What is a security?
You mean, besides being the title of the biggest pain-in-the-ass business law course in law school?
There are many definitions on the interwebs with EXTENSIVE details. If you’re learning about securities for the first time, however, these details might just send you down a frustrating semiotic rabbit hole of looking up the definitions for words in the definition you just found. Here are some definitions you’ll find online:
Oxford Dictionary: A security is “a certificate attesting credit, the ownership of stocks or bonds, or the right to ownership connected with tradable derivatives.”
Not bad…
Section 2(a)(1) of the Securities Act of 1933: A “security” means “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of or warrant or right to subscribe to or purchase, any of the foregoing.”
…right…
Falling down the rabbit hole yet? Let’s just talk about the basics first.
The Basics
A security, at its most basic non-technical level, represents ownership of a part of something else that has monetary value. For purposes of this short explanation, we will focus on the most straightforward scenario where that something else that has monetary value is a company.
An investor can own a security by purchasing a percentage of the company, which is called an equity security, or by loaning money to the company, which is called a debt security. Equity securities and debt securities can also be referred to as stocks and bonds, respectively. PAUSE: Yes! to the gunner in the front row! There are other forms of securities, such as options and hybrid equity-debt securities, but again: stay away from the rabbit hole for now.
When an investor purchases a security, they are given documents that explain what the ownership interest is. Those documents are sort of like the title to the car you own, except with a security, the investor typically owns only a portion of the company.
The Example: Equity & Debt Securities
Say Cassie has a coffee company that she wants to grow by opening up multiple new brick-and-mortar locations, but she needs more money than she currently has to do it. Specifically, she needs $1 million to open 10 more locations in the state where she is located. The company is healthy and running at a profit and she knows just where to place the new locations. She doesn’t want to save up for the expansion because it will take years and she sees excellent opportunities that will expire over time. So, Cassie decides to take on investors—that is, other people interested in purchasing a portion of the company. Investors purchase interest in a company because they believe they can increase the value of their initial investment. So, Cassie needs to attract investors by sharing information about the company that illustrates that their investment will result in increased value and profits. To attract investors, Cassie hires a family friend to audit the company’s current value. She puts together an attractive presentation with the auditor’s data that explains how she can expand the company with 1 million dollars, increasing the overall value of the company and therefore the value of an investor’s stock. She presents it to potential investors.
The Equity Security Route
Investor 1, let’s call him Jorge, loves the coffee business! He invested in another coffee company in Chicago that is doing well, so he knows the space and is interested in replicating that success. After studying Cassie’s valuation of her company, Jorge decides to make an offer. He wants 10% of the company for $200,000. This offer values Cassie’s company at $200,000 x 10, which is $2 million. Based on his own evaluation of Cassie’s data, he thinks this is fair. Cassie valued her company at $3 million, so his initial offer is a little low for her. She counters at $500,000 for 20% (valuing the company at $500,000 x 5, or $2.5 million), and investor Jorge agrees. Jorge just purchased what is commonly known as company stock, or an equity security in Cassie’s coffee company.
The Debt Security Route
Investor 2, Laurie, doesn’t like coffee; can’t even stand the smell of it. She’s not interested in helping Cassie with the day-to-day grind of the business, but she was relatively impressed by the presentation and believes that Cassie can execute her plan to expand. Laurie also notices that Cassie owns multiple roasters, trucks, and other company assets. Her advisors tell her that unlike the vehicles, roasters do not depreciate in value very fast. So, instead of purchasing a portion of the company, Laurie offers Cassie a loan. The terms of the loan are pretty simple: Laurie will lend Cassie $500,000 at 10% interest accruing monthly over a fixed term of 3 years. Laurie requests that Cassie put up some of the company assets, including the roasters, as collateral. That is, Cassie needs to pay the $500,000 back, including interest, within 3 years. If she can’t pay it all back, she agrees to liquidate (essentially, sell) certain company assets—like the roasters—to repay the remainder of the loan. Cassie is confident that she’ll be able to pay the loan on time and accepts the offer. Laurie now has a debt security in the company. Even if Cassie defaults at the end of the three-year term, Laurie isn’t too worried because she knows that she can recover a good portion of the money from the roasters alone. How great, right?! Cassie got her $1 million, Jorge gets to recreate the coffee biz success he had in Chicago, and Laurie is making money every month with her debt investment.
What could go wrong?
Securities litigation has become one of the most complex and lucrative areas of litigation for many reasons. There are often millions and millions of dollars involved and lots of people jump off the “go big or go home” diving board before checking if there’s any water in the pool.
In the corporate litigation world, you have straight forward securities litigation, mergers & acquisitions litigation, derivative litigation, etc…They all involve different types of wrongdoing; but again, this is a basics article. So, to put it simply, things often go real sideways real fast when people lie about the company and the value of the security.
For example, what if Cassie’s valuation was way off? What if her growth plan wasn’t as solid as she said it was? Let’s say Cassie misrepresented both the value of the company, and the future profits. When auditors value a company, they take everything into account, including all company assets. So in the case of Cassie’s company, assume she said her three roasters are worth $50,000 each, but they were really worth $15,000 because the barrels were permanently damaged. She also had some other original parts replaced with cheaper low-grade steel parts and didn’t tell anyone or disclose the repair records. The roasters made up a healthy portion of the company assets and they were listed as collateral for the loan from Laurie. Cassie defaults on her loan with $150,000 left to pay, so Laurie, barely phased, asks her to liquidate the roasters. Then, and only then, does Cassie inform Laurie that the fair market value of of each roaster is about $15,000 due to the damage and bad parts. OOPS.
Laurie is understandably fuming because instead of making money on her loan, she’s now losing money. Remember Jorge? He is part owner and just now learns of the actual value of the roasters. After hearing this, he has new doubts about the valuation of the company. Jorge asks that the company be audited again. The accountants inform him that the company was not worth what Cassie said it was worth when he purchased the stocks. Laurie, as a creditor of the company, sues Cassie for the balance of the loan. She also sues the firm that Cassie hired to value the company and help her with the presentation. Jorge sues Cassie on behalf of the company. He also sues the firm, arguing that Cassie’s and the firm’s misrepresentations damaged the company, and in turn, its investors…
Enter Stage Left: the Securities Act of 1933
The simplified scenario above and other similar scenarios ran rampant at the turn of the century in the US stock market. With the Roaring Twenties at full mass, companies and brokers were selling stock with extravagant promises of quick profits in record time. However, they were providing minimal disclosure of important information about the actual value of the stock. Americans were taking out loans to purchase said stock at record rates assuming the stock market would continue to increase quickly and indefinitely. (Ahem,…sound sort of similar to the housing market?) As we all know, that sure as hell didn’t happen. On Tuesday, October 29, 1929, (“Black Tuesday”), the United States Stock Market saw the greatest crash in American history, marking the beginning of the Great Depression.
As a direct result, Congress passed the Securities Act of 1933 to “provide full and fair disclosure of the character of securities sold in interstate and foreign commerce and through the mails, and to prevent frauds in sale thereof, and for other purposes.” This law was borne from the realization that companies and brokers were misrepresenting the value of their companies, causing investors to pay inflated prices for stocks and bonds. This misrepresentation was only exposed after it was too late and investors became saddled with large loans they could not repay. At its core, the Securities Act of 1933 is a disclosure law. It requires companies making a public offering of securities to register their securities with the Securities Exchange Commission and disclose accurate and complete information that investors would need to make a properly informed decision about their investment. It also “prohibit[s] deceit, misrepresentations, and other fraud in the sale of securities.” Of course, not all securities must be registered with the SEC.
So, there you have it: a basic definition of a security.
