Slaying the Securities Regulation Dragon Part 1: What is a Security?

Entrepreneurs sometimes overlook the fact that any attempt to raise capital for their ventures is most likely governed by federal and state securities laws. Complying with these laws generally entails registration, a time-consuming and expensive proposition for companies that almost always have little of either. This series will be a very brief overview of federal securities regulation exemptions (be mindful, of course, that each state has its own set of securities laws that usually have to be complied with in addition to compliance with federal securities laws); however, here in Part 1 I’ll simply start off with discussing the definition of a security.

Although many may believe that securities laws are only the worry of publicly-traded companies, the fact is that they apply to EVERY business that offers them. Every start-up, when it raises capital, may be issuing securities. The default position of the securities laws is that every security is subject to the registration requirements; it is then up to the issuer to determine and prove whether they they fit under an exemption from the registration requirements, of which SEC rules provide several. Practically speaking, many securities issued by most startups are exempt from the laws. But it is important for entrepreneurs to understand what a security is, so when their startup gets involved with them they know to ensure that their offerings comply with the exemptions in the law (or bite the bullet and register the securities).

The statutory definition of a security is found in Section 2(a)(1) of the Securities Act of 1933, which defines a security as:

“‚Ķany note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, reorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fraction undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or 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.”

In what has to be a contender for the longest sentence ever written, it is clear that Congress intended to cast a broad net to cover a wide swath of investments to be considered “securities”. Indeed, in cases interpreting the statute, the Supreme Court has rejected literal interpretations of the categories of investments and taken a flexible approach to defining securities that looks at the “economic reality” of the investment. Emblematic of this is the Court’s test for the largely catch-all security, the “investment contract”, first described in the opinion in SEC v. W.J. Howey Co.. In Howey, the Court defined an investment contract as “an investment of money in a common enterprise with profits to come solely from the efforts of others.”

As the Howey test demonstrates, the government has a broad definition of a security. Entrepreneurs should cognizant of when their businesses are offering securities and ensure they are in compliance with state and federal laws. Not only does it avoid raising red flags and creating headaches down the road when, ideally, the business takes off and seeks significant private or public capital and must register with the SEC, but it also avoids problems with disgruntled investors who may seek to rescind their investment and retrieve their money. While it’s true that most startups do raise capital without a hitch, you can ensure that your business does so by having a basic understanding of the laws that govern securities.