All companies, whether start-ups, mid-market, or public, at some point in their history have borrowed money from one source or another. For many start-up and mid-market companies, unsecured loans are often obtained from current shareholders, family, friends, wealthy acquaintances, or other angel investors. Obtaining necessary financing through debt is often a necessary way to fund a company’s short-term financial needs, without unnecessarily diluting the ownership of the company.
Prior to entering into a promissory note with a third party, parties should be aware that just because it is called a promissory note, and it is listed as debt instead of equity on the balance sheet, does not mean it is not considered a security subject to federal and state securities laws. The Securities Act of 1933 (Securities Act) defines security to include “any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness . . .” In interpreting the definition of security, the courts look beyond the form of an instrument into the economic substance of the transaction as a whole.
In 1990, the United States Supreme Court decided that unsecured demand notes issued by a farmers’ co-op to raise capital were considered securities. In deciding that the notes should be considered securities, the Court judicially crafted a list of notes that are not considered securities, including notes:
- Delivered in consumer financing
- Secured by a home mortgage
- Secured by a lien on a small business
- Evidencing a ‘character’ loan to a bank customer
- Secured by an assignment of accounts receivable
- Formalizing an open-account debt incurred in the ordinary course of business.
The Court went on to adopt a family resemblance test for determining whether a particular promissory note is similar to one of the above listed notes, and therefore considered not to be a security. In applying the family resemblance test, various factors must be considered and analyzed by your securities counsel.
A promissory note may be a great way to obtain the financial resources your company needs, without diluting the current ownership structure, however, the decision to enter a promissory note does not end there. Prior to entering a promissory note, further inquiry is necessary to determine (i) if the promissory note would be considered a security under the Securities Act, and (ii) if the promissory note is a security, does it comply with all applicable federal and state securities laws.
This is not a new issue, but it is an issue that corporations face everyday. Often, we see clients enter promissory notes without considering the securities law ramifications of their actions. Hawley Troxell’s corporate attorneys are attuned to federal and state securities law issues, including those concerning the issuance of promissory notes. If you are contemplating entering a promissory note, or have entered a promissory note in the past and have questions regarding whether or not it complied with federal and state securities laws, please contact a member of our Business Group at 208.344.6000