Apprarently, the question about whether something is or is not a security has become a hot issue, judging by two consecutive blog entries.
Link: U.S. v. McKye
I noticed a case that primarily involves procedural issues for trial, a subject to which I have not paid much attention since law school. However, the substance of the appeal involved securities fraud and whether or not the instruments in question were securities.
McKye was convicted of securities fraud and conspiracy to commit money laundering. As it turns out the McKey case provides an interesting take for transactional lawyers on how this issue may come up at trial.
McKye prepared revocable trusts for clients and financed the costs with loans for those who could not pay. Promissory notes represented the loans, and in some cases, there would be a lien on the client’s house. He also sold “investment notes” that offered a guaranteed annual return of 6.5% to 19.275%. There was some documentation showing a pledge of collateral supporting the investment notes, which turned out to be from the persons who financed the costs of the revocable trust services.
McKye and his salesmen told people that the instruments were backed by real estate notes and mortgages and that they were not securities.
McKye received about $5.9 million in proceeds from the sales of investment notes, which he used to pay other investors (you may know this structure as a “Ponzi scheme”) and to pay his own expenses.
At trial, McKye requested a jury instruction to determine whether the investment notes were securities. The court said that the notes are presumed to be securities and that McKye failed to present evidence overcoming that presumption. A jury instruction indicated that the notes were securities.
After a discussion about the analysis of whether a note is a security, the appeals court determined that the question of whether a note is a security is a mixed qustion of fact and law. Mixed questions of fact and law must be submitted to a jury if they implicate an element of the offense. In this case, securities fraud requires . . . the offer or sale of any security . . .” Because the government was required to prove that the investment notes were securities as an element of its case, the trial court erred when it instructed the jury that the notes are securities.
For those interested, here are some excerpts regarding the ‘note as security’ analysis, discussing the U.S. Supreme Court case of Reves v. Ernst & Young, the primary case in this area:
“Although 15 U.S.C. § 77b(a)(1) defines a security to include “any note,” the Supreme Court held in Reves that “the phrase ‘any note’ should not be interpreted to mean literally ‘any note,’ but must be understood against the backdrop of what Congress was attempting to accomplish in enacting the Securities Acts.””
“The Court then identified a list of notes falling “without the ‘security’ category,” to include (1) a note delivered in consumer financing, (2) a note secured by a mortgage on a home, (3) a short-term note secured by a lien on a small business or some of its assets, (4) a note evidencing a character loan to a bank customer, (5) a short-term note secured by an assignment of accounts receivable, (6) a note which simply formalizes an open-account debt incurred in the ordinary course of business and (7) notes evidencing loans by commercial banks for current operations.”
“The Court further explained that any note bearing a “family resemblance” to the enumerated notes also does not fall within the Act’s definition of a security. Id. at 65-67. It adopted a four-part test to determine whether a note meets the family resemblance test. Id. at 66-67. The four factors are: (1) “the motivations that would prompt a reasonable seller and buyer to enter into it,” (2) “the ‘plan of distribution’ of the instrument,” (3) the “reasonable expectations of the investing public,” and (4) “whether some factors such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.