When is a Promissory Note a Security?

Website Provided by HG.org

It is important to differentiate between notes and securities. When a note is not a security, security law compliance does not need to be considered. Having a note that is not considered a security is often attractive to issuers who wish to avoid the expense of securities law compliance.

General Definition

Promissory notes are defined as securities under the Securities Act. However, notes that have a maturity of nine months or less are not considered securities. There is a rebuttable presumption that notes with a maturity date over this time period are securities unless they resemble notes that are not usually considered securities.

Notes that Are Not Securities

The United States Supreme Court has explained that a number of notes are not securities. This includes notes that are secured by a mortgage or lien on a home, a small business or business assets. It also includes character loans for bank customers or notes delivered through consumer finance. Notes that commercial banks provide to business in order to operate the business or short-term notes that are secured by a business’ accounts receivables are also not considered securities. Finally, notes that are considered commercial loans that are acquired through the ordinary course of business are not considered securities.

Factors to Consider

The above categories of notes are specified by the courts as not being securities. It is possible that other notes may also not be considered securities. However, the court needs to consider a number of factors to determine whether a note is also a security.

The court considers the following factors in order.

The first factors is whether the borrower’s reason for acquiring the note is to acquire money for operational purposes and whether the lender’s reason for issuing the note is to profit from it, such as by charging interest. Since this is often true of most notes, the analysis continues.

The second factor is whether the plan of distribution for the borrower of the note is similar to a security distribution. For example, if a note issuer sells a note as an investment to someone who can be considered an investor, it may be considered a security. If there is not a general offering of the note to the lender and investor, the number of potential lenders is very small and if the note is secured by collateral, the court often finds the note to be a commercial loan rather than a security. Under this factor, the court may also consider whether the note has an interest rate that is below the prime rate.

The third factors is whether a reasonable investor would consider the note to be a security. The fourth factor is whether a regulator scheme exists in order to protect the investor besides securities law, such as those notes that are subject to laws such as ERISA or Federal Deposit Insurance.

Overall, the courts often consider the issue of fairness. If the issuer of the note attempted to defraud the lender or investors, the court may use the above factors more liberally.

Legal Assistance

When issuing a note that may appear similar to a security, it is important to consult with a securities lawyer who can help structure the note in a way that does not trigger securities law compliance.

Copyright HG.org

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.

Contact a Lawyer

Find a Local Lawyer