Corporate Finance & Securities

What is a Security and Why Does it Matter to Your Business?

492px-BernardMadoff When a company sells stock to raise money, the stock is called a “security.” But “security” is not just another word for stock. The term “security” can be many different things. And unfortunately there are scammers who try to sell phony company stock and other securities to raise money and give nothing in return. Consequently, securities are one of the more heavily regulated business practices. There are all sorts of restrictions on who and how and when and where you can sell securities. If you violate these restrictions you may face financial ruin or jail or both (see: Madoff, Bernie). Because securities are so heavily regulated, it is important to know whether something you sell or purchase is a security, and therefore subject to these regulations. You may be surprised to learn that it is not always so clear whether or not something being sold fits within the legal definition of a security.

Different Definitions for State and Federal Regulation
Each of the states and the federal government has its own definition and tests for determining whether or not something is a security. While there is a lot of overlap in the definitions, there are also important differences.

The Federal Definition of a Security

Section 2(a)(1) of the Securities Act of 1933 has a definition of security that includes 30 examples of what a security is, including an “investment contract,” and then expands the definition by adding: “any interest commonly known as a security.” This definition left a lot of room for judicial interpretation. The most important and influential case defining a security is the U.S. Supreme Court case SEC v Howey.

Orange Grove BlogThe Howey Case
In the Howey case, the Howey Company owned citrus groves in Florida and sold land along with a service contract to farm the land. The service contract gave Howey-in-the-Hills Service, Inc., (a different company than the company selling the land) a 10 year lease to farm the land. The service company received a fee plus cost of labor and materials to cultivate the land as they saw fit, and the owners of the land would receive an allocation of the profits.

The Howey Court opined that an investment contract (which is a type of security under the federal definition) is “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.” This definition can be broken down into three parts, and is commonly called the Howey test:

  1. A person invests money in a common enterprise–this prong requires that the investor must be subject to financial loss
  2. Is led to expect profits–the focus here is on what was offered or promised; could be capital appreciation from development of investment or participation in earnings
  3. Solely from the efforts of promoter or third party–if you put money into a company you operate it wouldn’t be an “investment contract”

The Howey Court also added “[The definition of an investment contract] 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 Howey Court concluded that the Howey companies did offer securities, failed to comply with applicable regulation, and were properly subject to penalties imposed by the SEC.

The Definition of a Security in Washington State

In Washington, a security is defined by RCW 21.20.005(17). The definition looks a lot like the federal definition, except in the middle of the long list of things that count as securities, Washington has an extra item: “investment of money or other consideration in the risk capital of a venture with the expectation of some valuable benefit to the investor where the investor does not receive the right to exercise practical and actual control over the managerial decisions of the venture.” This means Washington has an even broader definition of a security than the federal government; the extra clause is known as “the risk capital test.”

The risk capital test balances six factors to determine whether something is a security: (1) the length of term–longer terms tending to favor finding an instrument a security; (2) collateralization–an unsecured instrument favoring a security characterization; (3) the form of the obligation; (4) the circumstances of issuance–whether to a single party or to a class of investors; (5) the relationship between the amount borrowed and the size of the borrower’s business–the larger the amount, the greater the risk; and (6) the contemplated use of funds–whether enterprise formation or ongoing business financing. The ultimate inquiry in the risk capital test is whether the plaintiff contributed “risk capital” subject to the entrepreneurial or managerial efforts of others.


Almost all published Washington cases would result in the same determination of whether or not something was a security regardless of whether the Howey or the risk capital test was applied. But if we look to other jurisdictions we can see how there may be meaningful differences.

Golf_OudenaardeConsumption Contracts
Consumption contracts are the most commonly cited contracts as having different outcomes under the Howey and risk capital tests.

In United Housing Foundation v Forman, residents of a housing project received “stock” which entitled them to live in the building. The court, applying federal law, determined that while the interest sold was called a stock, it was not a security because it was more akin to a lease–the purchaser was going to acquire a residential apartment for personal use.

The Forman case can be contrasted with Silver Hills Country Club v Sobieski, where a California court, applying the risk capital test, found that the an interest in a country club counted as a security even though the purchaser was going to consume a benefit in the form of access to the club. The Court stated that the focus of the inquiry is on what the investor has to lose rather than what the investor can gain; the purchaser of a country club membership relies on third parties to manage the club so that the purchaser can receive the benefits of the interest–therefore he or she has risked capital and purchased a security.

What Does This Mean for Your Business?

Because the definition of security is difficult to pin down, your business should be careful to do a complete analysis before taking money from anyone. The term security has a broad definition, and you and your business face substantial risk if you do not ensure that every deal complies with securities laws. This is especially true because the way the regulations are generally drafted, a disgruntled investor has an incentive to pursue (and report) the company and the officers of the company who offered a non-compliant deal if that deal doesn’t pan out as expected.

Photo: Orange Groves | State Archives of Florida | Florida Memory

If you’d like to learn more about securities, securities offerings, or different ways to raise capital for your business, please don’t hesitate to contact us today.

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Kyle Hulten

When I'm not in the office I enjoy cooking, gardening, and watching my toddler son explore his little universe.

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