Commercial Litigation and Arbitration

When Notes Are Securities — Reves’ Family Resemblance Test — Issue of Law in Civil Cases — Notes with Durations Shorter Than Nine Months

Securities and Exchange Comm'n v. Thompson, 2013 U.S. App. LEXIS 20342 (10th Cir. Oct. 4, 2013):

This appeal arises out of a civil-enforcement action brought by the Securities and Exchange Commission ("SEC") against Defendant-Appellant Ralph W. Thompson, Jr., in connection with an alleged Ponzi scheme Thompson ran through his company, Novus Technologies, L.L.C. ("Novus"). The district court granted summary judgment in the SEC's favor on several issues, including the issue of whether the instruments Novus sold investors were "securities," as that term is defined under the Securities Act of 1933 and the Securities Exchange Act of 1934 (collectively, the "Securities Acts").

Thompson's sole claim on appeal is that the district   court ignored genuine disputes of material fact on the issue of whether the Novus instruments were securities, and that he was entitled to have a jury make that determination. We conclude, under the test articulated by the Supreme Court in Reves v. Ernst & Young, 494 U.S. 56 (1990), that the district court correctly found that the instruments Thompson sold were securities as a matter of law. Exercising jurisdiction under 28 U.S.C. § 1291, we AFFIRM. ***

i. The "loan" instruments

The boilerplate "UNSECURED  PROMISSORY NOTE" (the "Instrument"), which governed the majority of the transactions between Novus and its "lenders" (the "holders"), stated in relevant part that Novus "promise[d] to [re]pay" the principal amount (Novus required a minimum "loan" of $100,000) after a term of six months,  plus monthly interest of between three and five percent, depending upon whether the holder chose monthly payments or a lump sum at maturity. Id. at 246. The Instrument also stated the following:

   It is expressly understood between the parties that the Borrower shall be using proceeds from the Note for further investments and it may not be financially prudent because of the market conditions to pay the principal at the end of the Note term. Therefore, Borrower shall have the option to extend the term of the Note for a period of 6 months as long as the monthly interest payments on the unpaid principal are made on a timely basis.

Id. (emphasis added). Finally, the Instrument stated on its face that it was not a security, and it bore features such as acceleration conditions, a waiver-of-presentment clause, a non-assignment clause, an attorney-fee-collection clause.***

A. The broad definition of "security" under the Securities Acts

In response to "serious abuses in a largely unregulated securities market," Reves, 494 U.S. at 60, Congress enacted the Securities Acts "to restore investors' confidence in the financial markets," Marine Bank v. Weaver, 455 U.S. 551, 555 (1982) (discussing specifically the '34 Act). To meet that end, Congress "painted with a broad brush" in defining "security," so as to capture under the ambit of the Acts the "countless and variable schemes devised by those who seek the use of the money of others on the promise of profits." Reves, 494 U.S. at 62 (internal quotation marks omitted) (citing W.J. Howey Co., 328 U.S. at 299). Section 2(1) of the Securities Act of 1933 thus defines "security" in broad and general terms as:

   any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of  interest or participation in any 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, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a "security", or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscript to or purchase, any of the foregoing.

48 Stat. 74, as amended, 15 U.S.C. § 77b(a)(1).  

Footnote 5.   The Supreme Court has "repeatedly ruled that the definitions of 'security' in § 3(a)(10) of the 1934 Act and § 2(1) of the 1933 Act are virtually identical," and should be treated as such in decisions dealing with the scope of the term. Landreth Timber Co. v. Landreth, 471 U.S. 681, 685 n.1 (1985)   (citing Marine Bank, 455 U.S. at 555 n.3 (1982)); compare 15 U.S.C. §§ 77b(a)(1) & 77c(3) with 15 U.S.C. § 78c(a)(10). We "therefore . . . refer to cases involving the 1933 and 1934 Acts without distinguishing between which Act each case involved." Resolution Trust Corp. v. Stone, 998 F.2d 1534, 1538 n.3 (10th Cir. 1993).

