I. Arizona’s Broad and Flexible Definition of a Security.
The Arizona Securities Act (A.R.S. § 44-1801, et seq.) sets forth Arizona’s securities laws. The legislature has directed that the Arizona Securities “Act ‘shall not be given a narrow or restricted interpretation or construction, but shall be liberally construed as a remedial measure in order not to defeat the purpose thereof.'” Siporin v. Carrington, 200 Ariz. 95, 103, 23 P.3d 92, 100 (Ct. App. 2001). Such a broad and liberal interpretation and construction satisfies the “intent and purpose of this Act [which] is for the protection of the public, the preservation of fair and equitable business practices, the suppression of fraudulent or deceptive practices in the sale or purchase of securities, and the prosecution of persons engaged in fraudulent or deceptive practices in the sale or purchase of securities.” 1951 Ariz. Sess. Laws ch. 18, § 20. See also Rose v. Dobras, 128 Ariz. 209, 212, 624 P.2d 887, 890 (Ct. App. 1981) (“securities laws were designed to protect the public from speculative and fraudulent schemes of promoters”).
In accordance with that liberal construction and interpretation and its remedial purpose, the Arizona Securities Act broadly defines a “security” to include an investment contract as follows:
note, stock, treasury stock, bond, commodity investment contract, commodity option, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, viatical or life settlement investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas or other mineral rights, real property investment contract or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.
A.R.S. § 44-1801(26) (emphasis added).
This “definition of a security ’embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.'” Siporin, 200 Ariz. at 101, 23 P.3d at 96 (quoting Nutek Info. Sys., Inc. v. Ariz. Corp. Comm’n, 194 Ariz. 104, 108, 977 P.2d 826, 830 (Ct. App. 1998)). See also MacCollum v. Perkinson, 185 Ariz. 179, 185-86, 913 P.2d 1097, 1103-04 (Ct. App. 1996) (“The definition of security for purposes of the registration statute is broad,” and “even broader” for purposes of the securities fraud statute as it even includes exempt securities).
“The supreme court has consistently construed the definition of ‘security’ liberally. In searching for the meaning and scope of this term, form should be disregarded for substances and the emphasis should be on economic reality.” Rose, 128 Ariz. at 212, 624 P.2d at 890 (citing Tcherepnin v. Knight, 389 U.S. 332, 336 (1967)).
Therefore, like the Arizona Securities Act in general, Arizona courts are to “give a liberal construction to the term ‘security,'” and look to substance over form. Siporin, 200 Ariz. at 101, 23 P.3d at 96 (citing Rose, 128 Ariz. at 212, 624 P.2d at 890).
II. Notes under the Reves
Test for Anti-Fraud Purposes.
Although the statutory definition of a security specifically includes any “note,” that term is not defined by A.R.S. § 44-1801(26) or any other provision of the Arizona Securities Act. Thus, it “has been left to the courts to decide which of the myriad of financial transactions come within the coverage of the securities fraud statute,” and the courts “are not bound by legal formalisms, but instead take account of the economics of the transactions under investigation.” MacCollum, 185 Ariz. at 186, 913 P.2d at 1104.
Since Arizona’s statutory definition of a security is “substantially similar to” the federal statutory definitions, Arizona courts look to federal interpretations for guidance. Id. at 186, 913 P.2d at 1104. In doing so, the Arizona Court of Appeals adopted the “family resemblance” test forth by the U.S. Supreme Court in Reves
v. Ernst & Young, 494 U.S. 56 (1990), to decide whether a particular transaction is a note for purposes of Arizona’s anti-fraud securities statute, A.R.S. § 44-1991. Id. at 186-87, 913 P.2d at 1104-05.
“Because the federal statute defines security to include ‘any note,’ the Reves
test begins with the presumption that a note is a security.” Id. at 187, 913 P.2d at 1105. Short term notes, such as those set to mature within nine months are not automatically excluded from this presumption and the Reves
analysis. Reves, 494 U.S. at 70-73; Purvis v. Ariz. Corp. Comm’n, 2011 Ariz. App. Unpub. LEXIS 576, at *7 (Ct. App. Feb. 24, 2011) (finding Reves
did not endorse exemption for note with term of nine months or less).
