When is a promissory note more than meets the eye? Does your transaction have a securities issue hiding in "plain sight?"

Sometimes a promissory note can be a security. If that happens, then a slew of additional considerations may need to be addressed. Is there an exemption available to having the note registered? Are all material facts disclosed? Are the parties associated with the transaction required to be licensed?

One exemption to a promissory note being defined as a security exists in federal law and it includes a note with a term of nine months or less. The test that determines if a promissory note is a security was handed down from the United States Supreme Court in the Reeves v. Ernst & Young decision.

The Supreme Court expressly rejected the commercial versus investment distinction for deciding when a promissory note is a security. All promissory notes are presumed to be securities but that presumption may be rebutted by the party making the claim the note is not a security. Under the “family resemblance test,” four factors must be examined to determine if the note qualifies as a security.

First, the court reviews the motivations that prompt an objective buyer and seller to engage in the transaction. If the seller uses the funds to finance an investment in the business or for general purposes and the buyer is seeking a profit, then the instrument is likely a security. Receipt of interest counts as a purchaser seeking to make a profit. However, if the purchase and sale is to facilitate the purchase or sale of a consumer item or other commercial purpose, then the note is likely not a security. Examples of this are using a promissory note to finance real estate or an auto.

Secondly, courts will look to the “plan of distribution” of the notes and this will determine whether there is trading of the investment. Next, the court examines the objective expectations of the investors for buying the notes. Lastly, the court evaluates the existence of another regulatory regime that reduces the risk that the purchaser will need the securities laws protection. An example of the foregoing are banking laws such as the Federal Deposit Insurance Corporation (FDIC).

The facts of Reeves aid in the understanding of the four-part “family resemblance test.”  In Reeves, an agricultural co-op sought to raise money for its general business operations and the buyers of the note sought a profit in the form of interest. The notes were offered to 23,000 members of the co-op and more than 1,600 people held the notes when the co-op filed for bankruptcy. Thus, the co-op widely offered the notes, and while less than trading on an exchange, this was a significant distribution nonetheless. The public believed these notes were investments because they were advertised as such. Finally, the risk-reducing factor required in order to determine whether the notes were securities was not in place because the notes were not insured nor was the collateral associated with them. Therefore, the Supreme Court held that the promissory notes were securities

Feel free to contact a Chuhak & Tecson Corporate Transactions & Business Law attorney to assist with evaluations of promissory notes.

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

Client alert authored by: Andrew S. May, Principal               

This alert originally appeared in the Spring 2019 Corporate Focus newsletter.