Corporate Finance & Securities

When is a loan subject to securities regulations?

SEC LogoBackground

What is a security?
Securities are contracts for an interest in a company, sometimes called an “investment contract.” A typical example of a security transaction is the sale of company stock in exchange for cash. The SEC’s definition of “security” includes a 30-item list that stocks, notes, bonds, and investment contracts, among others. We recently discussed the Howey case, which provides the test courts use when determining whether something is an investment contract. Today’s post looks into the circumstances under which a note or loan would fall within the SEC’s definition of a security.

To start: Why does it matter if something’s a security?
Securities are extensively regulated because of the real risk that individuals and the companies they control could swindle unwitting investors. A typical scheme goes like this: a fraudster creates a company, but puts nothing into it. At this point the entity is just an empty shell. The fraudster then goes around telling potential investors all the reasons it’s a great idea to invest in this company. People invest in the company thinking the fraudster will grow it into the next Google or Facebook. The fraudster then goes on some lavish vacations, and a few months later our friends at the Washington Department of Financial Institutions coordinate with local prosecutors to get the fraudster sent to jail.

To protect against these fraudsters, state and federal government regulators have built some complex regulation schemes. To avoid these regulatory schemes, people sometimes try to structure transactions so the transaction falls outside the scope of securities regulations.

Reves v Ernst & Young

This US Supreme Court case answers the question of when a note or a loan is a security.

The story of the case
A co-op issued notes with variable interest rates. The notes were payable on demand and offered interest rates exceeding those offered by local banks.  The co-op induced investment by promising that the investment was “Safe… Secure… and available when you need it.” Nevertheless, the co-op subsequently filed for bankruptcy owing more than $10 million to 1,600 different note holders.

What was at stake
Holders of the co-op’s notes sued Ernst & Young alleging that the accountants improperly valued one of the co-op’s major assets in an effort to inflate the assets and net worth of the co-op. It is a violation of federal law (Rule 10b-5) to make a false statement in connection with the purchase or sale of a security. If you violate Rule 10b-5 you will likely have to pay the plaintiffs back for their losses. So if the co-op’s notes were securities, Ernst & Young was looking at a potential $10 million liability.

The Supreme Court’s Test for Determining Whether a Note is a Security

The family resemblance test
The Supreme Court recognized that some notes are plainly not meant to be within the federal definition of a security. The court stated that a home loan, consumer financing, a loan secured by a lien on a small business or some assets of a small business, short term notes, or notes that formalize a debt incurred in the ordinary course of business are not securities.

The four factors
If the note resembles the items listed above (home loans, etc.) then the note will not be deemed a security. The Supreme Court provided four factors to determine if a note sufficiently resembles the types of notes that are not classified as securities. The four factors are:

  1. The intentions of the company and the individual—if the company raised money for general use in a business enterprise, then the note is more likely to be a security; if the individual agreed to the loan primarily for the profit the note was expected to generate, the note is more likely to be a security.
  2. The plan of distribution—the more widely the note is offered, the more likely it is to be found a security.
  3. The expectations of the investing public—if the investors thought they were investing in a business to make a profit on their investment, the note is more likely to be found a security.
  4. Other risk-reducing factor—if the note is collatoralized or otherwise less risky than common notes, the note is less likely to be found to be a security.

The court’s determination in Reves
The court found that the investors thought they were investing to make a profit, the co-op was using the funds for general business purposes, and there was no other risk reducing factor, so it held the notes were a security.

What Does This Mean for You?

If you are raising money for your business by offering notes to investors, know that you may be subject to state and federal securities regulations. As Ernst & Young found out the hard way, the question of whether or not your transaction involves securities can have a $10 million answer.

If you’d like to learn more about securities, securities offerings, or different ways to raise capital for your business, please contact us today.

*Thanks to Sarah Youssefi for her help drafting this post. Sarah is a legal assistant at InVigor Law Group who currently attends law school at the University of Washington.


Kyle Hulten

When I'm not in the office I enjoy cooking, gardening, and watching my toddler son explore his little universe.

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