A promissory note is a contract whereby the borrower – usually a business- promises to repay the lender at a specific time in the future. Sometimes the contract calls for the payment of periodic interest; oftentimes the interest is paid upon maturity, along with principal.
Promissory notes with maturities longer than nine months are generally considered to be securities, and as a result they must be registered for sale, or exempt from registration. Usually this entails a filing with either the SEC or with a state securities regulator.
In addition strict rules govern who can sell the promissory notes; generally, they can be sold only by employees of the business, and only to people with whom an existing relationship exists. These restrictions are why these types of investments are rarely sold through traditional brokerage firms.
When determining whether a promissory note is a security courts often rely on the “family resemblance test” which was established in Reves v. Ernst and Young 494 U.S. 56, 57, 110 S. Ct. 945 (1990) to help the court determine whether a note is a security. There are two components to the test, with four subparts to the second component.
The test begins with a presumption that all Notes are securities except for those Notes which traditionally have been used in consumer financing, or among sophisticated investors such as large commercial banks. These exceptions include mortgage notes, interbank loans or accounts receivables.
If the Note is not deemed to belong to the class of financing that has not traditionally been considered to be a security, the first component of the test is completed. The next step is to apply four factors to the investment at issue:
- What are the motivations of the buyer and sellers to enter into the transaction;
- What manner was the Note made available to the public;
- Did the purchaser view the Note as an investment; and,
- Is there a need for regulatory protections.
Step One: The Motivation test:
The first step is to analyze what motivations would prompt a reasonable seller and buyer to enter into the transaction. “If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a `security.'”
Step Two: The Distribution test
The second step examines the distribution of the note “`to determine whether it is an instrument in which there is common trading for speculation or investment.'” Common trading occurs when the instrument is “offered and sold to a broad segment of the public.”
Step Three The “Investor Expectation test
The third step of the analysis considers “whether … [the notes] are reasonably viewed by purchasers as investments.” Under this step, we must determine if the seller of the notes calls them investments and, if so, whether it is reasonable for a prospective purchaser to believe them.
Step Four: The need for Regulation
“The final step of the analysis examines the adequacy of other regulatory schemes in reducing the risk to the lender.” The purpose of the federal securities acts was to eliminate serious abuses in a largely unregulated securities market. Recognizing “the virtually limitless scope of human ingenuity … by those who seek the use of the money of others on the promise of profits, Congress broadly defined the scope of securities laws.
The Law Office of David Liebrader practices exclusively in the field of investment loss recovery and our securities attorneys have successfully resolved over 1000 investment loss cases over the past 27 years. Recoveries for clients top $50 million. The types of claims we have successfully handled include those involving unsuitable investments (suitability claims), excessive trading or “churning”, misrepresentations and omissions, unauthorized trading, over-concentration of illiquid or overly risky investments, pump and dump scams involving “penny stocks”, direct participation programs (private placements) involving real estate investment trusts (REITS), oil and gas exploration programs, leasing equipment deals and receivable financing, promissory notes whether sold through a broker dealer or as part of the outside business activities of a registered representative, ponzi scheme losses, failure on the part of the broker dealer to perform due diligence, state securities law (blue sky) violations and failure to supervise.
If you have suffered investment losses please call The Law Office of David Liebrader at (702) 380-3131 for a free, confidential consultation