ATTORNEY EXPLAINS When Is a Promissory Note a Security (Step-by-Step Analysis) (Ep. 51)

When is a promissory note a security? Like I can’t get the answer. I can look at you everywhere. I can’t get a black and white answer. And the reason is that there is no black and white answer to whether a promissory note is a security. In fact, the judges, you know what the judges say? If it looks like a security, it acts like a security. It walks like a security, it’s a security. Like, wow, great. Thanks so much for that help. So in this episode, what I wanted to do is talk about three things. One is when is a promissory note clearly not a security? When is a promissory note clearly a security? And then when are we not sure that we’ve got to do a little bit of a deep dive? Because actually, if you look at the definition of the security, which shows up in two places in the Securities Act, the first word, it literally says the term security means any note, any promissory note. So right there in the definition of security, when it enumerates all the stuff, a promissory note is a security by definition, except, and this is the only time that you can go to the bank that it’s not a security, is when it’s a note that’s less than nine months. So when you put together a note less than nine months, the government considers that sort of commercial paper, and it’s not gonna be considered a security. But you’ve got to make sure that it’s one promissory note less than nine months. People start getting creative with that as well, and they start fractionalizing the note, or getting two or three or four different investors. We’re talking about one promissory note, one person, one borrower, one issuer, less than nine months, it’s not gonna be a security. So that typically works pretty well for flippers, right? So if you’re a flipper out there, I know it’s not really something that sort of, although we do have some syndicators that are doing flips, then this is a great tool to potentially use. Where it’s clearly a security is anytime you’re using it to raise capital, certainly for a real estate deal, but really at any time, even for your own business, if you’re raising it for general purposes, then that’s gonna be considered a security. There’s really no doubt about that. So most of the time, when I get calls from potential clients or clients says, hey, I wanna raise capital, but instead of doing it in the form of equity, I’m gonna do it as a note or debt. Some people for some reason think that they magically will get around the securities laws by structuring it as debt versus equity. But debt, equity, promissory notes, you guys heard the story, it doesn’t really matter how you structure it. Anytime you’re taking money from passive investors where the returns are generated by your effort, it’s a security. Now, what’s interesting about promissory notes, and this I’ll get to my next point here, is that very, not very early, but you’ll have those situations a lot of times where it’s not less than nine months, it’s not a capital raise like a syndication, and you get these sort of one-offs, like what if it’s just one person or two people, it’s a very unique situation. What’s interesting is that most of the time we rely on the Howey test, which is what you guys are hopefully familiar with at this time. That’s where I get my sort of cheat sheet definition of anytime you take money from passive investors, where the returns are generated by your efforts, it’s a security. That’s the Howey test. When it comes to promissory notes specifically, there’s another test, I’ve actually rejected the Howey test because promissory notes are so wacky, and it’s actually a case called Reeves. And so it’s like the Reeves test. But here’s what’s interesting. Here’s when it’s also not a security, it’s actually technically a security, but it’s a rebuttable presumption. So you start with the idea that these are securities, except these specific six examples are not gonna be securities, or you’ve got the presumption, overcome that presumption, and I’m gonna read them off, but they are any note that’s delivered in consumer financing, right? Which kind of makes sense. So if you’re going to the store, Walmart or whatever, and you buy an iPad or something, and they give you terms, and that’s technically a note, that’s obviously not a security. Number two is a note secured by a mortgage on a home. And this one’s a little bit tricky because a loan or a mortgage on a home generally means your primary residence, single family. So again, if you’re gonna go buy a house, and I lend you money and you secured it with a mortgage, that’s likely not gonna be a security. The question then becomes, well, what if it’s for an investment purpose or it’s an investment period? And I’ll get to that in a second. Number three would be a short-term note secured by a lien on a small business or some of its assets. So you kind of do a UCC1 finance statement. I lend you whatever, 20 grand, 30 grand, and you’ve got some assets that I can put a lien against. And this issue of collateralization, by the way, just in order to have a mortgage on a home, and now we have a note secured on a lien, that plays a big part of this when we’re doing this analysis on whether it’s a security. Now, is it collateralized, right? Because an unsecured note is gonna look different from a non-collateralized. A note evidencing a character loan to a bank customer. That’s obviously not gonna be applicable to us because we’re not in the bank system. A short-term note secured, there’s that word again, a short-term note secured by an assignment of accounts receivables. So again, if you’re running a business, you’re gonna have all these accounts receivable. It’s not uncommon for people to get loans and secured by the accounts receivable. We’re actually personally going through that right now. We tend to have a lot of accounts receivable. So we’re gonna go get a line of credit because it’s quite a bit, and we’d like to have that, be