If you’ve studied for the SIE, Series 6, Series 7, or another FINRA or NASAA exam, you’ve likely seen the definition of a security before. In plain terms, securities are investments that are initially sold to the public by issuers.
Issuers are persons (usually companies, organizations, or governments) that raise capital (money) by selling securities. Investors purchase those securities, which provides funding for the issuer’s activities.
Issuers can be anything from a small start-up to a government. They raise capital when they identify a need, such as:
Real-world examples of issuers include:
Issuers raise capital by selling securities to the public. The Uniform Securities Act (USA) explicitly identifies the following as securities:
You’ll probably recognize some of the items on this list and not others. For exam purposes, questions are more likely to ask whether something is a security than to test detailed characteristics of the less common items.
*A future section in this material covers the basics of these securities. You can most likely skip this section if you’ve just passed the SIE, Series 6, or Series 7, since the security characteristics you’re most likely to be tested on were covered thoroughly on those exams.
Thanks to a 1946 Supreme Court decision - SEC v. W. J. Howey Co - we can use a specific set of criteria to decide whether something meets the definition of a security.
In that case, W. J. Howey Co. (a Florida citrus business) sold parcels of orange grove land and offered purchasers a leaseback arrangement through an affiliated company. This structure allowed Howey to raise money from selling the land while still having the groves managed and harvested.
The details aren’t important for test purposes. What matters is the outcome: the Court ruled that the leaseback program was a security, meaning it was subject to Securities and Exchange Commission (SEC)* and state (blue sky) regulation.
*The SEC is an agency of the US Government that enforces several federal securities laws, including the Securities Act of 1933 and the Securities Exchange Act of 1934. You don’t need deep SEC knowledge for this exam, but it may be referenced as a federal securities regulator.
In the Supreme Court’s majority decision written by Justice Murphy, a four-prong requirement known as the Howey test was created to determine whether an item or product meets the definition of a security:
A security exists when all four elements are present. “Investment of money” is straightforward, so let’s clarify the other three:
Let’s apply the Howey test to a well-known security: Amazon.com Inc. common stock (ticker: AMZN).
Amazon common stock meets all four prongs, so it’s a security. For test purposes, you’ll want to understand the legal definition and characteristics of a security, along with the typical security types available in the market.
What are some common examples of non-securities? The following could be cited on the exam as not meeting the Howey test, and therefore not considered securities:
*There are two commonly cited variable insurance products - variable annuities and variable life insurance. If the word “variable” is not in the name, then it’s not a security. Keep it simple!
**Condominiums might seem out of place, but they can meet the definition of a security if they satisfy all the requirements of the Howey test. For example, suppose you own a condominium as a time share and rent it out through a third-party management service when you’re not using it. That arrangement can involve an investment of money, a common enterprise (the timeshare structure), an expectation of profit, and third-party effort (the management company).
***A commodity is an economic good. Examples include oil, corn, soybeans, gold, rice, and wheat.
****While currencies and commodities are not considered securities, options on them are. An option is a type of derivative that allows a purchase or sale of the currency or commodity at a fixed price for a short period of time.
Some test questions focus on the difference between an issuer transaction and a non-issuer transaction. If you’ve studied for another licensing exam, you’ve probably seen this described as the difference between the primary and secondary markets.
Issuer transactions occur in the primary market. When a security is created and sold by an issuer, investors pay money in exchange for the security, and the issuer receives the proceeds. For example, AirBnB’s initial public offering (IPO) is an issuer transaction in the primary market. The company raised $3.5 billion after selling over 50 million shares to the public.
After AirBnB’s IPO, its shares began trading in the secondary market between investors. If an investor who bought shares in the IPO later sells those shares, that sale is a non-issuer transaction. The proceeds go to the selling investor, not to Airbnb.
A simple way to tell the difference is to follow the money:
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