Court Finds Promissory Notes Are Not Securities

Yesterday's post concerned the Court of Appeal's decision in People v. Black, 2017 Cal. App. LEXIS 130 (Cal. App. 6th Dist. Feb. 16, 2017).  The case involved the criminal prosecution of an individual for making false statements in connection with the offer and sale of a security in violation of Corporations Code Section 25401.  The trial judge ruled that the promissory note and its amendments did not constitute securities under either the risk capital test articulated by the California Supreme Court in Silver Hills Country Club v. Sobieski, 55 Cal.2d 811 (1961) or the investment contract test fashioned by the U.S. Supreme Court in S.E.C. v. Howey Co.,  328 U.S. 293 (1946).  The people then appealed.

The Court of Appeal found that the promissory notes failed the risk capital test because there was no “‘indiscriminate offering to the public at large where the persons solicited are selected at random . . .’”.  Here, the defendant had known the purchaser for several years and there were no other purchasers of the promissory notes.  In applying Howey, the Court of Appeal found that the promissory notes displayed certain essential characteristics of an “investment contract”, particularly given the undisputed evidence that the investor agreed to put his money toward the proposed deal and was led by the defendant to expect substantial profits as a result of the defendant's efforts.  However, the Court of Appeal also found that the promissory notes respresented individually negotiated, one-on-one transactions with the defendant.  In this respect, the promissory notes resembled the agreement between family members that the U.S. Supreme Court found not to be a security in Marine Bank v. Weaver, 455 U.S. 551 (1982).

In finding that the promissory notes did not constitute securities under the Corporate Securities Law, the Court of Appeal stressed:

This is not, as the People suggest, a finding that all one-on-one contracts are excluded as a matter of law from the definition of a security.  Rather, the individualized nature of the transaction is one factor that must be considered in determining whether that transaction comes within the regulatory purpose and purview of the securities laws.

Although Section 25019 includes "any note" within a long list of securities.  As this decision of the Court of Appeal makes clear, however, not all notes are securities.