August 26, 2022

Understanding Securities: What They Are and What Laws Govern Them

Securities form the bedrock of the investment world. Without them, economic growth is stunted as well. However, many people are unsure about what constitutes a security and unaware of the laws governing how they are marketed and sold, as well as how deals operate. In this post, we’ll explore what securities are and answer other important questions.

What Are Securities?

Unsure if a potential investment opportunity is a security or not? There’s a classic test that would-be investors can apply to determine the truth of the matter. Simply put, securities are a combination of passive investor funds, where investors are seeking profits from the efforts of a third party.

Here’s an example. A business is raising capital for its startup needs. To do so, it must attract investors. Each of these investors shares a single commonality – they are all the same type of investor. They bring money to the table, infusing the business with capital, but are passive in all other regards.

These investors do not take an active role in growing their wealth or managing the company. Instead, company management is entrusted to others who handle relevant fiduciary duties and strive to create value for the benefit of investors, as well as to support the growth of the business.

The business investment in question would be a security. Investors come together to pool their capital but take a passive role in the growth of that capital, while their success hinges on the efforts of the business and/or management firm handling the investment.

Understanding the Laws Governing Securities

Securities today are all covered by three very important laws. These include the following:

• The Securities Act of 1933 – This Act set the rules concerning offering investments to investors and what regulations apply to issuers. An issuer is a person or company issuing an investment, otherwise known as a security.

• The Securities Exchange Act of 1934 – This Act dealt with stock exchanges and set up the platform, the requirements of trading stocks, and what needs to be provided to facilitate that.

• The Investment Company Act of 1940 – This Act set the regulations for mutual funds and other investment vehicles investing in other securities. With the Investment Company Act of 1940, the situation in the US changed to require that investment companies were either registered as public companies or were exempt from registration. Some classic exemptions to this rule include:

o Real estate and private funds with 99 or fewer investors
o Companies with a limited number (45% or less) of securities as part of their holdings

Three Types of Investments for Issuers

For an investment issuer, three different types of assets are covered. These are:

• Real estate, including first lien mortgages
• Business startups for business expansion for operation
• Other securities

That final category includes mutual funds raising money by issuing securities to buy an additional security.

Equity, Debt, and Derivatives

When we talk about equity, we’re generally speaking about stock ownership or interest in partnerships, for-profit organizations, or voting. When we speak about debt, it is generally a promissory note or a debenture, where the issuer is borrowing money from investors on fixed terms, meaning there’s a maturity date and an interest rate, as well as stipulations governing how investors will collect.

When we talk about derivatives, we’re usually speaking of an investment contract that represents some other type of asset. For instance, a stock option is a good example. A stock option is a contract for 100 shares of stock, the shares of stock are equity, and the investment contract for the right to buy or sell those 100 shares would be a derivative contract.

When we speak of issuing securities, the first issue is whether we’re going to register the investment or find an exemption from registration. The path forward will be defined in large part by where we expect our investors to come from, what kind of company it is, and how much work we’re willing to do when it comes to registering or finding an exemption.

For instance, with a classic Regulation D securities exemption, issuers aren’t required to register with the SEC, but certain filings take place with the organization, as well as with the state in which investors are located. These deals also have specific documentation and information requirements concerning what’s provided to investors.

Another example would be a deal involving Regulation D Rule 506 B, where issuers are required to provide information about management and the investment itself. This includes:

• What the company intends to do with the money
• The reason for the company to be in business
• How the business intends to spend investor funds

Depending on the funds raised, the business may even be required to submit audited financials and statements from a third-party CPA to potential investors. These are all complex requirements, which is why potential issuers or business owners must work with an experienced, qualified attorney. Competent counsel can ensure the process is simple and straightforward, and that issuers can avoid unnecessary hurdles.

Charting a Course Forward

When it comes to investments and issuers, the first thing to determine is where investors will come from. That will dictate the type of marketing required. It might be social media marketing, email marketing, or direct marketing to an established pool of interested investors. The choice of investors will also affect what type of securities registration exemptions are and what issuers must do to find investors and accept their money.

For instance, company founders are prohibited from settling out right away. Rule 144 states that if someone founds a company and is given shares at startup, they must hold onto them for at least a year. That can be reduced to six months if the issuer registers the investment with the SEC, and there are other workarounds, too. Working with a qualified attorney can help ensure that issuers have access to all the options here.

However, Rule 144 does not affect the ability of investors to sell their shares. Nor does it place any kind of time requirements on them. For those considering an investment, it’s important to remember that there is always risk present. When speaking of private investments, it’s possible to lose the entire investment. There is no guarantee of success.

Still, for issuers, selling equity investments is always superior to accepting debt or looking for bank financing. The reason is that with debt, strict terms apply if you default. You must also disclose problems to any other potential investors. With equity investments, issuers are offering a higher profit than debt.

Still, there are less stringent requirements for when issuers must make those payments. It allows them to have more flexibility in pursuing their growth path. Seeking equity investors is always superior to finding debt or bank loans because, with equity requirements, there’s more flexibility for the issuer and promoter to do what they must to ensure the business’s success.

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