What is a security, anyway? The California Court of Appeal tackled that question recently in a case about a loan between friends.
A good starting point is that the law considers a security to be an investment contract, but there’s more to it than that. You may be familiar with common examples like publicly-traded stocks and bonds, but sometimes it’s a tougher call.
California law recognizes two tests to determine whether a deal or transaction is a security. One is the state’s risk-capital test, and the other is the federal Howey test (from a U.S. Supreme Court case). California courts may apply either one to your case, their goal being to protect the public from shady investment schemes.
The narrower risk-capital test asks whether you indiscriminately solicited passive investments from the public at large. A passive investment is one whose success depends mainly or exclusively on the efforts of people other than the investors.
The broader federal test simply asks whether you solicited people to invest passively.
In this case, the defendant had persuaded a guy he knew to invest in his land-development deal. The investment was a $280,000 promissory note that promised to pay out as follows:
- If the land were sold, the guy would share in the net profits from the sale.
- If the land were developed, he would receive one residential acre of his choosing.
- If neither event took place within one year, he could call the note and get interest on top of principal at a rate of ten percent.
But things didn’t exactly pan out, and some years later, the local district attorney’s office charged the defendant with securities fraud.
The trial court partly dismissed the case because it ruled that the promissory note wasn’t a security but a simple loan.
The government appealed that ruling, but the appeals court agreed. Even under the federal test, the note wasn’t a security because it was carefully negotiated between the parties, and it called for repayment whether the venture succeeded or not. The defendant had even personally guaranteed it.
So the case could’ve been a breach of contract, or it could’ve been a fraud.
But it wasn’t a securities fraud because the note wasn’t a security.