The Missouri Securities Act of 2003 (“2003 Act”) provides the definition of a “Security.” Section 409.1-102(28) (Cum. Supp. 2008) states that the term “Security” means:
[A] note; stock; treasury stock; security future; bond; debenture; evidence of indebtedness; certificate of interest or participation in a profit-sharing agreement; collateral trust certificate; preorganization certificate or subscription; transferable share; investment contract; voting trust certificate; certificate of deposit for a security; fractional undivided interest in oil, gas, or other mineral rights; put, call, straddle, option, or privilege on a security, certificate of deposit, or group or index of securities, including an interest therein or based on the value thereof; put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency; or, in general, an interest or instrument commonly known as a “security”; or a certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.
Whether or not the term “note” applies such that the financial obligation at issue is considered a “security” is an issue that has not been decided by the Missouri courts. However, the United States Supreme Court in Reves v. Earnst & Young, 494 U.S. 56, 62 (1990) recognized that not all notes, which are used in a variety of settings, involve investments. Thus, the Court found that the phrase “any note” contained in § 3(a)(10) of the Securities Exchange Act of 1934 should not be interpreted to mean literally “any note,” but must be understood against the backdrop of what Congress was attempting to accomplish in enacting the Securities Acts. Id. After all, “Congress was concerned with regulating the investment market, not with creating a general federal cause of action for fraud.” Id. at 65.
In order to determine which notes should be considered securities, the Supreme Court adopted the “family resemblance” test. Id. at 65. The test begins with a presumption that every note is a security. Id. This presumption can be rebutted in two ways. Id. The first way of overcoming the presumption is by showing that the note in question “bears a family resemblance” to a list of instruments commonly denominated “notes” that fall outside the “security” category. Id. This list includes:
the note delivered in consumer financing, the note secured by a mortgage on a home, the short-term note secured by a lien on a small business or some of its assets, the note evidencing a “character” loan to a bank customer, short-term notes secured by an assignment of accounts receivable, or 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). Id.
The second way to overcome the presumption is by convincing the Court to essentially add an item to this list. The Court must consider four factors before doing so. Id. at 65-66. These factors are: (1) the motivations that would prompt a reasonable seller and buyer to enter into it; (2) the “plan of distribution” of the instrument to determine whether it is an instrument where there is “common trading for speculation or investment”; (3) the reasonable expectations of the investing public; and (4) whether another regulatory scheme significantly reduces the risk of the instrument. Id. at 66-67. The Missouri Commissioner of Securities issued an interpretive opinion on October 1, 2003, that adopted the Reves’ “family resemblance” test for the State of Missouri. See Loan Participations under the Missouri Securities Act of 2003, IO-13-03. Because the notes at issue in this case do not appear to bear a family resemblance to those that are on the list of notes which fall outside the “security” category, an analysis of the four Reves factors is necessary.
A. Motivations of Buyer and Seller
In Reves, the Supreme Court stated that the first factor requires an examination of the motivations that would prompt a reasonable seller and buyer to enter into the transaction. 494 U.S. at 66. The Court stated that:
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.” Id.
The Supreme Court found that in the case before it this element weighed in favor of finding that the notes were securities because the defendant sold the notes in an effort to raise capital for its general business operations, and the purchasers bought them in order to earn a profit in the form of interest. Id. at 67-68.
Although at least one court has described this test as “somewhat tautological,” it nevertheless has been applied by a number of courts since Reves. See Singer v. Livoti, 741 F.Supp. 1040, 1049 (S.D.N.Y. 1990).
B. Plan of Distribution
In Reves, the Supreme Court stated that the second factor examines “the plan of distribution” of the instrument to determine whether it is an instrument in which there is “common trading for speculation or investment.” 494 U.S. at 66. The defendant in Reves offered the notes over an extended period to its 23,000 members, as well as to nonmembers, and more than 1,600 people held notes when the defendant filed for bankruptcy. Id. at 68. The Supreme Court found that this factor weighed in favor of finding the notes to be securities because, while not traded on a stock exchange, the notes were offered and sold to a “broad segment of the public.” Id.
