A reader’s attorney warned him that buying notes with an investor’s money might make him a seller of securities. Here is the question, and W. J. Mencarow’s opinion. As he says, it is not legal advice.
The reader’s question
1. My attorney is concerned that when a person places funds with another person who then invests the money to make a profit, that makes the lender an investor and the person who takes the money the seller of a security. His position is that when the results of a venture depend on another person’s performance, it is no longer a loan, but an investment, and therefore becomes a security.
2. Carrying that a step further, he thinks if I accept money from a lender and invest it for him, I need to have a securities license.
I don’t feel that I’m dealing in securities, but only buying notes for a lender. Will you please share your opinion on this subject? (Eddie McClellan)
The Howey test: what makes a security
The attorney is correctly applying the Howey test, which the Supreme Court has relied on for decades to decide what counts as a security. He seems to be quoting at least one of its three parts:
- The investment of money.
- Investment in a common enterprise.
- The investors’ reliance on the efforts of others to make a profit.
For example, suppose I announce to a group, “Everybody give me $100 (or $1,000, or $10,000, or even $1). I’ll invest it for you, and I think I can make you a nice profit.”
I have just created a security. Even with nothing in writing, it’s a security. If I don’t hold the right securities license for that offer, and the security isn’t registered, I have violated federal securities laws and the securities laws of every state.
How an offer can cross state lines
If I make that offer by U.S. mail, the internet, or TV, radio or newspaper advertising, I have also violated federal postal and communications laws.
Here’s something almost nobody thinks of: even the smallest rural weekly newspaper has out-of-state subscribers who get it by mail. So the paper carrying your ad crosses state lines, and that triggers federal postal laws.
Unless you have the required securities license and the security is registered, you should not accept money from anyone to invest for them.
How note brokering stays out of securities
It sounds as though the reader didn’t fully explain note brokering to his attorney, or the attorney misunderstood. Institutional note investors don’t place funds with brokers to invest for them.
If you work with private investors, never accept money from them unless it is to buy a note you already own, or at least have under contract. Buy it in your name and assign the contract. Don’t take their money and then go find a note for them. The investor’s profit must come from the performance of the note, not from your ability to find a good investment.
Note brokers find notes, do the due diligence, tie up the note (preferably by buying it themselves) and then find an investor.
Words to avoid: lender, loan and agent
- A note investor is not a lender. Never refer to your investors as lenders.
- A purchase money mortgage is not a loan. Never call it one.
- A note broker is not an employee, independent contractor or agent of a note investor.
At the time of writing, no court, law or SEC ruling had declared that note brokering, properly done, is a loan or a securities transaction. Some cases have tested the question.
