What Is a Security Under the Federal Securities Laws?

One of the most challenging questions in the securities laws is whether a particular interest or contract is a security. If the contract is not a security, the federal Securities Laws do not apply and the promoter does not have to register the investment. If it is a security, the investment must be registered. Thus, whether something is a security is litigated often. There is no definitive answer to the question. The main issue is whether the investor is relying on the efforts of others to earn a return or profit. An investor in a blue chip company purchases a share of stock and hopes to earn a return based on the work of the company and its employees. The question in analyzing an investment contract is whether the holder of the contract is trying to profit from the work of other people or not.

The term "Security" means:

"any note, stock, treasury stock, security future, 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." 15 U.S.C. §77b(a)(1).

The importance of the definition of security becomes apparent in the area of private actions for securities fraud because the standard for establishing securities fraud is much lower than that for common law fraud.

The Supreme Court has adopted a flexible and liberal approach in determining what constitutes a security. In its famous decision of SEC v. W.J. Howey Co., 328 U.S. 293, 90 L.Ed. 1244, 66 S.Ct. 1100 (1946), the Court held that land sales contracts for citrus groves in Florida, coupled with warranty deeds for the land and a contract to service the land, were investment contracts and thus securities. The Court stated that:

[a]n investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby 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. 66 S.Ct. at 1103.

According to the Court, it is immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise. 66 S.Ct. at 1104. The Howey investment contract analysis has been the starting point in determining the status of transactions in the securities area. In applying this analysis, courts have traditionally looked to the substance of the transaction to decide whether a security is involved and have made the determination regardless of the label placed on the interest by the parties to the transaction. Courts have found that countless schemes designed to produce profits for the participants, such as the sale of franchises, fur-bearing animals, and shares in fishing boats and cemetery lots, were covered by the 1933 Act. See 2 Louis Loss and Joel Seligman, SECURITIES REGULATION, pp. 948 – 956 (3d ed. 1989); Carl W. Schneider, The Elusive Definition of a Security — An Examination of the Investment Contract Concept and the Propriety of a Risk Capital Analysis Under Federal Law, 12 Tex.Tech.L.Rev. 911 (1981).

One significant question is whether an interest in a limited liability company is a security. In Robinson v. Glynn, 349 F.3d 166 (4th Cir. 2003), the Fourth Circuit held that an interest in an LLC is not a security. The Fourth Circuit held that the plaintiff investor was not seeking to profit ―solely from the efforts of others. The court claimed that he had significant control over the company, including the right to appoint two board members. However, in SEC v. Merchant Capital, 483 F.3d 747 (11th Cir. 2007), the Court held that interests in limited liability partnerships were investment contracts‖ under Howey. Also, see United States v. Leonard, 529 F.3d 83 (2d Cir. 2008) (affirming criminal convictions for violating the securities laws and holding that interests in an LLC sold by Defendants were securities under the Howey investment contract test.).

As the Leonard court noted, an LLC requires a case by case analysis to determine whether the purchaser had significant control over the operations of the company. 529 F.3d. at 89.
In SEC v. Edwards, 540 U.S. 389, 157 L.Ed.2d 813, 124 S.Ct. 892 (2004), the Supreme Court reaffirmed the validity of Howey, supra. In Edwards, the defendant controlled ETS Payphones, Inc., which sold payphones to the public. The payphones were sold under a sale and leaseback agreement, under which the investor would ―purchase the payphone and then lease it back to ETS in exchange for a payment of $82 each month. For each investor, the $82 payment represented a 14-percent return on the investment. After ETS filed for bankruptcy protection, the SEC filed a civil enforcement action against Edwards, alleging that he had violated the registration requirements of 15 U.S.C. §§77e(a) and 77e(c). The Eleventh Circuit in SEC v. ETS Payphones, Inc., 300 F.3d 1281 (11th Cir. 2002), held that the sale and leaseback scheme was not a ―security because it offered a fixed rate of return. The Eleventh Circuit also held that the Howey test ―that the return on the investment be derived solely from the efforts of others‘ did not apply because the investor had a contractual right to the $82 payment each month. 124 S.Ct. at 896, quoting ETS Payphones, supra, 300 F.3d at 1285. Thus, in the Edwards case, the Supreme Court reaffirmed Howey and held that an investment scheme promising a fixed rate of return can be an 'investment contract‘ and thus a 'security‘ subject to the federal securities laws. 124 S.Ct. at 898 – 899.

