Category: What is a Security?

Failing to Turn Real Estate Into a Security

hrsd_logo

Fee simple ownership of the “bricks and mortar” of real estate is not a security. “The offer of real estate as such, without any collateral arrangements with the seller or others, does not involve the offer of a security.” As you move further away from that model, you move closer and closer to the ownership a security than the ownership of real estate. The line between the two is not a bright line.

A transaction that looks nothing like a sale of stock and involving such diverse items as citrus groves and vacation homes may qualify as a sale of a security under federal law.

There has been a recent ruling in case battling over that line. In Salameh v. Tarsadia Hotels, the purchasers of real estate are suing the developer of the Hard Rock Hotel in San Diego. The project was a condominium- hotel ownership structure to help provide capital.  The purchase/investment turned out to be a bad one, so the purchasers sued the developer.

Their claim was that a series of documents, including the Purchase Contract, the Unit Maintenance and Operations Agreement, and the Rental Management Agreement turned the ownership of the hotel/condo interest into a “security” and not the mere ownership of real estate. Since the securities were not registered, they could seek rescission. In this case, the ownership and control issues were not just split into separate documents, some of the documents were entered into at significantly different times.

The purchasers lost the case and appealed. They just lost the appeal.

The Ninth Circuit Court of Appeals affirmed the ruling from the district court.  The Court distinguished these facts from Hocking v. Dubois, 885 F.2d 1449 (9th Cir. 1989)  in which it had found that there was a general issue of material fact whether the sale of a condominium along with a rent-pooling arrangement constituted a security.

In Hocking, the the purchaser would not have made the real estate investment but for the availability of the rental pool arrangement. The sale of the real estate was coupled together with the management and income sharing that made the real estate investment look more like a security.

In contrast, the Salameh plaintiffs failed to allege facts showing that the real estate was coupled together with the management and income sharing as a package. The hotel developer pointed out in its pleading that the rental management agreements were executed eight to fifteen months later.

The ruling is another loss for the SEC in this edge between real estate and securities. The SEC had filed an amicus brief that relied on its 1973 Guidelines as to the Applicability of the Federal Securities Laws to Offers and Sales of Condominiums or Units in a Real Estate Development (Securities Act Release No. 33-5347 (Jan. 4, 1973) as the standard.

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Is Bitcoin a Security?

bitcoin

You may have noticed that I focus on SEC actions against real estate companies. At the core of that interest is a look at whether the Securities and Exchange Commission has jurisdiction. The SEC is limited to securities. Commodities get covered by the CFTC and real estate gets covered by …..

Bruce Carton pointed to another item in the news that also addresses the realm of what is and is not a security: Bitcoin.

The SEC brought charges against Trendon T. Shavers, who is the founder and operator of Bitcoin Savings and Trust (BTCST). The SEC alleged that he was running a Ponzi scheme based on a “virtual currency” arbitrage on Bitcoin. Shavers apparently used the handle Pirateat40.

Beginning in November of 2011, Shavers began advertising that he was in the business of
“selling Bitcoin to a group of local people” and offered investors up to 1% interest daily “until
either you withdraw the funds or my local dealings dry up and I can no longer be profitable” Shavers obtained at least 700,467 Bitcoin in principal investments from BTCST investors, or $4,592,806 in U.S. dollars, based on the daily average price of Bitcoin.

Shavers argued that the BTCST investments are not securities because Bitcoin is not money, and is “not part of anything regulated by the United States. Shavers also contends that his transactions were all Bitcoin transactions and that no money ever exchanged hands.

The SEC argued that the BTCST investments are both investment contracts and notes, and therefore are securities. The SEC said that Shaver returned about 500,000 Bitcoins to investors, but made off with another 200,000

Bad news for Shavers. A decision in the case this week ruled that BTCST investments meet the definition of investment contract, and as such, are securities. The court concluded that it had subject matter jurisdiction to hear the SEC’s case.

15 U.S.C. § 77b of the U.S. Code defines “security” as “any note, stock, treasury stock, security future, security-based swap, bond…[or] investment contract…”  Under the Howey line of cases, an investment contract is any contract, transaction, or scheme involving (1) an investment of money, (2) in a common enterprise, (3) with the expectation that profits will be derived from the efforts of the promoter or a third party.

