Opinion ID: 2584287
Heading Depth: 2
Heading Rank: 1

Heading: The Ohs' HRS Chapter 485 Claim Against Fong

Text: The Ohs contend that the ICA erred in applying the standard from Hawaii Market Center to conclude that the anti-fraud provisions of Hawaii's Uniform Securities Act, HRS § 485-25, do not apply when a party sells all, as opposed to only a portion, of the stock of a corporation. Memo Op at 11. The Ohs make two arguments in support of this contention: (1) that the ICA misinterpreted this court's decision in Hawaii Market Center ; and (2) that the proper standard for what constitutes a security should be supplied by Landreth Timber Co. v. Landreth, 471 U.S. 681, 105 S.Ct. 2297, 85 L.Ed.2d 692 (1985), a United States Supreme Court case that interpreted Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) (Supp.2007), which has similar language to the Hawaii law. [12]
Analysis of whether HRS § 485-25 applies to this transaction must begin with the statute itself. HRS § 485-25 makes it unlawful for any person to engage in various types of fraudulent conduct or other prohibited practices in connection with the offer, sale, or purchase . . . of any security (whether or not of a class described in section 485-4), in the State, directly or indirectly. HRS § 485-25(a) (emphasis added). Among the provisions prohibiting certain conduct is Section 485-25(a)(2), which makes it unlawful [t]o make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading. The chief dispute between the parties is whether this section applies to the stock purchase transaction in this case; i.e., whether the transaction involved a security. Security is defined by HRS § 485-1(13), as follows: Security means any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, variable annuity contract, voting trust certificate, certificate of deposit for a security, certificate of interest in an oil, gas, or mining title or lease, option on commodity futures contracts or, in general, any interest or instrument commonly known as a security, or any certificate of interest or participation in, temporary or interim certificate for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. Security does not include any insurance or endowment policy or fixed annuity contract. HRS § 485-1(13) (1993) (emphases added). [13] The Ohs contend that the security was stock, as denominated by the conveying instrument.
In its Memorandum Opinion, the ICA held that HRS § 485-25 does not apply when a party sells all, as opposed to only a portion, of the stock of a corporation, based on our decision in Hawaii Market Center, which adopted the economic reality approach to defining an investment contract. In reaching this conclusion, the ICA did not distinguish between stock and investment contracts as different types of securities for purposes of HRS § 485-1(13) and applied Hawaii Market Center without further analysis. [14] At issue in Hawaii Market Center was whether the `Founder-Member Purchasing Contract Agreements' issued by Hawaii Market Center, Inc. . . . constitute[d] securities within the meaning of . . . HRS § [481] 485-1(12). 52 Haw. at 643, 485 P.2d at 106. Although framed broadly in the first sentence of the opinion, subsequent references make clear that the court's analysis only concerned a subset of the securities determination: whether the agreements at issue constituted investment contracts. Thus, after setting out the risk capital approach to defining an investment contract, id. at 648, 485 P.2d at 109 (emphasis added) (capitalization altered), this court concluded that the contracts in question constituted such investment contracts within the meaning of HRS § 485-1(12). Under the risk capital approach adopted by the court, an investment contract is created whenever: (1) An offeree furnishes initial value to an offeror, and (2) a portion of this initial value is subjected to the risks of the enterprise, and (3) the furnishing of the initial value is induced by the offeror's promises or representations which give rise to a reasonable understanding that a valuable benefit of some kind, over and above the initial value, will accrue to the offeree as a result of the operation of the enterprise, and (4) the offeree does not receive the right to exercise practical and actual control over the managerial decisions of the enterprise. Id. at 649, 485 P.2d at 109 (emphasis added). In adopting this test, the court rejected what it considered the overly-mechanical approach to determining what constitutes an investment contract enunciated by the United States Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946), which the court believed