Q. When is a stock not a stock?
A. When the buyer ends up owning the business.
That, at least, is the answer that most U.S. courts have been giving. But now there are indications that their attitude may be changing.
What is at issue is whether securities regulation laws passed in 1933 and 1934 come into play when a new owner buys all of the stock of a business, with the intention of running it himself. There are often good business reasons why such deals are structured not as a sale of the assets of the business but of the entire corporation. The corporation may, for instance, have a real estate lease at a rental rate well below the current market which cannot be transferred, but would stay with the business if the ownership of the coporation changed hands. But does the difference in form make it a different kind of deal legally?
The answer can make a lot of difference if the buyer of the business decides he was duped. To sue for fraud because the sales potential of the business was overstated, for instance, "is not an easy case to prove because of the standards that are built into the laws," explains Washington lawyer John Gibbons. There are a whole string of elements that have to be shown, proving not only that the facts were knowingly misrepresented, but also that the seller knew that the buyer would rely on the lie, and that the buyer did in fact believe the exaggerated claim. But suing under the securities laws "is an easier proof type of thing," Gibbons says. "You are required to make disclosures if you are selling securities." In other words, the buyer does not have to prove that he was misled, only that he was not told some important facts that should have been disclosed.
But even though the 1933 and 1934 statutes say they apply to stock sales, judges have decided that the buyer of a business is not the kind of investor in an anonymous enterprise that those laws were meant to protect. They hark back to a 1946 decision of the U.S. Supreme Court that tells lower courts to use an "economic reality" test in deciding what securities are covered by the federal acts. According to that ruling, investors have to expect profits "derived from the entrepreneurial or managerial efforts of others" in order for their transactions to be covered by the securities laws. That's just not what the buyer of a business has in mind.
Over the past five years, that has been the way most trial courts looked at the issue, telling business buyers that they just didn't have a securities law case. At least one Chicago decision even applied the rule to a purchase of only 50 percent of the stock in an enterprise, when the buyer planned to run the operation. Courts of appeals in Chicago and Denver have accepted the view, and in April of this year the country's newest appellate court, in Atlanta, went along.
But the rule isn't one that businessmen can be sure about. The court of appeals in Richmond, whose decisions control the law in Maryland and Virginia, has never adopted the "sale of business doctrine," and considers a stock sale a stock sale, regardless of what the buyer plans to do with the purchase. The court of appeals in Philadelphia has ruled the same way. But the most significant erosion of the principle came in May when a divided panel of the appellate court in New York unequivocally rejected the doctrine. The ruling is particularly important because the New York court is considered the standard-setter for corporate law cases, just as D.C. court is the one that other judges look to for rulings on federal agencies.
In the meantime, how much chance a business buyer has to make good a bad deal depends on just where the business is. But no rule of law can beat checking out any proferred business thoroughly and carefully.
Moskowitz covers legal affairs for McGraw-Hill World News.