Some items that give their holders a right of use do not constitute securities. In United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 44 L.Ed.2d 621, 95 S.Ct. 2051 (1975), the Supreme Court found that ―stock‖ entitling its holder to purchase an apartment from a cooperative was not a security because the purchasers were acquiring a right to purchase an apartment. The purchasers were not seeking the benefits accruing to investors. Rather, they were seeking the use of an apartment.

Ordinary commercial paper, even when described as a ―note, is not a security. In C.N.S. Enterprises, Inc. v. G. and G. Enterprises, Inc., 508 F.2d 1354 (7th Cir.), cert. denied, 96 S.Ct. 38 (1975), the court held that certain notes were not securities because the notes were ordinary commercial paper. The bank holding the notes was not acting as an investor or business partner. See also American Fletcher Mortgage Co. v. U.S. Steel Credit Corp., 635 F.2d 1247 (7th Cir. 1980), cert. denied, 101 S.Ct. 1982 (1981).

Bank certificates of deposit are not securities. Marine Bank v. Weaver, 455 U.S. 551, 71 L.Ed.2d 409, 102 S.Ct. 1220 (1982). In the Court‘s view, because the banking laws amply protect investors in bank CDs, it is unnecessary to subject the issuer banks to liability under the antifraud provisions of the securities laws.

The sale of 100 percent of the outstanding stock of a company involves the sale of a security. Landreth Timber Co. v. Landreth, 471 U.S. 681, 85 L.Ed.2d 692, 105 S.Ct. 2297 (1985). In so holding, the Supreme Court expressed its view that the instrument involved was stock under the plain language of the statute.

A real estate contract may also be a security. In Adams v. Cavanagh Communities Corp., 847 F.Supp. 1390 (N.D.Ill. 1994), investors who had purchased Florida real estate interests on land sales contracts sued the developers for securities fraud. The court held that the land sales agreements were investment contracts. Moreover, since the installment contracts called for a repeated series of decisions to invest, each term payment was a separate offer and sale for determining the statute of limitations. Other courts have held that mortgage participations (Pollack v. Laidlaw Holdings, Inc., 27 F.3d 808 (2d Cir. 1994)) and joint venture interests purchased in reliance on the expertise of the venture‘s managers to generate profits (Stone v. Kirk, 8 F.3d 1079 (6th Cir. 1993)) are securities.

Comment:

This is a short summary of some of the cases discussing the investment contract test. It is meant to give the reader a basic idea of how the test operates.

Whether a contract or other economic right is a security essentially depends on whether the holder of the contract is acting as an investor who seeks financial benefits based on the work of a promoter or a third party.

The practicing lawyer should remember that the statute makes it clear that a promissory note or share of stock in a small closely held corporation is a security. 15 U.S.C. §77b(a)(1).

Edward X. Clinton, Jr.

Read More

District Court Holds That Moorman Doctrine Bars A Conversion Claim

Lansing v. Carroll, Dist. Court, ND Illinois 2012 - Google Scholar:

The economic loss or Moorman doctrine bars tort claims where the damages are purely economic.    Moorman Mfg. Co. v. Nat'l Tank Co., 435 N.E.2d 443, 453, 91 Ill. 2d 69, 61 Ill. Dec. 746 (Ill. 1982); Fireman's Fund Ins. Co. v. SEC Donohue, Inc., 679 N.E.2d 1197, 1199, 176 Ill. 2d 160, 223 Ill. Dec. 424 (Ill. 1997).

