Negative Interest Rates and the Definition of Security

In some European countries, bank interest rates have dropped below zero. (See here and here.) That’s right; it actually costs you to put your money in the bank. You put $1,000 in a savings account and the bank promises to pay you, say, $999, in a year.

I came of age in the Gerald Ford/Jimmy Carter years, when annual inflation rates were in the double digits. Whip Inflation Now!  (Yes, children, I’m ancient.) I find it almost unbelievable that nominal interest rate (and bond yields) could drop below zero.

That hasn’t happened in the United States (yet), but what if it did? Set aside the huge macroeconomic issues, and let’s focus on a topic of greater interest to the readers of this blog—the effect on federal securities law, particularly the core notion of what constitutes a security.

The most important case in defining the scope of federal securities law is probably SEC v. W.J. Howey Co., 328 U.S. 293 (1946).  Howey says that an investment is an investment contract, and therefore a security, if people invest money in a common enterprise with an expectation of profits coming from the efforts of others.

The “expectation of profits” part of the Howey test is the problem in a negative-interest-rate economy. Assume, for example, that an entrepreneur asks people for money to start a business and promises to return that money, without interest, in two years. In other words, you put in $1,000 and he’ll pay you back $1,000 in two years.

That investment would not ordinarily be treated as a security because there’s no profit. That’s how the Kiva crowdfunding site,  which is based on no-interest lending, can avoid federal securities law. But, in a negative-interest world, a mere return of your principal is, in effect, profitable. Considering your opportunity cost, you come out ahead.

If we ever have negative interest rates and the courts hold that no-interest investments are securities, remember that you read it here first.