Fast track at last for LLCs and LPs in Illinois
By Robert J. Willson, Jr., Corporate Paralegal, Baker & McKenzie
Practitioners engaged in representing limited liability companies and limited partnerships in Illinois will welcome two recently adopted amendments the Illinois Limited Liability Company Act, as amended (the "LLC Act") and the Revised Uniform Limited Partnership Act of 1986, as amended of the state of Illinois ("RULPA"). On June 10, 1999, the Illinois Senate passed Senate Bill 0564 which, among other things, further amends the LLC Act and RULPA to extend the availability of expedited filing services to limited liability companies and limited partnerships. Sources at the Illinois Secretary of State's Office have confirmed that expedited services for LLCs and LPs should be offered beginning January 1, 2000.
For a nominal additional fee, certain services offered by the Department of Business Services of the Illinois Secretary of State's Office would be rendered on the same day or within 24 hours. For example, Articles of Organization for a newly formed Illinois LLC would be filed within 24 hours after submission in person to the Springfield office (or through a service company) upon payment of an additional expedite fee of $50. Without expedited service, LLC filings generally take anywhere from three to six weeks.
Although expedited requests for good standing or status certificates may be fulfilled at the Secretary of State's Chicago or Springfield offices, expedited requests for other filings must be presented physically in person (or through a service company) to the Secretary of State's Springfield office.
Another important development with respect to LLCs is contained in Senate Bill 0565 passed by the Illinois Senate on June 3, 1999. This bill adopts certain technical amendments and clarifications to the LLC Act. Among the amendments is the elimination of the often cumbersome requirement that an LLC provide its Federal Taxpayer Identification Number on all documents filed.
As of this writing, both bills await the governor's signature.
James J. Moylan, chair of the Corporation, Securities and Business Law Section Council was one of the participants at the ISBA Chicago Access Cable television presentation held in April on security laws. The program was part of the monthly series, "Illinois Law: Legal News You Can Use."
Also, Illinois Secretary of State Jesse White met with several members of the Corporation, Securities and Business Law Section Council recently to pledge continued cooperation in development of business-related legislation. Members included Charles W. Murdock, Alan Jay Goldstein, James J. Moylan and William A. Price.
By Professor Charles W. Murdock, Loyola University Chicago School of Law
The Illinois Securities Act defines a security 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, investment fund share, face-amount certificate, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas or other mineral lease, right or royalty, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, 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, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.1
One of the decisions dealing with the definition of a security under the Illinois Securities Act, Sire Plan Portfolios, Inc. v. Carpenter,2 recognized that the definition of a security in the federal Securities Act of 19333 is almost identical to the Illinois Securities Act definition. For that reason, Illinois courts have frequently looked to federal courts for guidance in interpreting this and other sections of the Illinois Securities Act.
In the Sire Plan Portfolios case, the Illinois court analyzed whether fractional undivided interests in income producing property located in New York could be considered an investment contract within the meaning of the Illinois Securities Act. In so doing, the court relied heavily upon the decision of the United States Supreme Court in SEC v. Howey,4 which also dealt with the sale of real estate as constituting a security. In Howey, the Court set forth the now well recognized definition of an investment contract as a scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or third party.
This is sometimes referred to as the "economic realities" or "passive investor" test. Unfortunately, in the period beginning in the mid 1970s, both state and federal courts began applying the Howey test -- which was the test as to whether an investment contract existed -- to shares of stock in a closely held corporation. While the concept of an investment contract is an amorphous one, covering a variety of nontraditional investments, almost everyone knows what a share of stock is. And shares of stock are explicitly enumerated in the definition as a security.
Why then did the courts tamper with what is a straightforward concept and introduce the possibility of confusion. Paradoxically it was to seek to bring equity to what was a confusing area -- namely, when do shares of stock need to be registered or a report of sale filed with the state securities commissioner? An example will illustrate.
The first Illinois case to hold that shares of stock in a closely held corporation were not securities was Condux v. Neldon.5 In this case, the defendant had owned all the stock of Blue Island Gun Shop, Inc., which he sold to plaintiffs who took over the business and then operated it for 2-1/2 years. They then sued to rescind the sale, claiming that the securities sold were not registered.
The basis for defendants' contentions went back to the Brown v. Gillian decisions.6 In Brown, defendant and plaintiff were 50% shareholders and plaintiff bought defendant's shares. Defendant was a controlling shareholder because he owned more than 25% of the shares and no other shareholder owed more shares.7 Since he was a controlling person, he did not have the 4 A exemption from registration8 and, since he did not file the 4 G report, he did not have the 4 G exemption.9 Plaintiff obtained rescission and defendant sued his attorney for malpractice in not filing the report. Defendant again lost because the attorney met the standard then prevailing -- which was ignorance of the securities laws.
