When Does a Private Business Loan Transaction Trigger Securities Laws?

What is a security?

Many find it surprising to discover that there is no specific statutory definition of a “security” under federal or state securities law. The Securities and Exchange Commission (SEC)’s definition of a “security” includes a laundry list of approximately thirty items ranging from stocks and bonds to notes and investment contracts. In the hallmark SEC v. Howey decision, the U.S. Supreme Court provided a test that courts still use today when determining whether something is an investment contract and, therefore, a security. The Howey test states that a contract, transaction, or scheme is an investment contract when there is an investment of money in a common enterprise with the expectation of profits solely from the efforts of the promoter or a third party. The discussion below examines the circumstances under which a promissory note or loan would fall within the SEC’s definition of a security.

Why You Should Care.

Securities are regulated under both federal and state law to protect the integrity of the marketplace and to protect investors. When a transaction involves the offer and sale of a security, it is necessary to comply with BOTH state and federal securities law. But, of course, not everything is a security. For example, purchasing a home is not a securities transaction. However, if you are raising money for your business through the use of loans, promissory notes, or other debt instruments, those types of transactions can trigger the securities laws. Accordingly, you will need to determine whether the instrument in question is a security under applicable law. Severe penalties may apply if you violate the securities laws (including criminal penalties). Further, it is entirely possible that something could be deemed a security under Virginia law but not federal law.

The following case explains how a court typically will determine whether a promissory note or a loan is a security:

The Reves v. Ernst & Young Decision

A co-op issued promissory notes with variable interest rates. The notes were payable on demand and offered interest rates exceeding those offered by local banks.  The co-op marketed the investment opportunity by promising that the investment was “Safe… Secure… and available when you need it.” Nevertheless, the co-op subsequently filed for bankruptcy owing more than $10 million to 1,600 different noteholders.

What was at stake?

Holders of the co-op’s notes sued Ernst & Young alleging that the accountants improperly valued one of the co-op’s major assets to inflate the assets and net worth of the co-op. It is a violation of federal law to make a materially false statement in connection with the purchase or sale of a security. Violations can result in a variety of penalties, including mandatory refunds to investors. So, if the co-op’s notes are considered securities, Ernst & Young would be looking at a potential $10 million liability.

The Court’s Analysis

The Supreme Court recognized that some notes are plainly not meant to fall within the federal definition of a security. The Court stated that a home loan, consumer financing, a loan secured by a lien on a small business or the assets of a small business, short term notes, or notes that formalize a debt incurred in the ordinary course of business are not securities.

The Court provided four factors to determine if a note sufficiently resembles the types of notes that are not classified as securities. The four factors are:

1. The intention of the company—if the company raised money for general use in a business enterprise, then the note is more likely to be a security.
2. The plan of distribution—the larger the audience to whom the promissory note opportunity is offered, the more likely it is to be found a security.
3. The expectations of the investors—if the investors thought they were investing in a business to generate a profit on their investment, the note is more likely to be found a security.
4. Other risk-reducing factors—if the note is collateralized or includes features that reduce the element of investment risk, the note is less likely to be deemed a security.

The Court’s Decision

The Court found that the investors thought they were investing to make a profit, the co-op was using the funds for general business purposes, and there was no other risk reducing factor, so it failed the family resemblance test (and passed the Howey test). Therefore, the Court held the notes were a security.

What Does This Mean for You?

If you are raising money for your business by offering promissory notes or other debt instruments to investors, be careful to structure your capital raising efforts in a manner that complies with applicable securities laws. Contact Perkins Law at (804) 205-5162 or [email protected] for assistance.