Definition of Securities
Stocks, Bonds, and the Howie Test: Investment Contracts Explained
Oct 15, 2008
Securities have been in the mainstream news lately, spilling over from the financial sections of the newspaper and newscasts to become top story items. Many people are confused, however, not knowing what exactly a security is. Knowing what a security is (and is not), how profit is generated, and a product’s status as a potential security will help anyone planning to invest their money, as well as helping those who want a better understanding of any and all financial news.
The Howey Test
The Howey test is a three step process used to determine if a product or offering is an investment contract, or in other words, a security. The test stems from a 1946 Supreme court case involving the Securities and Exchange Commission versus W. J. Howey Company. The court found that an investment contract is an investment of money or other tangible consideration in a common enterprise with reasonable expectations of profit derived solely from the efforts of others, i.e. investing money into a business where a profit is gained without effort on the investor’s part is a security.
Types of Securities
While numerous types of securities exist, the most common forms of securities are either shares of ownership of a company, usually referred to as a stock, or debt issued by the company, referred to as a bond. Each type of security can potentially earn a return for the investor.
Stocks and Bonds
Stocks generally create return on the original amount invested in one of two ways. The investor can sell the shares of the company if the company’s value per share has increased, or the company can pay dividends, which are earnings the company has made distributed to its shareholders.
Bonds usually generate return by their interest rate, which is paid at certain specified intervals to the bondholder. While the potential gains are generally not the same as stocks, bonds have the advantage of being a debt instrument; if the issuing company is declared bankrupt, all debt, including debt instruments such as bonds, have much higher priority in being paid from the company’s liquidation than any instrument reflecting ownership, such as stocks.
Products Mistaken for Securities
An investment of money where a tangible product is given is not considered a security; giving cash for an expensive new car, for example, is simply an exchange of money for services, and is not an investment contract. Additionally, any investment that does not meet the criteria of the Howey test is not a security; an example of this instance would be two investors combining their money into the ownership of a small business which they plan to operate. This does not pass the Howey test, as the investors are using their own efforts to generate return on their original investment.
A basic understanding of what a security is (and examples of what a security is not) is essential knowledge for comprehending the recent major changes in the financial markets. The Howey test is a basic definition of what constitutes a security, and securities are most commonly classified as either stock (shares in the ownership of a company) or bonds (debt issued by the company), while a return can be gained by dividends or interest paid out by the issuing company.
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