What Is Security?

Posted on May 14, 2012

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In law school, I took a course on securities law. It was an upper division course, so presumably I had acquired some knowledge on the subject before taking it. Alas, I had not. The first two weeks of classes we studied the question “What is the security?” Further, I realized it was really half way through the course that I had a broad general understanding of what defined security.

As I have practiced law, I realize that we use this term in a variety of places and ways, and each way is important in its own right. I thought a brief question and answer article that addressed the various contexts might be helpful to sort this material out. This may be a bit basic for some, but I think it may be helpful to have it all in one place.

Q. My college buddy told me that he just took a job in the securities industry, what kind of security is he talking about? 

A. Depending on what type of person he is (and you have to fill in the blanks here), he is either (a) working in the financial securities industry or (b) working to protect celebrities, politicians, buildings or other people from danger.

Q. Why is this important? 

A. It is important for navigating cocktail parties to distinguish between securities professionals who will try to sell you an alarm system or offer to protect your dog, versus individuals who will sell you stocks and bonds. The conversation really goes in different directions. More generally, with respect to financial securities it is important to realize that generally stocks and bonds are securities.

Q. My lawyer just told me to be aware of securities law when I was telling him about raising money for my new venture. What does that mean? 

A. Selling securities has state and federal laws and regulations consequences. Failure to follow these laws and regulations (which are complex) can create a variety of issues down the road from both a civil and criminal perspective.

Q. But these are not stocks, like GE, this is just a note in my little business? 

A. While the industry and regulation is more prevalent in the securities industry and the individuals who sell stocks and bonds of big public companies to retail investors (like the traditional stock broker), securities regulations apply to all sales of securities. Indeed, the statutory definition is very broad. Alabama Code Section 8-6-2 defines “securities” as:

(10) SECURITY. Any note, stock, treasury stock, 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, certificate of interest or participation in an oil, gas, or mining title or lease or in payments out of production under such a title or lease, annuity contract unless issued by an insurance company, bankers’ shares, trustees’ shares, investment participating bonds, investment trust debentures, units, shares, bonds and certificates in, for, respecting, or based upon any form of securities or collateral, subscriptions and contracts covering or pertaining to the sale or purchase on the installment plan of any security as herein defined, or subscription or contracts covering or pertaining to the sale or purchase of beneficial interest in title to property, profits or earnings, or any right to subscribe to any of the foregoing, or any instrument of any kind commonly known as a security.

As you can tell, this is a broad description. Generally, if you are taking money in exchange for a portion of future profits or earnings, you have created a security. Promissory notes and Gas and Oil Royalty Agreements are two instruments that are commonly believed to be (and sold to the unwary) not securities and accordingly not regulated. This belief is false; these instruments are securities.

Q. So who regulates these types of securities? 

A. At the federal level, the Securities and Exchange Commission (the “SEC”). See http://www.sec.gov. At the state level, the state’s security commission (or equivalent agency) regulates securities [1]. In Alabama, for example, the Alabama securities commission regulates securities. See http://www.asc.state.al.us.

Q. I am now a bit confused about promissory notes. When I go to the bank for a loan, my banker keeps telling me that he needs “security” and that he will need a ‘security agreement.’ Is this a separate concept? 

A. Yes, these are really separate concepts in both the law [2] and practice. When you are negotiating for a loan, a bank’s security in a lending situation is collateral. As discussed in last week’s article, a bank has to insure that a loan will be repaid. In addition to a corporation and a personal guaranty, a bank will want collateral in order to insure repayment of the loan.

Q. So what am I signing when I enter into a security agreement? 

A. A bank, which focuses, of course, on what happens when the deal goes bad, wants to be able to get paid when the business fails. When a business dissolves or goes into bankruptcy, the creditors and people who are owed money will seek to get something in return for their investment or loan. A security agreement allows a party to have a right to a particular asset. A security agreement provides a security interest in a business’s asset [3], which gives a creditor priority over other creditors in dissolution or a bankruptcy. For example, a company may give a security interest in its accounts receivables. If the business dissolves, the person with a security interest in the accounts receivables will be able to take that asset and gain whatever value is possible from the security interest. In order to have additional legal rights, a creditor will seek to ‘perfect’ their security interest by complying with the law. If a security interest is ‘perfected’, then that creditor will have first priority to that asset.[4]

Mike Goodrich
Goodrich Firm, LLC

[1] There is a tricky relationship between state and federal securities regulation, which is beyond the scope of this article. However, it is important to realize that if you are looking at doing a sale of securities you must comply with both federal and state law (and all states where you are selling securities).

[2] Because you are dealing with money and money made from the earnings, a connection between securities as stock and securities in lending exist, however, the law governs these transactions in two completely separate manners. For the layperson, I would use the analogy that they are related in the way that two words may be related because they share a common Latin ancestor from which they are derived.

Both the federal and state securities regulations exempt transactions from financial institutions which are regulated by different agencies. Accordingly, when they lend money (through notes, credit lines, etc.), banks do not have to be concerned about securities regulations; they have a whole different regulatory regime.

A potential cross over is Article 8 of the UCC, which governs among other things, secured interest. Article 8 of the UCC is connected to investment securities. However, this section is focused on the certificated of stock shares. It is rarely an issue in small business, and indeed, if it becomes an issue, you need to talk with an attorney who understands this article.

[3] A person may be required to pledge an asset, which means that they must grant a security interest in an asset which is not owned by the business.

[4] And to bring it full circle, at this point, a creditor will need to hire a security firm (in the bodyguard sense of the word) in order to get possession of the asset.

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