Promissory Notes as “Securities” – A Trap for the Unwary?
by Lee Lashway
In the current economic climate, bank financing can be difficult to obtain for even the most creditworthy borrower. Traditional lending sources for businesses have tightened the reins. Business owners may be tempted to turn to private lenders, which can allow their business to improve its overall financial situation, or to seize a business opportunity that would otherwise pass them by. It seems simple: the company borrows the money, issues a promissory note or notes evidencing the obligation to repay the private lender(s), and moves forward with the business. Unfortunately, things are not always as simple as they seem. Business owners should be aware that in many circumstances, issuing a promissory note to raise money may implicate federal and state securities laws.
Promissory notes are securities by definition. Although not widely known, both the Oregon Securities Law and the federal Securities Act of 1933 include a “note” and “evidence of indebtedness” in their respective statutory definitions of a “security.” However, that does not end the analysis.
“Family” of Notes?
Federal law expressly categorizes a note arising out of a current transaction with a maturity at time of issuance not exceeding nine months as an “exempt security,” meaning that federal registration requirements will not apply (Oregon has no such maturity-based exception in its definition). However, under the controlling U.S. Supreme Court ruling (Reves v. Ernst & Young, 110 S.Ct. 945 (1990)), federal law also sets up a rebuttable presumption that a promissory note with a maturity greater than nine months IS a security (as the statute requires) UNLESS it resembles one of a “family of notes” generally not considered to be a security for federal law purposes. The Reves court found the following family of notes not to be securities, regardless of maturity:
- Notes delivered in consumer financing.
- Notes secured by a mortgage on a home.
- Notes secured by a lien on a small business or some of its assets.
- Notes relating to a “character” loan to a bank customer.
- Notes that formalize an open-account indebtedness incurred in the ordinary course of business.
- Short-term notes secured by an assignment of accounts receivable.
- Notes given in connection with loans by a commercial bank to a business for current operations.
The court went on to hold that notes that do not fit cleanly in one of those categories can be evaluated for family resemblance using the following factors, in no particular order of importance:
- 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.
- Whether the borrower’s plan of distribution of the note(s) resembles the plan of distribution of a security.
- Whether the investing public reasonably expects that the note is a security.
- Whether there is a regulatory scheme that protects the investor other than the securities laws (e.g., notes subject to FDIC regulation).
While there is no definitive Oregon case law on this matter, it is reasonable to expect that the Oregon courts would be inclined to lean heavily on the federal law analysis in considering application of the Oregon statute.
So, there is no bright line? The evaluation of a note not clearly within the “family of notes” will be driven by the facts and circumstances of each situation. The presence or absence of any of the factors is not by itself determinative of whether the note sufficiently resembles one of the family of notes excluded from securities regulation.
What Should I Consider to Minimize the Likelihood That My Note is a Security?
None of the following is necessarily a safe harbor, but each can decrease the likelihood that your note will be found to be a security:
- Use private borrowing for specific rather than general business purposes.
- Consider whether the company is in a position to offer meaningful collateral security for repayment of the loan (but watch out for covenants in existing financing that might prohibit or require permission for subordinate financing).
- Minimize the number of private lenders, and do not publicly advertise for lenders.
- Limit private lenders to institutions or “accredited” investors.
What happens if a court, with 20/20 hindsight, finds my note to be a security? When a note has a maturity in excess of nine months and does not bear a “strong family resemblance” to one of the family of notes excluded from regulation, issuance will be subject to regulation under securities laws and administrative rules. Unfortunately, that conclusion is often not reached until months or years later when a disappointed lender is seeking legal recourse.
Whether inadvertent or purposeful, notes that are securities must be registered or exempt from registration under applicable laws, and appropriate disclosure requirements must be satisfied. Failure to comply with those requirements could render officers and directors of the issuing business personally liable under securities laws to repay the notes if the business, for any reason, should be unable to do so. Businesses contemplating private borrowing should consult legal counsel for assistance prior to accepting funds and issuing a note.
At Harrang Long Gary Rudnick P.C., we have several years of experience with securities exemptions, registrations, and related transactions and compliance activities for small businesses and individuals. Please contact J. Lee Lashway for assistance on any of these matters.
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