My name is Tilden Moschetti, syndication attorney with the Moschetti Syndication Law Group. We specialize in Reg D Rule 506b and Rule 506c offerings for syndicators and funds. About at least once a week, I have a meeting with somebody who believes that they have found a loophole around the securities rules. We’re going to talk about whether or not that is a real loophole or not.
All right, so what is this loophole that we’re talking about? Well, the story goes something like this: “I put a friends and family syndication together, but it actually wasn’t a security because what I did was I took a loan from a friend or family.” Okay, so let’s go through whether or not that is a security.
The big idea where that idea comes from, it’s not crazy that they came up with it. In fact, there was a case called Reeves v. Ernst and Young. You may know Ernst and Young, they’re a very large institution. It’s a company that not only does investments, but it also made loans and things like that. In that case, what had happened is Reeves, the plaintiff, had alleged that Ernst and Young had made a loan, which constituted a security, which means that Ernst and Young was responsible for all the things that would go along with having a security that was being sold to him.
It went all the way up to the US Supreme Court, in that case, Reeves v. Ernst and Young. And in that case, the Supreme Court said, well, there are types of loans that are not securities. A lot of people took that to mean that all loans are not securities. But that is not what the court said. Let’s go through what the court said were not securities. So then we can look and see, in the case of this person who was talking about getting a loan from friends and family for their venture, whether or not that was a security.
So the first item was a note delivered in consumer financing. If I use a credit card, for example, or I take a personal loan from a bank, that is something that is not considered a security. The bank is not obligated to go under all the regulations that go along with securities.
The second was a note secured by mortgage on a home. Surely that’s not a security, because then it would totally disrupt the entire home lending institution, which would cause endless problems in the real estate market. It would slow things down dramatically. It’s not a security.
Number three is a short-term note that’s secured by a lien on a small business or some assets. Now I can see where somebody could misunderstand this and think that this would apply to their case, who was doing that deal, because it was a short-term note that was secured by a lien. But it wasn’t really a lien, because I doubt that it was really structured like a lien. It would have been a promissory note, but not an actual lien on the property or on the small business that was being put in place.
The fourth one is a note evidencing a character loan to a bank customer. Now a character loan is when you get a loan, oftentimes you get them as a line of credit from the bank, who says they’ve been a longtime customer, we’re going to make that kind of loan to them. That is based purely on their character and their banking history. It’s the same thing as consumer financing in a sense from the court’s point of view.
The next item is a short-term note secured by an assignment of accounts receivable. But I’ve never seen a transaction put in place where they said okay, the entire thing is going to be an assignment of accounts receivable. Where you do see it is in Merchant Account loans. So in Merchant Account loans when a small business relies on their merchant account in order to make that loan, then they are assigning the accounts receivable to whoever’s making that loan to them. And then that is considered that short-term assignment that’s secured by the assignment of accounts receivable because automatically 20% or whatever that deal is of their accounts receivable is going to that lender. So it is not a security in and of itself.
Next to last is a note that simply formalizes an open account debt incurred in the ordinary course of business, particularly if, in the case of a customer of a broker, it is collateralized. So what they’re really looking here for is that the investor is basically borrowing money on margin, or something like that in order to use their account and be able to use that more freely in trade.
The last one is a note evidencing a loan by a commercial bank for its current operations. So that is, again, a loan from the commercial bank. Well, unless your friends and family are a commercial bank, it’s probably very unlikely that this would apply. This is much closer to a line of credit.
So those are the things that are debts, absolutely loans, but are not counted as securities. But that’s not really the test of a security. All of those things are part of things that take place in the normal course of business. But the example of the person asking me if their friends and family loans so that they could buy real estate or start their business is completely different.
There, we look all the way back to the Howey Test, where we have an investor putting out money. You know, “Hey, investor, come invest money with me. And you’re going to rely on my ability to make a profit of that, and you’re going to receive the benefits of that profit.” Clearly, in their instance, it is considered a security, even if it’s a debt, if it’s at a set rate, which a lot of times we’ll put together, then it still is a security.
Bottom line, it is not a shortcut, it is still a security. And the time you’re raising money from friends and family or from anybody where that investor expects a profit and they’re relying on your work. So they’re taking a passive role and they’re relying on you in order to generate that profit to pay them back. That is a security which must either be registered with the SEC, or fall under one of these exemptions such as Regulation D.
Hope that helps clarify it. Hope that keeps you out of hot water if you were thinking that you might have had a run around the regulations as well. It’s not, unfortunately, but I would be happy to talk more with you about it. If you are looking to do a syndication or put together a fund, let’s talk about how you can do it in compliance with SEC rules. Keep you out of hot water, make your investors happy and everybody wins.
My name is Tilden Moschetti. I am a securities attorney specializing in Reg D syndications and funds under Rule 506b and 506c.