The Reves Family Resemblance Test, Commercial Paper Exemptions, and the ICA Section 3(c)(5)(C) Analysis
By Asher Ang, Partner | Kelley Clarke, PC
I. Introduction
The promissory note is one of the oldest and most common instruments of commercial finance. Businesses borrow from banks. Sellers extend credit to buyers. Private equity funds acquire debt instruments as part of their investment strategy. In each case, the transaction is memorialized in a note, which is a contractual promise to repay a defined amount at a defined time.
But when a note is issued not to a single lender in a traditional bilateral borrowing, but to multiple investors in a capital-raising transaction, or when it is subsequently sold to a third party, the question arises: Is this note a security? If so, the full machinery of the federal securities laws applies: registration requirements (or an available exemption), antifraud liability, Investment Company Act analysis, and potential Investment Advisers Act implications.
The answer is not always intuitive, and the consequences of getting it wrong, either by treating a security as a non-security (and thus failing to register or claim an exemption) or by treating a non-security as a security (and triggering unnecessary regulatory burden), are significant. This article explains the statutory framework, the Supreme Court’s family resemblance test from Reves v. Ernst & Young, the commercial paper exemption, and the ICA Section 3(c)(5)(C) analysis for funds that acquire mortgage notes.
II. The Statutory Definition: Notes Are Presumptively Securities
Section 2(a)(1) of the Securities Act of 1933 and Section 3(a)(10) of the Securities Exchange Act of 1934 both include ‘any note’ within the broad definition of a ‘security.’ On its face, this would sweep every promissory note, from a home mortgage to a restaurant tab, into the securities laws. Congress and the courts have, however, crafted exceptions to limit this sweeping definition to notes that function as investment instruments rather than ordinary commercial transactions.
III. The Commercial Paper Exemption: Section 3(a)(3)
Section 3(a)(3) of the Securities Act exempts from federal securities regulation ‘any note, draft, bill of exchange, or banker’s acceptance that arises out of a current transaction or the proceeds of which have been or are to be used for current transactions, and which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.’
This exemption covers traditional commercial paper, short-term, unsecured promissory notes issued by highly rated corporations in the money markets to fund day-to-day operating needs. The key conditions are:
- (1) Maturity of nine months or less at issuance (excluding days of grace);
- (2) The note arises out of a ‘current transaction’, meaning it finances current operations, accounts payable, or working capital needs, not long-term capital investment;
- (3) The note is not ordinarily purchased by the general public (i.e., it is sold in minimum denominations to institutional investors, not offered broadly to retail investors).
Note: The SEC has historically interpreted this exemption as not applying to notes that are marketed to the general investing public, even if they have a maturity of nine months or less. Intent to market matters.
IV. The Family Resemblance Test: Reves v. Ernst & Young
For notes that do not qualify for the commercial paper exemption, meaning all notes with a maturity exceeding nine months, and many shorter-term notes that are marketed to the public, the Supreme Court’s decision in Reves v. Ernst & Young, 494 U.S. 56 (1990), provides the governing framework for determining whether a note is a security.
In Reves, the Supreme Court rejected the approach of several circuit courts that had applied the Howey investment contract test to notes. Instead, the Court adopted the ‘family resemblance test’ developed by the Second Circuit Court of Appeals. The test begins with a presumption that every note is a security, unless one of two things is true: (1) the note falls within one of the judicially recognized ‘family’ of instruments that are not securities, or (2) the note ‘bear[s] a strong resemblance’ to one of those instruments, based on a four-factor balancing analysis.
A. The Judicially Recognized Non-Security ‘Family’
The Supreme Court in Reves identified the following categories of notes that are not securities, based on prior case law:
- Notes delivered in consumer financing (e.g., a car loan);
- Notes secured by a mortgage on a home (traditional residential mortgages);
- Short-term notes secured by a lien on a small business;
- Notes evidencing character loans to bank customers;
- Short-term notes secured by an assignment of accounts receivable;
- Notes that formalize an open-account debt incurred in the ordinary course of business;
- Notes evidencing loans by commercial banks for current operations.
