Sale of Business Doctrine: Everything You Need to Know
Sale of business doctrine refers to a principle stipulating that a stock transfer attached to selling off a business doesn't amount to a transfer of securities.3 min read
2. Applicability of Federal Securities Law
3. Delineating Between Stock and Securities
4. Characteristics Depicting Stocks as Securities
5. Determining if a Stock is a Security
Sale of business doctrine refers to a legal principle stipulating that a stock transfer attached to selling off a business doesn't amount to a transfer of securities. Although outmoded, many courts adopted this principle; however, it was rejected by the Supreme Court in (U.S. 1985) in the case of Landreth vs. Landreth Timber Co. 471 U.S. 681.
Rejection of the Sale of Business Doctrine
The Supreme Court rejected the doctrine in cases that involved the sale of stock in closely held corporations. The court held forth that applying the sale of business doctrine could result in arbitrary distinctions between the transactions that were covered by federal securities law and those that weren't.
Since the applicability of these laws would then depend on factors aside from the characteristics and type of instruments involved, the stock of a corporation could be regarded as a security to the seller — but not to the purchaser.
Applicability of Federal Securities Law
Similarly, if a purchaser bought bits of stock through different transactions, the federal securities law could apply to some transactions; however, it won't be applicable in the transaction that gave control to the purchaser. Due to the primary purpose of the federal securities law in protecting investors, such distinctions don't make much sense.
Furthermore, the inability of the parties to ascertain if the federal securities law were applicable (at the time of transaction) neither served the purpose of the laws to protect investors nor allowed any compensation to the purchaser due to the additional risk of zero protection when negotiating such a transaction.
This notion has been adopted by several federal courts stipulating that sale of all the stocks of a closely-held corporation are exempt from the laws pertaining to federal securities.
Delineating Between Stock and Securities
Under the Act, securities include all stock. This is unlike the case of promissory notes where the definition of securities includes “any note”, but doesn't mean that all notes automatically became securities. In virtually all cases, stocks are considered to be securities.
Some of the principal cases that set the standard for determining that stocks are securities were Landreth vs. Landreth Timber Co. and United Housing Foundation v. Forman, 421 U.S. 837-(1975). In the case of Forman, the shares in question were that of a non-profit corporation. When purchased, this stock gave the owner rights to rent a home in a housing cooperative. Since the stock didn't have the characteristics of a traditional investment stock, the court ruled that the stock wasn't a security.
Characteristics Depicting Stocks as Securities
The court ruled that these characteristics did not apply to the shares:
- The capacity for appreciation in value
- The confer of voting right in proportion with the volume of shares bought
- The rights to receive dividends, upon the apportionment of profits
Since the stock in question lacked these characteristics, the stock in United Housing Foundation v. Forman could not be regarded as a security.
Determining if a Stock is a Security
Due to the results of this case as well as that of WJ. Howey Co. vs. SEC (1946), which set forth the standard that any economic arrangement was a security only if it was also an investment contract, some Court of Appeal then ruled that economic nature of the sale of a stock should determine if the stock was a security or not.
By applying the reasoning which held on Howey's case regarding the control and management of a business, the courts concluded that the transfer of the majority of a closely-held corporation's stock could not be regarded as a transaction in securities under the sale of business doctrine.
However, the U.S. Supreme Court chose to apply the literalist approach stipulating that a corporation's stock is a security unless it lacked the characteristics described in the Forman case. This approach applied even in sales involving all the shares of a corporation. This means that the sale of stocks would always be considered as a sale of securities unless it was proven that there was no investment motive in selling the stock.
This ruling had practical implication for businesses since a business owner who wanted to sell his/her business had an additional incentive for structuring the transaction as a sale of assets, not a stock sale.
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