to be based on a narrow concept of investor participation. The court preferred the broader economic realities test because it (1) recognized the economic reality of a security, [15] (2) was considered broad enough to fulfill the remedial purposes of the Securities Act, [16] and (3) supplied the necessary broad coverage to protect the public from the novel as well as the conventional forms of financing enterprises. Hawaii Mkt. Ctr., 52 Haw. at 649, 485 P.2d at 109. The Ohs argue that Hawaii Market Center should not control this case, for two reasons. First, the Ohs contend that the Hawaii Market Center test applies only to determine whether an investment contract exists, not whether the instrument is a security. The Ohs argue that a stock is by definition a security. Secondly, the Ohs argue that this court should apply the reasoning set out by the United States Supreme Court in Landreth, which analyzed whether a stock was a security within the meaning of the Securities Exchange Act of 1934. The United States Supreme Court's analysis in Landreth, although not binding as to the interpretation of our state law, provides guidance on both arguments raised by the Ohs. In Landreth, the Court was asked to consider whether the sale by a father and his sons of all the common stock of a lumber business they operated was the sale of a security within the meaning of the federal securities laws. The Court held that when an instrument is both labeled stock and possess[es] `some of the significant characteristics typically associated with' stock. . . . `a purchaser justifiably [may] assume that the federal securities laws apply.' Landreth, 471 U.S. at 686, 105 S.Ct. 2297 (quoting United Hous. Found., Inc. v. Forman, 421 U.S. 837, 850-51, 95 S.Ct. 2051, 44 L.Ed.2d 621 (1975)). [17] Those characteristics are: (i) the right to receive dividends contingent upon an apportionment of profits; (ii) negotiability; (iii) the ability to be pledged or hypothecated; (iv) the conferring of voting rights in proportion to the number of shares owned; and (v) the capacity to appreciate in value. Id. (quoting Forman, 421 U.S. at 851, 95 S.Ct. 2051). Under Landreth, the investment contract analysis of Howey is only used, therefore, for instruments unlike stock that do not bear these characteristics. The Court therefore rejected the sale of a business doctrine, followed by various courts prior to Landreth, according to which the sale of a business via a stock transfer was not covered by the federal securities laws. The Court in Landreth discussed three reasons why an economic reality analysis need not apply to a sale of stock that has the characteristics of stock. First, the Court distinguished prior cases that applied an economic reality test, stating that those cases involved unusual instruments not easily characterized as `securities[,]' such that an economic reality approach was appropriate to determine that the instruments were actually of a type that falls within the usual concept of a security. Id. at 690, 95 S.Ct. 1881. Secondly, the Court noted that the Howey economic reality test was designed to determine whether a particular instrument is an `investment contract,' not whether it fits within [any] any of the examples listed in the statutory definition of `security.' Id. at 691, 66 S.Ct. 1100. Lastly, the Court rejected the contention that the securities acts were intended to cover only `passive investors' and not privately negotiated transactions involving the transfer of control to `entrepreneurs,' id. at 692, 66 S.Ct. 1100, based on the purposes of the Act: The 1934 Act contains several provisions specifically governing tender offers, disclosure of transactions by corporate officers and principal stockholders, and the recovery of short-swing profits gained by such persons. Eliminating from the definition of security instruments involved in transactions where control passed to the purchaser would contravene the purposes of these provisions. Id. (citations omitted). The logic of Landreth applies with equal force to interpretation of Hawaii law in this case. As described in Landreth, the instruments in Hawaii Market Center constituted unusual instrument[s] . . . not easily characterized as `securities,' see Landreth, 471 U.S. at 690, 105 S.Ct. 2297. Specifically, they were Founder-Member Purchasing Contract Agreements issued by Hawaii Market Center, under which individuals who purchased from Hawaii Market Center certain goods (at highly-marked up prices) could become either founder-member distributors or founder-member supervisors entitled to certain commissions and fees for their activities in promotion of