This post is the fifth in a series exploring when securities laws impact business transactions.
In my previous posts, I provided a general overview of the definition of a “security” under federal securities laws, and covered when various categories of instruments constitute a security, including partnership and limited liability company interests and promissory notes. In this post, we’ll explore when corporate stock falls within the definition of a security under federal law.
Under the federal Securities Act, the definition of a security includes “any… stock.” Unlike promissory notes, where the inclusion of “any note” within the definition of a security does not literally mean that all notes are securities, courts have been far more literal when it comes to stock issued by a corporation. In almost all cases, stock is considered a security.
The principal cases setting forth the standard of whether stock is a security are United Housing Foundation v. Forman, 421 U.S. 837 (1975) and Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985). In Forman, the stock in controversy was the stock of a non-profit corporation, which, once purchased, allowed the owner to rent a dwelling within a housing cooperative. In this case, the court concluded that the stock in question was not a security because it did not have any of the traditional indicia of investment stock. In particular, the court noted that the stock did not have the following characteristics: (i) the right to receive dividends contingent upon an apportionment of profits; (ii) transferability; (iii) the conferring of voting rights in proportion to the number of shares owned; and (iv) the capacity to appreciate in value. Therefore, because these traditional characteristics of stock were lacking, the court concluded that the stock in Forman was not a security.
As a result of the Forman case and the SEC v. W. J. Howey Co. case which set out the standard of when an economic arrangement constituted an “investment contract” and thus a security, various circuits of the U.S. Court of Appeals ruled that the “economic realities” of a stock sale should determine whether corporate stock is a security. Under this line of reasoning, courts applied the Howey test’s emphasis on the management and control of a business to conclude that the transfer of a majority of stock of a closely held corporation would not be a securities transaction under the so-called “sale of business” doctrine.
The U.S. Supreme Court considered the sale of business doctrine in the Landreth case and rejected it. The Landreth Case involved the sale of 100% of the shares of a corporation, thus giving control over the corporation to the purchasers. The sellers and purchasers engaged in significant negotiation over the terms of the stock sale. Consequently, if the Howey test was applied to the sale of stock in the Landreth case, the stock would not be a security, because any expectation of profits would not be derived from the efforts of others, but rather the purchasers after the sale.
Nonetheless, the Supreme Court elected to apply a literalist approach to stock. Essentially, stock of the corporation is always a security, unless it lacks the traditional characteristics of stock described above in the Forman case. This is true even in the case of a sale of 100% of a company’s shares. Therefore, unless the sale of stock involves selling shares where there is no investment motive, stock must be considered a security. (For a good example of stock being offered for non-investment reasons, see my post on the offering of stock by the Green Bay Packers).
This ruling has a number of practical implications for businesses. First, this is an additional reason why the seller of a business would want to structure the sale as a sale of assets rather than a stock sale. Indeed, Justice Stevens, in his dissent in Landreth, mentioned that it seemed strange that protection of US securities laws should be conditioned on such a simple negotiable deal point as whether a transaction is an asset sale or a stock sale. Nonetheless, this simple difference in terms makes all the difference between when securities laws apply to the sale of a business. The second implication is for business brokers. Many business brokers structure all of their transactions as asset sales because a stock sale could subject them to regulation as a securities broker-dealer.
Your choice in structuring a transaction should be based on your own specific situation. Therefore, before making any final decisions you should speak with your attorney and/or accountant.
 The SEC has issued a no action letter which provides for a narrow exception where business brokers may assist with the sale of 100% of the shares of a company. However, since there are a large number of conditions specified within the no action letter, most business brokers prefer not to even deal with this and only structure their transactions as asset sales.
© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.