In financing transactions, many companies consider raising capital through debt rather than equity. The reasons for this vary, but many mistakenly assume that issuing debt eliminates the need for securities compliance. This misunderstanding often leads companies to overlook key compliance requirements, such as registration or qualifying for an exemption under securities law. Understanding when and why the issuance of debt requires compliance with securities law is essential to avoiding potentially severe consequences.

Understanding the Definition of “Security” and its Exceptions

Under the Securities and Exchange Act of 1934 (the “Exchange Act“) and Securities Act of 1933 (the “Securities Act“), the term “security” is broadly defined to include notes. However, not every note is a security. Courts have ruled that notes related to consumer financing, home mortgages, short-term business liens, character loans, accounts receivable assignments, open account debts, and commercial bank loans for operations are not securities. Furthermore, the Exchange Act excludes commercial paper with a maturity date of less than nine months. These exclusions have led some companies to incorrectly believe that issuing notes are not an offering of securities, particularly when they’re for less than nine months. However, courts have made it clear that the nature of the transaction determines whether it is a security.

The Reeves Test – Why the Issuance of Notes is Often Considered an Offering of Securities

In Reeves v. Ernst & Young, the Supreme Court established the “family resemblance” test to determine whether a note qualifies as a security. Under this test, courts first determine whether the note resembles a security or a traditional loan. Next, the court considers the following 4 factors:

Motivation of Borrower and Lender: If the company issues the note to raise capital for investments, and the lender’s motivation is to earn returns rather than secure repayment, the note is likely a security.
Plan of Distribution: If notes are offered to multiple investors for investment purposes, the note is likely a security.
Expectation of Investing Public: If the investing public perceives the note as an investment opportunity rather than as a traditional loan, the note is likely a security.
Existence of Alternative Regulatory Regime: If the note is not already subject to another form of regulatory oversight, then it is likely a security.

If after applying these factors, the note does not bear a “family resemblance” to traditional loans, then it is likely a security subject to securities regulation.

Compliance Considerations for Companies Raising Capital Through Debt

Companies raising capital through the issuance of debt should carefully consider whether their offering is a security. If the issuance of a note is for investment purposes to finance an investment, it is likely a security requiring compliance with securities law. This means compliance with applicable registration requirements, disclosure requirements, and/or qualifying for securities exemptions. Failure to comply with securities law can lead to severe legal and financial consequences including enforcement actions, lawsuits, fines, and the inability to raise future capital.

What This Means for You

If your company is raising capital from investors for investment purposes through the issuance of promissory notes, you are likely conducting a securities offering which requires securities compliance. This typically involves either registering the offering with the SEC or qualifying for an exemption such as those under Regulation D. If seeking to qualify for an exemption, you will need to provide investors with a private placement memorandum, file a Form D with the SEC, and submit the necessary state blue sky filings. By understanding and adhering to these requirements, you can protect your company and investors while successfully raising capital through promissory notes.