When does a deal involve securities regulation? Part 1: Introduction

Business owners and attorneys without a securities background will often engage in transactions that, while on first blush do not involve securities regulation, but actually are a securities transaction, and thus subject to federal and state securities laws.  For instance, real estate developers often finance projects by bringing in outside investors as limited partners.  They are likely to hire a real estate attorney to complete the deal, who will dutifully draft a limited partnership agreement for the transaction.  What neither of them often realize is that a securities transaction is occurring as part of the deal.  The sale of limited partnership interests is usually a securities transaction under federal and state law.  This means that the interests are subject to registration with the SEC and with the state of each investor’s residence[1], unless an exemption can be found. In addition, all statements made in discussions with limited partners are subject to the anti-fraud rules.

The reality is that the definition of “security” is a whole lot broader than many people realize.  In fact, it is a lot broader than what many attorneys realize, at least those without a background in securities law.  In this series of posts, I’ll explore when securities laws apply and when they don’t apply to particular transactions.

The Federal Definition of a Security

Each of the main federal statutes (the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940) has a definition of the term “security.”  For the most part, they are all very similar, with only minor differences between them.[2]  So lets start with the definition used in the Securities Act of 1933:

[U]nless the context otherwise requires… [t]he term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, 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, fractional 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.”[3]

That’s quite a lot to digest, but there are a couple of initial important points.  First, a large number of different types of transactions are securities transactions.  For instance, stock in a closely held business or a note evidencing a loan are both potentially within the definition of a “security.”  Therefore, when incorporating your business, the sale of stock to your fellow co-founders can indeed be a securities transaction.  In addition, the issuance of a promissory note, which happens in most loan transactions, can also be a securities transaction.  So there are a lot of transactions that may be subject to securities laws that you would ordinarily not think of as a securities transaction.  I’ve seen many entrepreneurs think that simply issuing notes, rather than equity, to investors gets them out of complying with securities law.  So does this mean that all loans are securities transactions?  No, it doesn’t, as I will explain below.

The second thing that should be pointed out is what the list contained in the paragraph above does NOT include.  Two examples that immediately come to mind are partnership interests and limited liability company interests.  In fairness, limited liability companies weren’t even invented at the time the Securities Act was passed, but Congress has amended the Securities Act several times since then (in Sarbanes-Oxley, Dodd-Frank, and many other instances as well) and it could have added to the definition.  So does this mean that limited liability company interests are never securities?  Again, the answer is no.

The potential overinclusiveness and underinclusiveness of the federal securities definition is ameliorated by the two phrases which I highlighted above in bold.  The phrase “unless the context otherwise requires” allows a court to, for example, treat a note that is issued clearly as part of an ordinary loan as an ordinary loan and not as a security.  Likewise, courts have interpreted the term “investment contract” very broadly, covering some limited liability company interests, partnership interests, and even the sale of citrus trees (though in this instance, what was being sold was more than just citrus trees).  Therefore, courts have wide latitude to exclude specific instances of the items listed within the “security” definition and to also include items that were not listed as well.

In future posts, I’ll explore what the legal standards are for such exclusion and inclusion in specific scenarios.


[1] And the interests are also potentially subject to registration in the states in which the interests are offered but not sold.  This is, if you send out any promotional material to any residents of a state, it is possible that the securities may need to be registered in that state.

[2] It is unclear if, but unlikely that, any of these minor differences actually makes a difference in the end result of whether a particular transaction involves securities.

[3] The bolding of certain phrases is mine, and is not in the statute.  The explanation of why I highlighted these phrases is explained later in the post.


© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Share your love
Alexander J. Davie

Alexander J. Davie

Alexander Davie is a corporate and securities attorney based in Nashville, Tennessee. Businesses of many varieties rely on his counsel and judgment throughout all stages of their growth. In particular, fund managers and investment management professionals seek the expertise Alex gained when he served as general counsel to a private investment fund. Alex also has significant experience and enjoys working with companies and entrepreneurial ventures, especially within the technology industry. As a believer in technology's ability to enrich people's lives and allowing people to connect with each other in new ways, he is passionate about helping tech startups achieve success. He is active in Nashville's startup community as a mentor at the Nashville Entrepreneur Center and participates in numerous other events geared towards making Nashville a nationally ranked location for starting a business.

Subscribe to Strictly Business

Enter your email address below and subscribe to our newsletter