SPRECHER, Circuit Judge.
The sole issue presented is whether promissory notes delivered to a bank for loans used to purchase the assets of a small business enterprise constitute "securities" under the Securities Exchange Act of 1934, investing the maker of the notes with a jurisdictional basis for bringing suit in the federal courts.
According to the complaint, the "Village Well" is a coin-operated laundry and dry cleaning business located in Justice, Illinois, which had been owned and operated by defendants Giselle Strausburger, Gladys Lucas and G. & G. Enterprises, Inc., in accordance with a license agreement from defendants Robert W. Casey and Kimlis Sales Company.
On January 20, 1972, the plaintiffs purchased the fixtures, merchandise, business and good will of the Village Well from Strausburger, Lucas and G. & G., having given Kimlis a promissory note for $5,000 as an earnest money deposit. As part of the transaction, the plaintiffs also (1) assumed a chattel mortgage in the amount of $73,515.26 on the fixtures, which mortgage was held by defendant National Bank of Austin, (2) gave the Austin Bank an "evidence of indebtedness" in like amount, (3) borrowed an additional $20,000 from the Austin Bank evidenced by a note secured by a junior chattel mortgage, and (4) paid a portion of the non-specified purchase price to Strausburger, Lucas and G. & G.
Plaintiffs alleged that from September through December 1971, defendants Strausburger, Lucas and Casey represented orally and in writing that the monthly sales of the Village Well ranged from $4,500 to $5,500, that October 1971 sales were about $4,800, that November 1971 sales were $5,700, that December 1971 sales would exceed those of November, and that defendants displayed to plaintiffs books and records purporting to reflect such sales. Plaintiffs further alleged that these representations were all false and that the books and records failed to reveal accurately the actual sales.
The plaintiffs operated the business for approximately four months, spending substantial sums in promoting the business, suffering financial losses and borrowing additional capital funds to carry on. On May 19, 1972, plaintiffs sent defendants a notice of rescission. Since May 28, the Village Well has been operated by Casey and Kimlis.
Plaintiffs sought rescission of all agreements with defendants, repayment of consideration paid and cancellation of obligations assumed. Plaintiffs relied exclusively for federal jurisdiction upon section 10(b) of the Securities Exchange Act of 1934 (15 U.S.C. § 78j) and Rule 10b-5 thereunder (17 C.F.R. § 240.10b-5).
All six defendants filed motions to dismiss on the ground that the 1934 Act does not apply to this transaction and therefore that federal jurisdiction does not lie.
The district court denied all motions on May 2, 1973, but, on motions for reconsideration, vacated that order. On September 26, 1973, the motions by all defendants to dismiss were granted "for reasons stated in the record." The
As we pointed out in Sanders v. John Nuveen & Co., Inc., 463 F.2d 1075, 1078 (7th Cir.), cert. denied, 409 U.S. 1009, 93 S.Ct. 443, 34 L.Ed.2d 302 (1972), the six basic federal securities acts each includes "any note" within its definition of "security."
In Sanders, we held that promissory notes with a maturity not exceeding nine months but offered to the public as an investment are "securities" within the meaning of the 1934 Act despite the broad implications of the exception inasmuch as Congress obviously intended to protect such investors against fraud. 463 F.2d at 1079-1080. We said:
Id. at 1080.
In effect, we are now called upon to consider a situation which is the reverse of Sanders. In Sanders we applied a congressional-intent-revealed-in-context approach as against a literal-text-reading of "any note [with] a maturity . . of not exceeding nine months" as those words are used in the exemption portion of the security definition of the 1934 Act, in order to avoid the exemption in the case where the short-term notes were offered to the investing public intended by Congress to be protected. Here we are asked to give the same context-over-text consideration to "any note" as those words are used in the security definition itself of the 1934 Act, in order to avoid federal jurisdiction of transactions claimed to fall beyond the protection intended by Congress in the enactment of the securities laws.
Analysis immediately reveals, however, much more serious differences between the two situations than the superficial analogy might lead one to believe. In Sanders, the effect of the contextual interpretation led to the non-application of an exemption and therefore to the inclusion of a kind of instrument within the protection of the 1934 Act. The effect of applying the same interpretation to the definition itself would lead to the exclusion of a type of instrument from the protection of the 1934 Act. When
The inherent difficulty in purporting to find that Congress intended to limit the reach of federal jurisdiction exercised through securities legislation when it used the words "any note" is therefore compounded by the fact that the Supreme Court was in the process of expanding that jurisdiction when it searched for and expounded the congressional intent behind the securities acts. Under these circumstances it is understandable that courts have been struggling to answer the question here: are the securities acts invoked every time a person borrows money from a bank and gives his promissory note in return?
In SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 350-351, 64 S.Ct. 120, 123, 88 L.Ed. 88 (1943), the Supreme Court, after noting that the defendants had invoked the ejusdem generis rule and the expressio unius est exclusio alterius maxim in interpreting the definition of a security under the 1933 Act, said:
In SEC v. National Securities, Inc., 393 U.S. 453, 89 S.Ct. 564, 21 L.Ed.2d 668 (1969), the Court, citing Joiner, said:
Id. at 466, 89 S.Ct. at 571-572.
"Finally, we are reminded that, in searching for the meaning and scope of the word `security' in the Act, form should be disregarded for substance and the emphasis should be on economic reality. SEC v. W. J. Howey Co., 328 U.S. 293, 298, 66 S.Ct. 1100, 1102, 90 L.Ed. 1244 (1946)." Tcherepnin v. Knight, 389 U.S. 332, 336, 88 S.Ct. 548, 553, 19 L.Ed.2d 564 (1967). See also, Milnarik v. M-S Commodities, Inc., 457 F.2d 274, 275-276 (7th Cir.), cert. denied, 409 U.S. 887, 93 S.Ct. 113, 34 L.Ed.2d 144 (1972).
Accordingly, we commence our analysis with the language of the statutes.
The only difference in the 1934 Act is the immaterial one that nine other definitions intercede between the contextual proviso and the security definition (15 U.S.C. § 78c):
Inasmuch as Congress specified the context-over-text approach in both acts,
In Eason v. General Motors Acceptance Corp., 490 F.2d 654 (7th Cir. 1973), cert. denied, 416 U.S. 960, 94 S.Ct. 1979, 40 L.Ed.2d 312 (1974), this court rejected the purchaser-seller "standing" rule of the Birnbaum case
Id. at 659.
Judge Stevens pointed out the language of section 10(b) itself:
15 U.S.C. § 78j (emphasis added).
490 F.2d at 660.
The Eason test is applicable here in defining a security. In SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 64 S.Ct. 120, 88 L.Ed. 88 (1943), the Supreme Court noted that:
Id. at 351, 64 S.Ct. at 123 (emphasis added).
The Supreme Court particularly considered the definition of "security" in the 1934 Act in Tcherepnin v. Knight, 389 U.S. 332, 88 S.Ct. 548, 19 L.Ed.2d 564 (1967):
Id. at 336, 88 S.Ct. at 553 (emphasis added).
The ultimate question is whether the plaintiffs are simply borrowers in a commercial transaction who are not protected by the 1934 Act or investors in a securities transaction who are protected.
In one sense every lender of money is an investor since he places his money at risk in anticipation of a profit in the form of interest. Also in a broad sense every investor lends his money to a borrower who uses it for a price and is expected to return it one day.
On the other hand, the polarized extremes are conceptually identifiable: buying shares of the common stock of a publicly-held corporation, where the impetus for the transaction comes from the person with the money, is an investment; borrowing money from a bank to finance the purchase of an automobile, where the impetus for the transaction comes from the person who needs the money, is a loan. In between is a gray area which, in the absence of further congressional indication of intent or Supreme Court construction, has been and must be in the future subjected to case-by-case treatment.
The Second Circuit held in Movielab, Inc. v. Berkey Photo, Inc., 452 F.2d 662 (2d Cir. 1971), that "notes issued by one publicly owned company to another publicly owned company for $10,500,000, payable over a period of 20 years, in exchange for the assets of the latter easily fall within the purview of the  Act . . . ."
After our decision in Sanders, supra, where we held that notes with a maturity not exceeding nine months but offered to the public as an investment were securities under the 1934 Act,
Id. (emphasis added).
The Third Circuit held in Lino v. City Investing Co., 487 F.2d 689 (3d Cir. 1973), that there was no federal jurisdiction over material misstatements made in connection with Lino's purchase from the franchiser of two franchise licensing agreements, partially with cash and partially with several promissory notes. Judge Hunter said:
Id. at 694-695.
The Fifth Circuit considered what it has called "the commercial-investment dichotomy" in four recent cases. In United States v. Rachal, 473 F.2d 1338, 1342-1343 (5th Cir.), cert. denied, 412 U.S. 927, 93 S.Ct. 2750, 37 L.Ed.2d 154 (1973), a criminal case under the 1933 Act, the court approved an instruction given by the trial court which provided that the exemption of short-term notes from the registration provisions of the 1933 Act applied only to commercial not investment paper (that is, the Sanders rationale).
