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The legal definition of a security can be quite broad! Before we get into the details, why is this such a big deal? If an investment you receive falls within the definition of a security, it will be governed by extensive federal and state securities rules and regulations that can be rather complex. It can be very expensive and time consuming to comply with securities laws. If you don’t comply when you have to, you risk being sued–which could result in you losing all the funds you received as an investment and even incurring fines. If you prefer to avoid this mess, the best route is to learn what a ‘security’ is and be sure your promissory note or other investment contract does not fall within its scope.
Securities laws serve to protect the ordinary or amateur investor. Surely you’ve heard of Ponzi schemes and other devious plots to get a bunch of people to invest in something with promises of great returns. The investors later find out that there was actually nothing to invest in; the orchestrator absconded with all the money and now lives in the Cayman Islands where he spends his days sipping fruity cocktails. The securities laws are meant to prevent such schemes of deception and fraud and to provide investors who’ve been taken advantage with some recourse to get their investment back. As much as there’s a lot for small business owners to complain about in the arena of securities laws, keep in mind that they are meant to ensure integrity and safety in certain investment transactions that are prone to fraud.
Over the years, many capital raising schemes have been crafted by folks seeking money in attempts to avoid securities laws, which are notorious for being complex and expensive. The courts don’t look too fondly on such schemes and have devised their own way of determining whether such schemes are in fact “investment contracts” that are subject to federal securities laws.
The most recent innovative scheme that has evolved in an attempt to avoid securities laws is crowdfunding. The SEC, the courts, and entrepreneurs are currently battling it out to figure out whether certain crowdfunding investments in start-up companies are subject to state and federal securities laws. The SEC recently made some revisions to federal securities laws to make certain crowdfunding transactions exempt, and some states are following suit. This is a great example of how the law evolves to address the changing landscape in culture, the economy, and society–albeit slowly.
Before going too much further, we’ll introduce one other legal term that is used in securities law–the “instrument.” This is not a violin or a guitar. It’s the legal document that sets the terms of the investment–how much money is involved, what does the investor get in return, under what conditions, what if the receiver of the money doesn’t abide by the terms, and so on. Used here, an instrument is basically an investment contract. This could be in the form of a stock certificate, a promissory note, a mortgage, etc. The courts don’t really care what the document itself is called. The ultimate question they ask is whether the terms of the investment instrument you’re using–no matter what its title is–falls within the definition of a security.
The official definition of a security, from the Securities Exchange Act of 1934, is: Any note, stock, treasury stock, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit, for a security, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a “security”; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker’s acceptance, which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.
Okay, so that’s not helpful. This is why the courts have stepped in to interpret what it all means.
The leading case on the definition of a security is the U.S. Supreme Court case, SEC. v W.J. Howey Co. Here, the court developed what is now known as the Howey test. The determinative factor of this test is what the investor was offered or promised in return for his or her investment. In the court’s language, a security is:
A contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.
Basically, under the Howey test, an instrument is a security if the investor is led to believe that he’ll get a return on his investment. Notably, the promised return may be fixed or variable and may be marketed as low-risk or even guaranteed.
When making this determination, courts frequently turn to the promotional materials connected to the instrument, which could include emails or other correspondence between the parties. If these materials or exchanges promise things like high returns or even guaranteed income, the court will almost certainly deem the instrument a security that is subject to the federal securities regulations.
Under the Howey test, pretty much every promissory note that charges interest would be deemed a security. Realizing promissory notes are quite common and can often be very low risk to the investor, federal courts have taken their analysis a step further when dealing with promissory notes and apply the Family Resemblance Test. This test has four steps.
If the borrower’s primary purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the lender is primarily interested in the profit the deal is expected to generate, the instrument will likely be deemed a security. However, if the note is entered into to help the borrower purchase a minor asset for her business, to alleviate some cash-flow difficulties, or to advance some other commercial purpose, the note is less likely to be deemed a security. The lender is seen as simply helping the borrower out without much benefit or great advantage on his part.
The court then looks to the ‘plan of distribution.’ For example, if the borrower plans to sell or trade the note to someone else–as if it is like stock in the company–then it will be deemed a security. If the borrower plans to simply keep it for herself and pay it off under the terms, it will not be deemed a security.
