A quick reminder of the family members participating in the conversation:
It is a sunny day in the San Francisco Bay Area where the Kingstons live. Joy the mom usually has a busy schedule but today she came home early and prepared the meal for the big family. When she saw her husband, Greg, before the meal, she could not wait to ask him a question:
Joy: Honey I am glad you are home! Guess what, I was at a client meeting early afternoon and one of my clients asked me a question that was totally out of blue. She wants to know how to define securities, you know, stocks and bonds. I told her I’d have to ask my husband for more details. What would say to her if she asked you in person?
Greg: Interesting question! (Turning to Cleo and Jason, the youngest daughter and son both in primary school): Did you learn from the school about what securities are?
Jason: Not that I can remember. But I can Google it. (Jason pulls out his Pixel 5: “Hey Google, define securities.” Google returned entries from Oxford languages in four categories: “All,” “Politics,” “Finance” and “Police.”) Dad, you want the financial definitions, right?
Greg: Yes that’s right.
Jason: Here you go. It has two entries. The first one says: “A thing deposited or pledged as a guarantee of the fulfillment of an undertaking or the repayment of a loan, to be forfeited in case of default.” The second says: “A certificate attesting credit, the ownership of stocks or bonds, or the right to ownership connected with tradable derivatives.” Wow, a lot of strange words for me!
Greg: Well the first is basically saying the same thing as collaterals. Please check on the definition of collateral, C-O-L-L-A-T-E-R-A-L.
Jason: Hey Google, define “collateral.” Here it is: “Something pledged as security for repayment of a loan, to be forfeited in the event of a default.” It sounds similar to the definition of securities but what do all these mean?
Greg: Let me ask you a question. I remember last time your buddy, Michael I believe his name is, wanted to borrow your bike for one day. Why did you ask to keep his iPhone before lending your bike to him?
Jason: Because I was concerned that he may damage my bike, and I almost said no to him. Keeping his iPhone made me feel a little bit better or safer.
Greg: That’s it. You had something similar to a collateral from Michael.
Jason: Oh, really! That’s it?
Greg: Yeah — in spirit, not exactly in monetary term because you guys never agreed that if Michael broke your bike, you’ll keep his iPhone, am I right?
Jason: No, of course not! I did that just to make me feel better and safer.
Greg: So strictly speaking the iPhone is not a collateral but the basic idea is this: Someone wants something valuable from you, and you ask something valuable in return as a kind of guarantee, or a token that make you feel better and safer. Just remember the key difference is whether you can permanently keep the iPhone — that’s what the word “forfeit” means — in case Michael smashed your bike. If you could then it is a collateral or a security, otherwise it is not.
(Turning to Joy): Sorry we haven’t got to address your question. Your client was clearly asking about the second definition that Jason was reading out. Jason, could you read that second entry again?
Jason: Sure: “A certificate attesting credit, the ownership of stocks or bonds, or the right to ownership connected with tradable derivatives.”
Greg: That basically says securities are ownerships, either currently or in the future, either complete or fractional/partial.
Jason: I didn’t see anything that says future or partial ownership.
Greg: This is the tricky part of formal definitions. They tell you something you must know, but oftentimes you must possess additional knowledge to be able to completely understand the words. The more you know, the better you understand. In this case, I know securities involve future and partial ownership because that is what financial derivatives do.
Kimberly: So dad, do you think the definition is a good one?
Greg: It’s as good as can be stated in a few words. Securities are a full pack of knowledge points, impossible to be covered in one or two sentences. You really need a Wikipedia entry to cover them all.
Joy: Would you offer a more complete view to us, like what is the major parts that are missing? I want to impress my client, you know.
Greg: In that case, the definition Jason just read is not even remotely complete. It says nothing about risk, nothing about ownership liquidity, nothing about investment contract, nothing about common enterprises, nothing about profit expectation and passive income. It misses completely the legal test of Howey defined by the Supreme Court.
Joy: Wow, a lot of misses. let’s slow down a bit and say one thing at a time, shall we?
Greg: Sorry about that. Let’s begin with risk. Like many things in the world, securities contain value but also risk. In fact, we can say that the minute you take risk out of securities, they are no longer securities. I always like to add two letters “I-n” to the front, so that we say all securities are “insecurities.”