Investment of money

Bitcoin can be used to purchase stuff. The only limitation (and its a big one) is that it is limited to places that accept it as currency. Bitcoin can also be exchanged for conventional currencies, such as the U.S. dollar. It was that recent spike in the exchange rate between Bitcoin and the US dollar that attracted so much attention.

Common enterprise

A common enterprise requires interdependence between the investors and the promotor, for example where the investors colelctively rely on the promotor’s expertise. The investors were giving Shaver their bitcoins and he was supposed to trade them and get more value back them.

Expectation of profits from efforts of others

In this case, the investors were not taking an active role in the investment. They were relying on Shavers.

The court’s finding that it has subject matter jurisdiction means that the SEC’s case against Shaver can  move forward. The SEC still has not proven fraud and will likely face another round of arguments on jurisdiction.  The SEC still has to prove fraud.

The interest rate Shavers gave to investors was a staggering 7% per week for large investments. That smells like a Ponzi scheme. Personally, I don’t think I’d hand any money, bitcoin or US dollars, to someone named “Pirate.”

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Update: SEC Charges Real Estate Executives with Investment Fraud But Fails to State a Claim

cay clubs 1

The Securities and Exchange Commission brought charges against Cay Clubs Resorts and Marinas and several of its executives for defrauding investors. The case originally caught my eye because it involved real estate and would likely play a role in my continuing quest to figure out what’s a security.

The first ruling came out and it was bad for the SEC. A Florida court said the SEC failed to prove its case.  (SEC v. Graham, Case No. 13-10011 (S.D. Fla. Ruling issued July 10, 2013).

In order for the SEC to bring a claim against Defendants for violation of the Securities Act, the SEC must allege enough facts to establish that the subject transactions are investment contracts. Under the Eleventh Circuit’s interpretation of the three-prong test set forth by the U.S. Supreme Court in SEC v. W.J. Howey Co. (328 U.S. 293 (1946)), the Plaintiff must show that there was an investment, that it was a common enterprise, and that the buyer lacked control over profitability of the investment. See Alumni v. Development Resources Group, LLC, 445 Fed. Appx. 288 (1 1th Cir. 201 1); see also Bamert v. Pulte Home Corp. , 445 Fed. Appx. 256 (11th Cir. 201 ).

The court ruled that the purchase agreement is at the heart of the control analysis. The SEC didn’t file a copy of the purchase agreement on the record and did not include adequate factual allegations concerning the contents of the purchase agreement.

The case was dismissed without prejudice. So if the SEC can dig up a copy of the purchase agreement, the SEC can try again.

The SEC’s complaint stated that the defendants “offered investors the opportunity to purchase undervalued condominium units and obtain an immediate 15 percent return through a two-year leaseback agreement with Cay Clubs.”

Investors were also told that their units would appreciate after being renovated by Cay Clubs. Cay Clubs even managed to find lenders who would provide 100% mortgage financing.

During the leaseback, purchasers were restricted from using their units. They could only use the units for 14 days per year. Cay Clubs owned the common areas and controlled access to the units. Cay Clubs had a right of first refusal on the sale of a unit. Cay Clubs controlled the renovation of the resorts and the units. Under the master leasing program, Cay Clubs would rent out the units, with 65% going to the unit owner.

 

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Update: Real Estate Investment Fraud or Securities Fraud?

Looks like a great investment?
Looks like a great investment?

Back in September, the SEC announced an asset freeze against Western Financial Planning Corporation and its principal Louis Schooler for a $50 million real estate fraud. That caught my eye because the SEC has little jurisdiction over real estate. The structure of the real estate investments went a long way to try to be not securities. I assumed the defendants would start out of the gate by arguing that the interests were not securities. That turned out to be true. But a California federal judge rejected the argument that the land investments didn’t count as securities.

Attorneys for Schooler had filed a motion to dismiss the suit and argued that the interests Schooler sold to investors were general partnership interests. Schooler argued that the general partnership interests were entitlements to land, rather than traditional securities. Without a characterization as securities, Schooler’s alleged failure to disclose material facts to investors would be outside the SEC’s enforcement authority.

Judge Gonzalo P. Curiel laid out the three factor test from Williamson v. Tucker for whether a general partnership is an investment contract, and therefore a security:

A GP is an investment contract—and thus a security—if one of the following factors is present:

(1) the general partnership agreement leaves so little in the hands of the partners that the arrangement in fact distributes power as would a limited partnership;

(2) the partners are so inexperienced and unknowledgeable in the general partnership business affairs that they are incapable of intelligently exercising their partnership powers; or

(3) the partners are so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that they cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.