If the investors have reasonable expectations that this is a securities transaction whereby they have some legal protections, then it will likely be deemed a security. For example, if the lender can prove that he reasonably expected that the borrower would disclose highly relevant information–including other debts or cash flow issues that the lender has that may impact whether the borrower is able to make the principal and interest payments on time–the court may deem the note to be a security.
Finally, the courts examine whether some other regulatory scheme significantly reduces the risk of the instrument. This could include notes that are subject to federal deposit insurance and ERISA (Employment Retirement Income Securities Act). Note that these regulations come into play in pension funds and institutional bank transactions. So this is not likely a relevant factor in determining whether promissory notes between friends, family members, or even strangers are securities.
Another way of looking at this is to ask yourself, is the investor in your farm operation investing or lending you the money with the primary goal of making some money in return–such as guaranteed interest charges on a promissory note? Or, is he lending you the money because he has the money on hand and believes in what your doing; he simply wants the money back within a reasonable time with some reasonable interest charges on top to compensate him for his decision not to invest in something else where he could make a higher return? If it’s more like the former, it’s likely a security; if it’s more like the latter, it’s likely not a security.
You may be asking, what does this mean for me? Well, what it really comes down to is fairness and expectations of the lender. If the farm owner who’s “borrowing” money is intending to defraud the friend or family member whose lending or investing in the farm business and that friend or family member is relatively unsophisticated when it comes to financial affairs or is otherwise unable to protect themselves–such as an elder who suffers from Alzheimer’s or a three-year old child who inherited a lot of money–then the court may find a way to conclude that the promissory note was a security.
The implications of this is that the court could order you to give all the money back and you could face hefty fines; you could even face imprisonment if you willfully intended to defraud your friend or family member. Scary stuff you definitely want to avoid.
Again, whether the court will deem a promissory note a security really comes down to fairness. With this in mind, there are some things you can do to ensure fairness for your lender, which will help build your case that the note is not a security. Basically, if a promissory note for a business operation is not a security, the courts will generally call it a commercial loan. Commercial loans typically have some characteristics and mechanisms to protect the lender. In this way, modeling your promissory note after a commercial loan can be a helpful way to ensure your note will not be deemed a security.
For example, commercial loans are typically provided by one or just a few lenders that the borrower approaches directly. They are not typically sought through public solicitation to a bunch of random strangers, by knocking on doors, or rallying people from off the street. In addition, commercial lenders generally require the loan to be collateralized, or secured by a valuable asset that you own outright such farm equipment, a house or farmland, a tractor or a car, and so forth. This is called a secured loan, as opposed to an unsecured loan where there’s no collateral. A secured loan reduces the lender’s risk by providing the added protection of being able to acquire the asset identified in the promissory note as collateral if the borrower defaults or fails to make the payments on time. While the courts haven’t definitively said that any of these measures are guaranteed to make your promissory note not a security, they can certainly help.
This guide focuses mostly on the federal definition of a security. Note that securities laws exist at both the federal and the state level. If your instrument or financing arrangement falls within the federal definition of a security you’ll have to comply with federal laws and if it falls within your state’s definition of a security you’ll also have to comply with your states laws. It’s not either or, it’s both.
The good news is that many states have adopted the Howey test. This makes it more straightforward to at least determine whether your instrument is a security in your state as you just have to apply one test. But remember, if it falls within the Howey definition, you’ll have to comply with both federal securities laws and your state’s securities laws.
However, some states have adopted completely different tests, including some form of the “risk-capital test.” The risk capital test considers four factors:
Basically, the risk capital test again reiterates the issue of fairness and protections to the lender. By modeling your note after a commercial loan– namely not soliciting funds from the public at large or seeking investments from random strangers–and having the loan secured by collateral, you will most likely meet this test.
States that have adopted the risk-capital test in some form include: California, Hawaii, Arkansas, Ohio, Oregon, Alaska, Georgia, Michigan, North Dakota, Oklahoma, Washington, Illinois, New Mexico, North Carolina, Wisconsin, and Wyoming. Generally, courts in states that apply the risk capital test will use both the Howey test and the risk capital test to determine whether something is a security. The court will conclude that an instrument is a security if it meets the definition of a security under either test.
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