W.J. Howey owned a large citrus operation in Lake County, Florida, in the 1940s. Visitors to his hotel were offered a deal: buy a small plot of orange trees in his grove, and his company, Howey-in-the-Hills Service, Inc., would manage the grove, pick the fruit, sell it, and send you a share of the profits. Most buyers had never touched an orange tree in their lives. The SEC argued the whole thing was a securities offering that should have been registered. The Supreme Court agreed.
SEC v. W.J. Howey Co., 328 U.S. 293 (1946), gave American law the four-part test that still determines, eighty years later, whether something is a security. The test has since been applied to whiskey casks, chinchilla farms, fractional condominium interests, payphone leaseback arrangements, and (more recently) token offerings. If all four prongs are met, it is a security. If any one prong is missing, it is not.
Section 1: What Is a Security [USA §401(l)]
The USA defines "security" with a long inclusive list. You do not need to memorize every item. You do need to recognize them on sight.
The Inclusive List
Under §401(l), a security includes notes, stocks, treasury stock, bonds, debentures, evidence of indebtedness, certificates of interest or participation in profit-sharing, collateral-trust certificates, preorganization certificates, transferable shares, investment contracts, voting-trust certificates, certificates of deposit for securities, certificates of interest in oil, gas, or mining titles, and warrants or rights to subscribe to any of the foregoing.
What the List Excludes
"Security does not include any insurance or endowment policy or annuity contract under which an insurance company promises to pay a fixed sum of money either in a lump sum or periodically for life or some other specified period."
Translation: a traditional fixed annuity is not a security. A variable annuity is a security because the payments are not fixed. That distinction gets tested.
Sale and Offer [§401(j)]
A sale is any contract of sale, contract to sell, or disposition of a security for value. An offer is any attempt or solicitation to dispose of a security for value. Two tested wrinkles:
- Gift of assessable stock [§401(j)(4)] is considered an offer AND a sale, because assessable stock carries a future obligation to pay. A gift of non-assessable stock is neither.
- Bonus security with a purchase [§401(j)(5)] includes an offer of the underlying security. If you sell stock and throw in a warrant, you have offered BOTH the stock and the security the warrant gives rights to.
Section 2: The Howey Test
SEC v. W.J. Howey Co., 328 U.S. 293 (1946), gave American securities law the test for "investment contract." W.J. Howey sold vacationers plots in his Florida orange groves alongside a service contract under which his company would manage the grove, harvest the fruit, and remit the profits. The Supreme Court held that the combination was a securities offering. The four-part test the Court invented that day has since been applied to whiskey casks, chinchilla farms, fractional condominium interests, and more recently, cryptocurrency token offerings.
The Four Prongs
- An investment of money
- In a common enterprise
- With an expectation of profit
- Derived primarily from the efforts of others
All four prongs must be met. If the fact pattern describes something that does not look like a stock or a bond (an interest in a citrus grove, a stake in a whiskey cask, a condominium with a mandatory rental pool, a token sale), run the four prongs. If all four are met, it is an investment contract and therefore a security under §401(l). If any prong is missing (for example, the investor does the work themselves, so profit is not from the efforts of others), it is not a security.
Section 3: Registration Requirement and Three Methods
USA §301
"It is unlawful for any person to offer or sell any security in this state unless (1) it is registered under this act; (2) the security or transaction is exempted under §402; or (3) it is a federal covered security."
Three paths to be lawful: registered, exempt, or federal covered. That is the whole framework. Everything in this chapter fits somewhere in those three buckets.
Three Methods of State Registration
| Method | USA § | Best for | How it becomes effective |
|---|---|---|---|
| Notification | 302 | Seasoned issuers | Automatic after waiting period, if no stop order |
| Coordination | 303 | Federal IPO (concurrent with federal) | Concurrent with federal effectiveness |
| Qualification | 304 | Intrastate, new issuers, catch-all | When Administrator orders |
Under §303 coordination, the state registration becomes effective at the same time as the federal registration, provided no stop order is in effect, the registration statement has been on file with the Administrator for at least 10 days, and a statement of the maximum and minimum proposed offering prices has been on file for 2 business days. Under §304 qualification, the registration statement becomes effective when the Administrator so orders.
