Corporation, Securities & Business Law Forum
February 2002 Vol. 47, No. 2
Statements or expressions of opinion or comments appearing herein are those of the editors or contributors, and not necessarily those of the association or section.
Contents
* Seventh Circuit decision discusses "deferral" of information as violation of 10b-5
* The NASD announces regulatory enforcement actions to curb annuity sales abuses
This edition of the newsletter has several interesting articles, including one that discusses the recent case of Gallagher v. Abbott Laboratories et al, 269 F.3d 806 (7th Circuit 2001). In this case, the court discussed the duty to disclose bad news in light of section 10(b) and Rule 10b-5. This edition also contains an article that should be of interest to all business lawyers that discusses the little known Illinois Environmental Protection Act, and it compares this act to CERCLA, its counterpart under Federal law. In addition, we present an article that describes how the National Association of Securities Dealers has increased regulatory enforcement actions against member firms and registered representatives in connection with variable annuity sales. Finally, this edition contains a sample client advice letter that deals with some of the issues involved in organizing a medical practice.
We look forward to your comments and suggestions. We also welcome your submissions to the newsletter.
David E. Doyle
10 S. La Salle Street
Suite 3500
Chicago, Illinois 60603
312/606-0529
Seventh Circuit decision discusses "deferral" of information as violation of 10b-5
By Howard Z. Gopman
In Gallagher v. Abbott Laboratories et al, 269 F.3d 806 (7th Circuit 2001), the court discussed the duty to disclose bad news in light of section 10(b) and Rule 10b-5 under the Securities Exchange Act of 1934. See 15 U.S.C.A. § 78j(b); 17 C.F.R. § 240.10b-5.
Abbott's Diagnostic Division was always in trouble with the FDA. The FDA continually found fault with Abbott's manufacturing quality control and issued warnings. In March of 1999, the FDA sent a letter, warning Abbott of dire consequences if it did not comply. In September of 1999, things became more serious as the FDA insisted on substantial penalties plus changes in Abbott's way of doing business. On September 29, 1999, after the markets closed, the company issued a press release, announcing that it was in substantial compliance and that the FDA and the Company were working things out. On the next business day, Abbott's stock fell more than six per cent. On November 2, 1999, Abbott and the government resolved their dispute, and a court entered a consent decree requiring Abbott to remove 125 diagnostic products from the market until quality control was improved and to pay a $100 million civil fine.
The next business day, Abbott's stock fell $3.50. Altogether, it was alleged that this episode caused losses of $5 billion.
Thus, the plaintiffs brought a class action under section 10(b) and Rule 10b-5 under the Securities Exchange Act of 1934, alleging that Abbott committed fraud by deferring public revelation of its problems with the FDA.
The court held that the key to the case was that Plaintiffs were unable to identify any false statement--or for that matter any truthful statement made misleading by the omission of the news about the FDA's demands.
Thus, the court derided the Plaintiffs' notion that the company had a duty to disclose information, which could bear on a stock's price as soon as such information comes into its possession. Instead, the court noted that securities laws state that a firm is entitled to keep silent (about good news as well as bad news) unless positive law creates a duty to disclose.
Thus, the Company has a duty to make an annual filing in its 10-K Report and quarterly reports on Form 10-Q. These reports did not require disclosure of the bad news from FDA. There have been proposals to require continuous disclosure but these rules have not been adopted.
In effect, the court is saying that this kind of modification is up to the legislature and continuous disclosure is not an appropriate undertaking under Rule 10b-5. The conclusion of the court is that a company does not commit fraud by "... standing on its rights under a periodic-disclosure system."
This is a must read case for those of us involved in 10b-5 litigation and for those drafting disclosure documents.
_______________
Howard Z. Gopman is a principal in Howard Z. Gopman & Associates, Ltd., located in Skokie, Illinois.
