Closely held companies routinely raise money by borrowing from founders, family members, private investors and institutional lenders, and typically document that borrowing with promissory notes. Because the transaction looks like a loan, the parties often assume that the securities laws have nothing to do with it. What may be surprising is that federal and Ohio law both start from the opposite premise: a promissory note is presumed to be a security. When the presumption holds, the offering must be registered or exempt, and the issuer is exposed to the antifraud provisions and civil remedies that come with issuing securities. This article explains how to determine whether a note is a security, where the federal and Ohio analyses meet, and how Ohio’s exemption for promissory notes works in practice.
Initially, a promissory note is a written promise to pay a sum of money, on demand or at a stated time, usually with interest. The label the parties choose does not control, and in the Perrysburg case discussed below, the Supreme Court of Ohio treated a loan agreement as a promissory note because it contained the borrower’s written promise to repay a definite sum with interest.
Why Would a Loan Be a Security?
The answer starts with the statutory text. The Securities Act of 1933 defines “security” to include “any note,” the first instrument in a long list, and the Securities Exchange Act of 1934 uses the same language. The Supreme Court has stated that the two definitions are “virtually identical” and that “the coverage of the two Acts may be considered the same.” If a note is treated as a security, then Section 5 of the Securities Act requires the note to be registered unless an exemption applies, and Section 12(a)(1) lets a purchaser in a sale that violates Section 5 recover the price paid with interest, or damages if the purchaser no longer owns the security.
Congress made one explicit exception for short-term notes. Section 3(a)(3) of the Securities Act exempts a note from registration if two conditions are met. First, the loaned money must be used for “current transactions,” meaning the company’s day-to-day operations, such as buying inventory or meeting payroll. Second, the note must be due within nine months of the date it is issued. A note that meets both conditions does not have to be registered with the SEC. It is still a security, however, so the issuer remains liable if it misleads the lender in connection with the loan. The Securities Exchange Act of 1934 uses similar nine-month language, but it treats these notes as not being securities at all.
Read literally, these statutory provisions would exempt short-term notes sold to anyone, including ordinary members of the public, but courts and the SEC have refused to interpret the exception so broadly. Relying on the history of the statute, the federal appeals courts and the SEC concluded that the exception covers only commercial paper, meaning short-term, high-quality notes that a company issues to fund its operations and sells to banks, funds and other sophisticated buyers. The Supreme Court has never decided whether that narrower reading is correct, and it left the question open in Reves. A company should therefore assume that a short maturity, by itself, does not exempt a note from federal securities regulation.
How Do Courts Decide? The Family Resemblance Test
Reves is the seminal case in evaluating whether a note is subject to federal regulation. In that case, a farmers’ cooperative with 23,000 members raised money for its general operations by selling uncollateralized, uninsured demand notes to members and nonmembers. A demand note has no fixed due date, and the holder can require repayment whenever it chooses. The cooperative advertised the notes as part of an “Investment Program.” When the cooperative went bankrupt, more than 1,600 people held $10 million of its notes and sued its auditor under the Exchange Act’s antifraud provisions. Their claims depended on whether the notes were securities.
The Court explained that notes cannot be treated like stock, because notes “are used in a variety of settings, not all of which involve investments.” A home mortgage note or a note given in a consumer purchase is not the kind of instrument Congress meant to regulate, so “the phrase ‘any note’ should not be interpreted to mean literally ‘any note.’” The Court adopted instead the Second Circuit’s “family resemblance” test. The analysis begins “with a presumption that every note is a security,” and the presumption is overcome only if the note strongly resembles an instrument courts have already recognized as something other than a security. That family includes a note delivered in consumer financing, a note secured by a mortgage on a home, a short-term note secured by a lien on a small business or some of its assets, a note evidencing a “character” loan to a bank customer, a short-term note secured by an assignment of accounts receivable, a note that simply formalizes an open-account debt incurred in the ordinary course of business, and a note evidencing a loan by a commercial bank for current operations. Several of these categories are limited to short-term notes, so a long-term note secured by business assets does not automatically fit within the exception.
The Court measured resemblance by asking what those instruments have in common. It looked first at the parties’ motivations. A note issued to raise money for general business use, bought by a lender interested primarily in profit, which includes interest, is likely a security, while a note given to buy a minor asset or to correct a cash-flow problem is less likely to be one. The Court next examined the plan of distribution, asking whether there is “common trading for speculation or investment.” Offering and selling the notes to a broad segment of the public is enough. It then considered the reasonable expectations of the investing public, treating an instrument as a security when the public reasonably perceives it that way. Finally, the Court asked whether something else already protects the lender enough that the securities laws are unnecessary. That protection might come from another body of regulation, such as federal banking rules, or from features of the note itself, such as collateral or insurance that makes repayment likely. No single factor decides the question. Instead, courts weigh the factors together, and a note can be a security even if one factor points the other way. If a note does not closely resemble any instrument on the list, a court may still decide that it is not a security. To do so, the court must weigh these same factors and conclude that the note belongs in a new category of its own.
