By John M. Jascob, J.D.
The Arkansas Supreme Court has held that a court must consider all factors surrounding the transaction in determining whether a note constitutes a security under the Arkansas Securities Act. Although declining to adopt the “family resemblance test” put forward by the Arkansas Securities Commissioner, the state high court ruled that the lower court incorrectly applied a narrower five-factor test in granting summary judgment for the defense in a civil enforcement action over the sale of unregistered securities. Accordingly, the court reversed the decision below and remanded the matter for a determination of whether the loan agreements at issue qualified as securities under Arkansas law (Waters v. Millsap, June 18, 2015, Baker, K.).
Background. In January 2012, the Arkansas Securities Commissioner filed a complaint against the appellees, alleging that they had unlawfully sold unregistered securities without being registered under the Arkansas Securities Act. According to the Commissioner, the appellees had solicited investors to purchase notes issued by the British American Group, which purportedly matched borrowers from the United Kingdom with lenders. Under the terms of the notes, the borrowers would borrow money for real-estate projects for one year at annual interest rates of 15 to 17 percent. The complaint further alleged that, although some of the British American Group investors received interest payments, the vast bulk of the money was never repaid.
Moving for summary judgment, the Commissioner argued that the notes were securities because, among other things, the investors had no control over the real estate projects and “expected their profits to come solely from the efforts of the borrower.” The Commissioner also contended that the proper test for determining whether the loan agreements constituted a security was the “family resemblance test” announced by the United States Supreme Court in Reves v. Ernst & Young (U.S. 1990).
The circuit court disagreed, however, reasoning that the Arkansas Supreme Court had not adopted the Reves test, and that the law in Arkansas remained the test set forth by the Arkansas Court of Appeals in Smith v. State. Decided in 1979, Smith set forth a five-element test for identifying securities: (1) the investment of money or money’s worth; (2) investment in a venture; (3) the expectation of some benefit to the investor as a result of the investment; (4) contribution towards the risk capital of the venture; and (5) the absence of direct control over the investment or policy decisions concerning the venture. After concluding that the notes did not meet the test for securities announced in Smith, the circuit court granted summary judgment in favor of the appellees.
All factors test. On appeal, the Commissioner contended that the Arkansas Supreme Court had never explicitly adopted the Smith test as the exclusive test of whether a transaction involves a security, and that the element of a fixed rate of interest does not automatically preclude the notes at issue from being securities. Reviewing the case law, Justice Baker noted that since its 1977 decision in Schultz v. Rector-Phillips-Morse, Inc., the court has held that the Arkansas Securities Act should not be given a narrow construction. Rather, the definition of what constitutes a security must necessarily depend on an analysis of all of the factors in any given transaction.
Although finding the Smith factors to be instructive, the Arkansas Supreme Court has never relied on those factors exclusively, Justice Baker wrote. Instead, the unifying thread in the court’s line of cases addressing whether an instrument constitutes a security is the Schultz test, which requires a review of all of the facts and is better suited to the Act’s purpose of preventing fraudulent practices and activities aimed at unsophisticated investors and the general public. The circuit court erred, therefore, because it failed to consider all the factors surrounding the transaction, including the sophistication of the parties, a factor that has been prominent in the court’s prior cases. Accordingly, the state high court reversed the decision below and remanded the case to the circuit court to consider all the surrounding factors, as required by Schultz. The court declined to formally adopt the Reves test, however, reasoning that all of the Reves factors are embraced within the flexible, all-inclusive Schultz test.
Dissent. Writing for the three judges in dissent, Justice Danielson stated that he would have affirmed the lower court’s order as reaching the right result, even without any mention of reliance on Schultz. Drawing a distinction between an investment and a loan, Justice Danielson reasoned that the clients of the appellees had extended sums of money with the sole expectation of receiving interest and ultimately having their money repaid. The realization of that interest was not tied to the efforts or successes of the borrower or the venture, but only to the borrower’s ability to pay. “In light of these circumstances,” he wrote, “I cannot say that the transactions at issue were securities; they were simply nothing more than loans, albeit in hindsight, risky ones.”
The case is No. CV-15-18.