What is a “Security”

Reves v. Ernst & Young

In Reves v. Ernst & Young, 494 U.S. 1092, 110 S.Ct. 1840, the Court considers whether certain demand notes issued by the Farmers Cooperative of Arkansas and Oklahoma are “securities” within the meaning of Section 3(a)(10) of the Securities Exchange Act of 1934.  The Court determines that they are.

The case is important for understanding whether “notes” are investments and therefore considered “securities” or whether notes are not securities because they are issued merely in a commercial or consumer context.

The Court finds that the “family resemblance” test is to be applied to distinguish between a note that is and is not a security.  Under this test, a note is presumed to be a “security.”  The presumption can be rebutted only by showing that the note bears a strong resemblance (determined by examining four specified factors) to one of a judicially crafted list of categories of instruments that are not securities.  If the instrument is not sufficiently similar to a listed item, the court must decide whether another category should be added by examining certain common factors.

The judicially crafted list of categories includes the following types of instruments:

  1. Note delivered in consumer financing;
  2. Note secured by a mortgage on a home;
  3. Short-term note secured by a lien on a small business or some of its assets;
  4. Note evidencing a “character” loan to a bank customer;
  5. Short-term notes secured by an assignment of accounts receivable;
  6. Note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized).

If a note is to be added to this list, courts should consider the following factors:

  1. Examine the transaction to assess the motivations that would prompt a reasonable seller and buyer to enter into the transaction.  If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a “security.”  If the note is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash flow difficulties or to advance some other commercial or consumer purpose, on the other hand, the note is less sensibly described as a “security.”
  2. Examine the plan of distribution of the instrument to determined whether there is “common trading for speculation or investment.”
  3. Examine the reasonable expectations of the investing public.  The Court will consider instruments to be “securities” on the basis of public expectations even where an economic analysis of the particular transaction may suggest that the notes are not securities in that transaction.
  4. Examine whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument thereby rendering application of the Securities Act unnecessary.
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