SECURITIES | 2026-10-29

What Counts as a “Security”? The Howey Investment-Contract Test and Its California Application to Startups, LLC Interests, and Digital Assets

Whether an instrument is a “security” decides whether the federal and California securities laws apply at all — and with them registration, disclosure, antifraud liability, and licensing duties. The Supreme Court’s Howey test defines the catch-all category of “investment contract,” and California’s own definition in Corporations Code §25019 tracks it. Misjudging the line exposes promoters to rescission and enforcement.

Almost every obligation in securities law — the duty to register an offering or qualify for an exemption, the antifraud rules, the licensing of brokers and advisers, and the private and governmental remedies that follow — depends on a single threshold question: is the thing being sold a security ? T

The word “security” sounds technical, but it is the gateway to an entire body of law. If an instrument is a security, the person selling it generally must register the offering or fit an exemption, must not make material misstatements, and may owe rescission or damages if the rules are broken. If it is not a security, none of that applies. This guide explains the definition, the controlling Howey test, the Supreme Court decisions that refine it, how California applies the same framework, and what it all means for startups, funds, and digital-asset projects.

The Statutory Definition and the “Investment Contract” Catch-All

The federal securities laws define “security” to include a long list of instruments — stock, notes, bonds, debentures, evidences of indebtedness, and more — and then add the flexible term “investment contract.” California’s Corporations Code §25019 defines “security” in parallel, broad terms and likewise includes the investment-contract concept. Congress and the Legislature used expansive language deliberately, to reach the countless schemes promoters devise to raise money from the public. The courts have read the catch-all to embody a flexible principle: the law looks to the substance of the economic arrangement, not the name the promoter attaches to it, so calling an interest a “membership,” a “license,” a “token,” or a “joint venture” does not control whether it is a security.

SEC v. Howey and Its Four Elements

In SEC v. W.J. Howey Co. (1946) 328 U.S. 293, the defendant sold tracts of a Florida citrus grove together with a service contract under which a related company cultivated, harvested, and marketed the fruit and remitted the net profits to the buyers. Most buyers were out-of-state investors with no farming experience who never set foot on the land. The Supreme Court held the package was an investment contract and therefore a security. It announced the test that still governs: an investment contract is a transaction in which a person (1) invests money (2) in a common enterprise (3) and is led to expect profits (4) solely from the efforts of the promoter or a third party. The word “solely” has since been read flexibly — the question is whether the efforts of others are the undeniably significant ones that affect the enterprise’s success, not whether the investor does literally nothing.

Element One: Investment of Money

The first element is usually satisfied whenever an investor commits assets in exchange for the interest. Courts read “money” broadly to include other forms of consideration — goods, services, or other valuable commitments — so a contribution need not be cash. This element is rarely the battleground; most disputes concern the later elements. It can matter, however, where value is distributed without any investment by the recipient — for example, a genuine gift or a reward requiring no economic commitment — because without an investment of value there is no investment contract.

Element Two: Common Enterprise

The second element — a common enterprise — has produced a circuit split on what kind of commonality is required. Most courts accept horizontal commonality, in which multiple investors’ funds are pooled and profits and losses are shared pro rata. Some courts also accept vertical commonality, in which the investor’s fortunes are tied to the promoter’s efforts (broad vertical) or to the promoter’s own success (strict vertical). The practical point for California promoters is that a pooled structure — a fund, a syndicate, a token sale whose proceeds finance a common project — almost always satisfies commonality, and structuring around this element is difficult because the economic reality of pooled, manager-driven ventures is exactly what Howey targets.

Element Three: Expectation of Profits

The third element asks whether the investor was led to expect profits. In United Housing Foundation, Inc. v. Forman (1975) 421 U.S. 837, the Court held that shares in a nonprofit housing cooperative — bought to obtain an apartment, not to earn a return — were not securities, because “profits” means either capital appreciation or a participation in earnings, not the use or consumption of a purchased good or service. Thus an instrument bought primarily for use (to live in, to consume, to operate a business the buyer runs) is less likely to be a security than one bought for financial return. In SEC v. Edwards (2004) 540 U.S. 389, the Court clarified that a fixed or guaranteed return can still be the kind of “profit” Howey contemplates, so a promised steady yield does not take an arrangement outside the securities laws.

