Many businesses obtain capital by borrowing money. If your business obtains capital by borrowing money, do you have to consider whether the loan is deemed to be a security under federal and/or state securities law? The answer is clearly yes. A business borrowing money gives the lender a promissory note (a “Note”) or a debenture or bond or some other instrument that sets forth the terms of the repayment obligations. Is that Note a security just as shares of stock are securities? The answer is maybe. Whether a promissory note is a security can be a very difficult analysis and a lender must consider federal securities law, state securities laws and a numerous court cases in an attempt to determine if its particular Note is a security. If your Note is a security, then you must comply with the registration requirements of federal and state securities law (unless an exemption from registration is available) and you must comply with the full disclosure and anti-fraud provisions of federal and state securities law. If your note is a security and you fail to comply with applicable federal and state securities law, you may be subject to various administrative, civil or criminal sanctions and investor rescission claims.
Under current law, whether a note is a security depends on whether the note looks like a security. I know this is not very clear or helpful but it is a starting place in our analysis. In general, under the federal 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).
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.
If the Note is not one of the Notes listed above, the Court in Reves gives several factors to consider in analyzing whether a Note is a Security. These factors include:
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.
By and large these factors are not particularly helpful in our analysis. Undoubtedly Factor 2 is the most helpful 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.
Depending on the facts and circumstances, a Note that has a term of less than 9 months may be security. So, a Note with a term of less than 9 months may be a security or it may not be a security and a note with a term of more than 9 months may be a security or it may not be a security. Is that clear enough for you?
State Security Law
Not only must you consider federal security law in determining whether your note is a security, you must consider the securities law of the state in which the lender resides. A note may be a security under federal security law but not state security law or may not be a security under federal law but may be a security under state law. The Utah Securities Division has commenced numerous enforcement actions in which promissory notes were involved. Some of these enforcement actions have turned into criminal prosecutions.
When I was in law school more than 33 years ago, one of my professors told us that “If it looks like a rose, if it smells like a rose or if it tastes like a rose, it is probably a rose”. A Note is a security when it looks like one or it feels like. If the borrower issues the Note in a manner that has the look-and-feel of a securities offering, then the note likely is a security.
Before your business borrows money, you should consider whether the loan is such that some regulator or some lender’s lawyer may take the position that the loan is a security. If they are correct, the result is more than just a lawsuit to collect a bad debt, it becomes a security fraud lawsuit or enforcement matter.
You should consult with experience legal counsel when planning a loan transaction for your business.
Contact A.O. “Bud” Headman at email@example.com for more information.
- On November 22, 2012