Chapter 2 - § 2.3 • DEBT AS A SECURITY

• Jurisdiction: Colorado

§ 2.3 • DEBT AS A SECURITY

§ 2.3.1—Introduction

Debt has long been considered a security in certain circumstances. As described above, 1933 Act § 2(a)(1) defines the term "security" to include "any note, . . . debenture, [or] evidence of indebtedness." 1934 Act § 3(a)(10) defines the term "security" to include "any note . . . [or] debenture . . . ; but shall not include . . . any note . . . which has a maturity at the time of issuance of not exceeding nine months. . . ."

In Marine Bank v. Weaver²³ the court held that a long-term certificate of deposit issued by a bank insured by the FDIC was not a security within the meaning of the 1934 Act. On the other hand, in Olson v. E.F. Button & Co.,²⁴ the court held that, when investors were trading certificates of deposit to generate revenue from interest rate changes, the CDs were "securities" and the broker could be liable for churning.

§ 2.3.2—The Reves Case

A seminal case in the consideration of debt as a security is Reves v. Ernst & Young.²⁵ In that case, the Farmers' Cooperative of Arkansas and Oklahoma sold uninsured and uncollateralized promissory notes payable on demand to its members. When the Co-op filed for bankruptcy, the holders of the notes sued the Co-op's auditors for violations of the anti-fraud provisions of the 1934 Act. The defendants attempted to use the "nine month" exception found in the 1934 Act definition, claiming that a note payable on demand was a note that matured within nine months of issuance. The plaintiffs countered that the exception was only to apply to high quality commercial paper. The court accepted neither interpretation, but found that the note in question did not fit within the exception in the context of the transaction at issue. However, the court held that where it was contemplated that demand would be made within the nine-month period, the notes may be within the 1934 Act exception.

Prior to the Reves case, courts recognized that promissory notes could be a security where the lending of money was in the nature of an investment, while in other circumstances debt is considered a commercial instrument and, therefore, not covered by the federal securities laws.

In Reves, the Supreme Court concluded:

that in determining whether an instrument denominated a "note" is a "security," courts are to apply the version of the "family resemblance" test that we have articulated here: A note is presumed to be a "security," and that presumption may be rebutted only by a showing that the note bears a strong resemblance (in terms of the four factors we have identified) to one of the enumerated categories of instrument.²⁶

The Court's "enumerated categories of instruments" was adopted from a 1976 Second Circuit decision,²⁷ which said that the types of notes that are not "securities" include "the note delivered in consumer financing, the note secured by a mortgage on a home, the short-term note secured by a lien on a small business or some of its assets, the note evidencing 'character' loan to a bank customer, short-term notes secured by an assignment of accounts receivable, or a note which simply formalizes an open-account debt incurred in the ordinary course of business." The Court added to the list "notes evidencing loans by commercial banks for current operations."²⁸

The Supreme Court said that "[w]e agree that the items identified by the Second Circuit are not properly viewed as 'securities.'"²⁹ The court then set forth four factors that should be analyzed to determine whether "an instrument bears a strong family resemblance" to one of the listed instruments and (therefore) should not be considered to be a security notwithstanding the statutory presumption that notes are securities.³⁰ Furthermore, as evidenced in various cases, courts may apply the four factors to determine whether the note at issue properly belongs on the enumerated list.³¹ The four factors are:

1) The motivation of the parties entering into the transaction. If the note maker's intent is to raise funds for general use in a business enterprise or to finance substantial investments, and if the payee is interested primarily in the return the note is expected to generate, the instrument likely will be considered a security. Conversely, notes that are delivered in consumer transactions or given to provide short-term working capital to address cash-flow problems are not likely to be considered a security.
2) The distribution plan —

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