Is a Note a Security?

In the post-Dodd-Frank world of securities regulation, the definition of a security remains important when looking at funding options and regulatory regimes. Kickstarter works from the securities law perspective because it’s not selling securities. It’s helping project mangers sell products or receive contributions, with no expectation of an a profits interest in the underlying project. Equity crowdfunding platforms will need to wait for new SEC regulations to be enacted before they go live.

I’ve spent most of my time looking at securities from the perspective of equity because that it where I spend my working time. Of course, debt instruments can also be securities. Section 3(a)(10) of the Securities Exchange Act of 1934 explicitly includes “notes” in the definition of a security, but does not include loans. Recently, the influential Delaware Chancery Court took a look at some promissory notes and found that some were securities and some were loans. ( Francis Pileggi highlighted this case in his Delaware Commercial & Commercial Litigation Blog.)

The case involves several promissory notes, each with different terms and attributes, issued by ION. A shareholder of ION, Fletcher International, Ltd., claimed that the issuance of the notes was a violation of the terms of the contractual rights that governed the terms of ION’s preferred stock that required ION to obtain Fletcher’s approval before issuing any securities. Fletcher claims that the promissory notes were “securities”.

The Delaware court sets the standard of review using the the four-factor formula set forth by the United States Supreme Court in Reves v. Ernst & Young (.pdf). That decision limits the Howey four part analysis of securities to “investment contracts”, Instead, it creates a new framework to determining if a note is a “note” under section 3(a)(10), and therefore a security. This is the Family Resemblance test.

This test came from another decision that gave a list of notes that are not securities:

  1. the note delivered in consumer financing,
  2. the note secured by a mortgage on a home,
  3. the short term note secured by a lien on a small business or some of its assets,
  4. the note evidencing a ‘character’ loan to a bank customer,
  5. short-term notes secured by an assignment of accounts receivable, or
  6. a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized [… and]
  7. notes evidencing loans by commercial banks for current operations.

The Reves decision states that this list needed more guidance. The Court starts from the position that “all notes are presumptively securities”.  Then you need to need analyze whether the note fits into one of those exceptions through a four part test.

First, we examine the transaction to assess the motivations that would prompt a reasonable seller and buyer to enter into it. If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a “security.” If the note is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash-flow difficulties, or to advance some other commercial or consumer purpose, on the other hand, the note is less sensibly described as a “security.” .

Second, we examine the “plan of distribution” of the instrument, to determine whether it is an instrument in which there is “common trading  for speculation or investment”.

Third, we examine the reasonable expectations of the investing public: The Court will consider instruments to be “securities” on the basis of such public expectations, even where an economic analysis of the circumstances of the particular transaction might suggest that the instruments are not “securities” as used in that transaction. […]

Finally, we examine whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.

You need to look at an instrument to see if it bears a “family resemblance” to one of the enumerated instruments. Under this test, the presumption can be rebutted if the note bears a strong resemblance to one of the enumerated types of notes.

I scratch my head with a bit of confusion with the Reves test. The Delaware Court shares that confusion:  “Multi-factor tests can sometimes make the mind glaze over, and obscure their own fundamental purposes. Some of the less-than-logically-compelling case law under Reves illustrates that danger.” (In my mind there is even more confusion in the mix given the trading activity of residential mortgages. They were readily traded around during the overabundant years of the real estate boom.)

The essence of the Reves analysis is to determine whether the note in question is more like an investment or, more like a commercial loan or consumer loan transaction. “If the note in question looks more like a corporate bond, debenture, or other instrument the value of which rises and falls with the success of the issuer’s business, has a term of several years, and is easily traded, then that presumption will not be rebutted, because the note will not bear a strong resemblance to any of the notes listed in Reves for the basic reason that such a note is easily characterized as an investment, and thus a

Going back to the Delaware case, the court found one of the notes to be a security. The determination seems to pivot mostly on the length of the loan: four years. Another factor was that the note had a securities legend with references to a security. So it looked like a paper security/bond instead of a promissory note.

In the end, this case does little to help me clarify my thoughts about typical private equity and real estate fund note holdings. I suppose if the note has securities legends, that will tip it more towards the category of securities than a typical vanilla promissory note.

One follow-up from the Reves analysis of a note. In SEC v. Edwards, 540 U.S. 389 (2004), the Supreme Court held that a note that falls outside the family resemblance test as a “note” could still qualify as an “investment contract” under the Howey test.


Image of the Sears, Roebuck bond is by SpreeTom

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