As a form of investment, securities continue to play a significant role in financial markets. Viewed as a financial instrument, a security is a representation of ownership situation in a corporation or stock that is traded publicly. Pertaining to the UK scenario, a security is viewed as a creditor association with a governmental corporation or entity in the form of a bond, or ownership rights represented as an option. Further afield, a security can be defined as a negotiable and fungible financial instrument which represents some form of financial value whereas an issuing company is referred to as an issuer. Based on the SEC v. W.J. Howey Co. case, a security is an investment contract in a scheme, contract or transaction that involves a party that puts money in an enterprise expecting to earn a profit, on the basis of efforts by a third party or promoter. The paper reviews securities based on a comparison between UK and US laws with particular focus on definitions, types of securities, attributes that make an investment a security and differences between the two jurisdictions.
Types of Securities
Categorization of securities is an important differentiating factor. According to Pritchard, securities fall into two broad categories: debts and equities. However, a hybrid form of securities exists. In general, debt securities are those that entitle holders a payment on the principal and interest besides other contractual rights based on the conditions of issuance. Typically, such securities are issued for a fixed duration. At the lapse of the term, they are redeemable by the issuer. Debt securities only attract the repayment of the principal plus interest without reference to the performance of the issuer. In addition, the securities can enjoy security through collateral or be unsecured. When unsecured, contractual prioritization takes precedence in comparison to other unsecured or subordinate debt in an event that the issuer is declared bankrupt. The above author proceeded to indicate that holders of the securities have no voting rights.
Equity securities capture a segment of equity interest in a corporation. Such includes a companys/ trusts or partnerships capital stock. In practice, common stock is a type of equity interest. In addition, capital stock is regarded as preferred equity. Hashemian noted that equity securities do not need payments contrary to the case of debt securities which are entitled to routine payments as interest. Further, equity securities proffer entitlement of partial ownership of a company or some control to holders, although on a pro rata basis. In addition, such holders enjoy capital gains or entity profits. Understood in other words, equity holders have voting rights that are linked to business ownership. However, in an event of bankruptcy, equity holders are entitled only to residual interest that is released after all other obligations (such as creditors dues) have been met.
Hybrid securities combine features from both equity and debt securities. Examples of these securities include preference shares, equity warrants and convertibles. Equity warrants are options that companies issue to stock holders giving them a right to buy stock within a given duration at a specified price. On the other hand, convertibles are bonds that can be changed to shares or stock in an entity. The above authors further observed that preference shares refer to entity stock whose returns on capital, dividends or interest payment is prioritized over normal shares.
Regulations of the securities demonstrate a contrasting approach within the two countries. Within the United States, the U.S. Securities and Exchange Commission (SEC) works alongside other self-regulating entities (SROs) such as the Financial Industry Regulatory Authority (FINRA) to control offers and sale of securities. In addition, public, sales, offerings and trades in securities within the United States require registration and filing with the SEC, a state securities organization. Regulatory positions are taken by Self-Regulatory Organizations by the brokerage industry. In the UK, the regulation of the securities markets emanates from the EC securities directives. The Commission supplements its role through the provision of technical regulations. The FSA securities regulations also play a major role in the governance of the securities markets. Based on the Financial Services and Markets Act 2000, the bodies rely on Listing Rules, Prospectus, Disclosure and Transparency Rules.
The regulation of financial services is generally under the purview of the FSA. Thus, FSA governs businesses in various ways including the approaches to be deployed when handling different clients. The FSA also oversees market operations to control abuse and insider trading. Directives such as the Criminal Justice Directive Act of 1993 are one of the relevant statutes regulating activities in the securities markets.
Supplementation of laws is also a common practice. According to Groz, laws on securities are supplemented by general law on offering documents misrepresentation, fiduciary duties of securities participants, remedies to losses, repossession rights or recovering equity, conflict law and other criminal offences that overlap to securities trading. Thus, fraud, theft, insider dealing and market manipulation are also covered. Within the UK, securities law is an integration of securities regulations and statutes that cover stock transactions. The general law in Wales and England also cover securities. Securities regulation is viewed as a two-fold term that encompasses general financial regulation, in addition to securities regulation. At another level, the regulation of securities encompasses a scheme of rules derived from EC securities arrangements that govern securities offers to the public.
