Highland Capital Management LP v. Schneider, 9 N.Y.3d 406 (2007)
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Promissory notes can be considered securities under UCC Article 8 if they are transferable, divisible, and traded in securities markets, or are a medium for investment that expressly states it is a security governed by Article 8.
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Summary
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This case addresses whether promissory notes issued by McNaughton Apparel Group to the Schneiders qualify as ‘securities’ under New York’s Uniform Commercial Code (UCC) Article 8. The New York Court of Appeals held that the notes were indeed securities because they met the UCC’s requirements for transferability, divisibility, and being traded in securities markets or being a medium for investment. This determination impacts the applicability of the statute of frauds to contracts for the sale of these notes.
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Facts
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McNaughton acquired two apparel companies owned by the Schneiders. As part of the deal, McNaughton owed the Schneiders an earn-out payment. Instead of paying the full amount in cash or stock, McNaughton issued four promissory notes to the Schneiders in August 2000, and another four in December 2000, totaling $69 million. The notes were subordinated to McNaughton’s senior debt and contained a restrictive legend prohibiting transfer without registration or a legal opinion. Securities professionals treated these notes as high-risk debt. After McNaughton was acquired by Jones Apparel, the notes were redeemed at par value. Highland Capital Management sued the Schneiders, alleging they breached an oral agreement to sell the notes before the acquisition was publicly announced. The Schneiders raised a statute of frauds defense, which is inapplicable to securities transactions.
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Procedural History
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Highland sued the Schneiders in Texas state court; the case was removed to federal court and transferred to the Southern District of New York. The District Court dismissed Highland’s breach of contract claims, holding the promissory notes were not securities, thus the statute of frauds barred enforcement of any oral agreement. Highland appealed to the Second Circuit, which certified the question of whether the notes were securities under UCC 8-102(a)(15) to the New York Court of Appeals.
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Issue(s)
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Whether the eight promissory notes issued by McNaughton Apparel Group, Inc. to the Schneiders fall within the definition of a security as contemplated by Section 8-102(a)(15) of the New York Uniform Commercial Code.
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Holding
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Yes, because the promissory notes satisfied the transferability, divisibility, and functional tests required to be considered securities under UCC 8-102(a)(15).
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Court’s Reasoning
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The court applied UCC 8-102(a)(15), which defines a ‘security’ as an obligation that is (i) represented by a security certificate in bearer or registered form, or the transfer of which may be registered; (ii) one of a class or series; and (iii) dealt in or traded on securities exchanges or markets, or expressly provides that it is a security. The court found that the notes met all three criteria.r
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First, the notes were in registered form because they specified a person entitled to the security and their transfer ‘may be registered’ on the issuer’s books. The court interpreted ‘may be registered’ to mean whether McNaughton would have been required to register the transfer if requested, not whether they actually kept separate transfer books. The restrictive legend itself contemplated possible transfer. Second, the notes met the divisibility test because there were eight notes issued, constituting a ‘class or series’ of obligations. McNaughton also treated them as a class of obligations in SEC filings. Third, the notes satisfied the functional test because they were ‘of a type’ dealt with in securities markets. Securities industry professionals treated the notes as securities, and McNaughton’s CEO described them as a “form of a convertible subordinated debenture.” The court emphasized the importance of adapting the definition of ‘security’ to evolving trading practices, quoting that “the definition will cover anything which securities markets…are likely to regard as suitable for trading.”