Lately when I met my friend James in the UC Berkeley soccer field, he would ask me how my security exam preparation was going. (A quick update: I have stopped taking or preparing for securities exams as I will never find a “sponsor” for getting my securities license even if I pass all the exam. The rule requires examinee to find a financial entity as a sponsor before even taking the exams.) We would both laugh at the word “security,” and would use the “quote and quote” sign around it. We both feel that word is a significant misnomer, almost like calling a jail a “freedom house.”
All Securities Involve Risk
A nice way to think of securities is to add two letters “In” to the front, turning it into Insecurities. This is an easy way to remember that security always involves risk. The minute when risk is gone, securities are no longer securities.
But securities are more than risks. For example, gambling and skydiving are risky but there is no such a thing called “gambling securities.” There must be something else in securities that gambling does not have.
Securities Have Voluntary Ownership Liquidity
How about “easy transferability,” meaning securities not only involve risk but the risk is easily transferrable, like selling your shares of Apple or Google stocks to someone else. This may not seem a big deal, but keep in mind not all risks are easy to transfer.
Gambling risk is again a good example. You can’t, sometimes won’t, sell your bet to someone else the minute when it is your turn to place the bet. Similarly, when you have a losing bet, nobody else is willing to buy the bet from you and pay for your loss.
Easy transferability leads to high liquidity, which is a good thing. But why are securities more liquid than others? I have seen nobody talking about it. In my view, it is ultimately because when some people see risk, others smell chances to gain. It is the different opinions, positions and perspectives that make the ownership of securities highly liquid.
Put differently, when somebody is ready to sell his or her securities, there will be somebody else standing ready to buy them. This creates a perpetuate market for securities, where buyers meet sellers for transactions and exchanges. It is also for this reason why the initial issuer of the security sees no need to limit the transferability of the securities.
From Liquid Ownership to Investment Contract
Unlike risk that is associated with most if not all things in life, transferability is associated with investment contracts. It is the latter that fully associated with the legal definition of securities.
Investment contracts have a formal interpretation from the authority no lower than the US Supreme Court itself.
This blog provides interesting legal and historical discussion. “Most states follow two U.S. Supreme Court cases when interpreting ‘investment contract’ under their state securities laws. The Court interpreted ‘investment contract’ under federal securities laws as ‘(1) a contract, transaction, or scheme whereby a person invests his money (2) in a common enterprise, and (3) is led to expect profits solely from the efforts of the promoter or a third party’ (‘Howey Test’). The Supreme Court later modified the third requirement, holding that in spite of the term ‘solely,’ what is necessary is only ‘a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others’ (‘Forman Test’).”
In plain English, an investment contract starts from a person investing his or her own money to an entity called “common enterprise” by the Court. This person is not necessarily doing charity (although charitable investment cannot or should not be excluded) but is driven by a reasonable expectation of financial gains from the investment. Such an expectation in turn is made reasonable by the efforts of third party entrepreneurs (or the blander term “promoter” by the Court).
To be honest, the Howey and Forman tests are not perfect. For one thing, Karl Marx would argue that the common enterprise can grow not because of the managerial efforts but because of workers or employees. To the extent that innovations and actual work are done by the latter more than the former, Marx has a point. Better yet, we don’t have to single out efforts by one group of agents. We can simply accept the fact that an entity cannot grow without joint efforts of all relevant agents.
The other point missed by the Court is the profitability of an entity depends not solely on the entity itself but its surrounding environment like the market, government regulators, geological endowments, legal system, competitors, infrastructure and logistics, historical trend, industrial landscape, even global environment nowadays.
The final point the Court missed is the ownership liquidity. This is a big miss because it is the ability for one investor to sell his or her shares of any stock s/he owns to another investor that creates the secondary stock market. I will come back to that later.
Still, the formal legal tests (putting the Howey & Forman together) are good enough as a working model for us to understand what exactly securities are. The biggest contribution is to raise the definition of securities up from more generic factors of risks and liquidity to more specific terms.
What Can We Learn from the Investment Contract?
The key criterion for securities is not risk, which is too ubiquitous to be uniquely linked with securities. Most financial transactions bear risks so do most non-financial activities (like hiking, camping and driving).
Similarly, ownership transferability alone is not sufficient. If you think of it, currencies beat securities hands down in ownership transferability or liquidity. The minute you spent money on the phone bill, the BART ticket, the gas to your car, or groceries from Trader Joe, some money will flow out of your wallet and into someone else’s hand. Yet we usually don’t call currencies securities.