One-Year Effectiveness [§305]
A state registration statement is effective for one year from its effective date. Unsold securities may continue to be sold during that year. The Administrator may require escrow or impoundment of proceeds until a specified amount is sold.
Stop Orders [§306]
The Administrator may issue a stop order denying, suspending, or revoking the effectiveness of a registration statement. Grounds include a misleading or incomplete registration statement, fraud in the offering, or failure to comply with the Act. The Administrator must give notice and opportunity for a hearing before the order becomes final.
Section 4: §402(a) Exempt Securities
This is where most Chapter 5 questions live. §402(a) lists 12 categories of securities that are exempt from the registration requirement of §301 because of WHAT the security is. The exemption attaches to the security itself, not to the transaction. If it is on this list, it is exempt no matter who sells it or how.
| §402(a)(#) | Category |
|---|---|
| (1) | US and state government securities (Treasuries, state and municipal bonds) |
| (2) | Foreign government securities (Canada and diplomatic-recognized countries) |
| (3) | Bank securities (bank stock, bank bonds, bank CDs) |
| (4) | Federal S&L, building and loan securities |
| (5) | Insurance company securities (stock and bonds, not variable products) |
| (6) | Credit unions and similar institutions |
| (7) | Railroads, common carriers, regulated public utilities |
| (8) | Listed securities (NYSE, AMEX, Administrator-designated exchanges) |
| (9) | Non-profit (religious, educational, charitable, fraternal) |
| (10) | Commercial paper, 9-month maximum maturity |
| (11) | Employee benefit plan investment contracts (30-day Administrator notice) |
| (12) | Cooperatives (bracketed, optional in model act) |
Test tip: The USA §402(a)(10) commercial paper exemption does NOT require a $50,000 minimum denomination. That requirement exists under federal Securities Act §3(a)(3), not in the USA primary text. The state-law requirements are the 9-month maturity cap and the current-transaction purpose.
Section 5: §402(b) Exempt Transactions
These are exemptions based on HOW the transaction is structured, not what security is being sold. The same share of stock might be sold unlawfully in one transaction and lawfully in another if the second transaction qualifies. The exemption attaches to the circumstances of the sale.
| §402(b)(#) | Transaction |
|---|---|
| (1) | Isolated non-issuer transaction |
| (2) | Non-issuer distribution listed in a recognized securities manual |
| (3) | Unsolicited non-issuer through a registered broker-dealer |
| (4) | Issuer-to-underwriter and among-underwriter transactions |
| (5) | Whole mortgage sold as a unit |
| (6) | Fiduciary transactions (executor, administrator, sheriff, receiver, trustee, guardian) |
| (7) | Bona fide pledgee |
| (8) | Institutional transactions (banks, insurance, investment companies, pension trusts) |
| (9) | Private placement (not more than 10 non-institutional offers in 12 months) |
| (10) | Preorganization certificate (not more than 10 subscribers, no payment) |
| (11) | Existing security holders |
| (12) | Offer (not sale) during SEC waiting period |
The Private Placement Exemption [§402(b)(9)]
The private placement exemption has three elements, all of which must be met:
- Not more than 10 non-institutional offers in any 12 consecutive months in the state
- The seller reasonably believes all buyers in the state are purchasing for investment
- No commission or other remuneration is paid for soliciting prospective buyers
Note that the cap is on offerees, not on closings. An offer to 11 people is over the cap even if only 3 buy. And institutional offers under §402(b)(8) do not count against the §402(b)(9) 10-offer limit.
Burden of Proof [§402(d)]
"In any proceeding under this act, the burden of proving an exemption or an exception from a definition is upon the person claiming it." If the exemption is challenged, it is the seller's job to prove the exemption applies. The state does not have to prove it does not.