Element Four: Efforts of Others

The fourth element — profits derived predominantly from the efforts of others — is often decisive. An interest is more likely a security where the promoter or a manager runs the enterprise and the investor is passive, and less likely where the investor exercises genuine managerial control over the venture’s success. This is why a general partnership interest, in which each partner has real management power, is often not a security, while a limited partnership interest, in which limited partners are passive, usually is. The inquiry is practical, not formal: if the paper gives an investor control the investor cannot realistically exercise — because of dispersion, inexperience, or dependence on the promoter — courts treat the investor as passive and the interest as a security.

Instruments With “Usual Characteristics”: Stock and Notes

Not every security runs through Howey. Where an instrument is called “stock” and bears the usual characteristics of stock — the right to dividends contingent on profits, negotiability, the ability to be pledged, voting rights, and the capacity to appreciate — courts treat it as a security without applying Howey, because it is stock in the ordinary sense. Notes are analyzed under a different framework: in Reves v. Ernst & Young (1990) 494 U.S. 56, the Court adopted a “family resemblance” test under which a note is presumed to be a security unless it resembles a category of notes that are not securities (such as consumer financing, a mortgage on a home, or short-term commercial paper), judged by the parties’ motivations, the plan of distribution, the public’s reasonable expectations, and the presence of alternative regulation. Promoters cannot assume a “note” or “loan” label removes an instrument from the securities laws.

California’s Parallel Framework and the “Risk Capital” Gloss

California courts apply the same investment-contract analysis under Corporations Code §25019, and California contributed its own influential refinement: the risk-capital approach from Silver Hills Country Club v. Sobieski, which asks whether a scheme seeks to raise capital for a venture and subjects the contributor’s funds to the risks of the enterprise in the hope of a benefit. The risk-capital test can reach arrangements — such as memberships sold to finance a new business — that a rigid reading of Howey might miss. In practice, California regulators and courts use both the Howey elements and the risk-capital principle to ensure that substance governs, and an instrument that is a security under either approach is subject to California’s qualification and antifraud requirements.

Application to LLC and Partnership Interests

Modern ventures are often organized as LLCs, and whether an LLC membership interest is a security turns on the fourth Howey element as applied to the operating agreement. A member-managed LLC in which each member genuinely participates in management resembles a general partnership and may fall outside the securities laws, while a manager-managed LLC whose passive members depend on a manager’s efforts resembles a limited partnership and typically involves securities. Drafting matters: an operating agreement that gives members paper control they cannot realistically exercise will not defeat security status if the economic reality is passivity. Founders raising money from passive investors through LLC interests should assume they are selling securities and plan their exemption strategy accordingly.

Application to Digital Assets

The Howey test has become central to digital-asset regulation. Where tokens are sold to fund the development of a network or platform and buyers expect the promoter’s continued efforts to build value, the sale often constitutes the offer of an investment contract — a security — regardless of the “token” or “utility” label. Courts conduct the same economic-reality analysis: was there an investment of money, in a common enterprise, with an expectation of profits from the efforts of others? Some digital-asset arrangements fall outside the definition — for example, where a token functions purely as present consumptive use on a functioning network, or where it is distributed without investment — but promoters cannot assume that outcome. Because enforcement in this area is active and evolving, projects should obtain securities counsel before a sale rather than litigate the question afterward.

Consequences of Getting It Wrong

Treating a security as a non-security has serious consequences. An unregistered, unqualified offering of securities can be rescinded, giving investors the right to their money back, and can expose the issuer to antifraud liability and to governmental enforcement by the SEC and the California Department of Financial Protection and Innovation. Individuals who promote or sell may face personal exposure, and selling without a required license is itself unlawful. Conversely, over-caution — registering or qualifying an interest that is not a security — imposes needless cost and delay. Because the threshold question drives everything, it deserves a deliberate legal analysis at the outset of any capital raise, documented in a memorandum the issuer can rely on.

Frequently Asked Questions

What is the Howey test?

From SEC v. W.J. Howey Co. (1946) 328 U.S. 293, it defines an “investment contract” — and thus a security — as an investment of money in a common enterprise with a reasonable expectation of profits derived predominantly from the efforts of others. Courts apply it to economic reality, not to the label the promoter uses.

Does the Howey test apply in California?

