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When does a deal involve securities regulation? Part 5: Corporate Stock

June 10, 2012 By 2 Comments

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.[1]

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.

Footnotes

[1] 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.

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When does a deal involve securities regulation? Part 4: Promissory Notes

May 19, 2012 By 2 Comments

This post is the fourth 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. In this post, we’ll explore when a promissory note falls within the definition of a security under federal law.

Under the federal Securities Act, the definition of a security includes “any note.” Taken literally, this could bring within securities regulation a vast number of transactions, including personal loans, commercial loans, and mortgage transactions, which would require the borrower to comply with securities laws. Fortunately, courts have not taken the words “any note” literally, and in the case Reves v. Ernst & Young, 110 S. Ct. 945 (1990), the Supreme Court adopted the “family resemblance” test to determine whether a particular loan transaction involves securities laws.

Under the family resemblance test, there is a rebuttable presumption that a note is a security, unless it resembles a type of note that commonly is not considered a security. However, the court also recognized that most notes are, in fact, not securities. The Court listed a number of categories of transactions that do not implicate U.S. securities laws:

  • A note delivered in consumer financing.
  • A note secured by a mortgage on a home.
  • A note secured by a lien on a small business or some of its assets.
  • A note relating to a “character” loan to a bank customer.
  • A note which formalizes an open-account indebtedness incurred in the ordinary course of business.
  • Short-term notes secured by an assignment of accounts receivables.
  • Notes given in connection with loans by a commercial bank to a business for current operations.

Just because a transaction does not fit within the list above does not mean that the note is a security. For other transactions, the Court set out a four factor balancing test. The four factors are:

  1. Whether the borrower’s motivation is to raise money for general business use, and whether the lender’s motivation is to make a profit, including interest. The second half of this factor is not particularly helpful, since almost all loans involve earning a profit.[1] However, the first half can often come into play. If purpose of the transaction is to raise money for general business use or to finance a substantial investment, the note is more likely to be security; conversely, if the purpose is to facilitate the purchase and sale of a minor asset or consumer good, or to correct for cash-flow difficulties, or to advance some other “commercial or consumer purpose,” the note is less likely to be a security
  2. Whether the borrower’s plan of distribution of the note resembles the plan of distribution of a security. In general, the more buyers and the less sophistication of the buyers, the more likely it is that the notes are securities. In addition, the presence of any significant negotiation over the terms of a loan (or if the lender dictates the terms of the loan) usually makes it less likely that the note would be considered a security.
  3. Whether the investing public reasonably expects that the note is a security. If the purchasers view the notes as a type of investment, they are more likely to be securities. In addition, if the notes are unsecured, they are more likely to be securities.
  4. Whether there is a regulatory scheme that protects the investor other than the securities laws. For example, if notes are regulated under Federal Deposit Insurance or ERISA, they are less likely to be a security.

Of course, with any kind of multi factor balancing test, there is a high degree of subjectivity. As a result, it is fair to say that a note is often a security when a court thinks that it should be, which makes structuring loan transactions all the more tricky. Here are some practical guidelines:

  • If you’re selling notes to multiple people, it is likely to be a security. This is even more the case if the purchasing parties are not in the business of making loans.
  • If you’re getting a loan from one party that is in the business of making loans (like a bank), then the note associated with the loan is not likely to be a security.
  • If you’re borrowing the money personally, it is less likely to be a security than if your business is borrowing it.

Beyond that, if the circumstances are ambiguous, be sure to find qualified securities counsel.

Footnotes

[1] However, a loan among family members, where the prime motive is not profit, would be a good example of a note where profit was not the motive behind making the loan.

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© 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.

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When does a deal involve securities regulation? Part 3: Partnerships and Limited Liability Companies

April 13, 2012 By 1 Comment

This post is the third 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.  One of the categories of investments that constitutes a “security” under federal law is an “investment contract.”  The term is a rather open-ended one, but under the so-called Howey Test, the term includes any arrangement or transaction that is “an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”  As a result, any transaction which constitutes an investment contract is a security under federal securities law.  In this post, we’ll explore when an interest in a limited liability company (“LLC”) or a partnership constitutes an investment contract, and consequently, a security.

When the Securities Act of 1933 was written, there was no such thing as an LLC or a limited partnership.  The only type of partnership-like entity available was a general partnership, which featured unlimited joint and several liability for the partners.  As a result, it was very rare that someone would invest in a partnership in a passive role.  Therefore, partnership interests were left out of the definition of a “security” under the Securities Act.