In line with Congress's broad regulatory aims, courts inquiring into an instrument's status as a "security" are not "bound by legal formalisms," but instead must "take account of the economics of the transaction under investigation" in order to capture and effectuate the regulation of "investments, in whatever form they are made and by whatever name they are called." Reves, 494 U.S. at 61 (citing Tcherepnin v. Knight, 389 U.S. 332, 336 (1967)). Indeed, "form should be disregarded for substance and the emphasis should be on economic reality." Tcherepnin, 389 U.S. at 336.

However, the Supreme Court has cautioned that, in enacting the securities laws, "Congress . . . did not intend to provide a broad federal remedy for all fraud." Marine Bank, 455 U.S. at 556 (emphasis added). Reflecting that principle, Congress tempered its broad definition of "security" under the Acts   with an exception applicable to short-term notes. Footnote 6.   The form of the short-term-note exception varies slightly between the two Securities Acts, although both purport to exclude from coverage "any note, draft, bill of exchange, or banker's acceptance . . . which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited." Compare 15 U.S.C. § 78c(10) ('34 Act) (including that language within the definition of the term "security"  itself), with 15 U.S.C. § 77c(3) ('33 Act) (including that language in a separate registration exemption). We have previously recognized that the short-term note exceptions are "limited to prime quality negotiable commercial paper of a type not ordinarily purchased by the general public." Holloway v. Peat, Marwick, Mitchell & Co., 900 F.2d 1485, 1489 (10th Cir. 1990). Thompson appropriately does not argue that the Novus Instruments, which were not "prime quality commercial paper," fall outside the Acts' regulatory ambit on the basis of the short-term-note exception.


 Similarly, the Supreme Court has held that "the phrase 'any note' [as it appears in the Securities Acts] 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." Reves, 494 U.S. at 63. Accordingly, in Reves, the Court articulated a test to enable courts to discern "notes issued in an investment context (which are 'securities') from notes issued in a commercial or consumer context (which are not)." Id. It is to that test that we now turn to determine whether the Instruments issued by Novus--which are akin to notes in some respects--were securities.

B. Reves's "family resemblance" test  

In Reves v. Ernst & Young, the Supreme Court resolved a circuit split on the proper approach to ascertaining whether a "note" is a security under the Securities Acts. 494 U.S. at 64-65. The Court adopted a version of the Second Circuit's "family resemblance" test, under which

   [a] note is presumed to be a "security,"7 and that presumption may be rebutted only by a showing that the note bears a strong resemblance . . . to one of the . . . categories of instrument [identified by the Second Circuit in the case of Exchange Nat'l Bank of Chicago v. Touche Ross & Co., 544 F.2d 1126, 1137 (2d Cir. 1976)].

Id. at 67  (emphasis added). The categories of instrument enumerated by the Second Circuit which are not securities include

   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) [,and] . . . notes evidencing loans by commercial banks for current operations.

Id. at 65 (quoting Exchange Nat'l Bank of Chicago, 544 F.2d at 1137, and Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930, 939 (2d Cir. 1984)).

Footnote 7.   The Court in Reves explicitly left open whether the presumption that a note is a security applies to notes that mature in less than nine months. Reves, 494 U.S. at 65 n.3. Specifically, the Court recognized that under the Second Circuit's version of the family resemblance test,

   No presumption of any kind attached to notes of less than nine months' duration. The Second Circuit's refusal  to extend the presumption to all notes was apparently founded on its interpretation of the statutory exception for notes with a maturity of nine months or less. Because we do not reach the question of how to interpret that exception, . . . we likewise express no view on how that exception might affect the presumption that a note is a "security."

