Four factors for small business owners when issuing equity
In a previous article—Keys to Issuing Equity for Small Business Owners—we covered the idea that issuing shares of stock, or membership interests, in a business could trigger obligations under the securities laws.
More specically we discussed that issuing equity interests to even friends and family could trigger disclosure obligations. What we did not address was the question of whether issuing debt, like issuing promissory notes to potential investors, could also trigger application of the securities laws.
While the issuing of stock is a classic example of a transaction where the securities laws apply, the issuing of debt instruments like “promissory notes” presents a less clear-cut picture.
The most significant legal authority on this subject is the U.S. Supreme Court opinion in the case--Reves v. Ernst & Young—wherein Justice Marshall discussed the standard that should be used to determine whether the securities laws apply to debt-instruments, like promissory notes.
That case involved an agricultural cooperative which issued promissory notes to its members to help raise capital, in the form of loans.
The notes that were issued paid a variable rate of interest to holders, and were “demand” notes, meaning that the holder could demand repayment of the debt at any time. As it happened, the cooperative ended up becoming insolvent and going into bankruptcy, leaving in the lurch almost 1,600 note holders holding, collectively, about $10 million of debt.
The note holders ended up suing the accounting firm, which had audited the cooperative’s financials, for securities fraud.
Their claim against Ernst & Young was that it had overvalued certain assets, which created the false impression that the cooperative was sounder financially than it really was.
In determining whether the notes were “securities,” Justice Marshall, writing for the majority of the Supreme Court, pointed to the statutory definition of “securities” which included “notes” with maturities exceeding nine months. He explained, however, that not all notes were traditionally thought of as vehicles of investment.
Adopting the Second Circuit’s “family resemblance” approach, Justice Marshall explained that there were certain categories of notes that were more clearly not securities.
These notes included the following;
- Notes delivered in consumer financing
- Notes secured by a mortgage on a home
- Short-term notes secured by a lien on a small business or some of its assets
- Notes that are “character” loans to a bank customer
- Short term notes secured by an assignment of accounts receivable
- Notes which formalize an open-account debt incurred in the ordinary course of business,
- Notes evidencing loans by commercial banks for current operations
The idea was that all notes were presumed to be “securities” unless they held a “strong” “family resemblance” to one of the above listed types of notes that were considered to be exempt from the securities laws.
Next page- The Court looked at 4 factors and The Takeaway
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In considering whether a note held a strong family resemblance to an exempt note, the Court looked at four factors:
1. Whether the seller intended the issuance of the note to raise capital for general business use and whether the purchaser intended the note to generate a profit (usually in the form of an advantageous interest rate.
2. Whether the issuance of notes was part of a “common plan” of distribution to generate investment
3. Whether the public had a reasonable basis for believing that the note in question was a security.
4. Whether other bodies of regulations existed, aside from the securities laws, that would have governed the type and issuance of the notes in question, i.e. certificates of deposit, for example, are substantially subject to regulations promulgated by the Federal Deposit Insurance Corporation.
Applying the “family resemblance” test to the case before them, the Supreme Court held that the notes issued to members and non-members of the agricultural cooperative were, indeed, securities and that more comprehensive disclosures were required under the securities’ laws anti-fraud provisions.
As explained in our prior article--Issuing Equity-- issuers of securities who run afoul the securities laws hazard personal liability as well as civil penalties and the fees and expenses incurred by claimants.
The take away:
- All debt instruments issued by a business should be carefully analyzed to ascertain whether they would fall into a category of note that would make them exempt from the securities laws.
- If there is any doubt that a note squarely fits into one of the exempt categories, it should be analyzed in terms of the four factors described above to determine if there is a “strong family resemblance” to one of the exempt categories of notes.
Basically, if it looks like a security, and feels like a security, it probably is, and the disclosure provisions of the anti-fraud provisions of the securities laws probably apply;
- When in doubt, consult with competent legal counsel.
Many a business owner has been inadvertently caught violating the securities laws leading to the end of their business before it had even begun. Ignorance of the law will not be deemed an excuse or mitigating factor, and the extent of personal liability associated with violating the anti-fraud provisions of the securities laws can be significant.
Related articles:
Part one: Keys to Issuing Equity for Small Business Owners