Opinion ID: 4565230
Heading Depth: 2
Heading Rank: 1

Heading: Reves v. Ernst & Young

Text: ¶22 The question of whether we should adopt the family resemblance test for determining whether a note is a security involves both statutory interpretation and consideration of the proper legal standard to be applied here. We review issues of statutory interpretation de novo. McCoy v. People, 2019 CO 44, ¶ 37, 442 P.3d 379, 389. In construing a statute, we seek to ascertain and give effect to the General Assembly’s intent. Id. To do so, we look first to the statutory language, giving its words and phrases their plain and ordinary meanings. Id. We read such words and phrases in context, and we construe them according to the rules of grammar and common usage. Id. Additionally, we “endeavor to effectuate the purpose of the legislative scheme.” Id. at ¶ 38, 442 P.3d at 389. In doing so, we read that scheme as a whole, giving consistent, harmonious, and sensible effect to all of its parts, and we avoid constructions that would render any words or phrases superfluous or lead to illogical or absurd results. Id. If the statute is unambiguous, then we apply it as written. Id. If the statute is ambiguous, however, then we may consider other aids to statutory construction, including the consequences of a given construction, the end to be achieved by the statute, and the statute’s legislative history. Id. A statute is ambiguous when it is reasonably susceptible of multiple interpretations. Id. 12 ¶23 A determination of the proper legal standard to be applied in a case and the application of that standard to the particular facts of the case present questions of law that we also review de novo. A.R. v. D.R., 2020 CO 10, ¶ 37, 456 P.3d 1266, 1276. ¶24 The CSA’s purpose is “to protect investors and maintain public confidence in securities markets while avoiding unreasonable burdens on participants in capital markets.” § 11-51-101(2), C.R.S. (2019). Additionally, the CSA is “remedial in nature and is to be broadly construed to effectuate its purposes.” Id. And, pertinent here, the CSA’s provisions are to be “coordinated with the federal acts and statutes” that the CSA references “to the extent coordination is consistent with both the purposes and the provisions” of the CSA. § 11-51-101(3). ¶25 The CSA defines a “security” to include, in pertinent part, “any note.” § 11-51-201(17). Notwithstanding this broad language, the parties agree that this definition, like its counterpart under the federal Securities Exchange Act of 1934 (the “1934 Act”), 15 U.S.C. § 78c(a)(10) (2012), is not to be construed literally and that the family resemblance test adopted in Reves, 494 U.S. at 64–67, should apply here. We also agree, and an understanding of federal jurisprudence regarding the definition of a “note” is important to our analysis in this regard. ¶26 Although not itself involving a note, the Supreme Court’s decision in S.E.C. v. W.J. Howey Co., 328 U.S. 293, 301 (1946), provides the starting point for 13 our discussion. In Howey, the Supreme Court defined an “investment contract” for purposes of the 1934 Act as a “scheme involv[ing] an investment of money in a common enterprise with profits to come solely from the efforts of others.” Id. We adopted the same test, for purposes of the CSA, in Lowery v. Ford Hill Investment Co., 556 P.2d 1201, 1204–05 (Colo. 1976), noting that although we are not bound by federal law in construing the CSA, we deem federal authorities persuasive, given that the provisions and purposes of the CSA parallel those of federal enactments. ¶27 Thereafter, in People v. Milne, 690 P.2d 829, 833 (Colo. 1984), we appear to have expanded the application of Howey to financial instruments other than investment contracts, including “investment notes.” We opined, “The touchstone of a security is the presence of an investment in a common enterprise that is premised on a reasonable expectation of profits to be derived from the entreprenurial [sic] or managerial efforts of others.” Id. ¶28 Notwithstanding our apparent decision to extend the Howey test beyond investment contracts, federal courts disagreed as to the proper test for determining whether a note is a security, with the Eighth and D.C. Circuits relying on Howey’s definition of an investment contract and other courts developing different tests. Compare Arthur Young & Co. v. Reves, 856 F.2d 52, 54 (8th Cir. 1988) (relying on Howey’s definition of an investment contract to determine whether the “demand 14 notes” at issue were securities), rev’d sub nom. Reves v. Ernst & Young, 494 U.S. 56 (1990), and Baurer v. Planning Grp., Inc., 669 F.2d 770, 778–79 (D.C. Cir. 1981) (relying on Howey to conclude that the short-term promissory note at issue was a security), rejected by Reves v. Ernst & Young, 494 U.S. 56, 64 (1990), with Futura Dev. Corp. v. Centex Corp., 761 F.2d 33, 40–41 (1st Cir. 1985) (adopting the “commercial/investment test” to determine whether a note is a security); Union Planters Nat’l Bank of Memphis v. Commercial Credit Bus. Loans, Inc., 651 F.2d 1174, 1181–82 (6th Cir. 1981) (applying Howey and the so-called “risk capital” test to determine whether a loan participation was a security); and Exch. Nat’l Bank of Chicago v. Touche Ross & Co., 544 F.2d 1126, 1137–39 (2d Cir. 1976) (applying the “family resemblance test” to determine that certain notes were securities). ¶29 In Reves, 494 U.S. at 64–67, the Supreme Court finally resolved this debate. As an initial matter, the Court declined to expand the Howey test to the context of notes because, in the Court’s view, “To hold that a ‘note’ is not a ‘security’ unless it meets a test designed for an entirely different variety of instrument ‘would make the [federal Securities] Acts’ enumeration of many types of instruments superfluous’ and would be inconsistent with Congress’ intent to regulate the entire body of instruments sold as investments.” Id. at 64 (quoting Landreth Timber Co. v. Landreth, 471 U.S. 681, 692 (1985)). 15 ¶30 The Court then proceeded to adopt the so-called “family resemblance test” for determining whether a note is a security. Id. at 64–65. Under that test, a note is presumed to be a security unless it fits into one of seven enumerated categories of non-securities: (1) notes delivered in consumer financing; (2) notes secured by a mortgage on a home; (3) short-term notes secured by liens on a small business or some of its assets; (4) notes evidencing a “character” loan to a bank customer; (5) short-term notes secured by an assignment of accounts receivable; (6) notes that simply formalize an open-account debt incurred in the ordinary course of business; or (7) notes evidencing loans by commercial banks for current operations. Id. at 65. ¶31 The presumption that a note is a security if it does not fit within one of these seven enumerated categories may be overcome, however, if it bears a “strong family resemblance” to one of those types of notes. Id. at 66–67. To determine if a note bears such a resemblance, a court examines four factors: First, we examine 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.” If 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, on the other hand, the note is less sensibly described as a “security.” Second, we examine the “plan of distribution” of the instrument to determine whether it is an instrument in which there is “common trading for speculation or 16 investment.” Third, we examine the reasonable expectations of the investing public: The Court 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. Finally, we examine whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary. Id. (citations omitted). ¶32 If an instrument is not sufficiently similar to one of the items on the list, then the decision as to whether another category should be added is to be made by examining the same factors. Id. at 67. ¶33 The question thus becomes whether we should overrule Milne, which, as noted above, appears to have adopted the Howey test for determining whether a note is a security, and adopt the Reves family resemblance test instead. Cognizant of the principles of stare decisis, but also recognizing that those principles allow us to depart from prior precedent when sound reasons exist for doing so, Russell v. People, 2020 CO 37, ¶ 20, 462 P.3d 1092, 1096, we conclude that we should overrule Milne and adopt the family resemblance test. We reach this conclusion for several reasons. ¶34 First, as noted above, section 11-51-101(3) provides that the CSA is to be coordinated with the federal acts and statutes that it references. As our case law shows, historically, we have tracked the Supreme Court’s interpretation of parallel 17 provisions of the federal securities laws, see Milne, 690 P.2d at 833–34; Lowery, 556 P.2d at 1204–05, and we perceive no basis for declining to do so here. This is particularly so given that (1) the definition of a “security” is identical in the CSA and the 1934 Act and (2) we have previously observed that “insofar as the provisions and purposes of our statute parallel those of the federal enactments, such federal authorities are highly persuasive.” Cagle v. Mathers Family Tr., 2013 CO 7, ¶ 19, 295 P.3d 460, 465 (quoting Lowery, 556 P.2d at 1204). ¶35 Second, the statutory definition of “security” in both the 1934 Act and the CSA includes many different types of financial instruments, including, but not limited to, notes and investment contracts. See 15 U.S.C. § 78c(a)(10); § 11-51-201(17). To apply the Howey test, which deals with the types of investment contracts that constitute securities, to determine whether any other kind of financial instrument constitutes a security would render the CSA’s enumeration of many different types of instruments superfluous. See Reves, 494 U.S. at 64. We, however, may not do so. See McCoy, ¶ 38, 442 P.3d at 389. ¶36 Third, in our view, the family resemblance test provides an analytical framework that harmonizes (1) the CSA’s broad definition of a security, which includes “any note”; (2) federal and state case law recognizing that, notwithstanding such broad language, some notes are not, in fact, securities; and (3) the above-referenced purposes to be achieved by the CSA. See § 11-51-101(2); 18 § 11-51-201(17); Lowery, 556 P.2d at 1205 (“The hallmark of state and federal securities regulation has always been close attention to the facts of each case and a substantive appraisal of the commercial realities of the offering.”). Specifically, the family resemblance test takes into account the language of and policy considerations animating the CSA while providing courts the flexibility to address the “countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” Reves, 494 U.S. at 61 (quoting Howey, 328 U.S. at 299). ¶37 Finally, we note that the clear trend among state courts around the country is to adopt the family resemblance test for determining whether a note is a security for purposes of their state securities acts. See, e.g., Silvia v. Sec. Div., 810 N.E.2d 825, 831–32 (Mass. Ct. App. 2004) (replacing the Howey test with the Reves test to determine whether certain agreements that were akin to promissory notes were securities under the Massachusetts Uniform Securities Act); State v. Friend, 40 P.3d 436, 439–40 (Nev. 2002) (adopting the family resemblance test for determining whether a note is a security under the Nevada Uniform Securities Act); cf. State v. Pedersen, 95 P.3d 385, 388 (Wash. Ct. App. 2004) (applying the family resemblance test to determine whether certain trust certificates and a loan agreement were securities under the Securities Act of Washington). Although we, of course, are not bound by such determinations, we have often found persuasive our sister 19 states’ interpretations of statutes and rules with language similar to our own, and for the reasons noted above, we do so here. See, e.g., People v. Julien, 47 P.3d 1194, 1198 (Colo. 2002) (considering federal precedent and that of states with judicial ethics rules similar to Colorado’s in construing the provisions of a parallel Colorado rule); Showpiece Homes Corp. v. Assurance Co. of Am., 38 P.3d 47, 54–55 (Colo. 2001) (finding persuasive the Washington Supreme Court’s interpretation of provisions of the Washington Consumer Protection Act in construing the Colorado Consumer Protection Act because of the similar provisions of those acts). ¶38 For these reasons, we now overrule Milne and adopt the family resemblance test for determining whether a note is a security within the meaning of the CSA. We thus turn to the facts before us and consider whether the note at issue was a security under that test. ¶39 To begin, we observe that the note at issue did not expressly fall within any of the seven enumerated categories of non-securities because it was neither (1) a note delivered in consumer financing; (2) a note secured by a mortgage on a home; (3) a short-term note secured by a lien on a small business or some of its assets; (4) a note evidencing a “character” loan to a bank customer; (5) a short-term note secured by an assignment of accounts receivable; (6) a note that simply formalizes an open-account debt incurred in the ordinary course of business; nor (7) a note evidencing a loan by a commercial bank for current operations. See Reves, 494 U.S. 20 at 65. Accordingly, we must presume that the note was a security unless it bore a strong family resemblance to one of the foregoing enumerated types of notes. See id. at 65–67. To determine whether the note bore such a resemblance, we must consider the four factors described above. See id. at 66–67. In doing so, we do not agree with Thompson’s contention that the note at issue bore a strong family resemblance to a short-term loan secured by a lien on a small business or some of its assets. ¶40 The first factor of the family resemblance test considers the motivation of the buyer and seller to enter into the transaction. Id. at 66. Specifically, if the record demonstrates that the seller’s purpose was to raise money for the general use of a business enterprise or to finance substantial investments and the buyer’s principal motivation was to make a profit on the transaction, then the note is likely to be a