Every factor pointed toward a security for the cooperative’s notes. The cooperative raised capital for general operations, buyers sought interest, the notes were sold widely and advertised as investments, and they were “uncollateralized and uninsured.” On the nine-month exclusion, the Court held only that a demand note does not mature in nine months or less, because demand “could be made many years or decades into the future.” The Court failed to articulate a bright-line rule, and the scope of the exclusion remains unsettled.
What Happens When the Loan Is Privately Negotiated?
The presumption that a note is a security is weakest when the note evidences a privately negotiated, secured loan from a sophisticated lender. In Bass v. Janney Montgomery Scott, Inc., an investor made two bridge loans totaling $600,000 to a company preparing a private placement, meaning a sale of its securities to a limited group of investors without registering with the SEC. He received a single one-year note bearing 12% interest, later amended to cover the second loan, secured by a lien on virtually all of the borrower’s assets, along with a guarantee, stock pledges and warrants. The Sixth Circuit went through the factors one at a time. On motivation, the two sides pointed in opposite directions. The borrower wanted money to run its business, as any company taking out an ordinary commercial loan does, but the lender was looking for a return, which made the deal look “more like a transaction for profit.” Because the two motives cancelled each other out, the court called this factor “a washout,” meaning it did not weigh for or against treating the note as a security. The plan of distribution militated against treating the note as a security. The note was not offered to the public but was “negotiated with a single buyer and negotiated term by term.” The court called reasonable expectations “again largely a washout,” even though the term sheet referred to the note as a security. The risk-reducing factor also weighed against treating the note as a security, because the loan was backed by collateral, and “the existence of collateral is significant as a risk-reducing factor.” Weighing these factors together, the court held that the note was not a security.
The warrants changed the outcome. A warrant is a right to buy the company’s stock at a fixed price, and it let the lender share in the company’s growth on top of the interest on the note. The court held that “the Securities Acts define warrants as securities no matter what the context in which they change hands.” Because the lender received warrants along with the note, the securities laws applied to the transaction even though the note itself was not a security. The court added that parties who want to avoid that result “need only structure it as a straight loan,” meaning a loan with no warrants or other equity attached.
The Second Circuit reached the same result in a much larger deal. In Kirschner v. JP Morgan Chase Bank, N.A., a group of banks arranged a $1.775 billion loan to a single company and then sold portions of the loan to more than 400 institutional lenders, such as investment funds and insurance companies. Applying Reves, the court held that the loan was not a security. Under Reves, the lenders’ expectation of profit favored treating the notes as securities, but the remaining three factors cut the other way. The lenders could resell their portions only with permission, which kept the loan out of the hands of the general public. Each lender had confirmed in writing that it was sophisticated and had made its own decision about the borrower’s ability to repay, so the lenders understood they were making a loan and not buying an investment. And the loan was backed by a lien on all of the borrower’s assets, ahead of every other creditor, which reduced the lenders’ risk.
How Does Ohio Approach the Question?
Ohio’s definition of a security, in Ohio Revised Code Section 1707.01(B), differs from the federal definition. Its first sentence defines a security generally as any instrument or agreement that “represents title to or interest in, or is secured by any lien or charge upon, the capital, assets, profits, property, or credit of any person.” Its second sentence provides that a security “includes” a long list of instruments, among them “promissory notes, all forms of commercial paper, evidences of indebtedness,” and “any instrument evidencing a promise or an agreement to pay money.”
The Supreme Court of Ohio read those sentences together in Perrysburg Twp. v. Rossford (2004). Rossford’s mayor, acting for a nonprofit authority formed to build an arena, persuaded Perrysburg Township to lend $5 million at eight percent interest. The arena was never built, the authority defaulted, and the township sued under the Ohio Securities Act. The court held that the second sentence of the definition “provides a list of certificates and instruments that are presumptively securities,” so the note the township received was “presumptively a security.” It then adopted Reves to decide when the presumption is overcome, explaining that the federal test “fills a gap in Ohio law and promotes uniformity in securities law.”
The court then applied the Reves factors. Motivation did not point clearly either way, because the authority’s motive was commercial and the township’s was investment. The plan of distribution pointed away from a security, because the note was not sold to the public but was “a private agreement between two sophisticated entities.” The remaining factors favored treating it as a security. The mayor had described the loan as an “investment,” and the note was “uncollateralized and uninsured,” with no other law protecting the township. The trial court had dismissed the township’s securities claims on a motion to dismiss, at the earliest stage of the case, when a court decides only whether a claim can go forward. The court of appeals reversed, and the Supreme Court of Ohio affirmed, holding that the motion “should not have been granted.” The court therefore did not decide whether the note was a security, and held only that the township “may be able to prove that the note in this case is a security.” The case went back to the trial court, which held that the note was a security, and the Sixth District agreed. Perrysburg Twp. v. Rossford Arena Amphitheater Auth. The appellate court found that both sides had treated the loan as an “investment” and “not a short-term, collateralized business loan.” A single loan, privately negotiated between a township and a nonprofit authority, was therefore a security because nothing secured it and the parties called it an investment. That is the main difference from Bass and Kirschner, where collateral helped the lenders avoid security status.