Id. After the Court decided Reves, we suggested in Holloway v. Peat, Marwick, Mitchell & Co., that the presumption does apply to notes maturing in less than nine months.  900 F.2d 1485, 1488-89 (10th Cir. 1990) (observing that "[e]ven if an issuer cannot rebut the presumption that a note is a security under the family resemblance test, the note may still be excluded from coverage of the Acts if it 'has a maturity at the time of issuance of not exceeding nine months,'" and reaffirming that the "exception for short-term notes is limited to prime quality negotiable commercial paper" (emphases added)); accord S.E.C. v. R.G. Reynolds Enters., Inc., 952 F.2d 1125, 1132 (9th Cir. 1991) (limiting the short-term note exception to "commercial paper and hold[ing] that the presumption that a note is a security applies equally to notes of less than nine months  maturity that are not commercial paper").

In this case, Thompson makes no arguments about how the Instruments' 6-month term might affect application of the presumption. See Aplt. Br. at 32 (arguing only that "courts are generally inclined to look more closely at notes maturing in less than nine months and are less inclined to automatically label them as securities" (emphasis added)). Perhaps this is because the Novus Instruments allowed Novus to extend the term for an additional six months at its own discretion. See 15 U.S.C. § 78c(a)(10) (excluding from coverage "any note . . . which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof . . . which is likewise limited"). In any event, because Thompson appears to accept that the presumption applies to Novus's Instruments, we address that issue no further.

To provide guidance to courts considering whether an instrument "bears a strong resemblance" to the instruments on the list, the Court prescribed application of the following four factors: (1) "the motivations that would prompt a reasonable seller and buyer to enter into [the transaction]"; (2) "the 'plan of distribution' of the instrument," with an eye on "whether it is an instrument in which there is common trading for speculation or investment"; (3) "the reasonable expectations of the investing public"; and (4) "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." Id. at 66-67 (internal quotation marks omitted). "Failure to satisfy one of the factors is not dispositive; they are considered as a whole." S.E.C. v. Wallenbrock, 313 F.3d 532, 537 (9th Cir. 2002); accord Stone, 998 F.2d at 1539 (concluding that, "on balance" of the family-resemblance factors, the notes were not securities).

The Court instructed that if application of Reves's four factors "leads to the conclusion that an instrument is not sufficiently similar to an item on the list," the analyzing court must then decide "whether another category should be added . . . by examining the same factors." Reves, 494 U.S. at 67. As the Court did in Reves, we have conceived of this analysis as comprised of two separate steps. See Holloway, 900 F.2d at 1487. However, "both inquiries involve the application of the   same four-factor test, and so the two essentially collapse into a single inquiry." Wallenbrock, 313 F.3d at 537; accord Stone, 998 F.2d at 1538-39 (treating the two steps as a single inquiry designed to facilitate the determination of whether the subject instrument's "'family resemblance' to [the enumerated] notes is sufficiently strong to cause [the subject instrument] to be included within the categories of notes that are not regarded as securities"). We construct our family-resemblance inquiry into the "securities" status of the Novus Instruments, then, around a single balancing of Reves's four factors, but stressing that those four factors only are directed toward assisting in a determination whether the Instruments in question are similar (or bear a family resemblance) to the types of "notes" enumerated by the Second Circuit in Exchange Nat'l Bank of Chicago, 544 F.2d at 1137, and Chemical Bank, 726 F.2d at 939.

Before we turn to apply the Reves factors in this case, however, we pause to address two additional points pertaining to the nature of Reves's family-resemblance inquiry generally, and at the summary judgment stage in particular.