Now, with the advent of limited partnerships, limited liability partnerships, limited liability limited partnerships, and limited liability companies, there are a myriad of choices available that allow an investor to invest in a partnership and enjoy limited liability.  Therefore, passive investing in partnerships and partnership-like entities is now common.  But because interests in these kinds of entities are not listed within the definition of a “security” under the Securities Act, a partnership or LLC interest will only be considered a security if it constitutes an investment contract.

That said, interests in many LLCs and partnerships fall under the definition of an investment contract.  For instance, in manager-managed LLCs, the non-managing members are essentially passive owners.  The same also applies to limited partners in a limited partnership.  An investment contract is, quintessentially, an arrangement where a passive owner invests money with another person who promises to use that money to make a profit for the passive owner.  Therefore, in each of these instances, the non-managing member interests and the limited partnership interests would be considered investment contracts and consequently securities.[1]

Conversely, a general partnership interest in a partnership or a managing member interest in an LLC are generally not securities, because the control that the general partner or managing member has over the company causes the general partner or managing member’s interest to fail to meet the final prong of the investment contract definition (that is, profit arising primarily from the efforts of people other than the investor).  Likewise, members in a member-managed LLC are usually not deemed to be holders of securities if they have the ability to participate in management.

However, even if a member of an LLC or a partner in a partnership has management rights on paper, the LLC or partnership interest could still be considered an investment contract, if in practice, there is no expectation that the investor will be active in generating profits.  In securities law, substance often trumps form.  Thus under Williamson v. Tucker, 645 F.2d 404 (5th Cir 1981), the Court of Appeals for the Fifth Circuit held that a general partnership interest could be a security if the investor was dependent on the promoter and could not exercise meaningful control.  Examples of such a situation are (i) where the managing partner cannot be replaced or is very difficult to replace, (ii) where the investors are inexperienced in business affairs and cannot exercise their abilities to participate in management, or (iii) where the promoter has unique managerial abilities which cause de facto reliance on the promoter.  Generally, if one of these situations exist at the time of initial investment, then the investment is likely to be an investment contract.

Whether a partnership interest or an LLC interest is a security often depends highly on context.  The less involved the holder of the interest is in the activities of the company, the more likely that the interest will be considered a security.  In addition, the relative sophistication of the purchaser of the interest as compared with company management also has a role to play.  Interests sold to less sophisticated investors are more likely to be considered a security than those sold to more sophisticated ones.  Unfortunately there is no bright line test that determines whether an LLC or partnership interest is a security, and consequently, the context of the transaction pays a significant role.

Footnotes

[1] It is possible that a limited partnership interest or a non-managing member interest in an LLC could be outside the definition of an investment contract if the economic realities indicate that the limited partner has significant and legal control of partnership management.  See Steinhardt Group v. Citicorp, 126 F.3d 144 (3rd Cir. 1997).

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© 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.

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When does a deal involve securities regulation? Part 2: The “Howey” Test

April 5, 2012 By Leave a Comment

This post is the second in a series exploring when securities laws impact business transactions.

In my previous post, I provided a general overview of the definition of a “security” under federal securities laws.  The Securities Act of 1933 provides for a very far reaching definition of a security, including “any note, stock… investment contract…, or, in general, any interest or instrument commonly known as a ‘security’…”  As explained in my prior post, this definition, taken literally, can result in both overinclusiveness and underinclusiveness.  I’ll discuss the issue of overinclusiveness and how it is addressed in future posts; this post will discuss how the inclusion of an “investment contract” within the definition of a security allows the definition to include classes of investments that are not specifically listed, like limited liability company interests and limited partnership interests, which are both concepts that had not even been invented when the Securities Act was passed.

The principal case which defined the term “investment contract” under federal law is SEC v. W.J. Howey Co., 328 U.S. 293 (1946).  In the case, the defendant, Howey was sued by the SEC to enjoin it from selling plots of land that had citrus trees planted on them.  Along with the plots of land, Howey offered management contracts where the purchaser would lease the plots back to Howey and Howey would harvest them.  However, the purchaser was not required to enter into such a management contract and could purchase the land without doing so.  Nonetheless, the Supreme Court held that the land sale together with the management contract collectively constituted an investment contract, and thus a security.

