Canada: When Is A Promissory Note A Security And Not A Loan?

Background

Tiffin Financial Corporation ("TFC") and its principal Daniel Emerson Tiffin ("Tiffin"), were subject to a cease-trade order (the "Order") issued by the Ontario Securities Commission (the "OSC") in relation to a foreign exchange investment scheme. The Order prohibited Tiffin and TFC from trading in securities or relying upon any exemption under Ontario securities laws.  However, after the Order was issued Tiffin solicited funds on behalf of TFC and TFC ultimately issued $700,000 in secured promissory notes to several clients.  The notes were for a one year term, with interest ranging from 10% to 25%, and expressly relied on the accredited investor exemption under the Act.  While Tiffin in fact disclosed the OSC investigation and the Order, the clients viewed the transaction as a loan and not an investment.

The OSC subsequently charged Tiffin and TFC with trading in securities without registration, distributing securities without filing a prospectus and breaching the Order.  The Act defines "security" broadly to include, among other things, "a bond, debenture, note or other evidence of indebtedness."

The Trial Decision

At trial in the Ontario Court of Justice, Tiffin and TFC argued that the promissory notes issued to clients were not securities subject to the Act but rather, "simple loan agreements".

Despite acknowledging that the broad definition of a security in the Act is intended to capture a variety of transactions, subject to specific statutory exemptions , the trial judge held that a broad interpretation "casts too wide a net" and was inconsistent with the purpose of the Act. The trial judge found that, on its face, the impugned promissory notes appeared to be securities within the Act's definition but acquitted Tiffin and TFC on the basis that adopting a liberal interpretation would be contrary to the approach taken by Canadian and US courts.  In doing so, the trial judge applied the American "family resemblance" test that assessed the promissory notes against four judicially crafted factors developed in the US to determine whether or not an instrument is a security.

The defendants were accordingly acquitted, and the OSC appealed.

The Appeal Decision

On appeal, Justice Charney of the Ontario Superior Court found the trial judge had erred in applying American extra-statutory judicial criteria to exclude the impugned promissory notes when they otherwise met the definition of a "security" in the Act.  Charney J. also disagreed with the trial judge's opinion that the statutory definition of security "casts too wide a net" and is inconsistent with the purpose of the Act, noting that this breadth is deliberate and consistent with the remedial purpose of the Act.  Further, it was found that there are fundamental differences between the Ontario securities regulatory regime and its counterpart in the United States, rendering the "family resemblance" test inappropriate in the context.

Interestingly, Charney J. was not swayed by the evidence that the clients understood the notes to be loans, and possessed no expectation of gain or loss based on the fortune of TFC:

There is nothing in the [Act] to exempt promissory notes on the basis of what the parties "understood". As a general proposition, it is unlikely that most of the investing public has any understanding what kind of lending transactions fall within the ambit of the Act and which do not.

The Court otherwise relied on the trial judge's findings that the loan arrangement between Tiffin, TFC and their clients was a "note or other evidence of indebtedness" under the Act, thereby falling within the Act's definition of a security.  Justice Charney accordingly overturned the decision and concluded that the promissory notes were "securities" within the meaning of the Act.

Tiffin and TFC were found to have traded in securities without registration, distributed securities without filing a prospectus and breached the Order.  Pursuant to a subsequent sentencing decision (2018 ONSC 5419), Tiffin was sentenced to imprisonment for 6 months, probation for 24 months and ordered to make full restitution to his clients for the amount of the promissory notes.

Conclusion

The decision inTiffin underscores the potentially serious consequences of reaching an incorrect opinion on whether securities legislation will permit the issuance of a note or similar instrument to evidence a loan or debt obligation.  In fact, as noted by Charney J., the understanding and intention of the parties will be given little weight in the Court's assessment of the note for the purposes of the Act.

The definition of a security under the Act is intentionally broad. To rely on an exemption, one must point to express statutory or regulatory exemption(s).  Failing this, a Court or the OSC will be reluctant to apply US jurisprudence or policy arguments to exclude an instrument that presumptively falls within the Act's definition of a security.

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