Small Business Debt As a Security- Issuing Equity
issuing small business equity and securities

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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