The “presumption can be rebutted only by a showing that the note bears a strong resemblance (in terms of the four factors identified in Reves
) to an item on the judicially crafted list of instruments that were not intended to be regulated as a security.” MacCollum, 185 Ariz. at 187, 913 P.2d at 1105. The “judicially crafted list” of non-security notes includes “consumer financing notes, notes secured by a home mortgage, notes secured by a lien on a business or its assets, notes reflecting a loan to a bank customer, short term notes secured by an assignment of accounts receivable, and notes which formalize a debt on an open account in a business.” Id. at 187, 913 P.2d at 1105. See also State v. Tober, 173 Ariz. 211, 212 n.3, 841 P.2d 206 (1992).
If the subject instrument does not closely resemble one of the listed instruments, then the court must examine the four-factor test set forth in Reves
to determine whether the instrument should be added to the list and thus not considered a security. MacCollum, 185 Ariz. at 187, 913 P.2d at 1105. The four factors include: (1) the parties’ motivations to profit from the transaction; (2) the plan of distribution of the instrument to determine whether it is an instrument in which there is common trading; (3) the reasonable expectations of the investing public; and (4) any risk-reducing factor, like the existence of another regulatory scheme that renders the application of the Arizona Securities Act unnecessary. Id. at 187-88, 913 P.2d at 1105-06. See also Tober, 173 Ariz. at 212 n.3. In conducting this examination, the focus is on whether “the note closely resembles the Reves
‘family’ of non-security notes.” MacCollum, 185 Ariz. at 188, 913 P.2d at 1106.
Each of the four factors of the Reves
test are discussed in turn below.
A. Parties’ motivations to earn profits. For the first factor of the
Reves test, the parties’ motivations, courts:
[E]xamine the transaction to assess the motivations that would prompt a reasonable seller and buyer to enter into it. 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.’
Reves, 494 U.S. at 66.
For purposes of the Reves
test, profit means “a valuable return on an investment,” which definitely includes interest. Id. at 68 n.4. If, however, “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 . . . the note is less sensibly described as a ‘security.’ Id. at 66.
For example, in Reves, the U.S. Supreme Court found that demand notes sold to raise capital for general business operations and purchased to earn a profit in the form of interest, did not demonstrate that the note closely resembled the Reves
family of non-security notes, and was therefore a security. Id. at 68. See also MacCollum, 185 Ariz. at 187, 913 P.2d at 1105 (holding both parties intended to profit from transaction, as seller’s purpose was to raise money to finance substantial investment and buyer’s purpose was to profit from investment through interest on note and potential bonus interest from lease, refinancing or sale of property). However, in an earlier case, the U.S. Supreme Court held that the share of “stock” carrying a right to subsidized housing did closely resemble the Reves
family of notes, and was therefore not a security, because the inducement to purchase was solely to acquire subsidized housing and not to invest for profit. See United Housing Found. v. Forman, 421 U.S. 837, 851 (1975)).
The key question for the first Reves
factor really boils down to whether the transaction is “most naturally conceived as an investment in a business enterprise” or, on the other hand, is “a purely commercial or consumer transaction.” Reves, 494 U.S. at 68.
B. Common trading plan of distribution. The second factor of
Reves requires courts to “examine the ‘plan of distribution’ of the instrument to determine whether it is an instrument in which there is ‘common trading for speculation or investment.'”
Reves, 494 U.S. at 66 (citations omitted). “Offering and selling to a broad segment of the public is all that is required to establish the requisite ‘common trading’ in an instrument.” MacCollum, 185 Ariz. at 187, 913 P.2d at 1105. Accordingly, the instrument does not have to be traded on any exchange to be a security. See, e.g.,
Reves, 494 U.S. at 68; Landreth Timber Co. v. Landreth, 471 U.S. 681, 694 (1985); S.E.C. v. W.J. Howey Co.,
328 U.S. 293, 295 (1946).
In Reves, the U.S. Supreme Court held that demand notes offered over an extended period of time to approximately 23,000 members and non-members, and held by 1,600 individuals at one time, although not traded on an exchange, were offered and sold to a broad segment of the public, and therefore established the requisite common trading that did not closely resemble a non-security note, but a security note. 494 U.S. at 68.
Where, however, the note is issued to a single individual, and is therefore not available for common trading and was probably only marketed to a limited number of investors, then the note resembles the Reves
family of notes that courts have deemed not to be securities. MacCollum
, 185 Ariz. at 187, 913 P.2d at 1105.
The common trading is not dispositive of the entire issue. Id. at 187, 913 P.2d at 1105.
C. Public’s reasonable expectations of the note. The third
Reves factor is the examination of the investing public’s reasonable expectations regarding the note.
