(Article from Securities Law Alert, May 2015)
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On May 21, 2015, the Sixth Circuit considered whether promissory notes representing what turned out to be “fake investments in Saudi Arabian oil” that were sold “to dozens of unsuspecting victims” were “securities” subject to the federal securities laws. SEC v. Zada, 2015 WL 2402136 (6th Cir. 2015) (Kethledge, J.). Applying the four-factor test set forth in Reves v. Ernst & Young, 494 U.S. 56 (1990), the Sixth Circuit determined that all four Reves factors “reinforce[d] [the] presumption” that the notes were “securities” subject to the federal securities laws.
The Sixth Circuit explained that in order “[t]o rebut the presumption that a particular note is a security, a defendant must show that the note bears a ‘family resemblance’” to “instruments that are not securities,” such as “consumer debt, home-mortgage loans, character loans to bank customers, and short-term commercial debt.” “Whether the note bears a resemblance to one of those instruments depends on four factors” established in Reves: (1) “the motivation prompting the transaction;” (2) the “plan of distribution;” (3) the “‘reasonable expectations of the investing public;’” and (4) “whether a ‘risk-reducing factor’ (for example, another regulatory scheme) makes ‘application of the [federal securities laws] unnecessary.’”
The Sixth Circuit stated that “[t]he first Reves factor — the motivations that prompted the buyers to enter into the transactions — turns on whether the buyers’ purpose was ‘investment (suggesting a security) or commercial or consumer (suggesting a non-security).’” In the case before it, “the SEC [had] presented testimony from several investors and an affidavit from another, all to the effect that [defendant had given] them the notes as part of a scheme to invest in Saudi oil.” With respect to defendant’s contention that “some of the investors referred to the transactions as ‘loans,’” the Sixth Circuit explained that a financial instrument can be at once a loan and a security. The court noted that “[a] corporate bond, for example, is both a loan to the corporation and an investment for the lender.” The Sixth Circuit underscored that “economic realities” are what matter most when determining whether an instrument is a security. Here, the court found it “doubtful that 60 investors — including several firefighters and a horse trainer — would make personal loans to a self-styled multimillionaire.”
The Sixth Circuit next considered the “plan of distribution” for the promissory notes at issue. The court stated that “[i]f notes are sold to a wide range of unsophisticated people, as opposed to a handful of institutional investors, the notes are more likely to be securities.” Here, defendant “sold the notes to a variety of laypersons.” The court found that this supported the SEC’s claim that the notes constituted “securities.”
As to the third Reves factor (“the reasonable expectations of the investing public”), the Sixth Circuit explained that notes are likely to be “securities if a reasonable person would expect the securities laws to apply” to those notes. In the case at hand, the court observed that defendant’s “victims thought they were making lucrative investments in oil, which is traded on global markets.” Because the “federal securities laws are broad enough to cover ‘virtually any’ marketable investment,” the Sixth Circuit determined that “a reasonable person who gave [defendant] money to invest in oil markets would expect that the securities laws appl[ied] to the transaction.”
Finally, the Sixth Circuit found that “[t]he final Reves consideration — whether a risk-reducing factor makes application of the Securities Acts unnecessary — likewise suggest[ed] that [defendant] sold securities.” The court explained that “[i]f the notes that [defendant] sold were not securities, then they ‘would escape federal regulation entirely.’” The court determined that “this factor
favor[ed] the SEC as well.”
Based on the Reves analysis, the Sixth Circuit concluded that the notes were securities subject to the requirements of the federal securities laws.