By William A. Price, Esq., Wheaton
I recently had occasion to counsel a physician interested in purchasing an Illinois medical practice, along with the building and medical laboratory facilities used by the practice. The note that follows outlines reasons to use an LLC, and to separate dissimilar investments (real estate and medical practice). Comments from other section members on their choice of organization analysis (and ways to make their advice clear to non-lawyer clients) would be much appreciated.
Dear Doctor,
1. Per our conversation, I have examined means of structuring a business organization to minimize liability and otherwise reduce the costs associated with forming an organization for operation of a medical practice in Illinois. In our conversation, we had discussed a medical corporation and some LLC or other asset-management alternatives.
2. An examination of the options suggests the best choice for you would be organization of a limited liability company for the purpose of practicing medicine, rather than a medical corporation. Lab services should be left inside the medical organization; however, real estate should be held in a trust or other entity which could separately hold the real estate and rent the property to the medical service organization. Loans from you to one or more of the entities might help reduce income taxable as self-employment income, and could also provide capital gains tax treatment for some income, instead of the higher individual income tax rates. Use of pension plans and other employee benefit arrangements for which you would qualify as an employee of either organization could create additional pretax shelters. These can be set up, if desired, after you have arrived here and are in business. The trust and organization should be set up before closing, to make sure transfer is made to the appropriate entity or person. Both the real estate organization and the medical services organization can be set up as "pass-through" entities for federal income tax purposes, which means that no organizational level income tax would be due. If you are the sole owner, you would also not need to file separate income tax returns for the organizations. They could simply be reported on separate schedule C's on your individual income tax return.
3. The primary benefit of a medical corporation is the possibility it offers for control of liability for the actions of other owners. Courts have held that a physician who was a shareholder of a corporation formed under the Medical Corporation Act (805 ILCS 15/1 et seq.) or under the Professional Service Corporation Act (805 ILCS 10/1 et seq.), was not liable for the alleged malpractice of another physician-shareholder of the corporation, where the shareholder being sued rendered no medical service to the patient, did not sign any hospital records or medical reports on the patient, did not exercise any supervision or control over the physician-shareholder who treated the patient, and was connected with the care of the patient only by signing a voucher form for the corporation to collect charges for physician's services from the patient's insurance carrier. Fure v. Sherman Hosp., 55 Ill. App. 3d 572, 13 Ill. Dec. 448, 371 N.E.2d 143 (1 Dist. 1977). You do not, however, propose to have any other physicians as owners in your current practice, and liability for members of limited liability companies is similarly limited to their investments in such organizations, and does not arise for the acts of others (as it would in general partnerships) as a result of their having the status of co-owners.
4. The primary problem with medical corporations is their exposure to the Illinois corporate franchise tax. This tax is imposed under the Business Corporations Act, which is made applicable to medical corporations by 805 ILCS 15/3. Under section 15.35 of the Act ( 805 ILCS 5/15.35 (West 1996)), domestic corporations are subject to a franchise tax for the privilege of transacting business in this State. An annual franchise tax based on the amount of the corporation's paid-in capital represented in this State is due when the corporation files its required annual report. 805 ILCS 5/15.35(d), 15.40 (West 1996). The rate of the annual franchise tax is one-tenth of 1 percent of a corporation's paid-in capital, but not less than $25 or more than $1,000,000 per year. "Paid-in capital" means the sum of the cash and other consideration received, less expenses, including commissions, paid or incurred by the corporation, in connection with the issuance of shares, plus any cash and other consideration contributed to the corporation by or on behalf of its shareholders, plus amounts added or transferred to paid-in capital by action of the board of directors or shareholders pursuant to a share dividend, share split, or otherwise. If you build up any significant amount of value in the entity (more than $16,667), the franchise tax will start to exceed the minimum amount otherwise payable. By contrast, LLCs are not subject to the franchise tax. They pay a $400 initial fee and a $200 per year annual report fee instead.
