Note defined:

A note is a debt instrument –– a legal contract between a borrower and a creditor, evidencing an obligation to repay some stipulated monetary amount (which could include principal plus interest or a discounted principal) at a defined point in time.

There are for two umbrella categories of notes: secured and unsecured.

A secured note is collateralized by an underlying asset, which is pledged as collateral for the benefit of the creditor. An example of a secured note would be any home mortgage where the borrower pledges a house as collateral for the benefit of a creditor.

An unsecured note carries no collateral, backed only by the promise of the borrower to repay. An example would be an IOU between parties, stipulating a certain interest rate and maturity. Once that arrangement is sold to a third party, the note may become a security.

Notes can take many forms including (but not limited to) corporate bonds, convertible notes, structured notes, banker’s acceptances, short-term Treasurys, etc.


Is a Note a Security?

The Securities Act of 1933 (“Act”) along with its sister statutes – the Exchange Act of 1934, the Investment Company Act of 1940 (“ICA”), and the Investment Advisers Act of 1940 — broadly sweeps “[all] note[s]” within the definition of a security.

However, Congress and the courts have crafted exemptions and exceptions that abrogate the sweeping statutory definition.

Statutory Carveout:
§ 3(a)(3) of the Act exempts from federal securities regulation the notes, commonly known as commercial paper, bearing a maturity of not more than nine months at the time of issuance.

Judicial Carveout:
The Supreme Court in Reves v. Ernst & Young (1) rejected the D.C. and Eighth Circuit courts’ approach in applying the Howey Test in determining if a note should qualify as a security and instead adopted the family resemblance test from the 2nd Circuit.

The test begins with a presumption that every note falling outside § 3(a)(3) of the Act is a security, unless rebutted by any of the following factors:

  1. The purpose of the transaction is examined. Unless it is resold to a third-party at a discount to its original face value, a note is not a security, if it was 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.”
  2. The plan of distribution of the transaction is examined to determine whether the note is traded for speculation or investment. Selling an instrument to the broad public constitutes a plan for distribution that likens the instrument to a security versus an instrument that governs the rights and obligations of two parties in a single transaction.  For example, factoring without recourse is securitization. Although not arranged with “the broad public,” the third-party resale or “factoring” of a discreet commercial invoice makes the note a security, because the resale is for speculation or investment.
  3. The reasonable expectations of the investing public are examined to determine whether the public would view the instrument as a tradeable financial instrument. If so, the instrument is likely a security.
  4. Whether some other law “reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.” For example, mortgage lenders are regulated under the Consumer Financial Protection Bureau (CFPB), the Federal Deposit Insurance Agency (FDIC), the U.S. Department of Housing and Urban Development (HUD), or other agencies. Such agencies would likely have promulgated regulations that would allow for the consumer to be sufficiently protected by the respective regulatory schemes without need for application of the securities laws.

Side Note: Even prior to Reves, The SEC has historically interpreted “[n]otes, drafts, bills of exchange, and bankers’ acceptances which are commercial paper and arise out of current commercial, agricultural, or industrial transactions, and which are not intended to be marketed to the public” be exempt from the Securities acts. (2)

Why does it Matter?

If a newly-founded, burgeoning company issues notes to lenders as a way to raise capital, such issuance could be deemed as an offering of securities, if it fails the Reves test. This would subject the company to the registration requirement for the offering of securities, absent an available exemption. In other words, the company may not simply engage in what is essentially a bond offering, without being subject to securities laws.

If a company with liquidity problems decides to factor its accounts receivables by selling such accounts to third-parties at a discount to face value, then such sale could be deemed as an offering of securities subjecting the company to registration requirements absent and available exemption.

Another example, if a private equity fund acquires mortgage notes, it must comply with the Investment Company Act. The general rule is that, if a fund raises capital to purchase assets that qualify as securities, then the fund must register as an investment company, absent an available exemption. One of the available exemptions upon which such a fund would likely rely would be § 3(c)(5)(C), which exempts from Investment Company Act registration any person who is primarily engaged in the business of “purchasing or . . . acquiring mortgages and other liens on and interests in real estate.” Furthermore, to receive protection from § 3(c)(5)(C), such fund cannot issue redeemable securities, face amount certificates, or periodic payment plan certificates.

The Securities and Exchange Commission (“SEC”) has adopted the Asset Composition Test in determining whether § 3(c)(5)(C) is available to an issuer (3).

The Test is as follows:

  1. At least 55% of the issuer’s assets are in mortgages and other liens on, and interests in, real estate (“qualifying interests”); and
  2. The remaining 44% of the issuer’s assets consist primarily of “real-estate type interests”; and
  3. At least 80% of its total assets consist of “qualifying interests” and “real estate-type interests”; and
  4. No more than 20% of its total assets have no relationship to real estate.

See also:  [What is your fund acquiring? Why does that matter?]

The applicability of the Securities Acts to promissory notes and similar instruments can create liability and other consequences to the parties involved in the transaction. The parties involved must pay close attention to the nature of the instrument and hidden regulatory landmines.


  1.  494 U.S. 56 (1990)
  2.  Securities Act Release No. 4412 (Sept. 20, 1961)
  3.  See e.g. Redwood Trust, Inc., SEC Staff No-Action Letter (October 16, 2017).