the company. Second, like the Howey case, Hawaii Market Center (which discussed Howey in some detail) involved the question of whether an instrument was an investment contract, not the broader question of whether it fit into any of the types of securities delineated in HRS § 485-1(12). Specifically, the four-point risk-capital approach was adopted by the court to determine whether an investment contract is created, 52 Haw. at 649, 485 P.2d at 109, not as a general rubric for determining whether a security exists. [18] Furthermore, HRS chapter 485 provides for registration of certain securities when offered for sale to members of the public, and nothing indicates that the legislature intended to limit these provisions to security transactions that do not pass control to the purchaser. Therefore, Landreth supplies convincing reasoning to hold that the Hawaii Market Center test should not apply to every security described in chapter 485. The majority of states with laws similar to Hawaii's Uniform Securities Act (so-called blue sky laws) have also followed the reasoning of Landreth to require that a stock characterization test be applied to determine whether an instrument labeled stock is considered a security. See Robert N. Rapp, Blue Sky Regulation, § 2.02, at 2-18 to 2-19 (2006) (citing cases from Georgia, Kansas, New Hampshire, Michigan, Alaska, North Dakota, Minnesota, and Washington); see, e.g., Cohen v. William Goldberg & Co., Inc., 262 Ga. 606, 423 S.E.2d 231, 233 (1992) ( Landreth Timber provides appropriate guidance in resolving issues of whether particular `stock' is a security under [the Georgia Securities Law]. In applying the Landreth stock characterization test to . . . transaction[s] . . . we will use a balancing test. The appropriate test to be employed is whether the . . . stock bears such characteristics usually associated with common stock that a purchaser justifiable may assume that appropriate security laws apply.). Nevertheless, some courts have rejected the Landreth approach. See, e.g., Anderson v. Heck, 554 So.2d 695 (La.Ct.App.1989) (declining to follow what it termed the literalist approach taken by the court in Landreth, and therefore finding that Louisiana Blue Sky law did not apply to transaction in which 100% of the stock of a closely held corporation was sold to the purchaser, because the purchaser had free access to and ample opportunity to examine the financial records, assets, and other matters relating to the business enterprise); Saunders, Lewis & Ray v. Evans, 158 Ill.App.3d 994, 111 Ill.Dec. 155, 512 N.E.2d 59 (1987) (refusing to extend coverage of blue sky law rescission remedy to an individual who, simultaneously with purchasing what was undeniably corporate stock, was elected to the corporation's board of directors and made an officer). Against this majority of opinion, Fong argues that economic conditions in Hawai`i and the [long-reign] long reign of the Hawaii Market Center approach counsel against adoption of the Landreth approach to stock under our law. Instead, Fong maintains that an economic reality test should govern business sales in Hawai`i, because although many transactions take the form of a stock transfer, they are often arms-length transactions among small businesses owners for which common law remedies are adequate to protect against fraud. Fong also suggests that adoption of a Landreth test would unsettle expectations and lead to an explosion of litigation by small business purchasers disappointed by businesses failure. The Commissioner, on the other hand, argues in its amicus brief that applying a test based on managerial control to stock transactions would produce uncertainty for investors and lead to litigation over whether a given stock transaction actually conveyed managerial control to a shareholder. The same concern was expressed by the United States Supreme Court in Landreth. See Landreth, 471 U.S. at 696, 105 S.Ct. 2297 ([I]f applied to this case, the sale of business doctrine would also have to be applied to cases in which less than 100% of a company's stock was sold. This inevitably would lead to difficult questions of line-drawing. The Acts' coverage would in every case depend not only on the percentage of stock transferred, but also on such factors as the number of purchasers and what provisions for voting and veto rights were agreed upon by the parties. . . . [C]overage by the Acts would in most cases be unknown and unknowable to the parties at the time the stock was sold. These uncertainties attending the applicability of the Acts would hardly be in the best interests of either party to a transaction.). It is