Definition of Security
Determining whether an instrument qualifies as a "security" is crucial because the USA's registration and anti-fraud provisions only apply to securities. The definition is intentionally broad to protect investors from a wide range of investment schemes.
What Is a Security?
Under the USA, "security" includes a wide range of investment instruments:
Securities INCLUDED Under the USA
| Category | Examples |
|---|---|
| Equity Securities | Common stock, preferred stock, warrants, rights |
| Debt Securities | Bonds, debentures, notes, commercial paper |
| Investment Contracts | Any contract where money is invested with expectation of profits from others' efforts |
| Certificates | Certificates of interest, participation, or deposit |
| Options & Derivatives | Puts, calls, options, futures on securities |
| Investment Company Shares | Mutual fund shares, ETF shares |
| Variable Insurance Products | Variable annuities, variable life insurance |
| Limited Partnership Interests | LP interests (typically passive investments) |
| Viatical Settlements | Agreements to purchase life insurance policies |
| Oil & Gas Interests | Fractional undivided interests in oil/gas programs |
The Howey Test
The Howey Test comes from the landmark 1946 Supreme Court case SEC v. W.J. Howey Co. and determines whether an arrangement qualifies as an "investment contract" (and therefore a security).
Four Elements of the Howey Test
An investment contract exists when there is:
| Element | Description |
|---|---|
| 1. Investment of Money | Capital is committed |
| 2. Common Enterprise | Pooling of funds with other investors |
| 3. Expectation of Profits | Investor expects financial returns |
| 4. From Efforts of Others | Profits depend primarily on a promoter or third party |
Exam Tip: If ALL four Howey elements are present, the arrangement is an investment contract and therefore a security—regardless of what it's called.
Howey Test Examples
| Scenario | Security? | Reasoning |
|---|---|---|
| Orange grove with management contract | Yes | Investors relied on promoter's farming efforts |
| Franchise where owner operates daily | No | Profits from owner's own efforts |
| Cryptocurrency with promises of developer profits | Potentially | Depends on centralization of efforts |
Securities EXCLUDED from the USA
The following are NOT securities under the USA:
| Exclusion | Reason |
|---|---|
| Fixed insurance products | Insurance contracts with guaranteed fixed payments |
| Fixed annuities | Annuities with guaranteed returns |
| Endowment policies | Life insurance with guaranteed maturity value |
| Whole life insurance | Fixed death benefit, not investment-dependent |
| Collectibles & commodities | Art, antiques, precious metals (physical) |
| Currency | Foreign currency itself (though currency options ARE securities) |
| Bank deposits | CDs, savings accounts (FDIC insured) |
| Precious metals | Gold, silver bullion |
Variable vs. Fixed Products
| Product Type | Security? | Why? |
|---|---|---|
| Variable Annuity | Yes | Investment risk on contract holder |
| Fixed Annuity | No | Insurance company guarantees return |
| Variable Life Insurance | Yes | Cash value depends on investments |
| Whole Life Insurance | No | Fixed cash value and death benefit |
Key Point: If the contract holder bears investment risk, it's likely a security. If the insurance company bears the risk, it's likely NOT a security.
Special Cases
Currency and Precious Metals
| Instrument | Security? |
|---|---|
| Foreign currency | No |
| Options on foreign currency | Yes |
| Gold bullion | No |
| Gold mining company stock | Yes |
| Futures contracts on gold | Yes |
Viatical Settlements
A viatical settlement is an agreement to purchase or sell a life insurance policy from someone who is terminally ill. Under the USA, viaticals ARE securities because they involve:
- Investment of money
- Expectation of profit (death benefit)
- Profits from circumstances beyond investor's control
Federal Covered Securities
Federal covered securities are securities that are exempt from state registration because they are covered by federal law. These include:
| Federal Covered Security | Regulation |
|---|---|
| NYSE, AMEX, NASDAQ listed securities | National exchange listing |
| Securities issued by investment companies | Registered under Investment Company Act |
| Securities sold to qualified purchasers | SEC Rule 506 offerings |
| Securities exempt under SEC rules | Federal exemptions |
Important: States cannot require registration of federal covered securities, but they CAN still enforce anti-fraud provisions.
Key Takeaways
- The security definition is intentionally broad to protect investors
- The Howey Test determines if something is an "investment contract"
- Variable products are securities; fixed insurance products are not
- Currency itself is not a security, but currency options are
- Viaticals are securities under the USA
- Federal covered securities are exempt from state registration but not anti-fraud rules
Which of the following is considered a security under the Uniform Securities Act?
Under the Howey Test, an investment contract exists when there is:
Which of the following statements about federal covered securities is TRUE?
Under the USA, which of the following is considered a security?
1.4 Offer and Sale
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