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Are Promissory Notes Securities?

Posted on November 6, 2019 in Firm News

Are you violating securities laws by raising money for your business through the issuance of a promissory note?

 

Most people know that the purchase and sale of instruments such as stocks and bonds are securities, making such investments subject to both federal and state securities laws.  This may mean an expensive registration process or filing requirements claiming an applicable exemption.  However, many are surprised that both the federal Securities Act of 1933 and Nevada’s Uniform Securities Act statutorily define a “security” very broadly to include a “note” and “evidence of indebtedness” among the laundry list of the types of investments subject to securities regulation.  Thus, business owners should be mindful that in many circumstances, issuing a promissory note to raise money may implicate federal and state securities laws.  The issues get more complicated when securities are offered to investors in multiple jurisdictions, since the securities laws of each state must be considered as well.

 

The United States Supreme Court has recognized that not all notes are securities despite being included in the statutory definition.  In Reves v. Ernst & Young, 494 U.S. 56 (1990), the Court recognized the following types of notes are not securities: (i) notes delivered in consumer financing; (ii) notes secured by home mortgages; (iii) a note secured by a lien on a small business or its assets; (iv) a note evidencing a character loan to a bank customer; (v) a note secured by an assignment of accounts receivable; and (vi) a note formalizing an open-account debt incurred in the ordinary course of business.

 

The Reves Court also adopted a “family resemblance” test for determining whether a particular note is similar to one of the above listed notes, and therefore considered not to be a security.  Under this test, one must presume that a note is a security, but this presumption is rebutted if the note bears a resemblance to one of the above enumerated categories.  If the note does not bear a resemblance to an item on the list, the analysis continues to determine if a new category should be judicially recognized.  In determining whether a note bears a resemblance to one of the enumerated exceptions, or whether a new exception should be added, the Reves Court instructed that four factors must be considered. First, one needs to consider the motivations of the issuer and purchaser of the note.  If the issuer’s motivation is to raise money for his or her business and the purchaser’s motivation is to earn a profit, then the note is likely a security.  Second, one must consider the plan of distribution.  If notes are being broadly marketed as an investment such as in a public or private offering, the note will be considered a security.  Third, the expectation of the investor must be analyzed.  An instrument will be deemed a security where the reasonable expectation of the investing public is that the securities laws (and accompanying anti-fraud provisions) apply to the investment.  Lastly, one must consider whether another regulatory scheme adequately protects the investor, such as banking laws for bank loans.

 

While not all promissory notes are securities, parties issuing them should be aware of the potential that such instruments could be subject to federal and state securities laws.