Thursday, December 15, 2016

Claim that sandwich shop equity interests were securities is toast

By Rodney F. Tonkovic, J.D.

A Tenth Circuit panel affirmed that membership interests purchased as part of a restructuring plan involving Quiznos sandwich shops were not securities. The panel agreed with the lower court's conclusion that the investors failed to adequately allege facts showing that their collective interests constituted investment contracts (Avenue Capital Management II, L.P. v. Schaden, December 13, 2016, Bacharach, R.).

Quiznos in a pickle. According to the complaint, in 2006, Quiznos and its related entities borrowed heavily from various lenders. Unfortunately for Quiznos, its business declined between 2007 and 2011, resulting in a loss of around 3,000 franchises and a plunge in profitability.

To avoid foreclosure, Quiznos restructured its debt via transactions that made the investor plaintiffs members of a manager-managed LLC that operated Quiznos. The investors held 80 percent of the LLC's shares and collectively had the power to amend the LLC agreement and appoint or remove managers. The members also received Quiznos's audited financial statements and were allowed to inspect, examine, and copy Quiznos’s records.

The investors ultimately sued, claiming that in 2012 and 2013, the restructured entity's performance was materially worse than what the offering memorandum had projected. In the district court, the parties clashed over whether the membership interests were investment contracts that were covered by the antifraud provisions of the Exchange Act. Applying the Howey analysis, the court determined that the complaint failed to establish the LLC shares were investment contracts and, thus, securities because investors had control over Quiznos and could not show an expectation of profits through the efforts of others.

No investment contracts. On appeal, the investors argued that the transaction involved investment contracts, stock, and instruments commonly known as securities. The panel rejected each argument, concluding that no investment contracts were involved. The panel also found that the investors failed to properly preserve their current arguments characterizing the interests as stock or instruments commonly known as securities.

At issue on appeal was whether the expected profits from the membership interests were "to come solely from the efforts of others." In the panel's view, the investors controlled the profitability of their investments, preventing characterization as investment contracts. The panel explained that the investors collectively owned about 80 percent of the LLC, a level of ownership that permitted them to freely amend the LLC agreement. Secondly, the investors had the power to choose and remove eight of the nine managers, including the chairperson of the board; with this power, they could supervise those handling day-to-day operations or even dissolve the LLC. Finally, the plaintiffs were sophisticated investors who made informed decisions and could intelligently exercise control over Quiznos. The interests could constitute investment contracts if Quiznos's management was irreplaceable or otherwise insulated from the investors' control, the panel continued, but that was not the case here.

Finally, the panel determined that the investors forfeited their appellate arguments characterizing the interests as stock or instruments commonly known as securities. The investors never made these arguments in the district court and, consequently, that court expressly declined to address these possibilities. The panel declined to exercise its discretion to consider these new arguments.

The case is No. 15-1389.

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