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Suit over corporation sale now will be easier

The sale of a closely held corporation generally is covered by the Virginia Securities Act, the Supreme Court of Virginia has ruled.
In doing so, the court rejected the “sale of business” doctrine, which some states apply to the sale of 100 percent of the stock in a corporation. 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.

Justice Donald W. Lemons said for a unanimous court, “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.”

It now will be easier to sue when problems arise from the sale of a closely held company.

The plaintiff’s attorney, James T. Bacon of Fairfax, said, “The practical effect [of the decision] is enormous.” The burden of proof under the act is a preponderance of the evidence rather than the clear and convincing evidence required for fraud, he said.
Generally, he added, a plaintiff must only prove a material misrepresentation in the sale of the stock. The burden of establishing reliance, causation and intent to deceive is substantially reduced, he 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.”

Attorneys representing sellers will have to advise them to make certain that they have disclosed 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.

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 (VLW 008-6-062), alleging fraud, common law civil conspiracy and material misrepresentations about the company under Virginia Code § 13.1-522.

LeRoy F. Millette Jr., then a Prince William County Circuit judge and now a member of the Virginia Court of Appeals, granted the defendants’ motion for partial summary judgment on the Securities Act count. Millette concluded that the Securities Act “is not intended to protect active purchasers of a business.”

Bacon nonsuited the remaining claims and appealed 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 outlines 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” test established in Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985).

Essentially, if the instruments denominated 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 purchase.

Bacon said, “The practical effect [of the decision] is enormous.” The burden of proof under the act is a preponderance of the evidence rather than the clear and convincing evidence required for fraud, he said.

Generally, he added, a plaintiff must only prove a material misrepresentation in the sale of the stock. The burden of establishing reliance, causation and intent to deceive is substantially reduced, he said.

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