Reves, 494 U.S. at 66. Courts “will consider instruments to be ‘securities’ on the basis of such public expectations, even where an economic analysis of the circumstances of the particular transaction might suggest that the instruments are not ‘securities’ as used in that transaction.” Id. at 66.
This third factor basically depends on how the public would reasonably perceive the note. For instance, where the note is characterized as a security, such as in advertisement, promotional or offering materials, and there are no countervailing factors that would lead a reasonable person to question this characterization, then it would be reasonable for the public to take the seller at their word that the note is a security and does not closely resemble the Reves
family of non-security notes. Id. at 68. See, e.g., Reves, 494 U.S. at 69 (advertisements characterized notes as investments); MacCollum, 185 Ariz. at 187, 913 P.2d at 1105 (private offering memorandum referred to transaction as offering for limited number of investment interests in promissory note and stated notes are securities being offered pursuant to private offering exemption).
D. Risk-reducing factors. For the fourth and final
Reves factor, courts “examine whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering the application of the Securities Acts unnecessary.”
Reves, 494 U.S. at 67. Therefore, one risk-reducing factor exists when the note is subject to other federal or state regulations. Id. at 69; MacCollum, 185 Ariz. at 188, 913 P.2d at 1106. See, e.g., Marine Bank v. Weaver, 455 U.S. 551, 556-58 (1982) (holding certificates of deposit subject to regulation under banking laws were not securities); Teamsters v. Daniel, 439 U.S. 551, 569-70 (1979) (holding pension plan comprehensively regulated by Employee Retirement Income Security Act of 1974 was not security).
A risk-reducing factor may also exist when the note is collateralized, insured or otherwise secured through, for example, repayment or some sort of ownership interest. Id. at 69; MacCollum
, 185 Ariz. at 188, 913 P.2d at 1106. See, e.g., Marine Bank, 455 U.S. at 556-58 (holding certificates of deposit insured by FDIC were not securities). However, this risk-reducing factor only applies when it is “called for under the original investment scheme.” MacCollum, 185 Ariz. at 188, 913 P.2d at 1106.
However, the demand nature of the note, which may give the note more liquidity, does not eliminate and may not necessarily reduce the risk. Reves, 494 U.S. at 69.
In short, when a note, presumed to be a security, is not on the list of non-security notes and meets all four factors of the Reves
test — parties are motivated to earn profits through a transaction with a common trading plan of distribution and instrument that the public reasonably perceives as a security without any risk-reducing factors — then the note is a security subject to Arizona’s securities anti-fraud statute, A.R.S. § 44-1991.
III. Notes under Arizona Securities Act for Registration Purposes.
The Arizona Supreme Court has rejected applying the Reves
test or any other judicial tests to determine whether a note is a security for purposes of Arizona’s securities registration statutes, A.R.S. §§ 44-1841 and 44-1842. Tober, 173 Ariz. at 212-13.
The Arizona Supreme Court held that it did not need to apply any judicially created tests, because A.R.S. §§ 44-1843, 44-1843.01 and 44-1844 “describe quite precisely exempt notes and exempt transactions in notes,” unlike the Arizona’s securities anti-fraud statute in which “one is literally left with the words ‘any note.'” Id. at 213. A.R.S. §§ 44-1841 and 44-1842 “are part of a comprehensive statutory scheme that defines the universe of securities, exempt securities, and exempt transactions . . . [that] leaves no room for judicial gloss, and thus there is no uncertainty in its application.” Id. at 212-13. See also Purvis, 2011 Ariz. App. Unpub. LEXIS 576, at *6-7 (recognizing and reaffirming Reves test does not apply to Arizona’s securities registration statutes).
Accordingly, “any note” is a security under A.R.S. § 44-1801(26) for purposes of the Arizona securities registration statutes, A.R.S. §§ 44-1841 and 44-1842, unless the subject note is specifically exempted under A.R.S. §§ 44-1843, et seq. MacCollum, 185 Ariz. at 185, 913 P.2d at 1103. See also A.R.S. §§ 44-1843 & -1843.01 (advising which notes are exempt); A.R.S. § 44-1844 (advising which transactions in notes are exempt).
Classic examples of exempt notes or exempt transactions in notes include notes secured by mortgages or deeds of trust on real estate or chattels (i.e., notes given in connection with the ordinary purchase of a house or automobile), some commercial paper, and notes involved in private offerings. Tober, 173 Ariz. at 213. But see MacCollum, 185 Ariz. at 185-86, 913 P.2d at 1103-04 (although promissory notes issued to fund real estate development were secured by junior deed of trust, trust deed was not part of original transaction, so not exempt under A.R.S. § 44-1843(A)(10)).
In short, “all consumer transactions involving the purchase of real property or goods are exempt where the buyer pays by giving a promissory note.” Id at 213.
The burden of establishing such an exemption from securities registration is on the party claiming it. See Purvis, 2011 Ariz. App. Unpub. LEXIS 576, at *6.
While the definition of a note as a security for purposes of the Arizona securities registration statutes is “broad,” it is important to remember that it is not as broad as the definition of a note as a security for purposes of the Arizona securities anti-fraud statute. MacCollum, 185 Ariz. at 185-86, 913 P.2d at 1103-04. “The securities fraud statute defines a security in even broader terms than do the registration statutes,” because it includes the sale of even those securities that are exempted from the registration statutes. Id. at 186, 913 P.2d at 1104. See also Purvis, 2011 Ariz. App. Unpub. LEXIS 576, at *9 n.3 (“‘security’ is defined more broadly for purposes of the anti-fraud provisions,” so if persons failed to establish exemption under registration provisions, they also failed to meet burden of establishing exemption under anti-fraud provisions).
In short, when a note is not an exempt note or exempt transaction in a note pursuant to A.R.S. §§ 44-1843, 44-1843.01 or 44-1844, the note is a security pursuant to the statutory definition set forth in A.R.S. § 44-1801(26). The offeror must then comply with all other securities law registration requirements, including registering the security under A.R.S. § 44-1841, and registering itself to sell the security under A.R.S. § 44-1842.
IV. Types of Notes.
Notes can involve a wide variety of transactions, and not just what one would normally consider a security, such as a stock or bond.
For example, Arizona courts have held that certain promissory notes, such as notes for bridge loans or real estate development, are notes and thus securities for purposes of the Arizona securities registration statutes and/or anti-fraud statutes. See, e.g., Purvis, 2011 Ariz. App. Unpub. LEXIS 576, at *7-9 & n.3 (holding bridge loan notes did not qualify as commercial paper for purposes of registration statutes and probably anti-fraud statutes); MacCollum, 185 Ariz. at 185-88, 913 P.2d at 1103-06 (finding promissory notes issued to fund real estate development were not exempt under A.R.S. § 44-1843(A)(10) for purposes of registration statutes, and qualified under Reves as security for purposes of anti-fraud statute); Tober
, 173 Ariz. at 214 (finding promissory notes issued to fund real estate development projects were not exempt under A.R.S. §§ 44-1843 and 44-1843.01 and transaction was not exempt under A.R.S. § 44-1844, and were therefore notes requiring registration under A.R.S. §§ 44-1841 and 44-1842).
The Arizona Corporation Commission Securities Division, which oversees the purchase and sale of securities in Arizona and enforces the Arizona Securities Act, has found promissory notes and other notes involving profit sharing arrangements, initial operating capital and reserves for a restaurant, business loans, loans to personal-injury litigants awaiting settlement/payment on their claims, real estate property and development, building projects, automobile sale-lease-back programs, gold, silver and gravel mining operations, and viatical settlements.
V. Whether Note Constitutes a Security Is a Question of Law.
“Whether an investment qualifies as a ‘security’ under the Arizona Securities Act is a question of law,” generally for the judge to determine rather than a jury. Siporin, 200 Ariz. at 100, 23 P.3d at 95. See also Nutek, 194 Ariz. at 107, 977 P.2d at 829.
Therefore, Arizona courts commonly decide whether a transaction is a security on a dispositive motion. See, e.g., Siporin, 200 Ariz. at 100-04, 23 P.3d at 96-99 (“conclud[ing] as a matter of law that viatical settlement agreements sold by [defendant] . . . constitute investment contracts. Accordingly, their sale constitutes the sale of ‘securities’ pursuant to A.R.S. section 44-1801” and directing trial court to enter judgment in favor of plaintiffs on securities violations claims that plaintiffs were sold unregistered securities by unregistered dealers); cf. MacCollum v. Perkinson, 185 Ariz. 179, 185-88, 913 P.2d 1097, 1103-06 (Ct. App. 1996) (concluding as matter of law promissory note was security, and thus finding trial court erred in denying plaintiff’s motion for leave to amend complaint to allege claims for securities law violations).
If you have questions regarding a possible securities law matter, or to arrange for a consultation concerning your legal matter, please contact Robert Mitchell at firstname.lastname@example.org or at (602) 452-2730.