5. You probably will not want to put ownership of the laboratory facilities in the facility where you plan to practice in a second organization. This can provide a way of receiving income not subject to self-employment tax, but may have self-referral problems on the laboratory and radiology or other procedures side that would not be present in a single organization. § 225 ILCS 47/20 prohibits certain referrals and claims for payment:
Statute text
Sec. 20. Prohibited referrals and claims for payment. (a) A health care worker shall not refer a patient for health services to an entity outside the health care worker's office or group practice in which the health care worker is an investor, unless the health care worker directly provides health services within the entity and will be personally involved with the provision of care to the referred patient
6. This may not be a major problem, since 225 ILCS 14/15 defines "office" as follows:
(i) "Office practice" includes the facility or facilities at which a health care worker, on an ongoing basis, provides or supervises the provision of professional health services to individuals.
7. There are, however, AMA ethics guidelines and Medicaid regulations affecting self-referral that might also apply. It is, generally speaking, easier to comply with these in creating in-house cross-referrals if you organize a "group practice," which is not possible until you have two or more physicians involved as owners. Having all lab and other functions inside a single medical services entity means there would be no "referral" and so would avoid the problem.
8. For self-employment and capital gains tax minimization, what you may want to do is have individual ownership of the real estate, or create a real estate trust, or other appropriate real estate holding entity (such as a limited partnership or second real estate LLC). Your medical LLC would pay you or the real estate holding organization a fair market rent for the property. This rent would not be self-employment income, but instead would be an ordinary and necessary business expense for the organization. The rent would be either ordinary income or capital gains income to you, depending on whether you choose to set up the real estate holding organization and wait until the long-term capital gains holding period is up (more than a year) before taking a distribution from same. The long-term capital gains tax rate is currently 28 percent, and the top individual income tax rate is 39.6 percent (31 percent on income from $63.5 thousand to $132.6 thousand, 36 percent on $132.6 thousand to $288.35 thousand.) If you anticipate substantial income from the medical practice, therefore, a real estate holding organization looks worthwhile.
9. The offsetting cost, which should be explored before the second organization is formed, could be insurance: you may need to have a second set of premises insurance if you own the property in one legal entity and operate a medical business in it through a second. Many insurers would be willing, however, to name both entities as covered organizations under a single policy for a single site, and I would explore that option if you decide to go with the real estate organization and the separate medical services LLC.
10. There is a substantial non-tax benefit to separation of the real estate investment from the services business. The practice of medicine is, as you know, subject to the risk of fairly frequent litigation, no matter how careful you are in the course of diagnosis and treatment. Removal of the real estate asset from common ownership is one way of reducing the exposure of that asset to the risks of litigation. If other family members own all or part of the real estate, this exposure can be further reduced. Your share would still be subject to personal liabilities, if insurance does not cover your losses, but real estate assets in a separate and non-identically owned organization would not have to be sold immediately to pay such liabilities. A judgment creditor would instead have a right to any distributions you would be entitled to, and no more. You and the other owners would not be required to declare any dividends or make any distributions until you sold the property.
11. The self-employment tax amount is 15.3 percent, which represents both Social Security tax and Medicare tax. The Social Security portion is capped after taxes are applied to $72,000 of income (year 2000 figure: amounts increase for later years), while Medicare taxes (2.9 percent of the 15.3 percent) are not capped by income amount. Self-employment taxes are due on wages, though not on corporate dividends, but only if a "substantial" portion of the income of the organization in question is not derived from the personal services of the owner. This means an additional tax benefit, even at low income, for amounts derived from the real estate, but does not mean much if your income exceeds the maximum taxable amount--though even the 2.9 percent may be worth saving.
12. It is also possible to create payments not defined as self-employment income if they come as repayments of loans or other guaranteed payments. If you make a loan to the medical services organization based on, e.g., proceeds of individually obtained second mortgages on residential or other real estate you own, or on other capital you have, the returns on such capital would not be taxed as self-employment income.