In this case a dispute arose concerning the provisions of a buy-sell agreement.  The plaintiff brought a conversion claim.  Because the conversion claim sought contract damages, it was barred by the Moorman doctrine. The court concluded that the plaintiff's conversion claim was really a breach of contract claim accompanied by the words "willful" and "wanton."

Moorman often swallows up tort claims in business litigation where the parties also have a contract.  The purpose of Moorman is to prevent clever lawyers from turning every breach of contract into a tort.  Interpreting Moorman is one of the main issues facing business litigators today.

Edward X. Clinton, Jr.

www.clintonlaw.net

'via Blog this'

Read More

Corporate Law - Piercing the Corporate Veil - Fontana v. TLD Builders, Inc., 362 Ill. App. 3d 491 (Ill. App. 2nd Dist. 2005)

Fontana v. TLD Builders 362 Ill. App. 3d 491 (Ill. App. 2d Dist 2005).

This is probably the most famous piercing the veil case in Illinois because it pierced the corporate veil and held liable a non-shareholder of the corporation. The result is counter-intuitive, but, is understandable when one considers the underlying facts of the case.

The Fontanas alleged that they entered into a contract with TLD under which TLD agreed to construct a single family home in Clarendon Hills for the sum of $1,475,800.

The Fontanas alleged that TLD breached the contract by failing to construct the home as specified in the contract and "by abandoning all work on the home in February 2001, leaving the home incomplete and uninhabitable."

After a bench trial, the court held that TLD breached the contract and failed to cure the breach. As to damages the court held that it would be too costly to complete the home, so the unfinished home should be demolished. The court held that the Fontanas had been damaged in the amount of $1,271,816.10. The trial court entered judgement against TLD and DiCosloa jointly and severally.

The only relevant appeal from the judgment was that of DiCosola. Plaintiffs alleged that DiCosola was the alter ego of TLD and that, after the lawsuit was filed, he caused TLD to cease its business operations so that it had no funds with which to compensate plaintiffs. DiCosola was not a shareholder of TLD.

Theresa DiCosoloa was called as a witness by the Plaintiffs. Mrs. DiCosola admitted that she was the incorporater of TLD. She could provide no evidence that the corporation had any start-up capital. There was no evidence that she or DiCosola ever paid for the stock issued by the corporation. The purported owner of the corporation, Theresa DiCosola, knew nothing about the corporation, did not sign checks, kept no records and did not know whether the corporation had ever earned a profit or a loss.

Theresa "said that she has never received a dividend from TLD and did not know if TLD had profits or losses in the years, 1998,1999, 2000, 2001 and 2002. However, Theresa did sign TLD's income tax returns for those years." She also admitted that she had no idea where the company's assets of $1.8 million went after the lawsuit was filed.

The company had almost no financial records, and almost no records of payments that it made to vendors and subcontractors.

As a result, the trial court found that "Mr. DiCosola is the dominant force behind this corporation" and that the corporation "was little more than a shell which was established to shield him from liability."

In Illinois a party seeking to pierce the corporate veil has the burden of making a substantial showing that the corporation is really a dummy or sham for another person or corporation. In re Estate of Wallen, 262 Ill. App. 3d 61, 68 (1994). The doctrine "imposes liability on the individual or entity that uses a corporation merely as an instrumentality to conduct that person's or entity's business."

The court first rejected the argument that DiCosola could not be held liable because he was not a shareholder. There is authority in Illinois and other states that a non-shareholder can be held liable if the other elements of the test are met.

Illinois uses a two-step test to determine whether the veil should be pierced:

"(1) there must be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist; and (2) circumstances must exist such that adherence to the fiction of a separate corporate existence would sanction a fraud, promote injustice, or promote inequitable consequences."