Judge Curiel found that the interests satisfied the second and third tests.

I don’t think this makes every real estate partnership interest a security. But it is a very fact dependent analysis. As you get more investors in the partnership and complicate the structure and management, the investment starts looking more like a security than a real estate investment.

However, the standard of review for the motion to dismiss is a based on an assumption that the SEC’s factual allegations are true and are viewed in the light most favorable to the SEC. If the case proceeds, the SEC will need to prove the allegations.

According to the SEC complaint, Schooler was marking up the price paid for the land investments. The aggregate price paid for investors in the land ownership was far in excess of the purchase price paid by Western. In one case the investors contributed $1.85 million for an undeveloped parcel of land in Stead, Nevada that had a fair market value of $355,000. A second issue was that Western was publishing investment brochures that hyped the value of the land and seemed to be marking the value improperly.

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Doesn’t Matter if Real Estate is a Security if You Lie to the Feds

pinocchio lie

I continue to look at the margins where real estate  and securities meet, so any case brought by the SEC against an real estate firm catches my eye. The latest to catch my attention was an investigation into Robert J. Vitale and his investment company, Realty Acquisitions & Trust. While there might be some argument as to whether the SEC had jurisdiction, that didn’t matter once Mr. Vitale lied to the Securities and Exchange Commission examiners.

The SEC was conducting an official investigation into allegations that Vitale engaged in violation of the securities laws. The SEC attempted to identify assets and bank accounts attributable to Vitale and asked for a statement of accounts. Vitale provided a “Background Questionnaire” form to the SEC purporting to list bank accounts and other assets attributable to him. But shortly before completing the questionnaire, Vitale transferred $100,000 from an account that was disclosed on the form, to a separate account that he controlled.

The Department of Justice stepped in and charged Vitale with willfully failing to disclose the existence of those funds and the bank account. To compound the problem, Vitale lied about the accounts and the cash during sworn testimony in an SEC investigation.

Vitale was likely a target because he had previously run into trouble with the SEC and been barred from the brokerage industry as a result.

As the blue fairy said to Pinocchio: “A lie keeps growing and growing until it’s as plain as the nose on your face.” That makes it really easy for the Feds to charge you with obstruction of justice, even if you may not have been guilty of the underlying crime.

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Revisiting the SEC’s Stance on When Real Estate is a Security

Compliance and real estate

After last week’s charges against Cay Clubs, I remembered that I wanted look at an old SEC Release on the applicability of the federal securities laws to condominiums and real estate development. Back in 1973 The Securities and Exchange Commission issued a release describing situations where a real estate offering could become a securities offering. At least according to the SEC.

SEC Release 33-5347 (pdf) discusses situations when the sale of condominium units, or other units in a real estate development, coupled with an agreement to perform rental or other services for the purchaser would become the offering of a security in the form of an investment contract or a participation in a profit sharing arrangement within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934.

The offering of real estate units in connection with any the following will cause the offering to be viewed as an offering of securities in the form of investment contracts:

  1. The condominiums, with any rental arrangement or other similar service, are offered and sold with emphasis on the economic benefits to the purchaser to be derived from the managerial efforts of the promoter, or a third party designated or arranged for by the promoter, from rental of the units.
  2. The offering of participation in a rental pool arrangement; or
  3. The offering of a rental or similar arrangement whereby the purchaser must hold his unit available for rental for any part of the year, must use an exclusive rental agent or is otherwise materially restricted in his occupancy or rental of his unit.

In all of the above situations, investor protection requires the application of the federal securities laws.

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Image is Western shot of Edgehill Condominiums in Edgewater NJ by Tguless. http://commons.wikimedia.org/wiki/File:Edgehill_Condominium.JPG

SEC Charges Real Estate Executives with Investment Fraud

cay clubs 1

The Securities and Exchange Commission brought charges against Cay Clubs Resorts and Marinas and several of its executives for defrauding investors. The case caught my eye because it involved real estate and would likely play a role in my continuing quest to figure out what’s a security.

The defendants have not settled with SEC, so I’ll be assuming the allegations in the complaint are true for this analysis.

Executives of Cay Clubs Resorts and Marinas raised more than $300 million from investors to develop resorts in Florida and Las Vegas. They promised investors a guaranteed 15% return through a two-year leaseback agreement and future income through a rental program. The developments didn’t succeed, so the investment turned to a ponzi scheme. New investments were used to ay the 15% return to earlier investors.

