Most new capital raisers quickly pick up on one key legal concept affecting whether an investment is subject to securities regulations. It’s the Howey Test.
The Howey Test has long been the standard for determining what qualifies as a security under the watchful eye of the Securities and Exchange Commission (SEC).
But here’s the twist: there are other tests for securities that don’t apply Howey. If your deal involves a promissory note or some other form of investor debt, you may be playing by a different set of legal rules altogether.
That’s where the Family Resemblance Test comes in. Lesser-known but no less important, it’s often the deciding factor in whether your offering crosses the line into regulated securities territory. And if you’re working in real estate, private lending, or early-stage financing, you need to know how it works.
Let’s walk through when the Family Resemblance Test applies, how it differs from Howey, and what it means for your securities compliance.
The Starting Line: Why This Question Matters
Before diving into the technicalities, consider the bigger picture. Why does it matter whether something is legally classified as a security?
Its because the moment your investment offering falls under that definition, a whole stack of legal requirements kicks in. You may need to file a Form D, follow specific advertising restrictions, vet your investors as accredited, and meet federal and state blue sky filing obligations. In short, your raise becomes subject to an entirely different regulatory framework.
One common mistake that we see is assuming that calling something a “loan” or “note” means it’s not a security. But legal classification isn’t based on labels, it’s based on how the transaction actually works. And that’s why courts apply different tests depending on the structure of your raise.
Not All Tests Are Created Equal
The Howey Test, drawn from a 1946 Supreme Court case, is the standard for determining whether something qualifies as an “investment contract.” It hinges on four criteria:
- There’s an investment of money
- Into a common enterprise
- With an expectation of profit
- Based primarily on the efforts of others
If all four are present, you’re almost certainly dealing with a security. This applies even if it’s not a share of stock in corporations or unit of membership in LLCs. This is why membership interests in LLCs, for example, often trigger securities law, especially when investors are passive and profits depend on the manager’s performance.
However, if the instrument you’re offering is a promissory note, Howey might not apply. That’s because the courts treat debt instruments differently. The question becomes whether the note a true commercial loan or a disguised security? And answering that starts with an entirely different test.
Every Note Is Presumed to Be a Security—Unless Proven Otherwise
In 1990, the U.S. Supreme Court clarified how to evaluate notes in Reves v. Ernst & Young, a case involving a farming co-op that issued promissory notes to the public.
The Court held that every note is presumed to be a security—unless the issuer can prove it closely resembles one of several types of notes that are clearly not securities.
That’s the foundation of the Family Resemblance Test.
So if you’re issuing investor loans, convertible debt, or other notes, you start from the assumption that securities laws apply. It’s your burden to show otherwise.
A Closer Look at the Family Resemblance Test
To determine whether a note deserves to be treated as a non-security, the Court outlined four key factors.
First is the motivation behind the transaction. If you’re raising money to fund a profit-making venture, and your investors are contributing capital with the expectation of returns, that leans heavily toward a security. On the other hand, notes used for straightforward commercial financing may fall outside this definition.
Second, the Court looks at how widely the note is being offered. A private transaction between two parties is less likely to be seen as a security. But if the note is being marketed to a wide audience or circulated broadly, it starts to look more like an investment vehicle.
Third, courts consider whether the investing public would reasonably view the note as an opportunity to earn a return. If your marketing materials, language, and structure invite that perception, it further supports a securities classification.
Finally, regulators ask whether another regulatory regime already governs the note. For example, a loan regulated by banking laws might not require securities oversight. But if no such framework exists, the SEC is more likely to step in.
None of these factors is decisive on their own. Courts evaluate the full context to make the call. But in most passive capital-raising situations, the Family Resemblance Test may conclude that this is a security.
What Types of Notes Are Clearly Not Securities?
In Reves, the Court also gave us a list of examples that typically fall outside the definition of a security.
Traditional mortgage loans, for instance, are considered non-securities because they’re secured by real estate and issued in the context of consumer finance. However, it doesn’t protect you if the real estate investment is for commercial purposes, and it is a similar structure offered to many investors.
A short-term business loan used to buy equipment also falls into this non-security category. In this case, the uses are for business equipment and not operations.
