When Does a Promissory Note Become a Security? Fletcher Int'l, Ltd. v. ION Geophysical Corp.

In Fletcher Int'l, Ltd. v. ION Geophysical Corp, Fletcher International Ltd (Fletcher), a preferred shareholder of ION Geophysical Corp. (ION), challenged the issuance of promissory notes by an ION subsidiary.  Fletcher asserted that the notes were securities and that under the rights and preferences of the preferred shares, it had a right to “consent” to the issuance of “any security.”  The Court of Chancery of Delaware granted in part and denied in part the parties’ cross-motions for partial summary judgment, concluding that one note ION issued was a security and its issuance violated Fletcher’s consent rights.  No. 5109-CS, 2012 WL 1883040 (Del. Ch. May 23, 2012).

The instant case concerned three promissory notes ION caused another subsidiary to issue in connection with ION’s acquisition of ARAM Systems Ltd. and its affiliate Canadian Seismic Rentals, Inc. (“ARAM”). The notes were issued to ARAM’s owner, Don Chamberlain and his family.  ION issued these notes as a condition of its agreement with ARAM to finance the purchase price through short-term bridge financing and to expedite the closing. This included a one-year, non-convertible $35 million “Escrow Note” and a one-year, $10 million “Tax Receivable Note.” After ION issued the first two notes, ION and ARAM amended the Senior Credit Facility of the purchase agreement that shortened the lives of both notes from one year to three months. 

The third note was issued as a result of Lehman Brothers’ collapse and the resulting credit market freeze.  Instead of going forward with its planned bond offering, ION issued the five-year, transferrable, $35 million “Final Note” with a quarterly interest rate of fifteen percent.  ION failed to consult with Fletcher before causing any of the three notes to be issued.  

The court had to determine whether the notes were securities under the Certificate of Rights and Preferences for the preferred shares.  As in an earlier decision involving the same parties, the court relied on the four-factor test set out in Reves v. Ernst & Young, 494 U.S. 56 (1990).  Reves set out a four-part “family resemblance” test for determining when, under the federal securities laws, a note constituted a security.  The test required consideration of: “(1) the motivations that would prompt a reasonable buyer and seller to enter into the transaction; (2) the plan of distribution of the note; (3) the reasonable expectations of the investing public; and (4) whether some factor, such as the existence of another regulatory scheme, significantly reduces the risk of the instrument, thereby rendering the application of the securities laws unnecessary.”

In applying the test, the court determined that two of the loans were not securities but short-term bridge loans. Factors that led the court to this conclusion were the notes’ short terms, the inherent difficulty in pricing or selling the notes, and their short-term nature, something that made the protection of the securities laws unnecessary. The court was not dissuaded by the fact that the notes contained securities act legends and contained references to securities laws.   

The court found that the third note was a security.  The note was issued to finance a substantial investment in lieu of the planned bond offering; it had a long, high-interest life, necessitating securities law protection; and it included a securities legend and securities law references.

As a result, the court granted Fletcher’s motion for summary judgment, finding that the issuance of the one note had violated the consent rights under the Certificates.  

The primary materials for this case may be found on the DU Corporate Governance website.

Michael Shumate