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, 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" 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. 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
That's quite a lot to digest, but there are a couple of
initial important points. First, a large number of different types to
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.
 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
 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.
 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.
Read more articles by Alexander Davie at Strictly Business, a
business law blog for entrepreneurs, emerging companies, and the investment
For more information about LexisNexis
products and solutions connect with us through our corporate site.
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.