Many small businesses regularly use promissory notes, such as when they are borrowing money or when they are paying suppliers. Most small business owners never think about whether their promissory notes are securities. However, the issue is far from clear-cut and can have significant consequences.
Under the Ontario Securities Act (Act), a “security” is defined very broadly and includes any note or other evidence of indebtedness. This would seem broad enough to cover almost any promissory note. The consequences of a small business issuing a promissory note that is a security can be very serious. It would make Act applicable to the note. This means that the business would either have to comply with the Act, by issuing a prospectus, and if applicable, registering as a dealer, or more likely, the business would need to be able to rely on one of the exemptions from the prospectus requirements in the Act.
Ontario Securities Commission v. Tiffin et al.
This issue was recently considered by the Ontario courts in Ontario Securities Commission v. Tiffin et al. Mr. Tiffin was a financial advisor licensed to sell insurance. Previously he had been licensed to sell other investments and he had gotten into trouble with the OSC. In particular, the OSC had issued some orders against him preventing him from trading in securities and requiring him to pay over $500,000. This caused problems for his insurance business, Tiffin Financial Corporation (TFC). TFC borrowed about $700,000 from its clients and issued 14 promissory notes. The OSC learned of this and charged Mr. Tiffin with various breaches of the Act. The only issue at trial was whether the notes were securities.
After reviewing all of the evidence the court decided that the notes were not securities. The court stated that the literal interpretation of the word “note” in the definition of a “security” conflicted with the purposes of the Act, which are to protect investors from unfair, improper and fraudulent practices and foster fair and efficient capital markets.
The OSC had argued that all notes were securities unless there was a specific exemption under the Act or the regulations. The court disagreed and held that you need to look at the substance of the transaction and not just the definition in the Act and the specific exemptions available under the regulations.
In this case the court held that the notes were not securities for all of the following reasons.
- The notes were exempt because they were a type of note that the courts in the US and Canada have previously decided is not a security. They were notes to a small business that were secured by a lien on some of the assets of the business. The fact that the notes were secured was important because it provides protection to the lenders. In this case they were secured by a lien over a toy soldier collection owned by TFC. The court held that the protection of the Act was not necessary because the lenders could enforce the notes under contract law and they could also register their lien and enforce their security. If there is no collateral for a loan, then it is much more likely that a note will be deemed to be a security.
- Previous cases have held that were notes are issued to deal with a small business’ cash flow difficulties, they are less likely to be deemed securities.
- While TFC was seeking the loans for general business purposes and the lenders were expecting a profit in the form of interest, there was no sense that the notes were an investment in the traditional sense or that they represented any interest in the business of TFC.
- The notes were issued to TFC’s existing customers most of whom were friends of Mr. Tiffin. There was no general public solicitation of lenders or investors.
- The lenders all viewed the transaction as a loan and not an investment.
- Although the loans were made to TFC, the parties described them as personal loans. Some of the money was used by Mr. Tiffin to pay for his personal expenses. In addition, Mr. Tiffin was the sole shareholder and director of TFC. He appeared to run his personal finances through TFC and did not have his own bank account.
Summary
This decision provides some comfort to small business owners that if they issue secured promissory notes to specific lenders or suppliers, the money is used for business purposes, such as to help with cash flow, and the notes don’t provide the lenders with any other interest in the business, then they will usually not be securities. This is a practical decision that recognizes how small businesses operate.
This blog post was written by Paul Franco, a member of the Business Law team. He can be reached at 613-369-0363 or at paul.franco@mannlawyers.com.
