Court Concludes Demand Notes Were Securities Under Federal Acts

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The U.S. District Court for the Eastern District of Michigan declined March 13 to dismiss a Securities and Exchange Commission enforcement action against two men who allegedly sold fraudulent demand notes tied to a defunct real estate venture (SEC v. Mulholland, E.D. Mich., No. 12-14663, 3/13/13).

Applying the four factors enunciated in Reves v. Ernst & Young, 494 U.S. 56 (1990), Judge Thomas Ludington concluded that the instruments were securities within the meaning of the federal acts. 

High Returns Promised

The court said defendants Thomas Mulholland and James Mulholland Jr. operated a real estate business, Mulholland Financial Services Inc., that involved, buying, maintaining, and renting Michigan real estate. The Mulhollands financed their business by issuing demands notes, which they sold to friends, relatives, and clients, and via “word-of-mouth referrals.”

According to the court, MSFI began to fail in early 2009 and ultimately was dissolved by the defendants. However, the court said, the two “continued to raise investor funds through the defunct company.”

The SEC contended that the defendants raised $2 million during 2009 by selling demand notes to 75 investors, promising a 7 percent return on their investment--“all while they were losing money.”

According to the court, the Mulhollands allegedly told potential investors that returns would be generated by profits from MFSI, and that the principal and accrued interest would be returned within 30 days of a written demand.

Moreover, the court recounted, many of the investors were retirees, most with limited investment experience--a fact the Mulhollands “used to their advantage” in persuading them to invest.

In early 2010, the Mulhollands sought bankruptcy protection and the 75 investors lost everything they paid for the notes. The SEC filed an enforcement action but the defendants moved to dismiss for lack of subject matter jurisdiction, saying the demand notes were not securities as a matter of law. 

Reves Factors

The court disagreed. It explained that every note is presumed to be a security; however, the presumption can be rebutted if the note is--“or sufficiently resembles”--one of several categories of notes the U.S. Supreme Court has established is not a security.

Reves sets out four factors for deciding if a note is sufficiently similar to a category of non-securities instruments, the court continued: 

  • the parties' motivations; 
  • the plan of distribution; 
  • the public's reasonable expectations; and 
  • the existence of another regulatory scheme that significantly reduces the risk of the instrument.  

Addressing each factor in turn, the court said that while the defendants “now maintain” that the demand notes were issued to remedy cash-flow problems, they allegedly told investors that their funds would be used to buy, maintain, and rent real property. They also admitted that they financed their real estate business by issuing the demand notes, and that one defendant told investors that he and his brother ran a profitable real-estate operation.

“There can be little doubt that the lenders' primary motivation here was monetary gain,” the court concluded. Under Reves, this factor supports the conclusion that the demand notes were securities. 


Addressing the second factor, the court said it must determine whether the 75 investors constituted a “broad segment of the public.” Deciding in the affirmative, it noted that the investors were all individuals rather than institutions, and that the defendants “do not appear to have excluded any individual that had the ability to pay.”

Third, the court concluded, the fact that the demand note “specifically indicated that it would provide a guaranteed return-on-investment of 7%,” among other matters, suggest that the public “would, and did, view the notes as investments.”

Finally, the court noted that the demand notes were uncollateralized and uninsured, and that the defendants identified no regulatory scheme that would apply if the securities laws did not. As such, it concluded, the demand notes the defendants used to support their business were securities as defined by the federal acts.

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