B. The Four-Factor Balancing Test
For notes not obviously within the recognized non-security family, the Court prescribed a four-factor balancing test to determine whether the note ‘bears a strong family resemblance’ to a non-security instrument:
Factor 1: The Motivations of the Parties
Why was the note issued, and what motivated the buyer to purchase it? If the seller’s purpose is to raise money for general business operations or to finance a substantial investment, and if the buyer is primarily motivated by the expectation of a profit or return, rather than by the desire to use or consume something of value, the note resembles a security. If the transaction is driven by commercial necessity (e.g., a trade payable, a bank working capital line), it resembles a non-security.
Factor 2: The Plan of Distribution
Is the note ‘offered and sold to a broad segment of the public’? A note distributed to a large number of investors through a public or broad private offering resembles a security. A bilateral loan between a bank and a single corporate borrower or a note governing the rights of two specific parties in a discrete commercial transaction does not.
Factor 3: The Reasonable Expectations of the Investing Public
Would a reasonable member of the investing public expect to be able to trade this instrument in the securities markets and receive the protections of the securities laws? If so, the note resembles a security. This factor often turns on how the instrument is marketed and whether it is described as an ‘investment opportunity.’
Factor 4: Existence of Another Regulatory Scheme That Reduces Risk
Is there another body of law, such as federal banking regulation, state consumer protection law, insurance regulation, or other regulatory schemes, that adequately reduces the risk of the instrument, thereby making application of the securities laws unnecessary? For example, residential mortgage lenders are regulated by the CFPB, the FDIC, HUD, and state banking regulators. If those regulatory schemes adequately protect the relevant parties, the note may not be a security.
V. Practical Applications: When Does It Matter?
A. Capital-Raising by Issuance of Notes
A startup or operating company that raises capital by issuing notes to multiple investors, even if described as ‘loans’, risks having those notes characterized as securities if the Reves factors are satisfied. If the notes are securities, the company must either register the offering or qualify for an exemption (e.g., Rule 506(b) or 506(c) of Regulation D). Failure to do so constitutes an unregistered securities offering under Section 5 of the Securities Act, exposing the company to SEC enforcement and investor rescission rights.
B. Factoring and Assignment of Receivables
A company that factors its accounts receivable, selling invoices to a third party at a discount to face value, may be issuing securities if the factoring arrangement involves multiple investors and the primary motivation is investment profit rather than commercial liquidity. ‘Factoring without recourse’ could constitute a securities transaction when the transferred receivables are resold to investors for speculation or investment.
C. Private Equity and Debt Funds: ICA Section 3(c)(5)(C)
A private fund that raises capital to acquire mortgage notes and other real estate-backed debt instruments faces a specific analytical challenge under the Investment Company Act of 1940. Notes that have been securitized are likely to be deemed securities, and a fund that holds securities as its primary assets is an ‘investment company’ under ICA Section 3(a)(1)(C), unless an exemption applies.
Section 3(c)(5)(C) of the ICA exempts from registration as an investment company ‘any person who is primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.’ The SEC has adopted the ‘Asset Composition Test’ to determine whether a fund qualifies for this exemption:
- At least 55% of the fund’s total assets must be ‘qualifying interests’ (mortgages and other liens on and interests in real estate, including senior mortgage loans, mezzanine loans secured by real property, and similar instruments);
- At least 80% of the fund’s total assets must consist of ‘qualifying interests’ plus ‘real estate-type interests’ (instruments closely related to real estate, including agency mortgage-backed securities, CMBS, construction loans, and similar assets);
- No more than 20% of the fund’s total assets may have no relationship to real estate.
VI. Conclusion
The question of when a promissory note becomes a security is not merely academic or theoretical. It determines whether an entire capital-raising transaction is subject to SEC registration, whether a fund must register under the Investment Company Act, and whether buyers of the note have the full suite of federal investor protections at their disposal. The Reves family resemblance test provides a workable analytical framework, but its four factors require careful application to the specific facts of each transaction.
At Kelley Clarke, PC, we advise issuers, fund managers, and lenders on the securities law characterization of debt instruments, ensuring that note issuances, debt fund structures, and secondary market transactions are structured in full compliance with the applicable federal regulatory framework.
This article was authored by Asher Ang, Partner, Kelley Clarke, PC. It is intended for general educational purposes only and does not constitute legal advice. Please consult a qualified attorney before relying on any content herein.
