On May 23, 2012, the Delaware Court of Chancery (Court) issued an opinion in the case of Fletcher International, Ltd. v. ION Geophysical Corp. regarding certain promissory notes issued to the sellers of a business, and whether those promissory notes were securities, even though the notes bore legends disclaiming them from registration under the securities laws.

ION issued certain short-term promissory notes (the Short-term Notes) in connection with its acquisition of a business in July 2008. ION had intended to finance the acquisition largely through a bond offering, the proceeds of which would be used to repay the Short-term Notes. Because of the collapse of Lehman Brothers and the ensuing credit crisis, ION was unable to proceed with the bond offering and, in December 2008, instead sought to finance the acquisition with a combination of stock, cash, bank borrowings and a long-term promissory note issued to the seller (the Final Note).

The Final Note was for a principal amount of $35 million, had a term of nearly five years and an interest rate of 15%, with interest payable quarterly. The Final Note was transferable with ION's consent, unless an event of default existed in which case the Final Note was freely assignable. Although the Final Note was subject to deductions for post-closing adjustments to the purchase price of the acquired business, the amount of the Final Note would be fixed nine months into the nearly five-year term when the adjustment period expired.

By contrast, the Short-term Notes both had one-year maturities and related to particular aspects of the acquisition. One of the Short-term Notes financed an escrow amount against which post-closing purchase price adjustments could be offset, while the other concerned an income tax receivable, the receipt of which from the taxation authority would be used to repay the note. The Final Note and the Short-term Notes all bore legends disclaiming registration under the securities laws.

The issue in this case was whether the Short-term Notes and the Final Note constituted securities. Fletcher International was a preferred stockholder in ION and, under the terms of its investment documents, had a right to consent to any issuance of securities by any of ION's subsidiaries.

ION contended that the Final Note and the Short-term Notes could not be regarded as securities under federal and state securities (and under the terms of Fletcher International's investment documents) because they were issued as part of the purchase price for a business. If the notes were not securities, Fletcher International had no consent right over their issuance.

The Court applied the tests for determining whether a promissory note constitutes a security that were expounded in the well-known Supreme Court case of Reves v. Ernst & Young.

In Reves, the Supreme Court held that all notes are presumptively securities, but that this presumption can be rebutted for any particular note that:

In Reves, the Supreme Court held that these factors are considered as a whole and that no one factor settles the question. A court's analysis of the application of these factors to a promissory note is highly fact-specific and it should consider the economic realities of the transaction, rather than focusing on the note's label or moniker.

In the present case, the Court noted that the essence of the Reves tests is to determine whether a particular note represents an investment or a commercial or consumer loan. The examples of the excluded notes in Reves can all be characterized as short-term commercial loans and are not types of instruments that can easily be traded. The Court held that if a note shares these objective characteristics, the presumption that the note is a security is rebutted because the Reves "family resemblance" test is satisfied. However, if a note shares the characteristics of a corporate bond or debenture, the value of which fluctuates with the success of the issuer's business, has a term of several years and can easily be traded, the note is characterized as an investment and, therefore, a security.

The Court held that the Short-term Notes were not securities because they were short-term lending transactions entered into to aid in the closing of the acquisition, rather than constituting permanent financing for it. They were part of an intricate short-term relationship with ION directly related to the acquisition. While the Short-Term Notes each had terms of one year, the terms of ION's separate loan agreement required that the Short-Term Notes be paid off within three months. The Court noted that because of the short tenor of the Short-Term Notes, it would be very difficult to price or sell the Short-Term Notes which pointed away from a finding that the Short-Term Notes were securities.

By contrast, the Final Note was a permanent source of funds for the acquisition. The Final Note was issued to the sellers as consideration for selling their business to ION. The sellers received a transferable, long-term debt instrument that offered a high rate of interest with interest payable every three months. The profit that the sellers would make from the interest under the Final Note, together with their ability to sell the Final Note, are factors that the Reves tests describe as investment motives, which was consistent with the Final Note constituting a security.

Therefore, because the Final Note was a security, as that term was used in the seller's investment documents, its issuance without Fletcher International's consent violated Fletcher International's consent rights under its investment documents.

The key consideration in the Court's reasoning that the Final Note was a security was the long-term investment risk in ION that the sellers assumed by accepting the Final Note. If a promissory note is the sort of instrument that investors regularly buy and sell in the secondary markets where the value depends materially on the success of the issuer's business, it is more likely to be considered a security. In this case, after the expiration of a nine-month period during which post-closing purchase price adjustments could be made to the Final Note, the sellers could sell the Final Note free of any set off rights. At this point the Final Note would have four years of its term remaining during which high yields would be payable every quarter. Given the long-term nature of the Final Note and its substantial size, transferability of the Final Note was feasible. For promissory notes with similar characteristics, the inclusion of a securities legend on the note is an acknowledgement that potential investors would view the note as a security.

The Court held that the fact that the Final Note was issued to the sellers as consideration for the sale of their business did not mean, as ION contended, that the Final Note was not a security. The distinguishing features between the Short-Term Notes and the Final Note so far as their treatment as securities was concerned was the fact that the Short-Term Notes represented very short term bridge loans that did not involve any long-term investment in ION, while the Final Note was a long-term investment the value of which depended on the strength of ION's business.