Section 6: Federal Covered Securities [NSMIA, Securities Act §18]
The National Securities Markets Improvement Act of 1996 (NSMIA) amended the Securities Act of 1933 to create the category of "covered security." States may not require registration of a federal covered security. States retain the power to require notice filings, charge fees, and enforce antifraud rules.
Categories of Federal Covered Securities
- Securities listed or approved for listing on the NYSE, the former American Stock Exchange, or the Nasdaq National Market (and certain successor exchanges)
- Securities of the same issuer senior to or on parity with listed securities
- Investment company shares registered under the Investment Company Act of 1940
- Offerings under Securities Act Rule 506 (Regulation D private placements)
- Offerings to qualified purchasers as defined by the SEC (the federal $5 million minimum purchaser category)
State Authority Over Covered Securities
| States MAY | States MAY NOT |
|---|---|
| Require notice filings and fees | Require state registration |
| Enforce antifraud rules | Impose substantive merit review |
| Investigate and prosecute fraud |
Even though a federal covered security is exempt from state registration, §101 antifraud still applies. The NASAA commentary from Chapter 8 is just as true here: exempt from registration is not exempt from fraud.
Section 7: Thresholds, Traps, and Memory Tactics
Quantitative Thresholds for Chapter 5
| Threshold | What it governs |
|---|---|
| 9 months | Max maturity of exempt commercial paper (§402(a)(10)) |
| 10 offerees | Private placement cap per 12 months (§402(b)(9)) |
| 10 subscribers | Preorganization certificate cap (§402(b)(10)) |
| 12 months | Counting window for 10-offeree cap |
| 30 days prior notice | Employee benefit plan investment contracts (§402(a)(11)) |
| 5 business days | Administrator window to disallow existing-holder exemption (§402(b)(11)) |
| 90 days | Max exercise period for "existing holder" warrants |
| 10 days / 2 business days | Minimum filing periods for coordination effectiveness (§303) |
| 1 year | Effectiveness period of a state registration statement (§305) |
| 4 prongs | Howey test elements |
Common Traps
Trap 1: Exempt SECURITY vs. exempt TRANSACTION. Single most confused area. An exempt security is exempt because of what it is (a US Treasury bond). An exempt transaction is exempt because of how the sale is structured (a sale to a bank, a fiduciary sale, an isolated non-issuer sale). Same instrument could go through a non-exempt transaction today and an exempt transaction tomorrow.
Trap 2: Neither type of exemption escapes §101. See Chapter 8. Exempt from registration is not exempt from fraud.
Trap 3: Commercial paper $50,000 minimum. Not in the USA text. That is a federal Securities Act §3(a)(3) requirement, not a state requirement.
Trap 4: Annuities. Fixed annuity is not a security. Variable annuity is a security because payments vary.
Trap 5: Gift of assessable stock. It is an offer AND a sale under §401(j)(4), because assessable stock carries a future payment obligation.
Trap 6: Private placement offerees, not buyers. The §402(b)(9) cap is on offerees, not closings. An offer to 11 people blows the exemption even if only 3 buy.
Trap 7: Burden of proof. Under §402(d), the seller has to prove the exemption applies. The state does not have to prove it does not.
Trap 8: Three registration methods. Notification is for seasoned issuers. Coordination requires a concurrent federal registration. Qualification is the catch-all.
Trap 9: One year effectiveness. A state registration is effective for one year from the effective date, not from the filing date.
Memory Tactics
- Howey has four prongs. Money, enterprise, profit, others' efforts. All four required.
- Three paths to lawful. Registered, exempt, or federal covered.
- Three registration methods. Notification, Coordination, Qualification.
- One year effective. State registration §305.
- 9 months, no fifty thousand. State commercial paper exemption.
- 10 and 10. Private placement (10 offerees, 12 months) and preorganization (10 subscribers, no payment).
- Burden on the claimant. §402(d).
Chapter 5 closes the framework on what gets regulated. Chapter 6 (Investment Advisers) shifts focus to the people and firms whose job is to tell others what to do with those securities.