Overruling its 1984 Milne decision, the Colorado Supreme Court has adopted the Reves test for determining whether a note is a security under Colorado law.
The Colorado Supreme Court has adopted the Reves "family resemblance test" developed by the U.S. Supreme Court for determining whether a note is a security under the Colorado Securities Act. In overruling more than three decades of state court precedent, the panel reasoned that the application of the Howey test to financial instruments other than investment contracts, including "investment notes," would make superfluous the enumeration of the different types of instruments included in the definition of a "security" under both Colorado and federal law. As the promissory note met the four-factor test for a security under the Reves test, the court affirmed the defendant’s convictions for securities fraud (Thompson v. People, September 14, 2020, Gabriel, R.).
The appellant had borrowed $2.4 million to continue development on a real estate project without disclosing to the investors that the lots were in foreclosure and his company had filed for bankruptcy. After the appellant defaulted on the promissory note and filed for personal bankruptcy, the State of Colorado charged the appellant with two counts of securities fraud and one count of theft. A jury found the appellant guilty on all three counts, and the trial court sentenced him to a combined term of 30 years in prison.
On appeal, the appellant argued that because his note was not a "security" within the meaning of the Colorado Securities Act, insufficient evidence supported his securities fraud convictions. The Colorado Court of Appeals disagreed, however. Following the so-called "family resemblance test" developed by the U.S. Supreme Court in Reves v. Ernst & Young (U.S. 1990) and adopted by a prior division of the court in People v. Mendenhall (Colo. App. 2015), the unanimous panel concluded that the promissory note at issue was a security.
All in the family. The Colorado Supreme Court began by observing that in People v. Milne (Colo. 1984), decided six years before Reves, the state high court had appeared to expand the application of the Howey test for a security to financial instruments other than investment contracts, including "investment notes." As the U.S. Supreme Court in Reves had explicitly rejected expanding Howey to the context of notes under the federal securities laws, the question thus became whether the Colorado Supreme Court should overrule its decision in Milne and adopt the Reves family resemblance test instead.
Answering the question in the affirmative, the panel noted that Colorado case law construing the state's securities statutes has historically tracked the U.S. Supreme Court’s interpretation of parallel provisions of the federal securities laws. Given that the definition of a "security" is identical in the Colorado Securities Act and the Exchange Act, applying the Howey test to determine whether any other kind of financial instrument constitutes a security would render superfluous the enumeration of the many different types of instruments found in the definition in both statutes.
In addition, the state high court reasoned, the family resemblance test provides an analytical framework that harmonizes: (1) the Colorado statute's broad definition of a security; (2) federal and state case law recognizing that, despite such broad language, some notes are not securities; and (3) the purposes of the Colorado Securities Act to protect investors and maintain public confidence in securities markets. Finally, the court noted that there is a clear trend among state courts around the country in adopting the family resemblance test for determining whether a note is a security for purposes of their own securities acts.
Turning to the facts of the case, the state high court concluded that the note was a security under the four-factor family resemblance test. With regard to the motivation of the buyer and seller to enter into the transaction. the record showed that the appellant’s stated motivation in entering the transaction was: (1) to raise money to buy more properties 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 undermined the appellant’s suggestion that the note at issue was merely a short-term loan to cover his company’s temporary cash-flow problems.
Regarding the plan of distribution, 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 sufficient to satisfy the second prong of the family resemblance test. The court also had little difficulty concluding that a reasonable member of the investing public would have considered the note at issue to be an investment, observing that in soliciting the loan, the appellant himself repeatedly referenced the fact that the purchasers were making an "investment."
Finally, there was no other regulatory scheme that significantly reduced the risk of the instrument. Although the appellant argued that this factor weighed in his favor because the note was secured by his two personal residences, the fact that the collateral was provided in name did not reduce the investment's risk so as to make the application of the securities laws unnecessary.
Accordingly, the court concluded that the promissory note was a security for purposes of the Colorado Securities Act and affirmed the defendant’s convictions for securities fraud.
The case is No. 18SC543.
Attorneys: Megan A. Ring (Colorado State Public Defender) for Steven Curtis Thompson. Philip J. Weiser (Office of the Attorney General) for The People of the State of Colorado.
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