Can an Ohio Note Offering Be Exempt?
An issuer that sells notes in Ohio must either register the offering or fit it within an exemption. Ohio law contains several exemptions, including exemptions that follow a federal private placement, but the one written specifically for promissory notes, in Section 1707.02(G), is the most direct fit for a note offering.
The note exemption is the one most often used for a small offering. Under Section 1707.02(G), “commercial paper and promissory notes are exempt when they are not offered directly or indirectly for sale to the public.” The statute does not define “public,” so the Division of Securities has done so by rule, in Ohio Adm. Code 1301:6-3-02(D). Under that rule, notes are not offered to the public if their sale is restricted to the officers and directors of the issuer (or of its parent company or corporate general partner), the issuer’s general partners, the people who control it, or a small number of outside purchasers. Most issuers rely on the last category, which permits sales “to not more than ten persons in this state during any twelve month period.” Those sales qualify only if the issuer reasonably believes, after reasonable investigation, that each purchaser is buying for investment. The issuer also may not use any advertisement or other public communication, other than an offering document or other communication that the issuer delivers to selected individuals. If it pays anyone a commission for selling the notes, the commission may not exceed ten percent of the initial offering price (not counting legal, accounting and printing costs) and may be paid only to a dealer or salesperson licensed in Ohio. In applying the ten-purchaser limit, some groups count as a single purchaser: a married couple, a parent holding notes for a child, a partnership or other unincorporated entity, and a trust that was not set up just to buy the notes. Sales to the company’s own insiders, such as its officers and directors, are left out of the count entirely, and so are sales the company makes under a different exemption.
Ohio courts treat this rule as the definition of “public” for the note exemption. Perrysburg II upheld the rule as one that “merely amplifies and defines” the statute. The court also held that nonprofit issuers may use the note exemption, and that an entity, such as a township or a company, counts as a “person” toward the ten-purchaser limit, so a business lender uses up one of the ten places just as an individual does. The Fifth District has since called the Division’s definition “a practical one, providing a clear line between the public and private sale of securities.”
Whatever exemption the issuer chooses, the issuer must prove that it applies. Section 1707.45 places that burden “upon the party claiming the benefits” of an exemption. In Mathias v. Rosser, the seller had sold notes to twenty to thirty people over about ten years, but nothing in the record showed how many of those sales fell within any twelve-month period. The trial court ruled for the seller after requiring the purchaser to prove that the exemption did not apply. The Tenth District reversed, because the seller, as the party claiming the exemption, had the burden of proving that the exemption applied.
What Is at Stake If the Exemption Fails?
Under Section 1707.43, a sale made in violation of the Ohio Securities Act “is voidable at the election of the purchaser,” meaning the purchaser may choose to undo the sale and get its money back, and both the seller and “every person that has participated in or aided the seller in any way in making such sale” are “jointly and severally liable to the purchaser” for “the full amount paid by the purchaser.” Officers, directors and others who help with the sale can therefore face personal liability. A purchaser must sue within two years after it “knew, or had reason to know,” of the facts making the sale unlawful, and in any event within five years of the sale. For a lender holding a defaulted note, undoing the sale in this way, called rescission, can be more attractive than a suit on the note, because it reaches the people who arranged the sale as well as a borrower that may be insolvent. The exposure is also criminal and regulatory. Knowingly selling an unregistered, nonexempt security violates Section 1707.44(C)(1) and is a felony under Section 1707.99, graded by the amount involved, and the Division may act administratively, as it did in Henneforth when it revoked the license of an investment adviser representative who sold unregistered notes.
Practical Takeaways
A company that plans to issue notes, and its counsel, should start from the presumption that the note is a security under both federal and Ohio law. The features that most often overcome it are private negotiation with a small number of sophisticated lenders, limits on the lenders’ ability to resell the notes, a written statement by each lender in the loan documents that it made its own judgment about the borrower’s ability to repay, and collateral. A note sold to individuals, described as an investment, and unsecured will rarely escape security status. If the note is a security, the offering should be planned to fit an exemption from the start, under both federal law and the securities laws of the states in which the notes are offered. A promissory note is often the simplest way for a growing company to raise funds, and treating it from the start as a possible security, with an exemption planned and documented before the first lender signs, is the surest way to keep a simple loan from turning into a costly dispute.
If your company plans to raise money through promissory notes and needs guidance, please contact KJK attorneys Christopher Hubbert (CJH@kjk.com), Andrew Wilber (AJW@kjk.com) or Cynthia Saad (CS@kjk.com).