---|---|
| Fixed annuities | Insurance product, not variable/investment-linked |
| Whole, term life insurance, and ordinary/indexed universal life | Insurance products regulated by state insurance departments (variable universal life IS a security, since it has an investment component) |
| Bank CDs | Insured deposit products |
| Commodities futures | Regulated by the Commodity Futures Trading Commission (CFTC), not the SEC (security futures are the exception; they're regulated as both) |
| Collectibles (art, coins, stamps) | Direct ownership is tangible property, not an investment contract, absent a pooled arrangement that itself meets Howey |
| Real property (real estate) | Direct ownership is tangible property (but Real Estate Investment Trusts (REITs) and limited partnerships in real estate ARE securities) |
Exam Tip: Gotchas
- Variable annuities ARE securities (because their value depends on the performance of underlying investments). Fixed annuities are NOT. The word "variable" is your clue.
Federal Covered Security
A federal covered security is a security where federal law preempts state registration requirements. The National Securities Markets Improvement Act of 1996 (NSMIA) created this category.
Think of it this way: Federal covered securities have already cleared the bar at the federal level, so states cannot add their own registration requirements on top. States can still charge notice-filing fees and go after fraud, and (for certain categories) can suspend an offering that fails to make its required notice filing.
Federal covered securities include:
- Securities listed on national exchanges (NYSE, Nasdaq, AMEX/NYSE American)
- Securities issued by registered investment companies (mutual funds, ETFs)
- Securities sold to qualified purchasers
- Securities sold through a valid Regulation D private-placement exemption (both the traditional exemption, which can include up to 35 non-accredited sophisticated purchasers, and the verified-accredited-investor exemption are federal covered; not just offerings limited to accredited investors). The Regulation D small-issue exemption is different and does NOT produce a federal covered security
- Bank and government securities, with one exception: a municipal security is NOT federal covered in the state where its issuer is located
What states CAN and CANNOT do with federal covered securities:
- Require state registration: No
- Require notice filings and fees: Yes, except exchange-listed securities (which owe no filing or fee at all)
- Enforce antifraud provisions: Yes
Exam Tip: Gotchas
- A valid Regulation D private-placement offering is a federal covered security, whether or not it includes non-accredited purchasers. States cannot require registration for these offerings, but they CAN collect notice filing fees and enforce antifraud rules. This distinction is frequently tested.
- A municipal security is federal covered everywhere EXCEPT the state where its issuer is located. A bond issued by the city of Columbus, Ohio is federal covered in the other 49 states. In Ohio itself, the bond simply isn't federal covered; but municipal securities are already an exempt security under the Uniform Securities Act, so Ohio doesn't require registration either way; it just isn't limited from doing so by federal preemption the way it would be for out-of-state investors.
- Stop order for notice-filing failure applies to non-listed federal covered securities (investment company shares and Regulation D placements are the commonly tested examples), not exchange-listed securities. If an investment company (mutual fund, UIT) fails to file the required notice or pay the fee, the Administrator may issue a stop order suspending the offering. Exchange-listed securities are different: the state may not require a notice filing or fee on them at all, so there is nothing to fail to do, and the Administrator separately has no stop order power over them at all. The state's only authority over an exchange-listed security is antifraud enforcement.
Person (USA Definitions)
- Includes individuals, corporations, partnerships, associations, trusts, and other entities
- Broadly defined to cover virtually any legal entity
Issuer (USA Definitions)
- Any person who issues or proposes to issue a security
- For certain certificates of interest/participation and unincorporated investment trusts, the issuer is the depositor or manager; for certificates of interest or participation in oil, gas, or mining titles, the Act treats there as being no issuer at all
- Understanding this term matters for distinguishing issuer from non-issuer transactions
Non-Issuer Transaction
- A transaction in which the proceeds do NOT go to the issuer
- Most everyday stock market transactions are non-issuer transactions (secondary market trades)
- Example: You buy shares of Apple on the NYSE. Apple doesn't receive the money; the seller does
Issuer vs. non-issuer transaction:
| Feature | Issuer Transaction | Non-Issuer Transaction |
|---|---|---|
| Who receives the proceeds? | The issuer (company) | The selling shareholder |
| Examples | IPO, issuer follow-on offering of newly issued shares | Regular stock market trade, existing-shareholder resale |
| Registration requirements | Generally must be registered | May qualify for exemptions more easily |
What Should You Check on Exam Day?
- Can you name what does NOT count as an offer or sale: bona fide pledges or loans, stock dividends with nothing of value given, and stock splits?
- Can you recite all four Howey Test prongs and explain that all four are required, not just some?
- Do you know that variable annuities ARE securities but fixed annuities are NOT?
- Can you list what a federal covered security includes, and the one exception (a municipal security in its issuer's home state)?
- Do you know what states CAN and CANNOT require for federal covered securities: no registration, but yes to notice filings/fees (except exchange-listed securities) and antifraud enforcement?
- Can you distinguish an issuer transaction (proceeds to the issuer) from a non-issuer transaction (proceeds to the seller)?