Since the 1946 U.S. Supreme Court decision in Securities & Exchange Commission v. Howey, securities lawyers have known the test for determining whether a financial instrument or contract is a security. As the Howey Court put it:
“The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.”
Using that test, it is relatively easy for one to assume a convertible promissory note is a security and, therefore, subject to regulation by the SEC and state securities regulators. State and Federal definitions of “security” include the term “note.” Once a convertible note is transformed from a promise to pay money to shares of a company’s stock, it is clearly an investment of money in an enterprise with profits to come solely from the efforts of others.
The potential for conversion, not actual conversion, is what often makes a convertible note a security. That fact is what can make it easy to reflexively consider all convertible promissory notes to be securities. And that would be a mistake, according to decision issued just last month by a U.S. Federal District Court in New York.
The case is called Intelligent Digital Systems, LLC (“IDS”) v. Visual Management Systems, Inc. (“VMS”). In 2008, IDS sold assets, including proprietary digital video recorder (DVR) technology, to VMS. The transaction involved an Asset Purchase Agreement and a convertible promissory note for $1.544 million. The terms of the note were straightforward: a maturity date in 2011, no interest or payments until the maturity date, at which time the full principal amount is due in full, interest at an annual rate of 12% after maturity and the accrued principal and interest is convertible at IDS’s option into shares of common stock of VMS. When VMS defaulted on some obligation in the Asset Purchase Agreement, IDS alleged that VMS, after signing the letter of intent for the transaction, learned that its former CFO had committed financial wrongdoing that would likely make VMS insolvent and unable to make payments under the note and did not inform IDS of these facts prior to the closing of the transaction. To a securities lawyer, this is a failure to disclose material information, which is considered securities fraud. So, IDS sued VMS claiming securities fraud, and VMS filed a motion to dismiss, arguing that the convertible promissory note was not a security.
The Court agreed with VMS and dismissed the securities fraud claim. Why? How can a note that is convertible into securities not be a security itself? Frankly, I suspect most securities lawyers would have presumed the note to be a security, conducted an exemption analysis and probably included representations and warranties in the transaction documents of the sort found in securities transactions. In fact, the note at issue in the IDS case stated on its face that “…neither the Note, nor the common stock issuable upon exercise of the right to convert, have been registered under the Securities Act of 1933 as amended.” The lawyers who put that deal together clearly thought it prudent to treat the note as a security. Yet, the IDS note is not a security, and here is where the analysis becomes interesting.
A note is presumed to be a security unless facts show the note bears a “family resemblance” to traditional debt instruments. In its 1990 opinion in Reves v. Ernst & Young, the U.S. Supreme Court described some of these instruments:
• Promissory notes in consumer financing transactions;
• Notes secured by a mortgage on a home;
• Short –term note secured by a lien on a small business or some of its assets;
• Notes in connection with personal bank loans;
• Short-term notes secured by an assignment of accounts receivable;
• Notes formalizing an open-account debt incurred in the ordinary course of business;
• Notes in connection with loans by commercial banks for current operations
To determine whether a note resembles one of these debt instruments, a court examines the following 4-factors:
1. The motivations that would prompt a reasonable buyer and seller to enter into the transaction;
2. The plan of distribution of the instrument;
3. The reasonable expectation of the investing public; and
4. Whether some factor, such as the existence of another regulatory scheme, significantly reduces the risk of the instrument, thereby rendering application of the securities laws unnecessary.
Evaluating these factors, the Court determined IDS’ motivation was not to invest in VMS in a transaction where the purchase price for the assets sold might vary. Instead, the Court noted that the purchase price for the assets was contractually fixed and must be paid by VMS in cash or in stock, if IDS elects to convert the note to stock. In the Court’s words:
“The transaction here is best described as the sale of technology from one business to another for a lump sum. The motivation of the seller is not to invest in the future success of the buyer, where the price to be paid might vary along with the success, or lack thereof…[T]he fact that a note is convertible to stock is not a factor identified by the Supreme Court when it adopted the family resemblance test…[T]he transaction is best characterized as a commercial sale of assets, and not as an investment. The commercial motivation of the parties weighs against a finding that the Note is a security.”
The obvious lesson of the IDS case is that there can be no securities fraud claim without a security. A more subtle lesson involves the importance of due diligence in any transaction, whether or not it involves securities. IDS were clearly upset about the fact that VMS defaulted on the note and that VMS had not disclosed its financial trouble before the deal closed. If IDS had known about VMS’s financial troubles, it might not have closed the deal or the terms might have been different. It is impossible to tell from the Court’s opinion whether IDS conducted any due diligence into VMS’ financial strength. Of course, it is also true that even the most thorough due diligence examination will not always uncover intentional fraud.
Another lesson may be the importance of negotiating for collateral in transactions calling for payments over time. It is impossible to tell from the IDS opinion whether the note was secured by the assets sold or any other property of VMS. I suspect it was not. It is possible that IDS decided to accept a convertible promissory note in lieu of collateral. IDS may have been in a better position had it structured a security interest in VMS assets under Article 9 of the Uniform Commercial Code.
In the end, the dismissal of the securities fraud claim may not be fatal to IDS since it also brought a claim for common law fraud based on the same facts and the Court refused to dismiss that claim before trial. Nevertheless, the IDS decision reminds us that it is not wise to assume that a convertible promissory note is a security.