A with most investment frauds, the executives spent lavishly with the investors’ money. They bought homes, planes, cars, and boats. At least they diversified and spent some of the cash on buying gold mines, coal refining machinery, and a rum distillery.

That all sounds like investment fraud. But the charges are under sections 5(a), 5(c), and 17(a) of the Securities Act and 10(b) of the Exchange Act. The SEC is saying that the defendants sold securities, and did so fraudulently. They were selling real estate interests, or at least what looked like real estate.

According to Cay Clubs’ marketing materials, the Company would finance the purchase of the properties, renovation of the units, and development of the luxury resorts with funds raised from investors through the sale of units, which ranged in price from $300,000 to more than $1 million, and a required membership fee ranging from $5,000 to $35,000 per unit.

Cay Clubs promised a 15% return by leasing back the units from the buyers. The materials stated the leaseback was optional, but 95% of the investors entered into the arrangement. To participate, purchasers would have to pay a membership fee in excess of $5,000. The 15% return would be needed by the investors to cover carrying costs. Cay Clubs even managed to find lenders who would provide 100% mortgage financing.

During the leaseback, purchasers were restricted from using their units. They could only use the units for 14 days per year. Cay Clubs owned the common areas and controlled access to the units. Cay Clubs had a right of first refusal on the sale of a unit. Cay Clubs controlled the renovation of the resorts and the units. Under the master leasing program, Cay Clubs would rent out the units, with 65% going to the unit owner.

You can go back to the Howey case and use the four part test to determine if there is an investment contract, where there is

  1. an investment of money,
  2. a common enterprise,
  3. a reasonable expectation of profits, and
  4. a reliance on the entrepreneurial or managerial efforts of others.

This reminds me of the Boutique Hotel case. In that case the judge found that the investment was not an investment contract because the owners were not required to participate in the rental program. An owner could chose to not rent out its condominium or rent it out on its own. That means the business arrangement did not have a reliance on the entrepreneurial or managerial efforts of others. Therefore it was not an investment contract.

That distinguishes the Boutique Hotel arrangement from the one being contested in the Salameh / Hard Rock San Diego case. Hard Rock San Diego restricted the rental program to the one run by the seller/issuer. That was found to be an investment contract.

The Hard Rock case is still under appeal and the Boutique Hotel case is still running its course, so those are ones to keep en eye on.

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Is a General Partnership Interest a Security?

Looks like a great investment?

When the SEC announced an asset freeze against Western Financial Planning Corporation and its principal Louis Schooler, I was a bit troubled by the structure of the investments in question. The firm had structured the real estate investment vehicles as general partnerships. The presumption is that a general partnership interest is not a security. So if the investments are not securities, then there can’t be securities fraud, and the Securities and Exchange Commission loses the case.

During the temporary restraining order hearing, the court was willing to accept that the interests could be securities and granted the temporary injunction and asset freeze. The court recently ruled on whether to convert the temporary restraining order into a preliminary injunction. The ruling has a detailed discussion of the law on when a general partnership interest is considered a security. In my ongoing quest to find the line between what’s a security and what’s not, I spent a few minutes looking at the decision.

The defendants make the argument that “the case law over many decades has consistently held that there is a presumption that (1) interests in general partnerships are not securities, and (2) interests in raw land held solely for market appreciation are not securities.”  The court agreed and cited three key cases.

  1. SEC v. Merchant Capital, LLC, 483 F.3d 747, 755 (11th Cir. 2007) “A general partnership interest is presumed not to be an investment contract because a general partner typically takes an active part in managing the business and therefore does not rely solely on the efforts of others.”
  2. Shiner, 268 F.Supp.2d at 1340 “The general rule is that units in general partnerships are not investment contracts and therefore not securities under federal law.”)
  3. McConnell v. Frank Howard Allen & Co., 574 F.Supp. 781, 784 (N.D. Cal. 1983) “There is persuasive authority for the position that if an investor in a real estate syndicate expects profits to come solely from the general appreciation of property values, then the investment is not a security.”

But like any presumption, the presumption that general partnership interests aren’t securities can be overcome.  The securities laws define “security” to include an “investment contract” and general partnership interest could be considered an investment contract.  The Supreme Court, in 1946, defined an investment contract as “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.” SEC v. W.J. Howey Co., 328 U.S. 293(1946). The requirement that profits be expected “solely” from the efforts of the promoter has been given a liberal reading and has largely dropped the term “solely” from the investment contract test.

