Buyer will have easier time suing over company sale

June 27, 2008

The purchaser of a closely held corporation now has a powerful tool to come back at a seller if the corporation turns out not to be quite what it appeared.

The Supreme Court of Virginia ruled recently that the sale of a corporation through the purchase of stock is covered by the Virginia Securities Act.

Before that ruling, it was not clear whether such a transaction would be covered by the act because some states apply what is known as the “sale of business” doctrine. Those states say that the transfer of all the stock to a purchaser who manages or directs the business does not constitute the sale of securities.

In rejecting the doctrine, the court said unanimously, “When the instrument purchased bears the label ‘stock’ and possesses the characteristics of traditional stock, the purchaser is justified in assuming that the Virginia Securities Act applies.”

The plaintiff’s attorney, James T. Bacon of Fairfax, said, “The practical effect [of the decision] is enormous.”

The technical requirements to prove misrepresentation under the act are much less onerous than trying to prove fraud, he noted. For example, the purchaser must prove his case by a preponderance of the evidence – more likely than not – rather than by the stricter standard of clear and convincing evidence.

Also, the purchaser does not necessarily have to prove that he relied on the misrepresentation or that the seller intended to deceive him, Bacon said.

Edward B. Lumpkin, a Richmond attorney who frequently represents closely held corporations, said the ruling “really gives a disgruntled purchaser another arrow in his quiver.”

Sellers need to be make sure that they disclose all material information to a purchaser or even structure the sale as the transfer of an asset rather than stock, Lumpkin said.

Analyzing the adequacy of disclosure and considering other forms of transferring control could drive up the cost of the transaction, he added.

Health club sale

The issue arose from the sale of all the stock in Manassas Health Club Inc. by its two shareholders to three purchasers, one of whom subsequently bought the shares of the other two.

The sellers provided the purchasers with a document called “Manassas Income & Expense Report” prepared by the bookkeeper-wife of one of the sellers. After the deal closed, the sellers gave the purchasers a computer disc containing the financial history of the corporation.

They told John Edward Andrews, who became the sole owner of the corporation, that the disc was “too damaged to be accessed.” However, Andrews was able to get access to the information from the disc, which was different from what was provided to him before closing.

Andrews filed suit against the sellers in Andrews v. Browne, alleging fraud, common law civil conspiracy and material misrepresentations about the company under the Virginia Code.

LeRoy F. Millette Jr., then a Prince William County Circuit judge and now a member of the Virginia Court of Appeals, ruled that the Securities Act “is not intended to protect active purchasers of a business.” Bacon appealed that ruling to the Supreme Court.
“I knew the court was interested because there was such a split of authority,” both among the states and among Virginia circuit judges, Bacon said.

Lemons outlined the history of the Virginia Securities Act, which closely tracks the federal Securities Act of 1933 and the Securities Exchange Act of 1934, and the development of the split of authority, first in federal courts and more recently among the states.

The U.S. Supreme Court resolved much of the split in the federal courts by establishing what has come to be known as the “stock characterization.”

Essentially, if the test instruments described as stock meet the definition of a security, the transaction is covered by federal securities laws. Lemons said the same analysis applies to the Virginia Securities Act and examined the characteristics of the health club stock.

The five features of traditional stock are the right of the owner to receive dividends, negotiability, the ability to be pledged or hypothecated, bestowal of voting rights in proportion to the number of shares owned, and ability to appreciate in value, Lemons noted. The shares in the health club met that definition and are therefore securities covered by the act, he said.

Lemons said the “sale of business” doctrine “invites many practical difficulties,” including determining whether and when control has passed to a purchaser.

Written by Alan Cooper  |  Filed Under Uncategorized 

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