Excerpts of “When is a Promissory Note a Security?”

In this article, I discuss when a promissory note is a “security.”  The issue is important because, if the note is a security, then the issuer of the note must comply with securities laws.  If the note is not a security, then the loan transaction can go forward without securities law compliance.  Given the costs of securities law compliance, issuers want to avoid it whenever possible.

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In general, under the 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).  Likewise, 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.

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“If a business note is not a security, usually the courts will call it a commercial loan”.  …  “It also helps if the number of lenders is very small, and the note is secured by collateral.”

For example, the Sixth Circuit held that a $600,000 bridge loan was a note, not a security.  Bass v. Janney Montgomery Scott, Inc., 210 F.3d 577 (6th Cir. 2000).  The bridge loan note was not a security because there was only one investor and the note was collateralized. 

Likewise, the Ninth Circuit (in an unpublished opinion) concluded that a $5 million note from a limited partnership was not a security.  Piaubert v. Sefrioui, 208 F.3d 221 (Table), 2000 WL 194140 (9th Cir. 2000).  The lender made the loan to support the borrower, not as an investment.  The lender had an ownership interest in the borrower.  In addition, the note bore an interest rate substantially below the prime rate and interest was payable only at maturity (5 years).

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“Structure your transaction as best as possible to avoid classification of your notes as securities.”

http://www.mattdickstein.com/Files/99Securities/Note%20as%20Security.htm