Federal and state laws govern the issuance and sale of securities by a business. If the instrument being issued or sold is not a “security”, the securities laws do not apply. A key question, then, is whether an instrument that a company is issuing or selling is a security. Both federal and state laws define a “security” and those definitions largely overlap. The definitions are lengthy and include numerous types of instruments, but in this Securities Law Primer we’ll identify some of the most common types.
A security includes those types of equity instruments which are commonly understood to be securities, such as common stock and preferred stock. A security also includes notes, bonds, and any instrument that is convertible into a security, such as an option to buy a share of common stock (i.e., a stock option), a warrant to purchase a share of preferred stock, and a promissory note that is convertible into stock.
A security encompasses any agreement to sell a security. For example, an owner of corporation sends a simple letter to a prospective employee that states, “Come work for my company and in one year I’ll sell you 20% of the company.” The prospective employee accepts. That letter is itself a security because it includes the right to buy an equity interest in the business.
Finally, federal and state laws include catch-all definitions. Under both federal and California law, an arrangement is a security if it is classified as an “investment contract”. Under California law, an arrangement is also a security if it meets a “risk capital test”. Several factors are analyzed to determine whether an arrangement satisfies the investment contract or risk capital tests, but essentially, these tests are met if a person gives money to another person for use in a venture or enterprise and any return or growth in the value of those funds are dependent primarily on the efforts of someone other than the person who gave the money.
The broad scope of what constitutes a security is intended, in the words of a seminal Supreme Court case, “to meet the countless and variable schemes devised by those who seek the use of the money of others.” (SEC v. W. J. Howey Co., 1946)
A common question is the extent to which interests in partnerships and limited liability companies constitute securities. The answer generally depends on whether the particular interest is accompanied by management responsibility of the business. Thus, a general partnership interest is typically not a security because the interest holder is usually responsible for the operations of the business (along with other general partners). On the other hand, a limited partnership interest is most always a security because limited partners do not have management responsibility in the partnership. An interest in a member-managed LLC, where all members in fact participate in the management of the business, is treated like a general partnership interest and generally is not a security. Whereas, an interest held by a non-manager in a manager-managed LLC is treated like a limited partnership interest and is usually a security.
Other posts in this series (more to come):
Securities Law Primer | Part 1: Applicability of securities laws
