It Depends On What The Meaning Of the Word “Note” Is: Tenth Circuit Holds That The Jury Must Decide When a Note is a “Security”

September 20, 2013

By: Sara Kropf

The Tenth Circuit recently issued an opinion affecting criminal securities cases and making it slightly harder for the government to prevail at trial. In United States v. McKye (No. 12-6108), the Tenth Circuit reversed the jury’s verdict for the government in a securities fraud case, holding that the judge had improperly instructed the jury that a “note” is a “security.”

Brian William McKye was charged with eight counts of securities fraud and one count of conspiracy to commit money laundering in the Western District of Oklahoma. The indictment alleged that Mr. McKye and his co-conspirator used several different entities to engage in a classic Ponzi scheme. One of these entities was Heritage Estate Services LLLC. Heritage would set up revocable trusts for clients, allowing clients to finance the cost of preparing the trust by signing a promissory note. The notes were sold to another related entity called Global West.

What happened next?

Heritage would sell investors what they called “Premium 60 Account” notes issued by Global West. These notes had a guaranteed annual return between 6.5% and 19.275%. Some of these notes included documentation titled “Assignment of Note/Lien/Mortgage Collateral (Blanket Assignment).” I won’t even try to decode that title but it suffices to say that it listed the trust loans taken out by Heritage customers who had financed their trust preparation. (If you are now completely lost, don’t worry.  Re-read the above paragraph—the notes from the revocable trust customers are the supposed collateral for the Premium 60 Account notes.)

However, at least one Heritage salesman testified at trial that he was instructed to tell potential investors that the Premium 60 Account notes were secured by real estate or mortgages, and not by a list of revocable-trust-financing documents.

Essentially, though, according to the Court’s summary of testimony of an IRS agent at trial

McKye was operating a Ponzi scheme because the principal from newer investors was being used to make the interest payments to older investors.

Mr. McKye did take the bold step of testifying at trial. At least based on the Court’s description of some of his testimony, he may not have done himself a lot of favors. (I’m quite, sure, however, that he testified to a lot more than what the Court describes.) He admitted that he would intentionally list the same revocable-trust loan on several collateralization documents, that he believed he had insurance to protect investors and that the liens associated with the trust loans were not always recorded.

The indictment, tracking 15 U.S.C. § 78j(b), alleged that Mr. McKye’s acts were “in connection with the sale and purchase of securities.” Mr. McKye proposed a jury instruction that required the jury to decide whether the investment notes at issue counted as a “security “for the securities fraud counts.

The judge rejected Mr. McKye’s proposed instruction. Instead, it concluded that notes are presumed to be securities and the defense had failed to overcome that presumption with evidence at trial.

Mr. McKye was ultimately convicted of the conspiracy charge and seven of the eight securities fraud charges. He was sentenced to 262 months in prison (yes, that’s nearly 22 years).

That was a lot of lead up for a fairly straightforward opinion by the Tenth Circuit. Relying heavily on United States v. Reves, 494 U.S. 56 (1990), the court explained that even though the statutory definition of a “security” includes “any note,” this does not mean that any document referred to as a “note” is a security. Rather, the Reves Court set forth a list of seven types of notes that “are not properly viewed as securities” because Congress did not intend to regulate them under the Securities Act of 1933.

These non-security notes include instruments such as “a note secured by a mortgage on a home” and a “note delivered in consumer financing,” among others. This list, however, is not exhaustive. If an instrument bears a “family resemblance” to the listed instruments, then it too is excluded from the definition of a security. The Reves Court offers a four-part test for whether there is a family resemblance:

(1) “the motivations that would prompt a reasonable seller and buyer to enter into it,” (2) “the ‘plan of distribution’ of the instrument,” (3) the “reasonable expectations of the investing public,” and (4) “whether some factors such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.”

There is a presumption that a note is a security unless it fits into the seven categories set out by Reves or meets the four-part “family resemblance” test.

The key issue in McKye was the judge or the jury should decide whether a note is a security.  The Tenth Circuit concluded that this was a mixed question of law and fact, thus requiring the jury to decide it. Because the district court judge had refused to allow the jury to decide the question and instead concluded himself that the notes were securities as a matter of law, the convictions were reversed.

Congratulation to Mr. McKye, at least temporarily. I assume that the case will go to trial again since DOJ does not usually give up this easily. But this is an important ruling for criminal securities law cases since it may affect exactly what questions will be decided by the jury on other elements of criminal securities law offenses.

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