In the recent decision of Shaper v. Zadek, Case No. 21-cv-00493-EMC, 2021 WL 3885958 (N.D. Cal. Aug., 31, 2021), the court addressed whether loans purchased by investors were “securities” under federal securities laws and, if so, whether the seller of the notes had violated federal securities laws by failing to, among other things, register as an investment adviser and/or broker-dealer. The answer is lawyerly and, perhaps, unsatisfactory, i.e., it depends! Where the notes were purchased for investment purposes, offered and sold to a broad segment of the population, reasonable investors would view them as securities and not merely notes, and there is no other statutory scheme directly regulating the transaction, they should be treated as “securities.” Nonetheless, additional considerations will determine whether the party offering the note must register as an investment adviser or broker-dealer under federal securities laws.
In the Shaper case, the plaintiff investors alleged that Lenders Funding, the lender/loan seller, boasted on its website that “since formation, we have worked with over 150 lenders and factors and have supplied several hundred million dollars in funding.” According to Plaintiffs, “Lenders Funding gets the money to loan to third parties by selling Promissory Notes.” Plaintiffs further alleged that Lenders Funding represented that it “has sold ‘hundreds of millions of dollars of Promissory Notes to hundreds of investors.’”
According to plaintiffs, Lenders Funding further expressly represented to them that “the investments were safe and secure” and that they “could have [their] money back at any time.’” As alleged, this turned out not to be true. When there was trouble with the loans, the investors requested their money back. Lenders Funding, however, was not able to refund their investments. The plaintiff investors thereafter brought a lawsuit alleging, among other things, the failure of Lenders Funding to register as an investment adviser in violation of the Investment Advisers Act and as a broker-dealer in violation of the Securities Exchange Act.
Lenders Funding argued that the loans purchased were not “securities” under federal law and, accordingly, it did not have register itself and could not be liable for failing to do so. The Securities Exchange Act and the Investment Advisers Act both broadly define “security” to mean “any note, stock, treasury stock, security future, bond,” etc. Thus, the plain language of the statutes would appear to indicate the promissory notes purchased would be treated as “securities” under the law. Citing to the United States Supreme Court decision in the matter of Reves v. Ernst & Young (1990) 494 U.S. 56, the district court noted, however, that “a note is not always a security, notwithstanding the fact that the Securities Exchange Act includes “any note” in its definition of “security.” Rather, “there is a presumption that a note is a security, but that presumption may be rebutted.”
To determine whether the notes purchased by the investors in the Shaper case were “securities,” the court outlined “four Reves factors”: “(1) the ‘motivations that would prompt a reasonable seller and buyer to enter into’ the transaction; (2) the ‘plan of distribution’ of the instrument; (3) the ‘reasonable expectations of the investing public’; and (4) ‘whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument.’”
As to the first factor, the court appeared to accept that plaintiffs’ allegations that they were motivated to purchase the notes as an investment for profit, thereby support plaintiffs’ argument that the notes should be treated as “securities.”
As to the second factor, the court noted that “if a note is ‘offered and sold to a broad segment of the public,’ that ‘establish[es] the requisite ‘common trading’ in an instrument.’” Here, the court found that there was conflicting evidence—while Lenders Funding boasted of selling hundreds of millions of dollars in notes to hundreds of investors on its website, its filings with the SEC suggested a much narrower distribution which resulted in only “8 investors” or so.
As to the third factor, the court indicated that the standard of whether a claimant would view the transaction as an investment in a security is “what a ‘reasonable investor’ would think, not what the ‘specific individuals in question’ might have thought.” Here, the court found that a “reasonable investor” would have viewed these notes as securities.
As to the fourth factor, the court found that there was not “another regulatory scheme [which] significantly reduces the risk of the instrument,” and therefore the transaction should be treated as a “security” under federal securities laws.
Thus, the court found that, while the facts were somewhat mixed, the allegations were sufficient to consider the notes “securities” under federal law. The court then turned to whether Lenders Funding needed to register and whether it had violated securities law in failing to do so. The court found that Lenders Funding did not need to register as an “investment adviser” because “the fact that Defendants sold Promissory Notes to Plaintiffs does not mean that they were in the business of giving investment advice” and “even if Defendants did give investment advice to Plaintiffs, there is no allegation that Plaintiffs compensated Defendants for that advice.” The court likewise found that it did not need to register as a broker-dealer because “they did not sell any Promissory Notes for others but rather issued such Notes on their own behalf,” concluding that they, thus, could not have acted as a third-party broker-dealer on behalf of anyone as they necessarily acted directly on behalf of themselves.