When is a Promissory Note a Security?



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In this article, the author discusses 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.

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:

1. 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.

2. Whether the borrower’s plan of distribution of the note resembles the plan of distribution of a security.

3. Whether the investing public reasonably expects that the note is a security.

4. 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.

ABOUT THE AUTHOR: Matt Dickstein
I have been a business attorney since 1994. I work with domestic and international businesses on all aspects of corporate and business law. My work includes all types of business transactions, for example, contracts, venture capital (VC) financings, loans, shareholder / member / partner disputes, protecting customer lists from employees and competitors, IP licensing, contractor agreements, software development agreements, joint ventures, strategic partnerships, commercial real property leases and more.

I am also a corporate lawyer, meaning that I form LLCs (limited liability companies), incorporate C corporations, S corporations, close corporations, professional corporations, limited partnerships, Delaware Series LLCs and other entities. I also draft operating agreements, shareholder (buy-sell) agreements and the like. I take care of my corporations and LLCs from incorporation / formation to dissolution.

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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.



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