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.

Alexander J. Davie About 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.

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  1. Nice idea for a set of blog posts. Some of my ongoing work will be in this area, so I will enjoy following this series.

    I hope that you will get into how the Williamson test is used to help determine whether partnership interests and LLC interests are investment contracts. I think many practitioners have not bothered to dig in that deep, as you suggest. But it’s critically important to corporate finance practice that more folks know about these cases . . . .

  2. Simon Kogan says:

    Might a suggest another line for you to investigate. Some real estate developers looked to finance development by selling interests in real property to a group of purchasers as Tenants-in-common. These developers believe that selling deeded interests in real estate and nothing more meant they were not selling securities. I would like to see your thoughts on the issue, especially in light of Howey and Forman.

  3. Nice suggestion, Simon. Howey and its progeny, of course, teach us that any contract, transaction, or scheme that represents an investment in a common enterprise creating the expectation of profits principally derived from the efforts of others is an investment contract and, unless the context otherwise requires, a security for purposes of the 1933 Act. A tenancy in common in real estate certainly raises issues in this regard.

    It is, typically, easily identified as (or as part of) a contract, transaction, or scheme.

    Forman tells us that we must ask whether that tenancy in common is an investment interest or a consumption interest. Is there any right of the purchasers to occupy the real estate or otherwise use it for their benefit (other than as a potential source of profit)? If not, the tenancy is likely an investment interest.

    But is the tenancy an interest in a common enterprise? Given that the circuits have different tests on commonality. In jurisdictions that have adopted horizontal commonality, we would ask whether the investor funds are pooled for purposes of conducting the enterprise. If they are (examples: Howey and Edwards), then this part of the Howey test is satisfied. But some jurisdictions may apply vertical commonality in one of two forms: broad and strict. Both involve looking at the relationship between the promoter and the investors (as opposed to the relationship among the investors, on which horizontal commonality is based). Broad vertical commonality asks us to look at whether the promoter’s efforts are the principal source of the investors’ potential profits. Strict vertical commonality asks us whether the promoter’s compensation is tied to the investors’ profits. Not sure whether the tenancies in common you have in mind would raise issues here.

    Next, assuming these tests have been satisfied, we would ask whether the investors’ profits (current income or capital appreciation) are generated principally from the efforts of the others. Two questions here: is the tenancy in common part of a profit-sharing or revenue-sharing scheme, and if so, do the investors’ efforts contribute (as they would in a prototypical general partnership) to the generation of those profits/that revenue?

    Assuming all of these tests are satisfied, an investment contract exists. The context of the investment would be reviewed to determine whether that investment contract is a security for purposes of the 1933 Act. There have been real estate schemes that courts have found to be securities, and there have been a number of good law review and practice articles written on this subject. In short, you are right to be concerned. It doesn’t matter in the end what the interest is labeled (although that does have importance in how the analysis under the 1933 Act proceeds). After all, the interests at issue in Howey were represented by property deeds and management contracts . . . . Need I say more?

    I look forward to Alexander’s response . . . .

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