In Zhang-Kirkpatrick v. Layer Saver LLC, 2015 BL 85374 (N.D. Ill. Mar. 26, 2015), the United States District Court for the Northern District of Illinois held the promissory note documenting the parties’ agreement did not fall within the definition of a “security” under the federal securities law. Thus, the court granted defendants’, Layer Saver LLC, Kiolbasa, Pierson, and Seldon Fox (collectively, “Defendants”), motion for summary judgment on Plaintiff, Zhang-Kirkpatrick’s claim for securities fraud.
According to the allegations in the case, Plaintff, Zhang-Kirkpatrick invested $150,000 in Layer Saver LLC (“Layer”). The investment arose from a series of meetings between Zhang-Kirkpatrick and Defendants, in which Pierson conveyed to Zhang-Kirkpatrick that Layer was a potential investment opportunity. Defendants told Zhang-Kirkpatrick the loan amount would be $150,000 with an interest rate of 15% a year and assured her Layer would be able to repay the loan. The parties agreed upon a promissory note with a July 2012 maturity date and secured with Kiolbasa’s intellectual property. Layer paid the accrued interest from January 2012 to April 2012, but failed to make any further payments. As a result, Zhang-Kirkpatrick brought suit claiming among other counts, securities fraud.
Defendants moved for summary judgment arguing the promissory note was not a “security.” A note is presumed to be a security. The presumption may be rebutted by showing that “a note bears a close resemblance to one of the enumerated categories of instrument” not considered to be securities. Defendants argued the promissory note fell into one of the enumerated categories, namely the note was a short-term note secured by a lien on a small business or some of its assets.
In determining whether the promissory note was a security, the court relied on the Supreme Court’s four-factor test in Reves v. Ernst & Young, created to assist in discerning between notes issued in an investment context and notes issued in commercial or consumer context. In order to determine if the note bore a close resemblance to one of the enumerated Ernst categories, the court assessed four factors: (1) the motivations that would prompt a reasonable buyer and seller to enter into the transaction; (2) plan of distribution of the instrument; (3) reasonable expectations of the investing public; and (4) whether the existence of an alternative regulatory scheme significantly reduces risk of the instrument.
In considering the first factor, the court disregarded the Plaintiff’s motivation (“looking to make a profit”) and focused on Defendants’ motivations to “correct for its cash-flow difficulties,” concluding that motivation “less sensibly describes a ‘security.’”
Second, the court considered the plan of distribution of the instrument and whether there was common trading for speculation or investment. The court concluded this factor weighed in favor of Defendants because the transaction appeared to be “between two parties engaging in a short-term commercial financing agreement.” The court concluded the third factor and concluded, because there was no investing public involved in the transaction.
Finally, the court considered whether protection provided by federal securities laws was Zhang-Kirkpatrick’s only source of protection. The court concluded Zhang-Kirkpatrick had a remedy outside of federal securities laws. In sum, because the factors weighed in favor of Defendants, the court held the promissory note was not a security.
Accordingly, the court granted Defendants’ motion for summary judgment with respect to the securities fraud count.
The primary materials for this case may be found on the DU Corporate Governance website.