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When is a Promissory
Note a Security?
In
this article, I discuss when a promissory note is a “security.” The issue
is important because, if the note is a security, then the issuer of the note
must comply with securities laws. If the note is not a security, then the
loan transaction can go forward without securities law compliance. Given
the costs of securities law compliance, issuers want to avoid it whenever
possible.
Whether a promissory note is a security is one of the most vexatious issues
in US securities laws. To sum up current law on the issue, whether a note
is a security depends on whether the note looks like a security. As laws
go, this one is as clear as mud. It should not surprise anyone that court
cases on the issue are a rat’s nest of contradictions.
In
general, under the Securities Acts, promissory notes are defined as
securities, but notes with a maturity of 9 months or less are not
securities. Securities Act § 2(1), 3(a)(3); Exchange Act § 3(a)(10).
Likewise, the US Supreme Court sets a rebuttable presumption that a note
with a maturity over 9 months is a security unless it resembles a type of
note that commonly is not considered a security. Reves v. Ernst &
Young, 110 S. Ct. 945 (1990).
The
US Supreme Court in Reves recognizes that most notes are, in fact,
not securities. The Court provides the following list of notes that are
clearly not securities, irrespective of their maturity. Notes that fit into
any of these categories are not securities.
-
A note delivered
in consumer financing.
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A note secured by
a mortgage on a home.
-
A note secured by
a lien on a small business or some of its assets.
-
A note relating to
a “character” loan to a bank customer.
-
A note which
formalizes an open-account indebtedness incurred in the ordinary course of
business.
-
Short-term notes
secured by an assignment of accounts receivables.
-
Notes given in
connection with loans by a commercial bank to a business for current
operations.
For
situations that are less clear, the Court gives the following factors, in
order:
-
Whether the borrower’s motivation is to
raise money for general business use, and whether the lender’s
motivation is to make a profit, including interest.
-
Whether the borrower’s plan of
distribution of the note resembles the plan of distribution of a
security.
-
Whether the investing public reasonably
expects that the note is a security.
-
Whether there is a regulatory scheme
that protects the investor other than the securities laws. Examples
include notes subject to Federal Deposit Insurance and ERISA.
For
planning purposes in structuring transactions, I do not consider the US
Supreme Court’s factors to be very useful. Factor 1 has little real-world
value because it will be true for almost all business loans – the borrower
usually raises money for business purposes, and the lender usually seeks a
profit through interest. Factor 3 is not useful because it begs the
question, why would the public have an expectation that a note is a
security? Factor 4 is only relevant for a small minority of notes; in
addition it is almost impossible to predict in advance whether it will apply
to any given transaction.
This
leaves Factor 2 as the most relevant factor. If the issuer of the note
sells a note as an investment to persons who resemble investors, in an
offering that resembles a securities offering, then the note is a security.
In addition, the note resembles a security if the lender takes the note as
an investment, in the same sense that the lender might buy stock as an
investment.
After review of a number of cases that apply the above law, I note for the
record that the cases frequently turn on the simple question of fairness.
If the issuer of a note defrauded the lender / investors, and if the
investors were unsophisticated and unable to protect themselves, then the
court would argue the four factors however it pleased to rule that the note
was a security.
If a
business note is not a security, usually the courts will call it a
commercial loan. So when is a note a commercial loan and not a security?
Based on Factor 2 above, if there is no general offering to lender /
investors. It also helps if the number of lenders is very small, and the
note is secured by collateral.
For
example, the Sixth Circuit
held that a $600,000 bridge loan was a note, not a security. Bass
v. Janney Montgomery Scott, Inc., 210 F.3d 577 (6th Cir. 2000).
The bridge loan note was not a security because there was only one investor
and the note was collateralized.
Likewise, the
Ninth Circuit (in an unpublished opinion) concluded that a $5 million note
from a limited partnership was not a security. Piaubert v. Sefrioui,
208 F.3d 221 (Table), 2000 WL 194140 (9th Cir. 2000).
The lender made the loan to support the
borrower, not as an investment. The lender had an ownership interest in the
borrower. In addition, the note bore an interest rate substantially below
the prime rate and interest was payable only at maturity (5 years).
In
conclusion, a promissory note is a security when it looks like one. If the
issuer sells the note in an offering that has the look-and-feel of a
securities offering, then the note likely is a security. Not much more can
be said.
If
you take nothing more from this article, please take this: when issuing
promissory notes that even remotely might be considered as securities, get a
competent securities lawyer. Structure your transaction as best as possible
to avoid classification of your notes as securities.
Call
me to schedule a legal consultation:
510-796-9144
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