security. Id. If, in contrast, the parties entered into the transaction to correct for the seller’s cash-flow difficulties or advance some other commercial or consumer purpose, among other things, then the note is less likely to be deemed a security. Id. ¶41 Here, the record demonstrates that Thompson’s stated motivation in entering the transaction was (1) to raise money to buy more properties in Timber Ridge for residential development and (2) to pay a lower interest rate and fees on the loan than he would have obtained from a different lender. These facts alone 21 tend to undermine Thompson’s suggestion that the note at issue was merely a short-term loan to cover Timber Canyon’s temporary cash-flow problems. See Douglass v. Stanger, 2 P.3d 998, 1004 (Wash. Ct. App. 2000) (observing that a note that “anticipated the purchase of land and development of a substantial shopping center” was not a “short-term note for a noncommercial purpose,” as a developer had alleged). ¶42 The Witts, in turn, testified that they agreed to the deal because it was a “no risk” investment that essentially guaranteed them a substantial profit. Indeed, the note at issue reflected the primacy of the Witts’ profit motive, as it required Thompson to repay the $2.4 million in full plus a “profit” of $240,000 and 8% annual interest. Accordingly, the first factor of the family resemblance test supports a finding that the note at issue was a security. ¶43 The second factor requires a court to examine the plan of distribution of the note to determine whether it was an instrument in which there was “common trading for speculation or investment.” Reves, 494 U.S. at 66 (quoting S.E.C. v. C.M. Joiner Leasing Corp., 320 U.S. 344, 351 (1943)). This does not mean, however, that the seller must have had a plan for distribution of the note to a broad segment of the public. McNabb v. S.E.C., 298 F.3d 1126, 1132 (9th Cir. 2002). To the contrary, the limited distribution of an instrument like that at issue here “must be weighed against the purchasing individual’s need for the protection of the securities laws.” 22 Id. Thus, even if an investment instrument will not be commonly distributed, it may contemplate a “speculative venture” that would be deemed to satisfy the second prong of the family resemblance test. See Douglass, 2 P.3d at 1004; see also Speculation, Black’s Law Dictionary (11th ed. 2019) (defining “speculation” as “[t]he buying or selling of something with the expectation of profiting from price fluctuations”). ¶44 Here, the promissory note and guaranty secured a $2.4 million loan in a real estate development project that, while allegedly “low risk,” was still a speculative venture, as its success was contingent on Thompson’s being able to secure longer-term, permanent financing that would “take out” what was represented to be the short-term loan and to complete the purchase of the lots that would further secure the Witts’ investment. We therefore conclude that the second factor likewise tends to support the conclusion that the note at issue was a security. ¶45 The third factor requires a court to consider the reasonable expectations of the investing public regarding the character of the note. Reves, 494 U.S. at 66. The “fundamental essence of a ‘security’ [is] its character as an ‘investment.’” Id. at 68–69. Thus, in deciding whether notes are securities, a court must consider “whether a reasonable member of the investing public would consider these notes as investments.” McNabb, 298 F.3d at 1132. “Under this step, we must determine if the seller of the notes calls them investments and, if so, whether it is reasonable 23 for a prospective purchaser to believe them.” Friend, 40 P.3d at 441; see also Stoiber v. S.E.C., 161 F.3d 745, 751 (D.C. Cir. 1998) (explaining that when a seller calls a note an “investment,” it is reasonable for a prospective purchaser to take the seller at its word, absent indications to the contrary). ¶46 We have little difficulty concluding that a reasonable member of the investing public would have considered the note at issue to be an investment. In soliciting the loan, Thompson himself repeatedly referenced the fact that the Witts were making an “investment.” In addition, he emphasized that he would use the money from the Witts to purchase additional lots in Timber Ridge. And the note specified that the Witts not only would be paid back in full, but also would receive 8% interest and $240,000 in “profit.” Because these facts speak to motivations and business objectives commonly associated with securities, a reasonable member of the investing public would likely believe that the investment was a security. See S.E.C. v. Wallenbrock, 313 F.3d 532, 539 (9th Cir. 2002) (noting that