Chapter 2: Regulations of Securities and Issuers - B. Securities

Question 1

Securities

Answer 1

If an offering is defined as being a security, before it can be sold, it must be registered in the state in which it is to be offered to the public. A broad definition of a security is an investment in an enterprise for profit, with a third party performing the management.

This definition was from a Supreme Court decision called the Howey Test. The Howey Test comes from a 1946 Supreme Court case (SEC v. Howey). It is the legal test for determining whether an investment is a security subject to the Securities Act of 1933 and the Securities Exchange Act of 1934.

In general, a “security” means an interest, certificate, participation in, receipt for, guarantee of, or warrant or right to subscribe to or purchase any of the following:

• Note;
• Stock;
• Treasury stock;
• Bond;
• Debenture;
• Evidence of indebtedness;
• Commodity options;
• Certificate of interest or participation in a profit-sharing agreement;
• Collateralized Mortgage Obligations (CMOs);
• Collateral trust certificate;
• Preorganization certificate or subscription;
• Transferable share;
• Investment contract;
• Variable contract;
• Whisky warehouse receipt;
• Voting trust certificate;
• Certificate of deposit for a security;
• Fractional undivided interest in oil, gas, or other mineral rights; or
• Put, call, straddle, option, or privilege
  - On a security, certificate of deposit, or group or index of securities, including an interest therein or based on the value thereof;
  - Entered into on a national securities exchange relating to foreign currency.

Question 2

The term security does not include:

Answer 2

• An insurance or endowment policy or annuity contract under which an insurance company promises to pay a fixed sum of money;
• Commodities or futures contract (note that commodity options contracts are securities; commodities futures contracts are not);
• Interest in contributory and noncontributory retirement plans such as pension plans, individual retirement accounts (IRAs), and Keogh plans. Even though the underlying investments within these plans are usually defined as securities, the plans themselves are not securities.

Question 3

Corporate securities

Answer 3

• Common stock, preferred stock, transferable shares, rights, warrants, and treasury stock;
• Notes, bonds, debentures, or other evidence of indebtedness;
• Certificates of deposit for a security, such as American Depositary Receipts (ADRs), which are foreign securities on deposit in a foreign branch of a U.S. bank;
• Real estate investment trust certificates (REITs), in which real property and mortgages are the main investments;
• Equipment trust certificates, in which equipment owned by the issuing corporation is used as collateral to back the certificate;
• Collateral trust certificates, in which marketable securities are used as collateral to back the certificate;
• Voting trust certificates, which are special corporate issues used in proxy positions to attempt to remove existing management; and
• Collateralized Mortgage Obligations (CMO), in which the collateral backing the obligations is a pool of conventional mortgages.

Question 4

Government securities

Answer 4

The following security types are issued either by the U.S. government or by the government of another country:

• Obligations of the U.S. government, such as Treasury bonds;
• Obligations of foreign governments, such as bonds issued by Canada (as well as political subdivisions of Canada) or Mexico;
• Obligations of state and local governments and political subdivisions, such as townships; and
• Government agency obligations, which include Government National Mortgage Association (Ginnie Mae).

Question 5

Options

Answer 5

An option is considered a derivative because it derives its value from the underlying security. Options include call and put options (enabling the investor to buy or sell the underline security), which are option contracts on stocks, debt instruments, market indexes, and foreign currencies.

Question 6

Investment company securities

Answer 6

An investment company is an issuer in the business of investing, reinvesting, owning, holding or trading in securities. Investment companies fall into the following classifications: management companies (open-end and closed-end), unit investment trusts, and face-amount certificate companies:

• Open-end investment company shares are most commonly referred to as mutual funds. The sponsor redeems these shares.
• Closed-end investment company shares are commonly referred to as publicly traded shares. These shares are negotiated on the open market and are not redeemable.
• Unit Investment Trusts (UITs) are investment contracts that have fixed portfolios or contractual plan companies, which are used to purchase other investment company shares.
• Face amount certificates are investment contracts in which the issuer pays an investor a stated face amount at a specified future date.

Question 7

Tax-sheltered securities

Answer 7

• Limited partnership agreements;
• Certificates of interest in mining, oil, or gas drilling programs;
• Real estate cooperatives and condominiums; and
• Farmland, planting, and breeding programs, when a third party manages the enterprise.

Question 8

Guaranteed securities

Answer 8

A guaranteed security is one in which the payment of principal, interest, and/or dividends is assured (guaranteed) by the party backing the security. Government securities are guaranteed by the U.S. government. Other securities are guaranteed by an insurance company or by a parent corporation of the issuer.

Question 9

Miscellaneous securities

Answer 9

• Merchandising marketing schemes and multilevel distributorship programs are also known as network marketing arrangements. These have been defined as securities in order to protect investors from past abuses in the selling of these interests.
• Whiskey warehouse receipts, or simply warehouse receipts — when the barrels of whiskey age, they become more valuable. There are receipts that are traded during the time the whiskey is aging. It is these receipts that are considered securities.
• Commodity options contracts — note that in order for the commodity option contract to be considered security, the word option must be included because the option is what actually creates a security. A commodity in and of itself is not a security.