Promissory Notes 101

Published: 18th June 2015
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Private companies going public seek to raise capital for a variety of reasons. This capital may be sought from the sale of equity ownership of the corporate entity or debt such as a loan. Frequently, loans are considered to be securities and as such, are subject to federal and state securities laws. It is important for any company going public to know whether its debt instruments are securities to ensure compliance with relevant securities laws. This includes compliance with federal and state registration requirements, or access to an exemption from those requirements. If a debt instrument is not a security, a capital raising transaction is much simpler.

For many companies, the issue of whether a debt instrument is a security is complex and confusing. Current law essentially holds that whether a note is a security or not depends on whether it looks like a security. Case law on the subject is contradictory and often offers little useful guidance.

Both the Securities Act of 1933 ("Securities Act") and the Securities and Exchange Act of 1934 ("Exchange Act") hold that promissory notes are securities, except those with a maturity of 9 months or less. Promissory notes convertible into stock are always defined as securities, no matter when they mature.

In Reves v. Ernst & Young, a landmark case from 1990, the Supreme Court recognized that most notes, regardless of their maturity, are not securities. These include:

♦ A note delivered in consumer financing.

♦ A note secured by a mortgage on a home.

♦ A note secured by a lien on a small business or some of its assets.

♦ A note relating to a "character" loan to a bank customer.

♦ A note which formalizes an open-account indebtedness incurred in the ordinary course of business.

♦ Short-term notes secured by an assignment of accounts receivables.

♦ Notes given in connection with loans by a commercial bank to a business for current operations.Where it is unclear whether a promissory note is a security, the Court established a test based on four factors:

♦ Whether the borrower's motivation is to raise money for general business use, and whether the lender's motivation is to make a profit, including interest.

♦ Whether the borrower's plan of distribution of the note resembles the plan of distribution of a security.

♦ Whether the investing public reasonably expects that the note is a security.

♦ Whether there is a regulatory scheme that protects the investor other than the securities laws. Examples include notes subject to Federal Deposit Insurance and ERISA.

All this is not very helpful, especially for small businesses going public. It's rare to find a lender uninterested in making a profit; and impossible to determine whether the "general public" would have any opinion at all about the nature of notes issued in any circumstances. But it is clear that if the issuer of the note sells it as an investment to a person or persons resembling investors, then the transaction is a securities offering. Therefore the promissory note is a security.

Generally speaking, notes generated by commercial loans are not considered to be securities.

In structuring a debt transaction, issuers should be aware that in the event of a dispute between borrower and lender, whether the note must be considered a security will be of great importance. When possible, it's best to ensure that the note cannot be classified as a security. If that is impossible, then meticulous compliance with federal and state securities laws is required.


please contact Brenda Hamilton, Securities Attorney at 101 Plaza Real S, Suite 201 S, Boca Raton, Florida, r visit

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