the third Reves factor “is closely related to the first factor—motivation for the transaction—and thus the considerations discussed vis-à-vis that factor also come into play here”). ¶47 Finally, the fourth factor requires a court to consider the existence of any other regulatory scheme that significantly reduces the risk of the instrument, thereby making the application of the securities laws unnecessary. Reves, 494 U.S. at 67. Thompson contends that because the note was secured by his two personal 24 residences, against which the Witts could proceed, this factor weighs in favor of a finding that the note was not a security. As noted above, however, this purported collateral was already heavily leveraged, a fact that Thompson never disclosed to the Witts. In such circumstances, the fact that collateral was provided in name did not reduce the risk of the investment so as to make the application of the securities laws unnecessary. See Pedersen, 95 P.3d at 390 (rejecting the defendant’s argument that the purported collateral significantly reduced the risk of the instrument at issue when such collateral was unavailable because it “had previously been assigned to other creditors”). ¶48 Accordingly, consideration of the family resemblance test’s four factors persuades us that the note at issue was a security. ¶49 In so concluding, we are unconvinced by Thompson’s reliance on Bass v. Janney Montgomery Scott, Inc., 210 F.3d 577 (6th Cir. 2000). In Bass, a sophisticated investor agreed to provide financing to a Canadian company that manufactured golf simulators. Id. at 581. The investor made two loans that “were intended to serve as ‘bridge loans’ to help [the borrower] meet its operations costs in the period leading up to the issuance of [the borrower’s] securities in a private placement.” Id. at 580. The loans were secured by a lien on “virtually all assets” of the borrower and a related company. Id. at 581. In addition, the investor received a purchase warrant for the borrower’s stock, as well as a hypothecation and pledge of all of 25 the related company shares held by the borrower and an assignment of a debenture held by it. Id. ¶50 Ultimately, the private placement failed due to insufficient subscription, and the borrower defaulted on the bridge loans. Id. at 582. The investor then filed a civil suit under the 1934 Act and other federal and state securities laws, but the Sixth Circuit subsequently concluded, as pertinent here, that the notes at issue (as distinct from the purchase warrant) were not securities. Id. at 585–86. In support of this determination, the court observed that (1) the first and third Reves factors were “washouts” because the notes at issue had characteristics of both securities and non-securities; (2) the plan of distribution tilted against the notes being securities, given that the transaction was unique and heavily negotiated with a single buyer; and (3) the extensive collateral securing the notes militated against deeming them securities. Id. ¶51 Here, it is true that Thompson characterized the Witts’ $2.4 million investment as a bridge loan with a “guarantee takeout.” The record, however, demonstrates that Thompson did not, in fact, use the loan as a “bridge loan” is typically used. “Bridge loans are short-term loans that ordinarily are intended to meet a company’s capital needs until it is able to obtain long-term financing.” David J. Kendall, Venture Capital Lending: Usury and Fiduciary Duty Concerns, 33 Colo. Law. 49, 49 (Apr. 2004). Thompson did not solicit the loan for purposes 26 of short-term operational funding for existing operations. Rather, he told the Witts that he would use the funds to purchase additional lots in the Timber Ridge project. Moreover, Thompson did not provide the “guarantee takeout” (i.e., the permanent financing that would be the source of repayment of the Witts’ loan) that the note required. See 2 Alvin L. Arnold & Myron Kove, Construction and Development Financing § 5:1 (3d ed. Supp. June 2020) (defining “takeout”). And the record shows that the Witts entered into the arrangement at issue because it was a “no risk” investment in additional lots that would make them a profit, not because it was a stop-gap resource to alleviate Thompson’s momentary cash-flow difficulties. Lastly, as noted above, the collateral that Thompson allegedly provided to secure the Witts’ loan was already highly leveraged, unlike the assets that the borrower in Bass had provided as collateral. See Bass, 210 F.3d at 581, 585. ¶52 For all of these reasons, Bass is distinguishable from the present case, and we conclude that the division correctly determined that the promissory note between Thompson and the Witts was a security for purposes of the CSA.