To determine whether the "unity of interest" test has been met courts examine many factors, including (1) inadequate capitalization; (2) failure to issue stock; (3) failure to observe corporate formalities; (4) nonpayment of dividends; (5) insolvency of the debtor corporation; (6) nonfunctioning of the other officers or directors; (7) absence of corporate records; (7) commingling of funds; (9) diversion of assets from the corporation by or to a stockholder or other person or entity to the detriment of creditors; (10) failure to maintain arm's length relationships amont related entities; and (11) whether, in fact the corporation is a mere facade fro the operation of the dominant stockholders." Jacobson v. Buffalo Rock Shooters Supply, Inc., 278 Ill. App. 3d 1084, 1088 (1996).

Obviously, the factors when analyzed strongly favored plaintiffs:

(1) no evidence of adequate capitalization; (2) failure to issue stock; (3) failure to observe corporate formalities; ... (5) insolvency; (6) no evidence that Theresa functioned as a real officer or director; (7) almost total absence of corporate records.

The Appellate Court affirmed the finding of piercing the veil.

Comment: this case involves a corporation and a shareholder who did almost everything wrong - no capital; no records; no consistent use of the corporate name; no effort to follow corporate formalities and evidence of commingling. The result - personal liability in excess of $1.2 million logically follows when one considers the underlying facts and the underlying transaction and the apparent effort to stiff the plaintiffs and deny them their legitimate recovery.

This case is a lesson to all entrepreneurs that it is not enough to form a corporation - you must use the corporation and treat it as a separate and independent person. You must use the corporate checking account or credit card and keep records of corporate expenses. You must keep your own affairs and accounts separate from those of the corporation. Finally, it is wrong to transfer funds to yourself or others to avoid paying your creditors.

A corporation should not be forgotten once established, but carefully maintained over time.

Edward X. Clinton, Jr.
Copyright 2010

Read More

Mortgage Foreclosure - Bank Fails to Make Diligent Efforts To Serve Defendant - Default Judgment Reversed

CITIMORTGAGE, INC. v. Cotton, Ill: Appellate Court, 1st Dist., 2nd Div. 2012 - Google Scholar:

This is a mortgage foreclosure case in which Citimortgage was unable to serve the defendant and obtained service by publication.  On appeal, the court held that the bank failed to make diligent efforts to serve the defendant and the default judgment was reversed.

There are two standards that govern service - diligent inquiry and due inquiry.  The court explains the difference: "The plaintiff must conduct both "diligent inquiry" in ascertaining the defendant's residence and "due inquiry" in ascertaining the defendant's whereabouts before the plaintiff can properly execute an affidavit stating that the defendant cannot be found. Bell Federal Savings & Loan Ass'n v. Horton, 59 Ill. App. 3d 923, 927-28, 376 N.E.2d 1029, 1033 (1978)."

Here, the bank failed to contact Cotton's attorney or attempt to reach Cotton at his job.  Thus, the bank may have failed to make "due inquiry."

After the judgment was entered, Cotton filed a motion for reconsideration, and a supporting affidavit, arguing that the bank's efforts to find him were lacking.

The case was remanded to the circuit court so that the court could conduct a hearing on what efforts the bank made.

Comment; the lesson here is that service by publication may be challenged.  Personal service is always the best idea.

Edward X. Clinton, Jr.

www.clintonlaw.net



'via Blog this'

Read More

Fraudulent Transfer - Appellate Court Upholds Judgment In Favor Of Creditor Against Wife Of Debtor

HARRIS NA v. Harris, Ill: Appellate Court, 1st Dist., 1st Div. 2012 - Google Scholar:

This is an appeal from a grant of summary judgment in favor of Harris Bank against Sheri Harris, the ex-wife of Stuart Levine.

The bank alleged that in 2002 Levine allegedly defaulted on a $3.3 million dollar note due to the Bank and to avoid collection had transferred assets to his wife for no consideration.  The asset transfers rendered Levine insolvent, so he was unable to pay Harris bank.

