Individualized Promissory Note Held Not To Be a Security

The following is the text of an e-bulletin that I authored and that was published by the Corporations Committee of the Business Law Section of the State Bar of California.

In People v. Black (Feb. 16, 2017), the court of appeal held that a single promissory note, negotiated one-on-one, to fund an investment in real property was not a security under the California Corporate Securities Law even though the note offered a share of profits to the lender as an alternative to fixed interest.

The promissory note at issue was written on the letterhead of “Atherton LLC, a land development company” and listed Atherton, LLC as “borrower” and Bronic Knarr as “lender.” In the note, the borrower promised to pay the lender the amount borrowed ($124,456) together with interest that would be calculated as follows:

  1. If the real property were sold by the borrower, the amount of interest would be a percentage of the profits from the sale.
  1.  If the borrower developed the real property, the lender would receive two lots chosen by the lender.

If the property were neither sold nor developed within one year, the principal, along with interest at the rate of 10%, would be due at the election of lender.

The note further stated that “Charles Black who is executing this Note has agreed that his separate property shall be bound hereby and that resort may be had to such separate property for the payment and enforcement of this Note.” The note was signed only by Black as “managing member” of Atherton, LLC.

Subsequently, the note was amended to reflect that Knarr had increased his loan and that Knarr would receive one residential acre, not two lots, if the property were developed. The maturity date of the note was extended several times.

Two other individuals separately gave money to Black for the deal. James McGuire, a real estate agent who knew Black from prior dealings, partnered with Black and invested about $160,000. David Faye gave Black $20,000 toward the deal but was unsuccessful in attempts to follow up with Black about his investment.

Trial Court Proceedings

The Santa Cruz County District Attorney filed an information charging Black with three counts of theft by false pretenses and three counts of making false statements in the offer or sale of a security. After the preliminary hearing, the magistrate found insufficient evidence of a false pretense but held Black to answer the charges of using false statements in the offer or sale of a security. Thereafter, the information was amended twice, and Black moved to dismiss on the ground that the promissory note was not a security.

The trial court concluded that the promissory note was not a security under either the risk-capital test or the Howey test.

Court of Appeal Opinion

On appeal, the People did not argue that the promissory note qualified as a security under the risk-capital test.

The court of appeal noted that Corporations Code section 25019 defines “security” to include “any note; stock; . . . bond; . . . evidence of indebtedness; certificate of interest or participation in any profit-sharing agreement; . . . investment contract….” Citing the California Supreme Court’s opinion in People v. Figueroa (1986) 41 Cal.3d 714, 734, the court of appeal noted that the definition of “security” is not applied literally. Rather, “the ‘critical question’ . . . is whether a transaction falls within the regulatory purpose of the law regardless of whether it involves an instrument which comes within the literal language of the definition [citations omitted].”

Black argued that the promissory note was not a security because it was a unique agreement that was negotiated one-on-one between the parties and was not designed to be publicly traded, citing Marine Bank v. Weaver (1982) 455 U.S. 551, which held that a unique agreement not designed for common trading might not be an “investment contract” or other type of security under federal law. The court of appeal noted that there was no prospectus or other indication that the arrangement with Knarr “could have been traded publicly” and thus the note at issue was not an instrument intended for wide distribution.

Black also argued that repayment to Knarr was not contingent on the success of the enterprise because Knarr had the right to be repaid the principal plus interest, whether or not the Idaho deal succeeded, and that the evidence was insufficient to show that Black would not have been able to fulfill that obligation. Knarr testified that he would not have invested with Black if the fixed repayment obligation not been included in the promissory note, and Black was unequivocal that he owed Knarr the money. The court noted that the fixed repayment obligation, together with the provision binding Black’s separate property, “inserted an element of redress that would be unlikely to come within ‘the ordinary concept of a security’ [citations omitted].”

Although the court of appeal rejected the notion that all one-on-one contracts are excluded as a matter of law from the definition of a security, it held that the individualized nature of the transaction is one factor that must be considered in determining whether that transaction comes within the regulatory purpose of the securities laws. Accordingly, the court of appeal held that the promissory note offered for Knarr’s investment in the real estate development scheme was not a security within the meaning of the Corporate Securities Law.


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