Seller-financed transactions, where the seller of a business takes back a note, are generally exempt as well, since they represent private payment arrangements rather than capital-raising instruments.
Finally, loans issued by commercial banks to their customers, governed by existing banking laws, are almost never treated as securities.
What these cases have in common is their lack of investor involvement. They aren’t marketed to the public as investments, and they’re not built around the idea of passive return. They serve practical, transactional purposes, and they’ve been treated that way by courts for decades.
Once a note strays from that pattern, especially if it’s used to raise capital from multiple investors or promises a financial return, it starts to look like a security again. And at that point, compliance with securities laws becomes unavoidable.
Why This Matters for Reg D Offerings
Most real estate syndicators raise capital through Reg D exemptions, specifically Rule 506(b) or Rule 506(c). These rules allow you to avoid full SEC registration, provided you meet certain requirements.
Where many first-time sponsors go wrong is assuming that using a note instead of equity lets them off the hook. But that’s not how the law works. If your note fails the Family Resemblance Test, and most do in this context, it’s a security. That means all the Reg D requirements still apply.
You’ll need to file a Form D within 15 days of your first investor closing. You’ll also need to provide detailed disclosures about the terms and risks associated with the offering through a PPM. If you’re raising under 506(c), you’re still required to verify that each investor is accredited. If you’re using 506(b), you’ll need to prove that you had a pre-existing relationship with each investor and didn’t use general advertising to promote the deal.
On top of all that, you’ll need to meet the notice filing obligations for every state where your investors live.
In some ways, debt offerings create even more legal complexity than equity. The gray area between a private loan and a security offering can be subtle, and if regulators decide you’ve crossed the line, calling it a “note” won’t protect you.
Common Missteps by First-Time Issuers
One of the most common mistakes we see is treating debt as a legal loophole. New issuers often assume that if they structure their raise as a loan, they can bypass securities regulations entirely.
That’s a dangerous assumption.
Calling it a loan doesn’t change the fact that you’re offering an opportunity to profit. The SEC looks past the title and examines how the deal actually works. If the investor is passive, if there’s an expectation of return, and if you’re using funds to support a broader business venture, you’re likely within the SEC’s jurisdiction.
And the risks are real. In recent years, the SEC has brought enforcement actions against sponsors who raised money using notes without complying with Reg D. Often, these deals involved verbal promises, vague documentation, or informal relationships that created a false sense of safety.
The bottom line: if you’re taking capital from others and offering fixed returns, profit splits, or conversion rights, you’re most likely in securities territory, regardless of the instrument’s label.
What You Should Do Before Issuing Notes
If you’re planning to use debt in your next capital raise, take the time to build a sound legal foundation before you collect a single dollar.
Start with experienced legal counsel. A securities attorney who understands Reg D and alternative investment structures can help you determine whether your offering passes the Family Resemblance Test, Howey Test, or whether it needs to comply with securities laws.
From there, carefully shape your marketing strategy. Don’t describe the deal as a “safe bet” or a “guaranteed return.” Even seemingly casual language in a webinar, email, or investor presentation can influence how regulators perceive your offering.
Also, consider how you’re presenting the opportunity. If you’re blasting announcements through email or social media, you may be triggering the general solicitation rules of 506(c), even if your intent was a private raise under 506(b).
In today’s digital environment, the line between education and promotion is thinner than ever. Sponsors need to be mindful of that line, especially when the offering involves debt.
Treat note offerings with the same care and scrutiny you’d give to an equity raise. The consequences of misclassification aren’t just regulatory headaches, they can put your entire business at risk.
The Bottom Line
The Family Resemblance Test isn’t as well-known as Howey, but it plays a critical role in the world of capital raising. I like to call it the “close enough” test.
If you’re issuing notes, convertible debt, or investor loans, this framework determines whether your raise falls under securities law. And more often than not, the answer is yes.
Understanding which test applies is about more than legal theory, it’s about protecting your raise, your investors, and your reputation. When in doubt, treat every offering like it could be a security. If it turns out you’re right, you’ve already done the work.
Need guidance on structuring a compliant Reg D offering, whether using equity, debt, or a hybrid model? Crowdfunding Lawyers has helped entrepreneurs raise billions through fully compliant securities offerings. Let’s make sure yours is next.