First, Thompson repeatedly claims that he  is entitled to have a jury make the ultimate determination under the family-resemblance test as to whether the Instruments were securities under the Acts. In making this claim, however, Thompson all but ignores authority in this circuit and elsewhere suggesting that the opposite is true: for example, we have previously held that, in the context of a civil suit, the ultimate question of whether an instrument is a security is "a question of law and not of fact," such that submitting the question to a jury was error. Ahrens v. Am.-Canadian Beaver Co., 428 F.2d 926, 928 (10th Cir. 1970); accord 4-82 Modern Federal Jury Instructions--Civil, ¶ 82-3, Comment, n.13 ("[T]he question of whether a security is within the terms of the Security Act is better viewed as a question of law for the court."); see also McNabb v. S.E.C., 298 F.3d 1126, 1130 (9th Cir. 2002) ("Whether a note is a security under the 1934 Act is a question of law, which we review de novo."); S.E.C. v. Life Partners, Inc., 87 F.3d 536, 540-41 (D.C. Cir. 1996) (same).

The Supreme Court's decisions in this area also suggest that, at least in the context of civil suits, the ultimate determination whether an instrument is a security is one of law. For example, in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the Court decided that interests in orange groves were securities as a matter of law over the dissent of Justice Frankfurter, who "call[ed] for the Court to uphold the district court's determination as a reasonable factual finding rather than a freely reversible legal issue." See U.S. v. Johnson, 718 F.2d 1317, 1332 (5th Cir. 1983) (en banc) (Williams, J., dissenting) (emphasis added). Similarly, both the Court's language in Reves and the complexity of the test it endorsed there--prescribing a rebuttable presumption, comparison of the subject instrument to a judicially crafted list of non-security instruments, and an inquiry into the existence and adequacy of alternate regulatory schemes--strongly suggest that, at least in the civil context, the ultimate conclusion that a "note" is a security is one for the court to make as a matter of law. See, e.g., Reves, 494 U.S. at 61 ("[T]he task has fallen to the Securities and Exchange Commission . . . and ultimately to the federal courts to decide which of the myriad financial transactions in our society come within the coverage of these statutes" (emphasis added) (internal  quotation marks omitted)); id. at 67 (instructing "courts" to compare the subject instrument to a "judicially crafted" list of non-securities, and if the subject "instrument is not sufficiently similar to an item on the list," to decide "whether another category should be added" by examining the "family resemblance" factors (emphasis added)).

Of course, none of this is to say that summary judgment will be appropriate where the parties have identified genuine disputes of material fact that could tip a reviewing court's balance of the "family resemblance" factors articulated in Reves.  Indeed, as we observed recently elsewhere in the context of a criminal case, the individual factors of the "family resemblance" test, which inquire into "motivation, distribution, expectation, and risk," lead us to conclude that "the question of whether a note is a security has both factual and legal components." United States v. McKye,    F.3d   , No. 12-6108, 2013 WL 4419330, at *4-*5 (10th Cir. Aug. 20, 2013) (holding that, notwithstanding the complexity of the Reves test, in the context of a criminal case, the ultimate question whether an instrument is a security must be submitted to the jury when it "implicate[s] an element of the offense."). However, following previous Tenth Circuit precedent, see Ahrens, 428 F.2d at 928, we hold that, in the context of a civil case where the "security" status of a "note" is disputed, the ultimate determination of whether the note is a security is one of law; thus, resolution of factual disputes will be necessary only in those rare instances where the reviewing court is unable to make a proper balancing of the family-resemblance factors without resolving those factual disputes.

That leads us to the second, related point: we conduct our analysis today mindful of the way in which the presumption that all notes are securities ... colors, at the summary judgment stage, the evidentiary burden of a non-movant who argues that a note is not a security. If, as here, the moving party can satisfy its "initial responsibility of presenting evidence to show the absence of a genuine issue of material fact," Hom v. Squire, 81 F.3d 969, 973 (10th Cir. 1996),  the non-movant must make "a showing sufficient to establish" that the note is not a security, because the presumption that all notes are securities means that the non-movant would ultimately "bear the burden of proof" on that issue at trial.  See Celotex, 477 U.S. at 322. This required showing, we think, means that the non-movant's evidence that notes are not securities, if believed, must create a material amount of persuasion above equipoise, because it would have to be sufficient to overcome the presumption that all notes are securities.

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