Promissory Notes as Securities
| Publication year | 1990 |
| Pages | 1585 |
| Citation | Vol. 19 No. 8 Pg. 1585 |
1990, August, Pg. 1585. Promissory Notes as Securities
Recent developments in the definition of a "security" for purposes of the Securities Act of 1933(fn1) ("1933 Act") and the Securities Exchange Act of 1934(fn2) ("1934 Act") illustrate that the U.S. Supreme Court is establishing a new conceptual framework for analyzing various investment transactions. Attorneys should be aware that this new analysis will result in the treatment of a number of promissory notes as securities, which will subject these notes to the full range of disclosure and liability provisions of the securities laws. This article reviews recent Supreme Court decisions, most notably Reves v. Ernst & Young,(fn3) and applies the conceptual framework of Reves to various lending and investment transactions.
The 1933 Act and the 1934 Act provide virtually identical definitions of a security.(fn4) In these Acts, Congress enumerated a number of instruments as securities, including "any note, . . . bond, joint venture, . . . investment contract. . . or participation in . . . any of the foregoing."(fn5) Congress intended to regulate investments, regardless of their name or form. Prior to the 1985 Landreth Timber Co. v. Landreth(fn6) case, counsel typically followed a case-by-case economic analysis of every transaction and instrument.
In Landreth Timber, however, the U.S. Supreme Court held that an instrument bearing the name "stock" was the quintessential security in the eyes of the investing public. Therefore, the Court held, virtually anything called stock was subject to the securities laws. It also held that a security was present where 100 percent of the stock of a corporation was sold to a person who acquired it for the purpose of operating and managing the corporation, thereby rejecting the sale of business doctrine exception to the definition of a security.
The Court in Landreth Timber adopted a per se rule for common stock, based primarily on the public perception of common stock as the paradigm of a security. It suggested that stock sold in any context, even where control also was transferred, should be treated as an investment within the reach of the securities laws.(fn7) Although the decision rejected a similar per se rule for promissory notes, the groundwork had been laid for the rebuttable presumption rule established in Reves.
In this U.S. Supreme Court case, a farmers' cooperative sold uninsured and unsecured promissory notes to a broad segment of the public. The notes, which were sold to raise capital for the general business operations of the cooperative, paid a variable interest rate in excess of rates paid by local banks and savings and loans. The notes were not publicly traded but were offered and sold to a large group of investors. Advertisements for the notes even characterized them as investments.
In Reves, the Supreme Court resolved questions that have troubled courts for several decades in analyzing whether a note is a security. A majority of the courts of appeal, including the Tenth Circuit,(fn8) had applied the investment/commercial dichotomy. These courts analyzed the economic realities and circumstances surrounding the transaction to determine if notes were issued in an investment context or in a commercial or consumer context.(fn9) Other courts of appeal had applied the investment contract analysis of SEC v. W.J. Howey Co.,(fn10) to determine if there was an investment in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.(fn11) The Second Circuit alone had followed a "family resemblance" test.(fn12)
Resolving any doubt as to the conceptual analysis to be applied, the Supreme Court in Reves showed rare unanimity
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