By Rodney F. Tonkovic, J.D.
A district court was faced with the dilemma of interpreting a statute correctly or disrupting 50 years of consistent case law. At issue was an exclusion from the definition of "security" for notes maturing in nine months or less. The court read the exclusion as creating a rebuttable presumption that any short-term note, such as the one it issue in this case, is not a security, whether or not the loan is commercial paper. But, the court declined to upset a nearly 50-year consensus holding otherwise, and, in any event, was saved from doing so by the fact that the complaint failed to plead fraud with the required particularity (Auctus Fund, LLC v. Sauer Energy, Inc., March 16, 2020, Young, W.).
Auctus Fund, LLC sued Sauer Energy, Inc. in May 2019, alleging that a loan transaction had soured. In April 2018, Auctus loaned Sauer $114,000, and, on that day, Sauer issued a convertible promissory note maturing exactly ninth months later on January 27, 2019; the note was sold to Auctus in a private sale. The purchase agreement stated that the parties were exempted (without specifying which exemptions applied) from registering the note as a security and required Sauer to comply with any obligations it might have under the securities laws. In July 2018, Sauer defaulted by failing to pay the principal and interest on the note.
The complaint alleged that Sauer violated the antifraud provisions of the securities laws as well as a number of duties under state common law and the Massachusetts securities laws. Sauer never appeared or answered the complaint, so, at a hearing in September 2019, the court accepted Auctus's factual allegations and proceeded to dismiss the Securities Act claim. The court, however, took under advisement whether to enter judgment on the remaining Exchange Act and state law claims.
Nine-month exclusion? Early in the proceedings, the court had ordered Auctus to show cause because it suspected that Auctus failed to allege that Sauer sold it a "security" as defined by the Exchange Act. At issue was the definition of security at Section 3(a)(10), which exempts "any note" that matures in nine months or less. After considering the matter, the court concluded that the Nine-Month Exclusion is best read as presumptively excluding short-term loans such as the one at issue here from the definition of "security." But the court was also leery of disturbing a longstanding judicial consensus to the contrary. In any event, the court ultimately concluded that, no matter what, Auctus failed to adequately plead fraud.
The Supreme Court has said that the phrase "any note" should not be interpreted literally, but must be understood against the backdrop of what Congress wanted to accomplish with the securities laws. No court in the First Circuit had considered the issue, but several courts (including the Ninth and Tenth Circuits) and the SEC construe the exemption to apply only to commercial paper. The court said that this reading was "strained" because the legislative history and purpose of the Nine Month Exclusion did not indicate that it was meant to apply only to high-quality commercial paper.
The court concluded that there was a better reading of the statute: in the usual course, courts are to presume that "any note" is a security, but notes maturing in nine months or less (such as the one here) are presumptively not securities. That said, the court did not adopt this reading, declining to unsettle nearly 50 years of case law consistently giving a narrow interpretation to the Nine Month Exclusion, and applying it only to commercial paper, not investment securities.
Fraud not pleaded. In any event, the court was not required to decide on the scope of the Nine Month Exclusion because it found that Auctus failed to adequately plead fraud. The complaint failed to plead fraud with the required particularity, the court said, providing ample reason to dismiss the Exchange Act fraud claim. The complaint failed to identify any specific statement that was false or misleading and failed to show that any material facts were omitted in any of Sauer's communications. Having found that the complaint did not involve a viable claim under the federal securities laws, the court dismissed the remaining state law claims for lack of subject matter jurisdiction.
The case is No. 19-11027.