Saturday, January 24, 2009

Securities registration

I really don't get this securities stuff--federal covered, exempt, non-exempt. What the heck is going on here?

The state regulators are out to protect their investors from scams and offerings of worthless investments. They let the SEC sweat the big exchange-listed companies like IBM or MSFT. It's the small companies trying to pay their American Express bills by selling "preferred stock" or "promissory notes" to gullible investors that the states worry about. So, before even offering securities, you have to either register them or claim an exemption.

Go to and click on the "Cease & Desist." The two "William Wesley" characters referenced in this administrative order demonstrate perfectly why we have state securities registration requirements. Starbucks is federal covered--register that stock with the SEC, the federal regulator. But, this crazy investment offering 120% annual interest to folks in Arkansas--the state would really have preferred that Mr. Webb register the investments first, if only to provide some overworked government employees with a really good belly laugh at two o'clock on a hot August afternoon in Little Rock.

So, if it's a "federal covered" security, the states let the SEC worry about the registration requirements. If it's a Treasury or municipal security, a bank security, a religious organization bond, etc., it's an exempt security--not required to register. Otherwise, if the investment is, in fact, a "security," it must be registered with the states before it can even be offered--let alone sold--to investors there.

But, is the thing even a "security"? If not, the securities Administrator has nothing to say about it. If so, registration and anti-fraud requirements apply. The Howey Case says that an investment contract, which is a security, is anything where the investor puts money into some enterprise and will benefit solely through the efforts of others. He doesn't work at the enterprise. He's just an investor. If so, whatever the promoters try to call the thing they're offering him, it's a 'SECURITY' and is subject to registration requirements plus the ever-present anti-fraud rules. If I go to the diner next-door to my office and try to sell "units of participation" to the other patrons, offering people a 3% profit participation in my business in exchange for, say, $10,000, I'm offering an investment contract, which is a security. So, if I do this without registration, I would be in huge trouble if the regulators found out. The IL Securities Dept would require that I register the securities and show them the disclosure documents I plan to provide to investors. They would make me print a section devoted to risk disclosures right up front in the prospectus informing investors of material facts like this:

This is a small company with limited operating history upon which to base an investment decision

This security does not trade on any active secondary market

You should not invest any funds you can not afford to lose in this enterprise

Wouldn't that sort of disclosure scare off some investors? Absolutely, which is just fine with the securities regulators. Only if investors know what the heck they're getting into can the securities markets function properly. Keep them in the dark or mislead them with deception, and you're talking about securities fraud.

So, once again, the first question a securities regulator has is this, "Does the investment meet the definition of a 'security.'?" If not, we're done talking about it. If so, it's subject to anti-fraud statutes. Does it have to be registered?

Yes. Unless it's an exempt security such as a T-bill, a church bond, bank stock, or short-term commercial paper issued by a highly-rated company, etc. Or, if the security is being offered and sold in an exempt transaction, then registration is either not required or it's completed in a fast-track, scaled-down approach that saves the issuer time and money.

Therefore, we can say with utter certainty that all securities have to be registered, except for all the securities that do not have to be registered.

Welcome to the Series 65, 66, and 63. Don't worry--it will all be over soon.


  1. Robert: From the test DVD again. I keep running into this question and don't get it:

    Which of the following is an exempt transaction?
    A. A transaction in large denomination commercial paper
    B. A transaction conducted at a customer's request
    C. A transaction in an exchange listed security
    D. A transaction in a US gov't security

    The answer is B and the rationale says: "An unsolicited transaction is an example of an unsolicited transaction."

    Have I missed something? What the heck does that mean? Thanks for your time.

  2. Hi, Steve

    This is the sort of question that gives the NASAA exams such a bad reputation. Basically, the writer of this ExamPrep question wants to trick you to see if you know the difference between an exempt security and an exempt transaction. Large denomination commercial paper is an exempt SECURITY (if it's rated in the top 3 tiers by Moody's/S&P/Fitch, at least 50K denomination, and no more than 9 months' maturity). Government securities are exempt SECURITIES. An exchange-listed security is federal covered and, therefore, an exempt SECURITY at the state leve. An unsolicited customer order is an exempt TRANSACTION. This means that if the stock isn't registered--oh well. The rep/broker-dealer/adviser did not solicit the order. If they had, they would need to make sure the security is registered.
    Extremely legalistic stuff--basically, it shows how absurd these exams have become. Do the regulators actually think that this level of "knowledge" will prevent fraud or weed out the bad eggs from the business?
    Ridiculous. But also a very likely type of question on the 65/66/63 exams.
    Again, exempt securities don't have to register. Securities that are "non-exempt" don't have to register only if you can sell them in an exempt transaction--private placement, unsolicited order, offers to institutional buyers, etc.