noteworthy that no decision of this court has applied the Hawaii Market Center test to bona fide stock transactions. [19] Although many business sales take the form of stock sales, it is not incongruous, as Fong suggests, to apply HRS chapter 485 to such transactions when consummated through stock purchases as opposed to asset sales. The purchase of securities entails greater risk than asset purchases, because the purchaser assumes all debts and liabilities of the company in addition to its physical inventory. It is the purpose of the Uniform Securities Act to protect against fraud in such a transaction, so long as it involves a security. Therefore, based on (1) the Landreth case and the many state courts who have adopted its interpretation with respect to their state securities laws, (2) the inclusion of stock within the definition of security in HRS § 485-1 and the intent of the legislature that definitional terms hew to the text of Hawaii's Security Act, see supra note [12] 13, and (3) the remedial purposes of Hawaii's Uniform Securities Act, see Hawaii Mkt. Ctr., 52 Haw. at 648, 485 P.2d at 109 (discussing the remedial purposes of the Securities Act, noted supra at note [15] 16), there are convincing reasons to apply the Landreth test to determine whether an instrument labeled stock is a security under Hawai`i law. Accordingly, the ICA erred in applying the Hawaii Market Center test to a type of instrument for which it was not intended. [20]
As the above analysis makes clear, whether the anti-fraud provisions of HRS chapter 485 apply to the stock purchase in this case depends on whether it had the traditional characteristics of stock. See Landreth, 471 U.S. at 686, 105 S.Ct. 2297((i) the right to receive dividends contingent upon an apportionment of profits; (ii) negotiability; (iii) the ability to be pledged or hypothecated; (iv) the conferring of voting rights in proportion to the number of shares owned; and (v) the capacity to appreciate in value. (Quoting Forman, 421 U.S. at 851, 95 S.Ct. 2051.)). Furthermore, an instrument may qualify as stock under the Landreth test even if the corporation is a close corporation, see, e.g., Sulkow v. Crosstown Apparel Inc., 807 F.2d 33, 37 (2d Cir.1986) (The fact that Crosstown was a close corporation, with the Shareholders' Agreement envisioning some limitations on the stock's negotiability and pledgeability, is insufficient to negate the character of the stock as a security. Limitations on the transfer of stock in close corporations are common, but neither the small size of the corporation nor the restrictions on transferability remove such a corporation's stock from the reach of Rule 10b-5.), or if the buyer purchases 100% of the common stock of the corporation and intends to manage the business. See Golden v. Garafalo, 678 F.2d 1139, 1146 (2d Cir.1982) (So far as the anti-fraud policies of the Acts are concerned, the possibilities of fraud and the ability to protect oneself through contract are the same as to a `passive' investor buying 30% of a corporation's shares from a sole shareholder or an `active' purchaser taking 100% and expecting to manage it directly. . . . In truth, purchasers of a business rightly regard themselves as investors as well as managers. Transfers of corporate control frequently are motivated by a hope for capital gains resulting from improved management, and it is altogether artificial to classify such transactions as exclusively commercial.). Fong's motion for summary judgment sought dismissal of the HRS chapter 485 claim on the grounds that the stock purchase agreement was not a security under the Hawaii Market Center test for investment contracts. The circuit court granted this motion without explaining its basis and the ICA affirmed on the grounds that the Hawaii Market Center test controls. Because this basis is incorrect, and Fong has not demonstrated that the stock purchasing agreement does not have the characteristics of stock explicated in Forman and Landreth, there remain genuine issues of material fact regarding whether the instrument qualifies as stock. Fong's motion for summary judgment did not allege that the instrument lacks the characteristics of stock, nor has Fong shown an absence of any genuine issue as to the material facts regarding this characterization. [21] Therefore, Fong has not met her burden on summary judgment to show the absence of any genuine issue as to all material facts regarding whether the transaction at issue involved the sale of security. Accordingly, the ICA erred by affirming the circuit court's judgment granting summary judgment to Fong on the Ohs' HRS chapter 485 claim.