The Reves Test and The Family Resemblance Test
Today is the final Lawcast in a series discussing “what is a security”. Although the term “note” is included in the statutory definition of a security, case law has determined that not every “note” is a security. Off the top, the Exchange Act and SEC specifically exclude notes with a term of less than nine months from the definition of a “security.” Also, numerous courts have carved out exemptions over the years for commercial paper type notes such as purchase money loans and privately negotiated bank loans.
Analyzing and bringing together the line of lower court opinions, the U.S. Supreme Court in Reves v. Ernst & Young, adopted the “family resemblance” test to determine whether a note is a security.
Under the “family resemblance” test, one must start with the presumption that a note is a security which presumption is rebutted if the note bears a resemblance to one of the enumerated categories on a judicially developed list of exceptions.
The following is a list of notes that have judicially been determined to fall outside the definition of a “security”:
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 which simply formalizes an open-account debt incurred in the ordinary course of business (such as a trade payable for office supplies); and
a note evidencing loans by commercial banks for current operations.
The “family resemblance” analysis requires a consideration of (i) the motivation of the seller and buyer – i.e. is the seller looking for investment and the buyer looking for profit; (ii) the plan of distribution of the note – i.e. is it being marketed as an investment such as in a private offering; (iii) the expectation of the creditor/investor – i.e. do they intend the investment to be a security; and (iv) the presence of an alternative regulation such as the banking laws for bank loans.
Also even if a note fits within one of the categories, if the note is a “convertible note” such that it can convert into a clear security such as common stock, it would become a security as the creditor would then be making an investment decision to exchange their debt for a security.