Securities Laws And Co-op Member Loan Programs
Last year, the U.S. Supreme Court handed down a decision that will have dramatic implications for co-op member loan programs. No longer may loan solicitations be casually and informally conducted; in truth they never could. But new opportunities have been opened for co-ops that are willing to commit the time and resources that a project of this nature demands.
The case and the context
The Supreme Court decision, reported as Reves v. Ernst & Young,1 involved promissory notes issued by an agricultural cooperative. In order to raise money to support its general business operations, the cooperative carried on an "Investment Program" as an ongoing activity by which it sold its payable-on-demand notes to both members and nonmembers. The notes were unsecured and paid interest that was periodically adjusted to keep it higher than the rate paid by local financial institutions. The Court determined that the notes were securities" within the meaning of federal securities laws.
Consumer co-ops that have funding needs beyond what is provided by member equity payments often use similar arrangements, except that such programs are usually limited to members and involve term loans with fixed interest approximating market rates. The advantages of such loan programs are significant in that co-ops may thereby avoid entanglements with institutional lenders, limit their obligations to "friendly debt" and save a few interest percentage points besides.
That securities laws generally apply to such loan programs is not a new proposition -- even if it has largely gone unacknowledged among consumer co-ops. In general, securities laws are applicable to the full scope of arrangements by which funds are solicited on the expectation of a monetary return. Without doubt, this has always included non-mandatory debt instruments issued by co-ops to their members.2
What's at stake
If notes offered by the co-op are securities then the co-op becomes subject to a wide range of obligations and sanctions. At the federal level, even though an exemption from registration may be available (most commonly under Regulation D), the anti-fraud rules would still apply. Avoidance of fraud requires full and fair disclosure of all material facts. The usual method of discharging this disclosure obligation is to prepare and distribute an "offering memorandum" that incorporates the same type of information as would be contained in a prospectus. This can be an enormously expensive, time consuming and operationally disruptive proposition.
Noncompliance with federal securities laws can involve potentially severe consequences. Civil actions for damages may be brought against the co-op and, if the requisite intent can be shown, against its directors, managers and other responsible persons. Securities regulators can also institute administrative proceedings, suits for injunction and, in appropriate circumstances, even criminal actions. In addition, there are separate obligations and sanctions under securities laws which exist in each and every state. Thus, there are considerable incentives for co-ops to carefully structure their loan programs to avoid securities laws.
In the Reves case the Court emphasized that notes are not securities if they are issued in other than an investment context.3 In determining whether a particular series of notes is of this character, the Court distilled four factors that must be examined: the motivations of the parties, the plan of distribution, the reasonable expectations of the investing public and the existence of other regulatory controls and risk-reducing factors.
These factors are uniquely relevant to the circumstances of consumer co-ops.4 In effect, they provide the basis for a "co-op exception" to securities laws for member loan programs in the same manner as was done by the Court in the mid-1970s with respect to member equity systems.5 Thus, despite the unfavorable holding as to the facts at issue in the Reves case, the Court's reasoning and the principles which it laid down for the guidance of other courts are of considerable potential benefit to small consumer co-ops.6 This is the real significance of the case.
Ideal features of loan programs
To be assured of compliance with the Court's guidelines, it would appear that a member loan program should ideally have the following features:7
- The offering and sale should be strictly limited to bona fide members.
- The purpose of the offering and use of the resulting funds should be limited to some specific project or undertaking other than for the general use of the business or to finance substantial investments.8
- The notes should not be offered on a continual or indefinite basis, but should be made available only for a limited period of time that is reasonable in relation to the purpose of the offering.
- Descriptive and promotional materials should emphasize the cooperative, social and other nonmonetary purposes of the offering, for example as a means by which members can assist and provide needed support for their co-op. All use of "investment" language should be strictly avoided, except for such alternative concepts as "social investment."
- The notes should pay a relatively low rate of interest. Interest payments can and should be augmented by other non-monetary entitlements.9
- The notes should be made nontransferable, except perhaps by inheritance and bequest. In addition, the co-op should not establish a pattern of serving as an intermediary for the exchange of notes, such as by systematically redeeming notes through reissuance to other lenders.
- Some minimal disclosures should be provided to deter the notes from being acquired by inappropriate parties. Descriptive materials should at least state that the notes are risky and they are suitable only for those who can assume the risks involved, afford to forego liquidity ofthe funds lent and possibly sustain a loss. Financial statements in proper format should also be provided before acceptance of any funds and regularly thereafter, with annual statements at least reviewed by an independent public accountant.
- The notes should be adequately and fairly secured by a lien on co-op assets. The co-op cannot assume that it should merely issue Uniform Commercial Code financing statements to individual lenders, because this would serve to automatically provide priority to those who happened to be first to respond to the offer. Unless the collateral is substantially in excess of what is needed for lender security, fairness in allocating risk would require a collateral trust agreement, an agreement whereby the security interest is granted to a selected person or institution acting as trustee for the benefit of all lenders.
- Other risk-reducing procedures should be adopted to the maximum practical extent. For example, a minimum amount of proceeds should be selected and stated in advance so that the success of the project is not prejudiced by inadequate resources. Likewise, loan proceeds should be escrowed in a separate account with restricted access pending receipt of minimum proceeds and fulfillment of other prudent preconditions to proceeding with the planned project.
Structuring loan programs
These features are admittedly restrictive and involve more time and financial resources than many co-ops have committed or might prefer to commit to their member loan programs. But the alternative to complying with the Reves criteria is to proceed on the basis of the notes being presumed to be securities under both federal and state securities laws.