In LeBrun v. Kuswa, 24 F.Supp.2d 641, 647 (E.D.La. 1998), the defendant obtained loans from eleven individuals personally known by an associate of the defendant in order to provide capital for operations of a business. 24 F.Supp.2d at 642. The court found that there was no common trading for speculation or investment in the notes, including no offering or sale to a “broad segment of the public.” Id. Therefore, the court concluded that this factor weighed against finding the notes in the case before it were securities. Id.
Other courts have also found that the second Reves factor weighs against finding a note a security where “the plan of distribution was limited to those persons in close proximity with Defendant and therefore not offered and sold to a broad segment necessary to establish the requisite ‘common trading’ in an instrument.” Ford v. Spartin, Civ. A. No. HAR 92-696, 1992 WL 297432 at *3 (D.Md. July 23, 1992) (finding that the second Reves factor was not met where notes were procured by four individuals); see also Tab Partnership v. Grantland Financial Corp., 866 F.Supp. 807, 809 (S.D.N.Y. 1994) (finding that securities laws are not properly invoked where a loan results from direct negotiations between the parties); see also Prochaska & Associates, Inc., v. Merrill Lynch Pierce Fenner & Smith, Inc., 798 F.Supp. 1427, 1431 (D.Neb. 1992) (finding that the four notes at issue failed to satisfy the second Reves factor where there was nothing in the facts to support a finding that the they were part of or comprised any sort of commonly traded or offered instruments); see also Premier Microwave Corp. v. Comtech Communications Corp., No. 88 CIV 2570 (KMW), 1991 WL 12430 at *5 (S.D.N.Y. Jan. 28, 1991) (finding that the second Reves factor was inapplicable to the note at issue because there was no plan of distribution and there was no “common trading for speculation or investment” for the note).
C. Reasonable Expectations of the Public
The third Reves factor looks at the public’s reasonable perceptions about the instrument at issue. 494 U.S. at 68. This is an objective factor whereby the Court must assess the beliefs of the investing public to determine whether there was a reasonable expectation that the instruments were securities, thereby affording the protections of the securities laws. LeBrun, 24 F.Supp.2d at 648.
In LeBrun, the court found that, even assuming the plaintiffs could be characterized as the “investing public,” their reasonable expectations “were nothing more than the payment of the notes, plus the specified high interest.” 24 F.Supp.2d at 648. The loan agreements were not publicly traded. Id. Moreover, there was no advertising or marketing of the notes to the general public, but only a specific inquiry into a select group of individuals. Id. Thus, the court concluded that the third Reves factor weighed against a finding that the notes were securities. Id. Other courts have also found that there is no expectation that instruments are securities where the notes represent a private transaction producing only a fixed return in the form of interest. See Campbell v. C.D. Payne and Geldermann Securities, Inc., 894 S.W.2d 411, 418-19 (Tex. App. 1995) (finding that notes representing loan to company for operating expenses with fixed rate of return were not of such a nature that would lead the general public to consider them as securities).
D. Other Risk-Reducing Regulatory Scheme
The final Reves factor examines whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument. 494 U.S. at 67. In Reves, the Supreme Court found that this factor weighed in favor of finding the notes were securities because the notes at issue were uncollateralized and uninsured. Id. at 69.
Several courts outside of Missouri have applied the regulatory scheme analysis to the notes at issue before them. In LeBrun the federal district court concluded that there was an absence of an alternative regulatory scheme to address the risks of the instruments. 24 F.Supp. 2d. 641. Regardless, the court concluded that, on balance, the application of the Reves factors justified a finding that the notes in question were not securities. Id., CF. Bradford v. Moench, 809 F.Supp. 1473, 1484 (D. Utah 1992).
In sum, while the statutes and caselaw provide some guidance on what the law deems to be a regulated and actionable security under the securities laws, each instrument should have its unique characteristics evaluated by competent legal counsel prior to issuance.