In this decision, the Supreme Court set forth a test, now known as the Howey test, for determining whether a transaction constitutes an investment contract.  Under the Howey test, a contract or transaction is an investment contract if “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third-party.”  Please note however that while the Supreme Court in Howey stated that the profit must arise “solely” from the efforts of others, later decisions by lower courts and the Supreme Court[1] have expanded this, so even if the investor has the power to be involved, the transaction may still be an investment contract if the efforts of others predominate.  Therefore, there are three essential components for this test: (1) investing money in a common enterprise, (2) the expectation of profit, and (3) the profit arising primarily from the efforts of people other than the investor.

In future posts, I’ll explore how the Howey test operates in specific situations.  In addition, I’ll also explore situations where some classes of investments are excluded from the definition of a “security” even if they are listed within the federal definition.

Footnotes

[1] More recently in United Housing Foundation v. Forman, 421 U.S. 837 (1975), the Supreme Court stated that an investment contract is “an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”  The word “solely” was conspicuously left out.

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© 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.

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When does a deal involve securities regulation? Part 1: Introduction

March 29, 2012 By 3 Comments

Business owners and attorneys without a securities background will often engage in transactions that, while on first blush do not involve securities regulation, but actually are a securities transaction, and thus subject to federal and state securities laws.  For instance, real estate developers often finance projects by bringing in outside investors as limited partners.  They are likely to hire a real estate attorney to complete the deal, who will dutifully draft a limited partnership agreement for the transaction.  What neither of them often realize is that a securities transaction is occurring as part of the deal.  The sale of limited partnership interests is usually a securities transaction under federal and state law.  This means that the interests are subject to registration with the SEC and with the state of each investor’s residence[1], unless an exemption can be found. In addition, all statements made in discussions with limited partners are subject to the anti-fraud rules.

The reality is that the definition of “security” is a whole lot broader than many people realize.  In fact, it is a lot broader than what many attorneys realize, at least those without a background in securities law.  In this series of posts, I’ll explore when securities laws apply and when they don’t apply to particular transactions.

The Federal Definition of a Security

Each of the main federal statutes (the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940) has a definition of the term “security.”  For the most part, they are all very similar, with only minor differences between them.[2]  So lets start with the definition used in the Securities Act of 1933:

“[U]nless the context otherwise requires… [t]he term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”[3]

That’s quite a lot to digest, but there are a couple of initial important points.  First, a large number of different types of transactions are securities transactions.  For instance, stock in a closely held business or a note evidencing a loan are both potentially within the definition of a “security.”  Therefore, when incorporating your business, the sale of stock to your fellow co-founders can indeed be a securities transaction.  In addition, the issuance of a promissory note, which happens in most loan transactions, can also be a securities transaction.  So there are a lot of transactions that may be subject to securities laws that you would ordinarily not think of as a securities transaction.  I’ve seen many entrepreneurs think that simply issuing notes, rather than equity, to investors gets them out of complying with securities law.  So does this mean that all loans are securities transactions?  No, it doesn’t, as I will explain below.

The second thing that should be pointed out is what the list contained in the paragraph above does NOT include.  Two examples that immediately come to mind are partnership interests and limited liability company interests.  In fairness, limited liability companies weren’t even invented at the time the Securities Act was passed, but Congress has amended the Securities Act several times since then (in Sarbanes-Oxley, Dodd-Frank, and many other instances as well) and it could have added to the definition.  So does this mean that limited liability company interests are never securities?  Again, the answer is no.

The potential overinclusiveness and underinclusiveness of the federal securities definition is ameliorated by the two phrases which I highlighted above in bold.  The phrase “unless the context otherwise requires” allows a court to, for example, treat a note that is issued clearly as part of an ordinary loan as an ordinary loan and not as a security.  Likewise, courts have interpreted the term “investment contract” very broadly, covering some limited liability company interests, partnership interests, and even the sale of citrus trees (though in this instance, what was being sold was more than just citrus trees).  Therefore, courts have wide latitude to exclude specific instances of the items listed within the “security” definition and to also include items that were not listed as well.

In future posts, I’ll explore what the legal standards are for such exclusion and inclusion in specific scenarios.

Footnotes

[1] And the interests are also potentially subject to registration in the states in which the interests are offered but not sold.  This is, if you send out any promotional material to any residents of a state, it is possible that the securities may need to be registered in that state.

[2] It is unclear if, but unlikely that, any of these minor differences actually makes a difference in the end result of whether a particular transaction involves securities.

[3] The bolding of certain phrases is mine, and is not in the statute.  The explanation of why I highlighted these phrases is explained later in the post.

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© 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.

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