This is not saying that risk and transferability do not matter. On the contrary they matter a lot. Risk for example plays a crucial role in separating securities from non-securities like whole life or term life insurance policies, fixed annuities, IRAs and retirement plans. All these financial instruments carry little risk, unlike securities.
Similarly, ownership liquidity helps set securities apart from other financial products where ownership is more or less fixed, such as, once again, the IRAs, social security, insurance policies. But let’s consider something else: employment contracts. When someone is hired by a firm, the contract is limited to that person only. You won’t hear the story that someone signed the contract with Apple or Google and then change the name on the contract to his or her sister or brother as his or her replacement.
The same goes to college enrollment. When UC Berkeley admits Lily, only Lily can come to study there, not her friend or relative. Nobody can buy the seat in the classrooms or the bed in the dorm from Lily, no matter how much money he or she is willing to spend — because the college would never grant the transfer. For this reason, employment contracts and college contracts are never securities.
Notice the similarity of a college contract with security contract. Here we have an individual (the student) who invests his or her money and time into an entity (the college), with the expectation of future gains (including financial gain) from the investment, just like in the security contract. Also, the university hires management term to run and to grow the place, just like in a security contract. What is missing is the ownership liquidity.
The Test of Passive Income
But there is something else that is missing. Let’s continue with the college and employment contracts and put them under the light of Howey & Forman tests. The thing that is in the securities contract but not in the college or employment contract is passive gains.
In order to understand this element, I will cite this blog that has an excellent reading of the Howey test as “a three-question test used to determine whether a financial instrument will be considered an ‘investment contract,’ and therefore, a security.
1. Is there an investment of money with the expectation of future profits?
2. Is there investment of money in a common enterprise?
3. Do any profits come from the efforts of a promoter or third party?
If the answer to these questions is ‘yes,’ then the asset is considered a security.”
The element I want to talk about for securities is the third question, which spells out a term of passive gains or passive income. The investors put in the money and then let the management, or the “promoters” using the terminology of the Supreme Court, do the job for them. They do not have the time nor the expertise to run the entity. They just want to see the gains in the end — or quit if no gain.
This does not fit the college nor the employment contracts. When one is hired by the firm or accepted by the college, one is expected to earn the credits or the wage by trying one’s best. Passivity has no value here and can only get one trouble and failures in career or in education.
In sum, securities must satisfy simultaneous criteria of risk, liquid ownership, individuals investing in entities with reasonable expectation of profits or gain but without active efforts of third party management.
A Test of Cryptocurrencies
All this discussion may sound informative and educational, but does it have any link with the real life we are living in?
The answer is yes. This blog by SoFi provides a good example how definition of securities matters in real life, especially on how to categorize the nascent cryptocurrency market.
Let’s define commodity first, so that we can better understand the debate on whether cryptocurrencies are commodity or securities. According to this Wikipedia page, “a commodity is an economic good, usually a resource, that has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them.” The term is further divided into hard commodities through mining like gold, silver, helium and oil, versus soft commodities through farming like wheat, rice, coffee and cotton.
Are cryptocurrencies like Bitcoin to be placed in the basket of commodities or securities? This is not a light question. We all know the government has much stricter regulation over securities than commodities, which explains why “some cryptocurrency industry executives as well as enthusiasts have pushed for the market to be categorized as a commodity market, and not a security.”
Of course, we can’t just listen to enthusiasts in our determination. What about the Howey test? The Sofi blog believes “cryptocurrencies are designed to be decentralized so, like commodities, don’t produce a return from a common enterprise. Some officials seem to agree. For instance, SEC Chairman Jay Clayton has indicated that Bitcoin is not a security.”
On the other hand, there are reasons to treat cryptocurrencies like securities, “like when they’re issued like stock in ‘initial coin offerings.’ These are capital-raising processes for blockchain or crypto-related businesses.”
But I see little dilemma in the case. Cryptocurrencies should be treated as commodity, but crypto-related business or financial products should be treated as securities. The recently issued Bitcoin ETF available to the US investors is a perfect example of crypto securities. This is the same idea as commodity futures contracts are not securities, but commodity options contracts are.
Another consideration is that regulation over cryptocurrencies can be light because the market is mostly participated by speculative investors who are sophisticated and accredited. Even SEC offers exemption to any securities on the private placement as long as they are purchased mostly by accredited and institutional investors, who do not need much governmental oversight or protection. However, with the introduction of products like Bitcoin ETF, regulators must step in to protect isolated, private and non-accredited investors.
