What is a Security? The Howey Test and Reves Test
What is a security? Sometimes it’s good to go back to basics. In my blogs and Lawcasts I often refer to the registration and exemption requirements in the Securities Act of 1933. Section 5 of the Securities Act makes it unlawful to offer or sell any security unless a registration statement is in effect as to that security or there is an available exemption from registration. Similarly, I often refer to the broker-dealer registration requirements. To be a “broker” or “dealer,” a person must be engaged in the business of effecting transactions in securities.
In today’s small cap world, corporate finance transactions often take the form of a convertible note, convertible preferred stock or cashless warrants. The conversion of these instruments often relies upon Section 3(a)(9) of the Securities Act which is an exemption available for the exchange of one security for another (such as a convertible note for common stock). Likewise, Rule 144(d)(3)(i) allows the tacking of a holding period where the securities being sold were acquired solely in exchange for other securities of that company, such as a convertible note.
Although it may be clear that an option, warrant or preferred stock is a security, it is not always so clear for a debt instrument such as a promissory note. In the wake of SEC enforcement actions against brokerage firms and in-depth investigations by both the SEC and FINRA related to these transactions, brokerage firms and transfer agent have been carefully examining whether the underlying “promissory note” is indeed a security qualifying for the use of Section 3(a)(9) and Rule 144 tacking of a holding a period.
Moreover, where a transaction involves a security, the anti-fraud provisions and accompanying rights and remedies found in the state and federal securities laws will apply and accordingly all parties to these transactions need to be informed of the applicable state and federal security law requirements.
Clearly the overriding question of “what is a security” is fundamental to the analysis of security law matters. Surprisingly (or not), what would appear to be a simple definitional discussion actually involves a lengthy and complex area of the securities laws. In this series of Lawcasts I will discuss the high-level definition as to what is a security, and although many convertible promissory notes are also considered derivative instruments, I will save the specific topic of derivatives for the future.