Yes. California’s Corporations Code §25019 defines “security” in parallel terms, and California courts apply the same investment-contract analysis, supplemented by the state’s risk-capital approach. An instrument that is a security under either Howey or the risk-capital test is subject to California qualification and antifraud law.

Is an LLC membership interest a security?

It depends on management. A member-managed LLC in which members genuinely participate in management may fall outside the securities laws, while a manager-managed LLC with passive members usually involves securities. Economic reality controls, so paper control members cannot realistically exercise will not defeat security status.

Are digital assets or tokens securities?

Often, when they are sold to fund a project and buyers expect profits from the promoter’s continued efforts, the sale is the offer of an investment contract and thus a security despite a “utility” label. Some tokens with purely present consumptive use may fall outside the definition, but the analysis is fact-specific and enforcement is active, so obtain counsel before a sale.

What does “profits” mean under Howey?

Per United Housing Foundation v. Forman (1975) 421 U.S. 837, profits means capital appreciation or a participation in earnings — not the use or consumption of a purchased good or service. SEC v. Edwards (2004) 540 U.S. 389 adds that a fixed or guaranteed return can still count as profit.

Is a promissory note a security?

It can be. Under Reves v. Ernst & Young (1990) 494 U.S. 56, a note is presumed to be a security unless it resembles a recognized category of non-security notes — consumer financing, a home mortgage, short-term commercial paper, and the like — judged by the parties’ motivations, the plan of distribution, public expectations, and alternative regulation.

Does “solely from the efforts of others” mean the investor can do nothing?

No. Courts read “solely” flexibly, asking whether the efforts of others are the undeniably significant ones affecting the enterprise’s success. An investor who performs minor or ministerial tasks can still hold a security if the promoter’s or manager’s efforts drive the returns.

What happens if I sell securities without registering or qualifying?

An unregistered, unqualified securities offering can be rescinded — investors may recover their money — and can expose the issuer and the individuals involved to antifraud and enforcement liability under federal law and California’s securities act. Selling without a required license is itself unlawful. The threshold security analysis should therefore be done and documented before any raise.

Documenting the Threshold Analysis

Because the security question drives every downstream obligation, sophisticated issuers reduce their analysis to a written memorandum before marketing an interest. The memorandum applies each Howey element — and California’s risk-capital principle — to the specific facts: the form of the instrument, the structure of the enterprise, the degree of investor control reflected in the governing documents and in practice, and the nature of the returns investors are led to expect. Where the conclusion is that the interest is a security, the issuer then selects a registration path or exemption and builds the corresponding disclosure. Where the conclusion is that it is not, the memorandum records the basis so the issuer can defend that position if a regulator or investor later challenges it. This discipline does not guarantee a particular outcome, but it converts a potentially existential question into a reasoned, contemporaneous record — the single most useful piece of evidence if the characterization is ever litigated.

Why the Definition Is Deliberately Flexible

The breadth of the investment-contract concept is a feature, not a defect. The securities laws were enacted to protect the investing public from schemes that take their money in exchange for a promise of returns dependent on someone else’s management, and promoters have always been inventive in dressing up such schemes as something else. By tying the definition to economic reality, Howey ensures that the protections follow the substance of the deal wherever it appears — in citrus groves, cooperative housing, payphone sale-leasebacks, viatical settlements, LLC interests, or digital tokens. For the California founder or fund sponsor, the lesson is that the label is irrelevant: what matters is whether investors are passively funding a common venture in hope of a return, and if they are, the securities laws apply with all of their registration, disclosure, and antifraud consequences.

Related Guides

For related reading, see our guide on Section 17(a) of the Securities Act and the Aaron scienter rule and our securities and governance practice overview. Whether an instrument is a security is the question on which every other securities obligation depends.

Speak With a California Securities Attorney

If you are raising capital, launching a token or fund, or evaluating an investment, the first question is whether you are dealing with a security under Howey and Corporations Code §25019. Trembach Law Firm analyzes the instrument and the enterprise, advises on registration and exemption strategy, and defends rescission, antifraud, and enforcement claims. Call (818) 514-7680 for a consultation. Anatolii Trembach holds an LL.M. and is admitted to the California Bar.

This article provides general information about federal and California securities law and is not legal advice. Whether an instrument is a security is fact-specific and depends on the structure of the transaction. Consult a qualified attorney about your particular situation.

Contact Trembach Law Firm at (818) 514-7680 for a confidential consultation.

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