In a divided decision, New York state’s highest court has concluded that promissory notes issued by a company to various holders constituted “securities” within the meaning of Article 8 of the Uniform Commercial Code (UCC8). Because the notes were deemed to be securities, the New York Court of Appeals determined that UCC8 governed the rights of the holders thereunder. Highland Capital Management, L.P. v. Schneider, 866 N.E.2d.1020 (N.Y., Apr. 3, 2007).

While the facts of the case are not unusual, they are instructive. A company issued notes that are similar to forms of subordinated indebtedness often issued in acquisition financings. The notes (which were governed by New York law) had a subordination legend placed on them and noted that they were not registered under the Federal Securities Act. Although not widely traded, most security industry professionals considered these notes to be “high-risk debt” akin to “junk bonds.” UCC Corner Promissory Notes Deemed To Be ‘Securities’ The case arose in federal court after certain parties alleged that they orally contracted with the noteholders to purchase the notes at a discount. The noteholders refused to sell the notes to the proposed buyers when the company repaid all of the notes in full. The holders argued that since the agreement was “oral,” the agreement violated the Statute of Frauds (requiring any agreement for sale to be in writing) and the buyers’ claims must be dismissed.

The trial court held that while the Statute of Frauds generally does bar oral agreements, the Statute of Frauds does not apply to a contract for the sale of a “security.” To determine whether the notes were “securities” under New York’s version of UCC8, the question was certified to the New York Court of Appeals.

UCC8 Securities

The Court of Appeals found that to qualify as a “security” under UCC8, the notes had to fulfill three requirements (i.e., transferability, divisibility and functionality). Although the court addressed all the elements, the primary matter of dispute involved the “transferability” element. One of the essential elements of transferability under UCC8 is whether the security is registratable. Registratability from the issuer’s perspective (not under federal securities laws) is the key factor.

In that regard, the court analyzed whether the obligations were represented by a certificate in bearer or registered form. Because the notes were evidenced by “paper” evidencing the underlying payment obligation, and because the notes were in a form that could be registered, the court concluded that the registerability (and therefore, transferability) test was satisfied. Since neither of the other elements was in dispute, the court concluded that the notes were securities.

The dissent argued that the majority’s “loose” reading of the registerability requirement implicates more than the subordinated indebtedness at issue in this case. Because the court read the requirement for UCC8 applicability to impact any obligation that “could be registered” rather than obligations that “actually are” registered, the majority’s decision likely expands UCC8 well beyond the original drafters’ intent. This case is somewhat problematic because of the court’s reading of the registerability requirement. In fact, following this decision, an argument can be made that “tranches” of notes issued in many syndicated loan transactions constitute “securities” within the meaning of UCC8. This is an especially important concern in connection with the “mega syndicated” deals governed by New York law, since this case stems directly from New York’s highest court.