Five-minute digest
Reves v. Ernst & Young
Summary
The Farmers Cooperative of Arkansas and Oklahoma, an agricultural cooperative with about 23,000 members, raised money for its general operations by selling promissory notes payable on demand. The notes were uncollateralized and uninsured but paid a variable interest rate set monthly to stay above what local banks paid. The Co-Op marketed them as an Investment Program, with newsletter advertisements describing them as safe, secure and available when needed. In 1984 the Co-Op went bankrupt, and more than 1,600 people held notes worth about $10 million. A class of noteholders sued Arthur Young & Co., the Co-Op's auditor and predecessor of Ernst & Young, claiming it had intentionally departed from accepted accounting principles in valuing a gasohol plant so as to inflate the Co-Op's assets. The noteholders won a $6.1 million judgment, but the Eighth Circuit reversed, holding that the demand notes were not securities. The question was whether these demand notes were securities under Section 3(a)(10) of the Securities Exchange Act of 1934, which lists any note but excludes notes with a maturity at issuance not exceeding nine months. The noteholders argued that the notes were sold to the public as investments and that the short-term exclusion was meant only for commercial paper traded among sophisticated parties. Ernst & Young argued that many notes are ordinary commercial instruments, that the notes resembled no recognized security, and that a demand note matures immediately and so falls within the nine-month exclusion. On 21 February 1990 the Court reversed. Justice Marshall adopted the family resemblance test drawn from the Second Circuit: a note is presumed to be a security unless it bears a strong resemblance to a recognized category of non-security notes, such as consumer loans or home mortgages, judged by four factors. Courts ask about the motivations of seller and buyer, the plan of distribution, the reasonable expectations of the investing public, and whether another regulatory scheme or risk-reducing factor makes the securities laws unnecessary. The Co-Op sold its notes to raise general capital, offered them widely, advertised them as investments and backed them with no collateral or insurance, so they were securities. On the exclusion, Marshall held that the maturity of a note is a question of federal law, that a demand note's maturity is ambiguous, and that read according to its purpose the exclusion did not cover these notes. Justice Stevens joined fully and added that the courts of appeals and the SEC had long read the exclusion as limited to commercial paper. Chief Justice Rehnquist, joined by Justices White, O'Connor and Scalia, joined the family resemblance analysis but dissented on the exclusion, arguing that by long legal usage a demand note is due at once and so has a maturity of less than nine months. The library text gives all three opinions without notes. The same litigation returned in Reves v. Ernst & Young (1993), which addressed the auditor's liability under the federal racketeering statute.
Top Lessons
Economic reality and the meaning of security
Marshall wrote that Congress meant to regulate investments in whatever form they are made and by whatever name they are called. The Court looks past labels to what an instrument does: here, notes sold widely to raise capital and paying interest to draw investors functioned as investments.
Presumptions and families
The family resemblance test begins by presuming that a note is a security and then asks whether it closely resembles a familiar type of non-investment note, such as a home mortgage or a consumer loan. The four factors give courts a structured way to decide close cases.
Plain words and settled meanings
The justices divided over the nine-month exclusion. Rehnquist read maturity by its long-established legal meaning for demand paper; Marshall found the word ambiguous as applied and turned to purpose; Stevens relied on decades of consistent lower-court and SEC interpretation.
Protection for ordinary investors
The noteholders were members of a farm cooperative and members of the public, not professional traders. The Court's analysis of the plan of distribution and public expectations reflects the securities laws' concern with offerings made to people who rely on the issuer's representations.
Verified Quotes
“In discharging our duty, we are not bound by legal formalisms, but instead take account of the economics of the transaction under investigation.”
Frequently cited
“Congress' purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called.”
Frequently cited
“A note is presumed to be a "security," and that presumption may be rebutted only by a showing that the note bears a strong resemblance (in terms of the four factors we have identified) to one of the enumerated categories of instrument.”
“Finally, we examine whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.”
“In my view such a settled construction of an important federal statute should not be disturbed unless and until Congress so decides.”
“But the terms "note" and "maturity" did not spring full blown from the head of Congress in 1934.”
Medical Lens
A dispute over whether a farm cooperative's demand notes were securities; the opinions concern statutory definitions and contain no medical subject matter.