In Bellah v. First National Bank, 495 F.2d 1109 (5th Cir. 1974), the court held that a promissory note of six-months maturity, secured by a deed of trust on real property, issued for a bank loan needed by the makers (husband and wife) to aid them in the development of their livestock business, was commercial paper and not investment paper and hence the note and deed were not securities.
In McClure v. First National Bank, 497 F.2d 490 (5th Cir. 1974), a one-year promissory note and a deed of trust issued for a bank loan alleged to be needed to pay the corporate obligations of a closely-held corporation, were held not to be securities. Judge Roney analyzed prior federal decisions and concluded:
Id. at 493-494.
The commercial-investment dichotomy delineated to some extent in the foregoing courts of appeals cases has been further demarcated in recent district court cases: Avenue State Bank v. Tourtelot, 379 F.Supp. 250 (N.D.Ill.1974) (series of short-term notes issued by travel agency for bank loan to pay off current debts held not to be securities); Joseph v. Norman's Health Club, Inc., 336 F.Supp. 307 (E.D.Mo.1971) (promissory notes given for lifetime membership in health clubs held not to be securities); City National Bank v. Vanderboom, 290 F.Supp. 592, 608 (W.D.Ark.1968), aff'd, 422 F.2d 221 (8th Cir.), cert. denied, 399 U.S. 905, 90 S.Ct. 2196, 26 L.Ed.2d 560 (1970) (notes given by corporate organizers for bank loans to purchase corporation's capital stock held not to be securities).
A comprehensive and perceptive student comment suggests a long list of possible criteria to distinguish ordinary commercial notes not protected by the act from investment notes or investment securities protected by the act: (1) how is the instrument characterized in the business community? (2) how are the proceeds to be used (if for consumer goods or particular business goods or services—not covered, but if for general financing of borrower's enterprise—covered)? (3) extent of reliance on efforts of others (placing funds at great risk, giving note payee extensive collateral rights, making repayment of funds contingent upon some event, all tend to indicate security rather than loan); (4) number of notes issued, number of payees, dollar amount of transaction; (5) payable on demand or if payable at fixed time, how long is the time between issuance and maturity? and (6) characterization of notes on relevant financial statements. Comment, Commercial Notes and Definition of "Security" Under Securities Exchange Act of 1934: A Note Is a Note Is a Note? 52 Neb.L. Rev. 478, 510-24 (1973).
The American Law Institute's tentative draft of the Federal Securities Code includes not only a definition of "security" but also sets forth certain items which are not included in the term "security" and hence are not subject to the registration, antifraud or other provisions. One of the exclusions is "a note or other evidence of indebtedness issued in a mercantile transaction." ALI Fed. Securities Code § 297(b)(3) (Reporter's Revision of Text of Tent. Drafts Nos. 1-3, Oct. 1974). However the term "mercantile transaction" is not defined.
The tentative code would exempt from registration requirements "commercial paper with a denomination of at least $100,000." Id. § 301(1). "Commercial paper" is defined as
Id. § 216A.
Again, there is no definition of "mercantile character." So we are left ultimately with the necessity for a case-by-case factual determination.
Although we have gone into what we believe is the congressional and Supreme Court basis for the commercial-investment dichotomy at some length in the hope that prospective litigants in this circuit may be enlightened as to its possible parameters, the application of the rule is not difficult in this case.
Three promissory notes were involved in the present transaction. The $20,000 note secured by a chattel mortgage was given to the National Bank of Austin as evidence of a loan. The $73,515.26 note was given to the Austin Bank upon the assumption by the makers of a pre-existing chattel mortgage on the fixtures of the coin-operated laundry and dry cleaning business which the makers purchased. The complaint did not have attached thereto a copy of either note, which would have seemed a prudent procedure inasmuch as jurisdiction is dependent upon them, but in any event nothing alleged in the complaint indicated that these two notes represent anything beyond the borrowing of money to make partial payment upon the purchase of the assets of a business.
Nothing alleged in the complaint indicated in any way that the bank was an investor in the business or a co-partner
The third note for $5,000 was an earnest money deposit subsequently redeemed. This note served for a time as a cash substitute. Since the security definition of the 1934 Act "shall not include currency,"
Inasmuch as no securities were involved, this transaction is not subject to the 1934 Act or Rule 10b-5 and the district court correctly concluded that it lacked jurisdiction of the subject matter.
26 Fed.Reg. 9159 (1961) (emphasis added).
497 F.2d at 494-495.
Id. at 696 n. 15.
Id. at 866.