Norton McNaughton, Inc. bought two companies from four family member shareholders. Part of the consideration was eight subordinated promissory notes as to which, upon default, the payee could elect to receive cash or stock. The notes contained a Securities Act of 1933 notice restricting transfer other than pursuant to a registration statement or an opinion of company counsel that the transfer was exempt from registration. The note holders orally agreed to sell seven of the notes at 50% of their face amount. However, before closing on the sale they learned that Norton McNaughton was being bought, and that the buyer would pay the full amount of the notes. They then refused to consummate the sale.
This suit followed in the U.S. District Court for breach of contract. The Second Circuit referred to the New York Court of Appeals the question whether the notes were a security under Article 8 of the Uniform Commercial Code (UCC). If they were, an oral contract of sale was enforceable. Otherwise, UCC Section 1-206(1) would require a written contract for the sale of personal property in excess of $5,000.
In a 5-2 opinion, the Court held the notes were securities as defined in UCC Section 8-102(a)(15). The Court’s majority applied the three part test of that section:
- Are the notes represented by a certificate and any transfer registered upon books maintained for that purpose by or on behalf of the company (transferability test);
- Were the notes part of or by their term divisible into a class or series (divisibility test); and
- Were the notes of a type traded in the market or a medium for investment that provided it is a security under Article 8 ( functional test).
The majority and minority agreed that the notes met the divisibility and functional tests. The majority held that if the notes were sold and the new owner presented them to the company, the UCC and the Securities Act legend contemplated transferability. It was not necessary for the issuer to maintain or to create books to register the transfer at the time of issuance as long as it may do so at some point in time – e.g., upon sale, so that the issuer would record the new payee.
The dissent pointed out that a security under the UCC is not defined the same as a security under the federal securities laws, but said the notes failed the transferability test because no transfer register ever existed, and noted the distinction between a transfer of a security where the transferor has no liability for the default of the issuer and an endorsement of a negotiable instrument where the endorser retains liability for default by the issuer.