Avoidance of securities laws does not necessarily require full conformity with all of the above-listed points. Undoubtedly, some liberties can be taken with these features -- particularly where the evidence can be strengthened as to the motivations and expectations of the parties and the absence of any need for the protections that would be provided under the securities laws.10 The process of weighing and balancing factors may be aided by the likelihood that lower courts will liberally construe the Reves case.11 But, until the parameters of the case are clarified, prudence and caution are dictated. Structuring tructuring of a member loan program should be done only after careful planning under the supervision of qualified legal counsel.
1. __ U.S. __,110 S. Ct. 945, 108 L.Ed.2d 47 (1990).
2. See, e.g., Parsons, Federal Regulation of Cooperative Securities Transactions: An Update, The Cooperative Accountant, Vol. XLIII, No. 1 (Spring, 1990) at 35, 42; and Middleton, Promissory Demand Notes: investor Protection or Peril Arthur Young & Co. v. Reves, 42 Ark. L. Rev. 1075 (1989). Loans required as a condition of membership, if properly structured, would probably not be exempt under the exception described in note 5, infra.
3. Since federal and state securities laws are parallel and often quite similar, and since the Reves decision dealt with general concepts as to the nature of a security, it seems likely that the case will be interpreted as also governing under state laws, as occurred with respect to the Forman case, infra note 5. In fact, the Reves case has already been determined to be controlling under Alaskan securities laws. Caucus Distributors, Inc. v. Alaska 793 P2d 1048 (Alaska 1990).
4. By reason of the uniqueness of the cooperative structure, the relationship between a small consumer co-op and its members typically involves: (i) with regard to mutual motivations and expectations, significant differences from that between a conventional business and its investors; (ii) with regard to information and distribution activities, systems that are internal and non-public; and (iii) with regard to selfregulatory controls, notable internal oversight mechanisms flowing from member access to information and participation in decision making.
5. United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 95 S.Ct. 2051, 44 L.Ed.2d 621 (1975). In this case, the Court held that stock issued by a cooperative to its members is not a security where the motivation of the purchasers is to gain access to the services of the cooperative rather than to invest for a profit and where the capital interests "lacked the common features of stock," i.e., dividend rights, transferability, realization of increased value of the investment and voting rights in proportion to invested capital.
6. Not surprisingly, commentators have found the Reves caseto be of no practical value to large agricultural cooperatives because of the inability of such cooperatives to structure notes in compliance with the Court's laws in regard to issuance of debt instruments. See Van Valkenberg & Bergquist, Securities Law Update: Reves v. Ernst & Young, The Cooperative Accountant, Vol. XLIII, No. 2 (Summer, 1990) at 36,40; and Smith, "Betting the Farm (On Co-op Capital Notes)" Co-op-A-Gram (Newsletter of Iowa Institute of Cooperation), Vol. 21, No.4 (April, 1990).
7. Some commentators have also recommended that loans be limited to terms not exceeding nine months, on the theory that the Reves case has opened a possible new interpretation of the exception under 15 U.S.C. 178c (a) (10). See, e.g., Block, Are Equity and Notes Issued by A Cooperative "Securities?" (privately distributed). But it seems unlikely that the courts will abandon their consistent and longstanding interpretation that this exception applies only to commercial paper. The majority opinion referred to the arguments supporting this interpretation as having "some force." But see dissenting opinion of Rehnquist, C.J. In any event, the exception is of limited usefulness in the present context because it only provides an exemption from the 1934 Act, not from the 1938 Act.
8. Projects involving expansion programs or purchasing of new equipment (which are among the major reasons for adopting a member loan program) would appear to be included with the prescribed purpose of financing substantial investments. In this case, all that may be possible is to combine such a purpose with other more benign purposes, such as extending or improving services, retiring indebtedness or meeting temporary or seasonal cash needs. It is arguable that this should not be fatal to non-security status. The purpose of the offering was not listed by the Court as an independent factor; it was merely one consideration bearing upon the issue of motivation. Thus, such a combined purpose should be acceptable if other circumstances sufficiently evidence non-investment motivations. See also note 9, infra.
9. The higher the interest rate the less likely it is that the instrument will be viewed as a non-security. Perhaps a useful standard would be an interest rate commensurate with the prevailing rate of inflation so that lenders would recoup no more than the purchasing power of the funds they provided. As a practical matter, however, it may be necessary for the rate to approach bank rates so that lenders will not have a significant lost-interest cost in addition to assuming greater risk. For the same reasons as discussed in note 8, supra, it is arguable that a rate that was at least somewhat below bank rates should not be fatal to non-security status.
10. The Reves decision did not state whether a series of notes that failed to meet one of the four factors would be considered securities, nor did it prioritize these factors. Where two or more factors are not met, the notes would probably be considered securities. Based upon the apparent emphasis of the case and its legal context, the factors relating to the plan of distribution and the reasonable expectations of the public are probably of critical importance. See Krabacher, Promissory Notes as Securities, August, 1990) at 1585.
11. Under very similar circumstances, the courts that were called upon to construe the Forman case, supra note 5, consistently focused on the broad issues of the intent of the purchasers and the economic realities and declined to interpret the case in a narrow or restrictive fashion, even as to nonconforming facts. Grenadier v. Spitz, 537 F.2d 612 (2d Cir. 1976); Seger v. Federal Intermediate Credit Bank of Omaha, 85 F.2d 468(8th Cir. 1988); B. Rosenberg & Sons, Inc. v. St. James Sugar Cooperative, Inc., 447 F.Supp. 1 (D.C. La. 1976); Heese v. DeMatteis Development Corp., 417 F.Supp. 864 (D.C. N.Y. 1976); and Van Huss v. Associated Milk Producers, Inc., 415 F.Supp. 356 (D.C. Tex. 1976).