Ms. Harris argued that the bank's case was barred by a 2008 federal forfeiture judgment.  The trial court and the appellate court disagreed, holding instead that the forfeiture judgment only applied to two of Levine's assets, not the rest of the disputed property.

The court found that Ms. Harris forfeited two arguments (a) that there was adequate consideration for the transfers; and (b) that the property was marital property in which she had a 50% interest, because Ms. Harris failed to raise these issues before the trial court.  The court states: "Because neither this argument nor any evidence supporting it was presented to the circuit court, we deem the argument forfeited on appeal. See Cooney v. Magnabosco,407 Ill. App. 3d 264, 268, 943 N.E.2d 290 (2011) (stating that an appellant that fails to raise an issue in the circuit court waives that issue for purposes of appeal)."

In sum, a classic fraudulent transfer case.

Edward X. Clinton, Jr.

www.clintonlaw.net



'via Blog this'

Read More

Contract Law - Personal Guarantee Enforced Because of Admissions By Defendant

NISSAN MOTOR ACCEPTANCE CORPORATION v. ABBAS HOLDING I, INC., Ill: Appellate Court, 1st Dist., 2nd Div. 2012 - Google Scholar:


The main issue in this case was whether the trial court properly ruled that an individual defendant, Joseph Abbas, was liable on a personal guaranty. The original document with Mr. Abbas' signature was lost. The court initially ruled in his favor. Upon reconsideration, the court ruled that the personal guaranty was binding on Abbas because he admitted in a verified answer that he signed it.

The admission in a verified answer was a binding judicial admission and was fatal to the defense of the personal guaranty claim. The analysis is worthy of quotation:

"¶ 19 Section 2-610 of the Code provides that every answer and subsequent pleading "shall contain an explicit admission or denial of each allegation of the pleading to which it relates," and that "[e]very allegation, except allegations of damages, not explicitly denied is admitted, unless the party states in his or her pleading that he or she has no knowledge thereof sufficient to form a belief, and attaches an affidavit of the truth of the statement of want of knowledge." (Emphasis added.) 735 ILCS 5/2-610(a), (b) (West 2010). "Any admission contained in the original verified pleading, which is not the product of mistake or inadvertence, is a binding judicial admission." Arpac Corp. v. Murray, 226 Ill. App. 3d 65, 80, 589 N.E.2d 640, 652 (1992). Such an admission "has the effect of withdrawing a fact from issue and dispensing wholly with the need for proof of the fact." Id. at 80-81, 589 N.E.2d at 652; Beverly Bank v. Coleman Air Transport, 134 Ill. App. 3d 699, 703, 481 N.E.2d 54, 57 (1985). A judicial admission in a verified pleading "makes it unnecessary for the opposing party to introduce evidence in support thereof." L.D.S., LLC v. Southern Cross Food, Ltd., 2011 IL App (1st) 102379, ¶ 35.

¶ 20 Paragraphs 22 and 23 of Nissan's first amended complaint pertained to its claim that Joseph breached the guaranty agreement (count III). As discussed, paragraph 22 alleged that "[o]n or about February 26, 2007, [Joseph] made, signed, and delivered to [Nissan] a certain Continuing Guaranty Agreement (`Guaranty') in writing, whereby he promised and agreed promptly to pay any and all liabilities of [Abbas Holding] to [Nissan] then existing or due or to be incurred or become due." In Abbas Holding and Joseph's verified answer, Joseph "denies the allegations contained within [p]aragraph 22 of [Nissan's] First Amended Complaint, except the allegation that on or about February 26, 2007, he made, signed, and delivered to [Nissan] a certain Continuing GuarantyAgreement (`Guaranty') in writing, subject to the production and examination of the original document." (Emphasis added.) Paragraph 23 of Nissan's first amended complaint alleged that the guaranty agreement "was continuing, absolute, and unconditional, including all costs and expenses in enforcing the Guaranty. (A copy of the Guaranty is attached hereto as Exhibit D.)" In Abbas Holding and Joseph's verified answer, Joseph "denies the allegations contained within [p]aragraph 23 of [Nissan's] First Amended Complaint, except the allegation that [Nissan] has attached a copy of theGuaranty as Exhibit D." (Emphasis added.)