13. One additional question: I'm assuming the medical office would not be your personal residence. Personal residences have capital gains exclusions not available to business property, and are probably not appropriately held in a business organization, since such use encourages I.R.S. challenges to any personal holding company. Retention of service income and operations and provision of a return on capital through a separate real estate investment or organization does not, even if the service business and the real estate business have common ownership, as they have different investment, liability, and operations characteristics.
14. I'll look forward to hearing from you. Let me know as soon as possible, so the organization documents can be drafted in time to get official filings done before closing.
Regards,
Bill Price
The NASD announces regulatory enforcement actions to curb annuity sales abuses
By Andrew J. Stoltmann, Maddox Koeller Hargett & Caruso, Chicago
I. Background
In the last eighteen months, the National Association of Securities Dealers ("NASD") has increased regulatory enforcement actions against member firms and registered representatives for variable annuity sales abuses. As part of their "continuing effort to address problem areas in the sale, distribution and marketing of variable products" the NASD announced on December 5, 2001, two new enforcement actions involving the sales of variable annuities and life insurance contracts by member firms and their representatives. These actions represent a continuing trend by the NASD to curb annuity sales abuses.
II. Recent NASD actions for annuity sales abuses
1. CUNA Brokerage Services, Inc. (Case No. C05010054)
The NASD announced they censured and fined CUNA Brokerage Services $100,000, of which $25,000 was assessed jointly and severally against the firm and Campbell D. McHugh, the firm's compliance officer. McHugh was also suspended for 45 days in any principal capacity.
The NASD found that the firm, through its compliance officer McHugh, failed to establish, maintain and enforce adequate written supervisory procedures relating to the sale of variable annuities and variable universal life insurance in the areas of suitability of recommendations, review of new business for suitability, training and supervision of principals, and the investigation and reporting of customer complaints. The firm also failed to maintain proper records detailing the rationale for the exchange of variable products. The NASD further found that the firm failed to demonstrate that reasonable efforts had been made to obtain certain customer information needed for suitability determinations.
2. Mutual Service Corporation (Case No. C05010053)
On December 5, 2001, the NASD also announced that Mutual Service Corporation was censured and fined $35,000 for various violations of the NASD Conduct Rules for the sale of variable annuities. According to the NASD, the firm failed to make reasonable efforts to obtain customer information for examining the suitability of the recommendations by failing to properly gather information on the customer's net worth, risk tolerance and information on products being exchanged such as surrender charges, and allocation of funds in sub-accounts. The NASD also alleged multiple supervisory violations by the firm in the sale of annuities including the manner in which home office principals were to review and approve the suitability of variable product sales and the manner in which the activity of variable product surrenders and product cancellations were to be monitored
3. NASD Notice to Members 00-44
The NASD released NASD Notice to Members 00-44 ("NTM 00-44" or "the Notice") in July of 2000. The purpose of the Notice was to provide "a set of guidelines to help members in developing supervisory procedures relating to the sales of variable life insurance." NTM 00-44 primarily focused on NASD Conduct Rule 3010 (requiring each member to establish and maintain systems to supervise the activities of each registered representative and associated person in order to achieve compliance with the securities laws, regulations, and NASD rules) and NASD Conduct Rule 2310 (which requires that a member, when recommending the purchase, sale, or exchange of any security to a customer, have reasonable grounds for believing that the recommendation is suitable for the customer.)
While NTM 00-44 warns that "variable life insurance may be appropriate for a customer with a need for life insurance and an ability to pay for permanent life insurance protection" a variable life insurance customer "should also be able to assume investment risk and understand the implications of adverse investment performance." NTM 00-44 reiterates the obligations firms have to enforce the supervision rules of the NASD with respect to variable annuities. The Notice focuses on three primary areas for supervision:
Customer information: NTM 00-44 reminds members that when their registered representative recommends a variable life insurance policy, the firm needs to "make reasonable efforts to obtain comprehensive customer information, such as the customer's age, annual income, net worth, liquid net worth, number of dependents, investment objective, sources of funds for investment, investment experience, existing investments and life insurance, time horizon, and risk tolerance."