Can a California Note Be A Security?

Debt instruments can be securities. Section 3(a)(10) of the Securities Exchange Act of 1934 explicitly includes “notes” in the definition of a security, but does not include loans. Federal law uses some variation of the factors stated in S.E.C. v. Howey Co., 328 U.S. 293 (1946) n analyzing whether an instrument is an “investment contract” and therefore a security.

California also has a “risk capital test” to test whether an investment is a security. That test came out of Silver Hills Country Club v. Sobieski, 55 Cal.2d 811 (1961).

The risk capital test, articulated by the California Supreme Court in Silver Hills Country Club v. Sobieski (1961) 55 Cal.2d 811, 815 describes:

an attempt by an issuer to raise funds for a business venture or enterprise;
an indiscriminate offering to the public at large where the persons solicited are selected at random;
a passive position on the part of the investor; and
the conduct of the enterprise by the issuer with other people’s money.

The test reflects the court’s assessment that the term “security” is defined broadly in order “to protect the public against spurious schemes, however ingeniously devised, to attract risk capital.” (Id. at p. 814.)

The instrument in question in the Black case was a note that provided:

“(a) In the event the real property located at 177 and 200 North Edgewood Lane, Eagle, Idaho is sold by Borrower, the amount of interest shall be based on the percentage of profits minus expenses Borrower receives from the sale; or “(b) In the event Borrower develops said real property, Lender shall receive two (2) lots based on the tentative map to be selected by Lender. “(c) In the event that neither (a) or (b) take place before one year from the making of this note, the principal together with interest at the rate of ten percent (10%) shall become due and payable at the election of Lender.”

Mr. Black was arguing that the note failed the risk capital test because it was a heavily negotiated agreement and not one that was intended to offered to the public at large. It failed the second prong of the risk capital test.

According to California’s Sixth Appellate District in People v. Black (page 12):

“It is generally accepted that both the risk capital and federal tests may be applied, either separately or together; a transaction is a security if it satisfies either test.”

Black’s argument that it was not a security under Silver Hills failed to find traction. But the court still found that the note was not a security under the Howey test.

The California court found that repayment of the note was not wholly dependent on the efforts of Mr. Black. There was other collateral that may have allowed for some repayment of the note.

Surprisingly, the court comes back to include the nature of the transaction being individually negotiated and not being intended for wide distribution as factor in reaching its conclusion. Although the court rejected Mr. Black’s argument that the Silver Hills risk capital test is ~~muted~~ mooted by the federal Howey test, it seems to still include it in reaching its conclusion.

Perhaps, the court and Mr. Black should have looked at the formula used by the United States Supreme Court in Reves v. Ernst & Young (.pdf). That decision limits the Howey four part analysis of securities to “investment contracts”. Instead, it creates a new framework to determining if a note is a “note” under section 3(a)(10), and therefore a security. This is the Family Resemblance test.

Sources: