In this opinion, Chancellor Strine analyzed whether the rights of a preferred stockholder under a certificate of designations, which required the consent of the preferred stockholder for the issuance of “securities,” had been violated by the issuance of certain promissory notes. The Chancellor granted in part defendant’s motion for partial summary judgment, holding that two of the promissory notes were short-term commercial loans and therefore not “securities,” and granted in part plaintiff’s motion for partial summary judgment, holding that one of the promissory notes was a long-term, transferrable, investment instrument and therefore a “security” that could only be issued with the preferred stockholder’s consent.
At issue were three promissory notes issued by ION Geophysical Corp. (“ION”) in connection with its acquisition of shares of a third party. ION agreed to fund the purchase price with, among other things, two promissory notes issued by an ION subsidiary (the “Escrow Note” and the “Tax Receivable Note”). The Escrow Note was not convertible into equity, had a reducible one-year term and escalating interest rate, and mimicked the escrow provision for setting off indemnification claims and purchase-price adjustments against the amount due on the note. The Tax Receivable Note, which had an interest rate that was one percent above the Escrow Note interest rate, was unsecured, guaranteed by ION, not convertible, due one day after the Escrow Note, and funded by a tax receivable that ION expected to receive from the Canadian tax authorities. The Escrow Note and the Tax Receivable Note each displayed a legend stating that the note was not registered under securities laws and that it could only be sold or transferred in accordance with securities laws.
As a result of the Lehman Brothers collapse and the freezing of the credit markets, ION was unable to raise cash to fund the acquisition and, in lieu thereof, caused its subsidiary to issue a third promissory note to fund the acquisition (the “Final Note”). The Final Note had a five-year term, 15% interest rate payable quarterly, and a legend disclaiming registration under securities laws. Like the other promissory notes, the Final Note would become freely assignable in the event of an uncured default, included a nine-month right of set off against the purchase price, and was guaranteed by ION.
Fletcher International, Ltd. (“Fletcher”), a holder of preferred stock of ION, commenced this action and asserted that the issuance of the promissory notes violated the terms of the certificate of designations, which required the consent of Fletcher for any issuance by an ION subsidiary of any “securities.” ION did not seek or receive Fletcher’s consent before issuing the Escrow Note, the Tax Receivable Note, or the Final Note.
The Chancellor first found that Vice Chancellor Parson’s earlier decision, regarding whether a promissory note issued by an ION subsidiary were a “security” requiring Fletcher’s consent, established the law of the case. Fletcher Int’l, Ltd. v. ION Geophysical Corp., 2010 WL 2173838 (Del. Ch. May 29, 2010) (“Fletcher I”). In Fletcher I, the Vice Chancellor stated that “securities” referred to “instruments generally recognized to be securities under federal and state securities statutes and regulations,” and that the United States Supreme Court, in Reves v. Ernst & Young, 494 U.S. 56 (1990), set forth the applicable test for that determination. The Chancellor stated that Reeves creates a strong presumption in favor of finding that a note is a security, which may be rebutted if (a) the note fits within one of five specific categories: (i) short-term note secured by a lien on a small business, (ii) short-term note secured by an assignment of accounts receivable, (iii) note evidencing loans by commercial banks for current operations, (iv) note evidencing a “character” loan to a bank customer, or (v) note formalizing an open-account debt incurred in the ordinary course of business; or (b) the notes bears a strong resemblance to one of these specifically enumerated types of notes, considering four relevant factors: (i) motivations that would prompt a reasonable buyer and seller to enter into the transaction, (ii) plan of distribution of the note, (iii) reasonable expectations of the investing public, or (iv) whether some factor, such as another regulatory scheme, significantly reduces the risk of the instrument, thereby rendering the application of securities laws unnecessary. The Chancellor repeated the Vice Chancellor’s guidance, in Fletcher I, that the “fundamental essence of a ‘security’ is its character as an ‘investment.’”
Applying the Vice Chancellor’s guidance from Fletcher I and the US Supreme Court’s test from Reeves, the Chancellor analyzed whether the three promissory notes in dispute more closely reflected short-term commercial loans or easily traded, multi-year instruments that correspond in value to the success of the issuer’s business. The Chancellor held that the Escrow Note and the Tax Receivable Note were not “securities” because they were short-term lending transactions entered into to facilitate the early closing of the acquisition and subject to set-offs and the tax receivable outside of a third-party’s control. The Chancellor acknowledged that these two promissory notes included securities act legends, but further noted that potential investors would have great difficulty pricing them and no additional protection from securities law is required because they do not trade like a security. The Chancellor next held that the Final Note was a “security” because it provided a long-term, transferrable debt instrument with a high interest rate, free from set-off rights for four years after the escrow closed. The Chancellor further noted that the Final Note included a securities law legend, that the noteholder would use the Final Note from ION to protect his equity position in ION stock, and that nothing about the Final Note obviated the need for securities law protection. The Chancellor, therefore, held that the presumption in favor of deeming a note to be a security had been rebutted with respect to the Escrow Note and the Tax Receivable Note, but that the presumption had not been rebutted with respect to the Final Note. As a result, the issuance of the Final Note without obtaining Fletcher’s consent violated Fletchers’ consent rights under the certificate of designations.
The full opinion is available here.