The Court summarizes the law on when general partnership interests qualify as securities and labels Williamson v. Tucker, 645 F.2d 404, 418 (5th Cir. 1981) as the seminal case. In Williamson, the Court devised a three part operational test for an investment contract.

A general partnership or joint venture interest can be designated a security if the investor can establish, for example, that
(1) an agreement among the parties leaves so little power in the hands of the partner or venturer that the arrangement in fact distributes power as would a limited partnership; or
(2) the partner or venturer is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers; or
(3) the partner or venturer is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.

In application of that test to this case, the SEC failed to meet the requirements of the first two tests, leaving the last test as the finale in the decision. Western Financial argued “that there’s no possibility for dependency because all the general partners do is invest in raw land and wait for it to appreciate in value.”

The SEC countered by focusing on the exit, arguing that it was up to Schooler and his firm to find suitable purchasers of the property. The defendants fought back and said that any offer to purchase would be forwarded to the partners to approve. In a telling piece of testimony, the Western Pacific employee said that was the procedure, but he had never put it to test because he had “never seen an offer during my time with Western ever come out.” That’s bad, but not necessarily securities fraud.

Ultimately, the court was most influenced by the parcels of land being owned by more than one partnership sponsored by Western Financial. The effect is that the partnership only owns a fractional interest in the land, making each partnership more dependent on Western and Schooler to manage the investment, at least with respect to the inter-partnership dealings.

At least for this court, the interests in a general partnerships that hold raw land are more likely to be considered not securities. Developed land has an operational side that would required management.  But having multiple general partnerships own the undeveloped land in common swings the interests back to the securities side.

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Real Estate Investment Fraud or Securities Fraud?

Looks like a great investment?

The SEC announced an asset freeze against Western Financial Planning Corporation and its principal Louis Schooler. At first the situation sounded like a complaint against a real estate investment fund, but after reviewing the complaint, I found it to be a much more twisted tale.

The defendants have not agreed to settle with the SEC, so the statements in the SEC’s complaint may or may not be accurate. I’ll assume so for purposes of finding some lessons.

The first issue is that Western was originating land investment deals and then selling them to investors. Nothing wrong with that, except for a big disclosure issue. According to the complaint, the aggregate price paid for investors in the land ownership was far in excess of the purchase price paid by Western. In one case the investors contributed $1.85 million for an undeveloped parcel of land in Stead, Nevada that had a fair market value of $355,000.

A second issue was that Western was publishing investment brochures that hyped the value of the land and seemed to be marking the value improperly.

Defendants continue to use incomparable “comps” to solicit investors.

The complaint cites an email sent to an investor comparing Western’s land to a nearby parcel purchased by Wal-Mart. Western paid $2.50 per square foot while Wal-Mart paid over $8 per square foot. Unfortunately for the comparison, Western failed to mention that its land lacked entitlements, zoning, grading, or groundwater rights.

One thing that bothered me in the complaint was that the investments were structured as general partnerships. That seemed very old school and could open the investors to claims since the entity lacked a liability shield. Then it dawned on me: securities. Western was probably taking the position that the general partnership units were not securities.

For a general partnership, those interests are generally not securities because they fail to satisfy the “from the efforts of others” part of the test of a security. Usually all general partners have decision making power with respect to the affairs of the partnership.

According to the complaint, Schooler exercised control over the general partnerships through the use of signatory partners and secretaries.  The secretaries were Western employees who ultimately controlled the bank accounts and executed documents.

Accordingly, the investors’ purchase of GP units was an investment of money in a common enterprise, and the investors holding those units were led to expect profits solely from Defendants’ efforts in managing, overseeing, and eventually selling the underlying property, Moreover, the GP Agreements left so little power in the hands of the investors that the GPs actually distributed power and functioned as if they were limited partnerships.

Western’s website gives the partnerships a different slant:

These investment groups are created within the structure of a general partnership. Each investment group stands apart from Western Financial; we do not manage the groups. We like to think of each one as a “mini-democracy.” All decisions are voted upon by members who own interest in the partnership, and no action is taken without a vote-by-ballot. A signatory partner is selected from the members who is authorized to sign on behalf of the group, but only after a vote. No one employed by Western Financial is eligible to vote in any of the general partnerships even though they may own an interest in a partnership. [My emphasis]

It sounds very American to own a piece of a mini-democracy. But unfortunately, it sounds like the investors got a bad deal.

