Court Rules That a Promissory Note is a Security
In April 1998, Norton McNaughton, Inc. acquired two women’s apparel companies – Jeri-Jo Knitwear, Inc. and Jamie Scott, Inc. – companies owned by Leonard Schneider and his three children. Under the terms of the purchase, McNaughton paid the Schneiders $55 million in cash, assumed $10.9 million in debt, and agreed to a future earn-out payment based on Jeri-Jo’s performance over a two-year period to be paid in either cash or stock of McNaughton at the option of Schneiders. Because McNaughton wished to avoid the dilutive effect of issuing stock to the Schneiders under their earn-out payment option, McNaughton and the Schneiders compromised on the payment of the earn-out, with the Schneiders agreeing in August 2000 to settle the earn-out obligation for $161 million, consisting of a combination of cash payment ($95 million to be paid immediately and $30 million to be paid by November 2000), issuance of stock and the issuance of four subordinated promissory notes with a combined face value of $10 million. They also agreed that if financing could not be arranged for the $30 million cash payment, McNaughton could pay the Schneiders $59 million in further unsecured subordinated notes.
In October 2000, McNaughton informed the Schneiders that the company was unlikely to raise the additional financing needed to fund the $30 million payment that was coming due and on December 10, 2000, four three-year subordinated promissory notes with an overall face value of $59 million were issued to them in lieu of the $30 million cash payment.
The eight notes with an aggregate face value of $69 million (the four issued in August 2000 plus the four issued the following December) were each payable to one or another of the four Schneiders.
McNaughton was acquired in June 2001 by Jones Apparel Group, Inc. As a result of the merger (which was an event of default under the terms of the notes) Jones redeemed the notes at par value, paying the Schneiders $69 million plus interest through June 19, 2001.
In October 2001, Highland Capital Management LP sued the Schneiders, alleging that the Schneiders breached an oral agreement to sell the eight notes to Highland for approximately 52 cents on the dollar after the Schneiders learned of the planned acquisition before it was announced to the public. The case eventually made its way the New York State Court of Appeals to determine the specific question of whether or not the eight promissory notes were securities under the New York Uniform Commercial Code. Highland Capital Management LP v. Schneider, 2007 NY Slip Op 02791.
The determination of whether the promissory notes were securities was essential to the outcome of the case because the “statute of frauds” provision of the Uniform Commercial Code generally bars enforcement of purported agreements to sell personal property in excess of $5,000 unless “there is some writing which indicates that a contract for sale has been made between the parties at a defined or stated price, reasonably identifies the subject matter, and is signed by the party against whom enforcement is sought or by his authorized agent.” However, this statute of frauds provision does not apply to a contract for the sale or purchase of a security as defined under Article 8 of the UCC.
The Court ruled that the promissory notes were securities under the UCC because they met the “transferability test” under Article 8; specifically they were represented by a certificate, the transfer of which may be registered upon books maintained for that purpose by the issuer. The Court noted that with regard to the transferability test, the proper inquiry is whether the notes could have been registered on transfer books maintained by McNaughton, not whether they were in fact registered on transfer books maintained by McNaughton at the time of the litigation, which they clearly were not.
The dissent in the case noted that the authors of the UCC attempted to make the question of what is a security for UCC purposes subject to the clear test of registrability, and that registrability is well suited for that goal since it is not hard to determine whether or not such books of transfer exist. The dissent went on to state that the court’s decision effectively undid the work of the UCC’s authors by reading the registrability requirement in so broad a way as to make it meaningless.
What’s the Point?
The court in Highland Capital Mgt. v. Schneider blurs the distinction between negotiable instruments governed by under Article 3 of the UCC and securities governed by Article 8 of the UCC, and this distinction matters. The rights and obligations of an issuer and holder of an Article 3 negotiable instrument are substantially different from those of an issuer and holder of an Article 8 security. For example, the issuer of a registered security may treat the owner as the owner for all purposes until the security is presented for transfer; the issuer of an unregistered negotiable instrument may not. The endorser of a negotiable instrument may also be liable to subsequent holders in the event that the issuer defaults, but the endorser of an Article 8 security makes no warranties regarding the issuer’s ability to satisfy the obligation.
The court’s reading of the registrability requirement is so broad that it deprives it of any real meaning, for it will always be hypothetically possible that books can exist on which transfers of any instrument could be registered.