The broad coverage of laws is also noted as a major feature. According to Stratmann and Akitoby, in the UK, securities law extends to include equity, tort and contract laws in addition to enacted statutes to cover securities transactions. In practice, such enactments cover criminal activities such as insider trading. The Criminal Justice Act of 1993 is an example of laws that have been enacted to cover criminality in securities transactions. However, the applicability of general law to the securities is similar to other jurisdictions and contextual relevancy must be established. It is noted however that attributes of the private law of liability, created by the Financial Services Markets Act of 2000 are applicable to securities activities.
Major laws that regulate the securities trade in the US draw from the New Deal that came up in the 1930s. The laws include the Securities Act (SA) of 1933, the Securities Exchange Act (SEA) 1934 and the Investment Company Act (ICA) of 1940. The SA regulates the distribution of new securities; the SEA focuses on the regulation of trading securities, exchanges and brokers while the ICA concentrates on the regulation of mutual funds. The initial laws have been amended on many occasions leading to the emergence of other popular Acts. Some of the new regulations are the Jumpstart Our Business Startups Act, SarbanesOxley Act, and the Private Securities Litigation Reform Act.
An Investment as a Security
In the UK, the term security is only applicable to anything that is admissible to the Official List, by the Financial Conduct Authority. Such include, but are not limited to the following: interests on investment, right to interest on such investments, personal pension schemes, stakeholder pension schemes, certificates of representation, warrants, public and government securities debentures and equities. The above demonstrates a slight difference to the United States which perceives a security as an exchangeable financial asset from any category.
Taking the US to understand what an investment is, reference is made to Sec. 2(a)1 under act 33 as well as section 3(a)(10) under act 34. Relying on these sections, courts in the US expand the definition of a security. In brief, investment in the form of money; a regular enterprise alongside profit expectation are the primary features of a security. Reference to the case of SEC v. W.J. Howey Co. is helpful in understanding the components of a security.
In the above case, the United States Supreme Court held that the offer of a sale of land alongside a service contract constituted an investment contract based on the Securities Act of 1933. Thus, the applicability of federal laws comes along with a wider definition of a security.
In general securities are investments or means through which enterprises employ to raise new capital. In this regard, an activity that contributes to raising capital for a business is both an investment and security. In practice, companies generate capital through funding from investors who buy securities after initial issuance. Although the method is common, the market standing of an institution in terms of demand or structure of pricing, raising capital is viewed as a good alternative to other sources such as bank loans.
One of the options of raising capital is buying securities using borrowed funds. Popularly known as buying on a margin, the method has become popular among investors. Companies prefer to deliver property rights as securities or cash either at the beginning or default in paying debt. In this regard, a loan facility which is deemed as an investment turns into a security. In other words, collateral is an investment which becomes a security at the point of inception or of default, depending on the circumstances.
Under the Federal Law, a security must fall under investment contracts. Reference to the SEC v. W.J. Howey Co. contributes to the understanding of a security. Popularly referenced as the Howey test, an investment contract is a scheme, contract or transaction involving an individual who invests money in an enterprise expecting to earn a profit based on the efforts of a third party or promoter. In the US, the law gives leeway for a broader definition such that funds loaned out towards an investment for any scheme qualifies as a security. The main focus is economic reality.
Thus, investment of money is one of the aspects to consider when evaluating an engagement whether it is a security. By investing assets or money, the investor is subject to a financial loss. However, the subject matter lies on what the investor is promised or offered. Thus, the case indicated that the Howey test to determine if an instrument/ investment is a security depends on the characteristics of the instrument on the basis of the offers commerce terms, the distribution plan, and economic incentives attached to it. Secondly, profits are significant parts of an investment that is deemed to be a security. From the Howey case, the US Supreme court held that capital appreciation linked to the initial investment is profit. An investor is entitled to earnings tied to his investment. Hence, the presence of promised returns whether variable or fixed counts as a feature of an investment as a security. In clear terms, an investment is a security if such activity promises returns or guaranteed steady income.
Reference to the case of United Housing Foundation v. Forman highlights the issue of consumption as a factor that makes an investment a security. In the above case, buyers into a cooperative housing project pursued charges against a developer for allegedly selling them unregistered securities. For a resident to rent out an apartment, he/she had to buy shares for every room at 25 dollars each. In the ruling, the court observed that stock was part of a security, although weight ought to be given to the economic realities surrounding the transaction. The court held that the involvement of a share/ stock in a state-subsidized apartment was intended for the acquisition of low cost housing rather than investing for profit. In essence, if a person pays or invests for consumption, then the securities laws do not apply. The latter part demonstrates that besides investing resources, the profit motif must be proved for an investment to qualify as a security.
Federal courts have also relied on the family resemblance test to determine if an investment is a security. In this regard, courts look at transactions motivations. In case, the agreement entails a profit expectation, then the assumption is that such an investment is a security. Hence, funds raised for investment purposes qualify as a security. Secondly, it is necessary to assess the distribution plan to understand if a common trading for investment or speculation exists. Thirdly, one needs to evaluate public expectations as pertains to investment.
In the case of Wals v. Fox Hills Development Corp., the complainants claimed that the offering of time-share units for sale based on a flexible agreement constituted a security as envisaged under the Securities Act 1993. The absence of a common enterprise in the case as anticipated by the Howey test meant that no investment contract existed. Given that part of the transactions between the parties did not constitute an investment contract, the court denied the plaintiffs motion requesting for partial summary judgment.
The case of S.E.C. v. Koscot Interplanetary Inc. pertains to Koscot Interplanetary Inc. which established a sales campaign on cosmetics. The company sold its shares internally. Based on the ruling, an investment contract existed if managerial efforts rather than those of investors were critically substantial, and the performance of the enterprise was dependent on them. The judgment indicated that the role of the investor was limited while the profit depended on the promoter. In this regard, the ole of the promoter in generating returns is central to an investment qualifying as a security.
The Mechigian v. Art Capital Corp case was originally brought up by Robert Mechigian citing conspiracy to prompt investment fraudulently in violation of securities laws among other issues such as negligence. However, the complaints were largely dismissed with prejudice. The major argument centers around the services of Gandolfo as an expert adviser to the plaintiff assuming that such provision amounted to an investment or a security. The court dismissed the position, observing that it could not be sustained under the law. In addition, the court determined that no fiduciary duty was owed the complainant by Gandolfo. To a certain extent, the presence of a fiduciary duty is necessary for an investment to be considered a security.
As a summary, an instrument or investment is a security if it meets the following expectations. First, if the offeror has the objective of raising funds for general business use or finance investments, and the investor/ buyer is primarily interested in earning a profit. In addition, if there is a plan to distribute the offer for purposes of trading, then the investment is a security. The expectation of investors such as deeming their investment as a security is likely to elicit similar assessments by courts or regulatory bodies.
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Based on the previous sections of the paper, in the UK, a security is anything admissible to the Official List such as interests on investment, right to interest on such investments, stakeholder pension schemes, personal pension schemes, certificates of representation, public and government securities, warrants, debentures as well as equities. In the case of the US, a security is an exchangeable financial asset from any category that is an investment in the form of money; in a regular enterprise involving owner/ investor expectation of profit.
Further, securities are differentiated based on classifications. For instance, certified securities capture representations in paper or physical form. Such securities can also be directly held in registration platforms that store records of stock in the form of book entries. Thus, transfer agents maintain shares of an entity without necessarily having physical certificates. The development is closely associated with modern advancement in technology which has done away with the need for physical certification. In some cases, new policies and technology have eliminated to maintain a security register and certificate lists. In the emerging system, issuers can rely on a single global certificate platform where all outstanding securities are deposited into a common depository known as the Depository Trust Company (DTC). In this framework, all traded securities take an electronic format. Despite the difference in format, no variation exists in terms of privileges or rights that accrue to holders of certificated or un-certificated securities.
The entitlement to rights also forms the basis of differentiating securities. In this regard, reference is made to bearer securities which are negotiable. Such securities are transferable from one investor to another. The exchange is done through endorsement and/ or delivery. Concerning the proprietary attribute, pre-electronic securities were often divided implying that such securities constituted separate assets that were legally distinct from others regardless of issue. Divided security assets are either fungible or non-fungible. The implication is that after lending, the borrower is free to return assets equal to the initial asset or an identical one at the maturity of the loan. In some instances, bearer securities are used in regulations and facilitating tax evasion, thus are sometimes viewed negatively among shareholders, issuers and regulatory entities. For the above reasons, bearer securities are uncommon in the United States.
The maintenance of registers also serves as a basis for differentiating securities. In this regard, reference is made to registered securities. Such securities bear the holders name. Besides, the issuer keeps a register that contains necessary details. Transferring registered securities takes place after amendments are made to the register. Often, registered debt securities are undivided, implying that an issue, in its entirety, is a single asset although each security is a portion of the whole. By its nature, an undivided security is fungible.