¶ 21 We find that the italicized and "excepted" portions of Joseph's answers were not explicit denials of the allegations under section 2-610 of the Code and, thus, constituted admissions that Joseph had signed and delivered the guaranty agreement to Nissan and that a copy of the guaranty agreement was attached to Nissan's first amended complaint as an exhibit. Because Abbas Holding and Joseph do not argue that these admissions in the verified answer were the product of mistake or inadvertence, we find them to be binding judicial admissions which had "the effect of discharging the need for any further proof" to prove the existence of the guaranty agreement, as the trial court correctly noted in its April 12, 2011 ruling which granted Nissan's motion to reconsider. Accordingly, Nissan was not required to produce the original guaranty agreement at trial under the best evidence rule, and Joseph's answer to the allegations under paragraph 22 that his admission was made "subject to the production and examination of the original document" had absolutely no legal effect upon Nissan. See Beverly Bank,134 Ill. App. 3d at 704, 481 N.E.2d at 57 (holding that personal guarantor's verified answer admitting plaintiff's allegations that a guaranty had been signed and delivered constituted a binding admission against personal guarantor); see generally In re Estate of Weiland, 338 Ill. App. 3d 585, 604, 788 N.E.2d 811, 827 (2003) (best evidence rule requires the existence of a contract or other writing to be proven by the original writing unless it is shown that the original was lost, destroyed, or otherwise unavailable)."


Comment: it is important to carefully consider any answer to any pleading. An answer that admits a paragraph of a verified complaint should usually be binding on the person making the admission, especially here where sophisticated people borrowed money from a finance company. This is a good decision.


Edward X. Clinton, Jr.

www.clintonlaw.net

'via Blog this'

Read More

For What It's Worth: Two articles in today's Law Bulletin suggest struc...

For What It's Worth: Two articles in today's Law Bulletin suggest struc...: Today's Chicago Daily Law Bulletin carries two articles that expose what may be a structural flaw in the legal profession itself. Too big...

Jack Leyhane points out today that (a) more lawyers are being created every year and (b) the demand for legal services is shrinking.  Worse still, lots of people who could pay for lawyers are now opting to litigate pro se.

He is, of course, correct about these long-term trends in the profession.  I graduated in 1991 and joined Mayer Brown in 1992.  From the first day I was there, it became obvious that there were extra people at the firm, people who were billing time to clients but who were not doing any real work.  The recession in 2008  obviously caused the corporations to notice that they were paying for extra people - lots of extra people.  The corporations became smart - they learned how to cut outside lawyers and bring the work in house or to handle the work very efficiently.  Lawyers who were used to attending team meetings were laid off never to return to the corridors of the large law firms.

The new problem is outsourcing - lots of work can be done competently by outsourcing firms in India and elsewhere.  The routine legal work that employed lots of people is slowly drying up - at least at the corporate level.

This all spells trouble for the law students who have graduated in the past 10 years.  While we produced too many lawyers in 1991, we now produce 2X as many lawyers as there are jobs to fill.  This means misery and unpaid debt for lots of young people.

It also suggests that the law schools have been graduating students who were not qualified to practice law and that this process (social promotion) has caused great harm to the profession.  It is difficult to quantify the number of people who graduate each year and do not have the skills necessary to practice.  What is beyond dispute is that this number is growing, even with an increase in law school tuition and more and more clinical programs.

Edward X. Clinton, Jr.

www.Clintonlaw.net

Read More