Tuesday, February 21, 2017

Promissory notes with repayment option were not securities

By John M. Jascob, J.D., LL.M.

Promissory notes issued to a single investor in connection with a real estate development scheme did not constitute securities under the California Corporate Securities Law. The California Court of Appeal found that the notes were issued in an individually negotiated, one-on-one transaction, while providing a repayment option that was not contingent on the success of the enterprise. As the promissory notes did not meet either the risk-capital or the Howey test for a security, the trial court properly set aside two criminal charges that the defendant used false statements in the sale of a security (People v. Black, February 16, 2017, Premo, E.).

Terms of the promissory notes. The defendant persuaded an acquaintance to invest in a real estate development opportunity in Idaho in return for a promissory note, the terms of which were amended and extended several times. The note promised that if the property were sold, the defendant’s company would repay the principal together with interest based on a percentage of the profits received from the sale. If the borrower developed the property, the lender would select and receive two parcels. If the deal failed and neither event took place within a specified period, the principal would come due, together with interest at the rate of 10 percent.

After the lender had not been repaid after several years, the district attorney filed a criminal information, ultimately charging the defendant with five counts of using false statements in the sale of a security. The first three counts pertained to the issuance of the original promissory note and subsequent amendments, and counts four and five concerned two additional extensions to the repayment period. The trial court, however, dismissed counts four and five, concluding that the promissory notes were not securities under either the risk-capital or Howey tests adopted by the California courts.

Howey test. On appeal, the court noted that the risk-capital test for a security requires a finding of an indiscriminate offering to the public at large, a factor that did not find support in the record. Turning next to the Howey test, the court observed that the state did not offer any cases in which an individualized contract with repayment provisions similar to the ones at issue had been construed as a security within the meaning of the California Corporate Securities Law. Instead, the court found that a repayment option not contingent on the success of the enterprise, together with a provision binding the defendant’s separate property for purposes of enforcing payment on the notes, inserted an element of redress that did not fall within the concept of a security.

Contrary to the state’s suggestion, this did not involve a finding that all one-on-one contracts are excluded as a matter of law from the definition of a security, the court stated. Rather, the individualized nature of the transaction is one factor that must be considered in determining whether that transaction comes within the scope of the securities laws. Accordingly, the order to set aside counts four and five was affirmed.

The case is No. H043360.

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