able to tap into that. And then the last one, number six, is a note which formalizes an open account debt incurred in the ordinary course of business, which also makes sense. Like if you, obviously, if you’ve been lending me money over the time, and we’ve made a couple of loans, and now we wanna formalize that in a formal note, that’s not gonna be a security. But those are pretty specific, right? Those sixes. And so if you don’t hit exactly one of those sixes, then you go sort of the next level, which is, well, does your specific fact pattern have a strong resemblance, what they call a strong family resemblance, to one of those six? And that’s gonna be your burden. You’re gonna have to be able to show, yeah, my specific fact pattern looks like one of these or doesn’t. And the one I always love to focus on is number two, which is a note secured by a mortgage or a home, because that’s the one that affects us real estate syndicators the most, or real estate investors, because there’s always real estate involved. And so I take the position, and this is not a black and white, I just feel comfortable with this, but I take the position is that if you get one person lending you money, giving them a promise, they lend you money, and it’s secured in first position, that is not gonna be a security. That’s my position. Now, if you start fractionalizing that, like if you get two or three investors that are lending you money to go buy a piece of property or whatever, that starts to look like an investment contract, which is a security. But if you’re acquiring a piece of property, you get a loan from somebody and you secure it in first position, I’m pretty confident that’s not gonna be security. I think that strongly resembles number two. The question that becomes, what about a second mortgage or a third mortgage? That gets a little bit more complicated because at that point, I look at whether it’s completely collateralized, how if for whatever reason you don’t pay the loan back, how easy is it for them to just go get the property? The easier it is for them to go get the property, the more likely it’s not gonna be security. I am searching to this day, case law that really just hits this macro in the middle. I’ve found some case law that talks about loans secured by assets or not securities. But again, a lot of the attorneys I spoke to are comfortable as well. I just haven’t been able to find a specific case and I always feel better about things when I can point to a particular case. If yeah, here’s a case that said, hey, this is a fact pattern that’s not crazy. People buy real estate all the time, people get loans on real estate all the times. And so if you end up raising money from one individual, they lend you 200 grand to go buy a piece of property, secured in first position, I feel pretty good about that. And then of course, one of the, not of course, but there’s all these other factors, which I didn’t wanna get too in the weeds of this, but if you’re not following, if you don’t fall in specific into one of these six and you’re having a hard time with the family resemblance, then you have to start looking at other factors. And there’s like four other factors that the courts look at. One is the motivation of the buyer and seller, like what’s the purpose of the loan, right? If the seller’s purpose, again, is to raise money for their general business, that’s probably gonna be a security. If on the other hand, they’re just looking to buy a piece of equipment, sort of a minor asset, then it starts to look less like a security. The one that’s really weird is, the intent of the lender, like if their goal is to actually make a profit, then that starts to look like a security, but then everybody understands that, well, why else would you lend money? So a lot of these factors aren’t super helpful, but these are the actual, the factors in the analysis that the courts have talked about. The plan of distribution is another pick. Like if you’re starting to blast out your note offering to a bunch of people, or certainly if that note is traded, if it starts to look like a plan of distribution, and it looks like that investment, that’s gonna be considered security. And then, just other factors, just that if some factors reduce the risk of investment, like there’s some alternative regulatory scheme, it just gets more and more complicated. So at the end of the day, what I wanted to really make a strong point here is that many people believe that, hey, if I just do a loan or it’s a promissory note, then somehow that’s not a security. And I want you guys to think of that the other way around. Like you should start with the presumption, unless it’s a note from less than nine months, that it is a security. And so as soon as that happens, you wanna be contacting us or somebody to start doing a facts and circumstances analysis as to whether this particular fact pattern serves the purpose of the security. Again, if you’re a flipper, I think you can use a nine months or less. And if you have one investor, maybe you have one money person who’s willing to lend you the money to go buy a piece of property and it’s secure, that’s fine. As long as they are not participating in the profits, right? If their main motivation is lending you money for the profit piece, meaning it’s a loan, but we split the profits 50-50 or 70-30, that’s gonna look like a security as well. But if it’s a straight up note, all you’re getting is an interest rate and it happens to be collateralized in first position, maybe even second position if there’s enough collateral, then I think we’re good on being a bit of security. But literally one of the reasons I have not done a live on this or any content, it’s just so fricking complicated. There’s no black and white answer of yes or no, is a promise or no security, yes or no. It really does depend. And you start looking at all these factors and circumstances and you’re looking at the case law, which makes things super, super complicated. So…