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Is a Note a Security?

In the post-Dodd-Frank world of securities regulation, the definition of a security remains important when looking at funding options and regulatory regimes. Kickstarter works from the securities law perspective because it’s not selling securities. It’s helping project mangers sell products or receive contributions, with no expectation of an a profits interest in the underlying project. Equity crowdfunding platforms will need to wait for new SEC regulations to be enacted before they go live.

I’ve spent most of my time looking at securities from the perspective of equity because that it where I spend my working time. Of course, debt instruments can also 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. Recently, the influential Delaware Chancery Court took a look at some promissory notes and found that some were securities and some were loans. ( Francis Pileggi highlighted this case in his Delaware Commercial & Commercial Litigation Blog.)

The case involves several promissory notes, each with different terms and attributes, issued by ION. A shareholder of ION, Fletcher International, Ltd., claimed that the issuance of the notes was a violation of the terms of the contractual rights that governed the terms of ION’s preferred stock that required ION to obtain Fletcher’s approval before issuing any securities. Fletcher claims that the promissory notes were “securities”.

The Delaware court sets the standard of review using the the four-factor formula set forth 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.

This test came from another decision that gave a list of notes that are not securities:

  1. the note delivered in consumer financing,
  2. the note secured by a mortgage on a home,
  3. the short term note secured by a lien on a small business or some of its assets,
  4. the note evidencing a ‘character’ loan to a bank customer,
  5. short-term notes secured by an assignment of accounts receivable, or
  6. a note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized [… and]
  7. notes evidencing loans by commercial banks for current operations.

The Reves decision states that this list needed more guidance. The Court starts from the position that “all notes are presumptively securities”.  Then you need to need analyze whether the note fits into one of those exceptions through a four part test.

First, we examine the transaction to assess the motivations that would prompt a reasonable seller and buyer to enter into it. If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a “security.” If the note is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash-flow difficulties, or to advance some other commercial or consumer purpose, on the other hand, the note is less sensibly described as a “security.” .

Second, we examine the “plan of distribution” of the instrument, to determine whether it is an instrument in which there is “common trading  for speculation or investment”.

Third, we examine the reasonable expectations of the investing public: The Court will consider instruments to be “securities” on the basis of such public expectations, even where an economic analysis of the circumstances of the particular transaction might suggest that the instruments are not “securities” as used in that transaction. […]

Finally, we examine whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.

You need to look at an instrument to see if it bears a “family resemblance” to one of the enumerated instruments. Under this test, the presumption can be rebutted if the note bears a strong resemblance to one of the enumerated types of notes.

I scratch my head with a bit of confusion with the Reves test. The Delaware Court shares that confusion:  “Multi-factor tests can sometimes make the mind glaze over, and obscure their own fundamental purposes. Some of the less-than-logically-compelling case law under Reves illustrates that danger.” (In my mind there is even more confusion in the mix given the trading activity of residential mortgages. They were readily traded around during the overabundant years of the real estate boom.)

The essence of the Reves analysis is to determine whether the note in question is more like an investment or, more like a commercial loan or consumer loan transaction. “If the note in question looks more like a corporate bond, debenture, or other instrument the value of which rises and falls with the success of the issuer’s business, has a term of several years, and is easily traded, then that presumption will not be rebutted, because the note will not bear a strong resemblance to any of the notes listed in Reves for the basic reason that such a note is easily characterized as an investment, and thus a
security.”

Going back to the Delaware case, the court found one of the notes to be a security. The determination seems to pivot mostly on the length of the loan: four years. Another factor was that the note had a securities legend with references to a security. So it looked like a paper security/bond instead of a promissory note.

In the end, this case does little to help me clarify my thoughts about typical private equity and real estate fund note holdings. I suppose if the note has securities legends, that will tip it more towards the category of securities than a typical vanilla promissory note.

One follow-up from the Reves analysis of a note. In SEC v. Edwards, 540 U.S. 389 (2004), the Supreme Court held that a note that falls outside the family resemblance test as a “note” could still qualify as an “investment contract” under the Howey test.

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Image of the Sears, Roebuck bond is by SpreeTom

http://www.delawarelitigation.com/author/francispileggi/