“Substance over form” in defining a security

The Ontario Court of Justice recently released a noteworthy decision considering the definition of “security” under the Ontario Securities Act (the Act). In Ontario (Securities Commission) v Tiffin1 (Tiffin), the accused was charged with three offences under the Act for issuing a number of promissory notes while prohibited from trading in securities. Under the Act, security is defined to include “a bond, debenture, note or other evidence of indebtedness.” The primary issue before the court was whether the notes fell within that definition, or were instead private loan agreements not subject to its application.

The court applied the United States Supreme Court decision in Reves v Ernst & Young2 (Reves) in finding that, although the notes were presumptively securities under the Act, they did not meet the overall statutory definition of security. The court held that neither the statutory goals set out at section 1.1 of the Act, nor the circumstances of the particular transactions, required that the promissory notes be regulated as securities.
 


Background

Following the imposition of sanctions and financial penalties against them by the Ontario Securities Commission (the Commission) in another proceeding, the accused, Mr. Tiffin, and his company, Tiffin Financial Corporation (TFC), issued a number of promissory notes to investment clients to raise funds to maintain the operation of TFC. At the time the notes were issued, Mr. Tiffin and TFC were prohibited from trading in securities or relying upon any exemption in Ontario securities law.

All funds received for the notes were deposited into TFC’s corporate account and disbursed for “general business purposes” and to cover Mr. Tiffin’s personal expenses. The notes expressly indicated the relationship created by them was solely that of debtor and creditor. The evidence at trial was that the notes were understood by the parties to be loans to Mr. Tiffin through his business. They were secured against assets of the business and carried no expectation of gain or loss based on the fortune of the business.

At trial, Mr. Tiffin did not challenge that he was not licensed to trade at the material time. He also conceded that promissory notes can be securities under the definition of “security” found at section 1(1) of the Act. However, he argued his issuance of the promissory notes was a private transaction not subject to securities laws.
 

The court’s dismissal of the charges

Although the court agreed with the Commission’s submission that the ordinary meaning of the definition of “security” in the Act is presumed to be the meaning intended by the legislature, it held that its interpretation must ultimately be consistent with the twin goals of the Act, namely: (i) to provide protection to investors from unfair, improper or fraudulent practices, and (ii) to foster fair and efficient capital markets and confidence in capital markets.

Noting the Act does not seek to regulate all commercial or private transactions, the court held that applying a literal interpretation of “note” in the context of the case against Mr. Tiffin would conflict with these goals. In rejecting the Commission’s arguments, the court explained: “Literal interpretation focuses on the form with no inquiry into the substance of the agreement.” Although the court agreed with the Commission that the general legislative scheme of the Act may be characterized as “catch and exclude,” it disagreed that the only bases on which to “exclude” are found in the statute or regulations.

The court followed the United States Supreme Court in Reves in finding there is an initial presumption that every note is a security. That presumption may then be rebutted by reference to a general list of notes, referred to in Reves as a “family” of notes, that have been held not to be a security. This “family resemblance test” presumes a note is a security unless it “bears a strong resemblance,” determined by examining a set of four factors, to one of a judicially crafted list of categories of instruments that are not considered securities. The four factors from Reves ask:
 

  • whether the borrower’s motivation is to raise money for general business use and whether the lender’s motivation is to make a profit;
  • whether the borrower’s plan or distribution of the note resembles “common trading for speculation or investment”;
  • whether the investing public reasonably expects that the note is a security; and
  • whether there is a regulatory scheme that protects the investor other than securities laws.

Notably, notes secured against an asset of a small business were included in the exempt family of notes in Reves. The court in that case also noted that where a loan is issued as a means to correct the seller’s cash-flow difficulties it is less likely the note will be considered a security.

Applying the Reves analysis, the court concluded that the TFC notes were presumptively securities under the Act but did not meet the overall statutory definition of “security.” The court noted that the TFC notes were akin to notes secured by a lien on a small business or its assets, one of the “family” of recognized non-security notes in Reves.

In dismissing the charges against Mr. Tiffin, the court held that neither the twin statutory goals found at section 1.1 of the Act, nor the circumstances of the particular transaction, required the promissory notes issued by him and TFC to be regulated as securities.
 

Footnotes

1 2016 ONCJ 543.
2 494 U.S. 56 (U.S. Ark. S.C. 1990).

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