Emily: Interesting and I have never heard that one before. Could you give us an example of something that has little or no risk and not a security?
Greg: Sure. All standard insurance products carry no risk because as long as you pay your premium, you are guaranteed for the death benefits and cash value. We don’t call insurance products securities. For people who are retired, their annuities are also risk free. Not surprisingly, they are not securities. Finally, your savings and checking accounts in the bank are protected by FDIC, they are not securities.
Cleo: What is FDIC?
Joy: It is Federal Deposit Insurance Corporation, an insurance company that protects depositors. Say someone saves $2,000 in his Bank of the West account and one day the bank declares bankruptcy, the person will get his $2,000 back from the insurance firm even though his bank is closed for good.
Emily: Oh that’s good. I was watching the movie Something the Lord Made the other day on Netflix, it shows this great guy Vivien Thomas saved his tuition money for college in a bank and lost it all because the bank was closed for bankruptcy.
Greg: Yeah, they created FDIC in 1933 exactly because the Congress saw thousands of bank failures in the 1920s and early 1930s. Did you guys know that the money for FDIC is from the premiums paid by the banks? They are not paid by our taxes. It’s really one of the greatest programs in the world! If you look at the FDIC website, you will see that ever since the birth of FDIC “on January 1, 1934, no depositor has lost a penny of insured funds as a result of a failure.” That’s how safe your money is with the bank.
Jason: How about something that is risky but not a security?
Lily: Gambling is risky, but it is not security.
Kimberly: but I heard people saying investing in stock market is just like gambling at a casino.
Joy: I’ve heard that, too. Sometimes people just want to dramatically simplify things to make them easier to understand or to remember. But how long do you stay in a casino to gamble? One hour? Two hours? Whole day? An entire long weekend? For most people, it is less than three days. But investing stock market is typically much longer than three days, sometimes one’s lifetime.
Lily: Also most people know they will end up losing money in a casino but expect making money from a stock market.
Joy: Yeah, especially when you go long term in the stock market.
Cleo: But daddy took me to a horse racing the other day and told me horse racing was gambling.
Joy: That may not be completely true. Horse racing is a legitimate sport but can be a way of gambling. Not all racetracks allow betting on horses, though.
Greg: You are right. Note the gamblers on a racetrack are just like gamblers in a casino, they play the game quick and short.
Joy: So what’s the next thing that the definition missed?
Greg: It’s called “ownership liquidity,” basically a fancy way to say that one can buy and sell his or her securities to anyone else in the market upon a short notice.
Kimberly: And why is that important?
Greg: It makes securities more attractive than your savings and checking accounts in the bank. Here is why: You can cash your securities out almost as quickly and conveniently as you can from your bank accounts, but you expect much higher returns than what you earn in interests from a bank.
Lily: But money in the bank is safer with FDIC, right? You don’t worry about losing it like sometimes you do with securities in the stock market.
Greg: True, and that’s the whole point of “no risk, no gain.” Securities have risk and bank accounts don’t, so securities bring higher gains than a bank account.
Joy: Okay, what’s next on your list of misses?
Greg: Let me see, I think it’s investment contract. This is fundamental and covers all the other issues like Howey test, expected profit, common enterprises and passive income.
Joy: Sounds like we are switching from business to law.
Greg: That’s because the US Supreme Court was involved and came out with a legal definition of securities that all come down to this thing called “Howey test.”
Joy: But when I invest our money into Google and Apple, I do not remember signing contracts with anyone.
Greg: The regulation is tight for security firms and also brokers and advisors but light for individual investors. You do not have to sign a formal contract, although the brokerage company may ask you to sign the paper to open your account. That has nothing to do with the Howey test.
Joy: So what is this almighty Howey test?
Greg: Instead of me talking all the time, how about we end here now, and everybody does his or her research online for the Howey test and we reconvene tomorrow to see what we get?
(Turning to Joy): Did you tell your client you will get back to her tomorrow?
Joy: No, I don’t get to see her tomorrow, we meet once a week.
Everyone agrees with the research idea and the conversation stops.