Back to the Condux case: Justice Simon did not like the idea of plaintiffs welshing on the deal after 2-1/2 years and resolved the matter by holding that the sale of all the stock in a corporation to one or a limited number of buyers is not the sale of a security. In so doing, he followed a then recent United States Supreme Court decision, United Housing Foundation v. Forman,10 which had held that shares in a housing cooperative were not securities but rather a recoverable deposit on an apartment and had applied the Howey "economic realities" test. However, Forman, like Howey, dealt with a nontraditional security, which had none of the characteristics normally associated with a share of stock.
In opting for a bit of judicial legislation by holding that traditional stock in a closely held corporation was not a security, Justice Simon was not alone. Other jurisdictions around this time were taking a similar tack. See Coffin v. Tricole11 and Frederickson v. Poloway,12 a Seventh Circuit case. Thus, it is not surprising that other Illinois Appellate Court decisions followed the lead of Justice Simon and held that the rule of stock in a closely held corporation did not involve the sale of a security.13 However, because of the split that had developed in the federal courts on this issue, the U.S. Supreme Court, in Landreth Timber Co. v. Landreth,14 granted certiorari and repudiated the "economic reality test," holding that shares in a closely held corporation are quintessentially a security.
Landreth, like Condux, involved the sale of stock in a business. To the argument that the Howey economic reality test should apply, the Court responded that the Howey test "was designed to determine whether a particular instrument is an 'investment contract,' not whether it fits within any of the examples listed in the statutory definition of 'security.'"15 Moreover, Howey, Forman, and other cases employing this test:
. . . involved unusual instruments not easily characterized as "securities" . . . In the case at bar, in contrast, the instrument involved is traditional stock, plainly within the statutory definition. There is no need here, as there was in the prior cases, to look beyond the characteristics of the instrument to determine whether the Acts apply.16
Thus, after Landreth, there is no basis for courts to attempt to delve into the economics of the transaction to determine whether that which is quintessentially a security is within the securities laws. However, the effect of the Landreth decision has not been fully recognized by Illinois courts, probably because counsel have not been diligent in bringing this development to the Illinois courts. None of the Illinois cases17 applying the economic reality test subsequent to Landreth cited Landreth, let alone recognized that Landreth had repudiated this test in determining whether stock in a closely held corporation was a security. On the other hand, the appellate court, in Discher v. Fulgoni,18 held that voting trust certificates in a closely held corporation were securities because specifically identified in the definition of a security in the Illinois Securities Act. The court stated:
The economic substance, or economic reality, test has been limited, however, in Landreth Timber Co. v. Landreth, where the U.S. Supreme Court stated that such a test is applicable only if the instrument involved is "unusual" and cannot be "easily characterized as a security, and did not fall within the statutory definition.19
Thus, should the Landreth decision be brought to the attention of Illinois courts in the future, it is likely that Illinois will also repudiate the economic reality test as applied to shares of stock and recognize that stock, in either a closely held or publicly held corporation is quintessentially a security and that "a corporate stock transaction -- the archetype of a sale of securities" cannot be edited out of the statutory definition of a security.20
Even if the precedential effect of Landreth were not available, the notion that stock in a closely held corporation is not a security should be rejected for three reasons:
(1) The statutory traps which led courts to reject strict application of the Illinois securities laws and apply equitable considerations have been legislatively corrected;
(2) The structure of the Act clearly reflects that stock in a closely held corporation is a security; and
(3) The "economic realities" actually dictate that stock in a closely held corporation is a security.
One reason that courts "reached" to hold closely held stock is not a security is because of the traps that lurked for innocent sellers under the Act. The Brown v. Gitlin litigation, discussed above,21 is a prime example. When one 50% shareholder sold to the other 50% shareholder, the seller would not expect to need to file a report with the secretary of state in order to validate the sale. While a sale to one or two persons could be exempt under section 4 G of the Illinois Act, filing a report was necessary to perfect the exemption and the Brown court allowed rescission when no report was filed.
However, in Condux v. Neldon, which dealt with a sale of stock by defendant to two plaintiffs who sought to rescind after 2-1/2 years because no filing was made, Justice Simon refused to interpret the Illinois securities law as "a sword with which the merely unskillful or unlucky businessman may oppress his predecessors."22 Unfortunately, Judge Simon was guilty of overkill. If plaintiffs had waited 2-1/2 years to see how their investment had turned out before filling suit to rescind, the case could better have been determined on a waiver or estoppel theory. Plaintiffs should not be able to sit on their rights and transfer the risk of their failure to run the business successfully to defendant.
Today the "trap" that so disturbed Justice Simon has been legislatively repaired. Section 4 G now explicitly provides that the failure to file the 4 G report "shall not affect the availability of such exemption." In addition, the legislature has added another exemption, 4 O, which provides that, if there are fewer than five purchasers who, after the sale, own 50% or more of the company, such sale is exempt from Illinois registration.23 Thus, a small group of buyers who purchase a controlling interest in a closely held corporation no longer have a technical right to rescind if reports are not filed or the securities not registered with the Illinois securities commissioner. The Illinois securities law no longer is a trap for the unwary.
The structure of the Act itself demonstrates that a sale of a controlling interest of stock -- the classic business sale situation -- clearly involves a sale of securities. Section 4 O, designed to provide an exemption so that an innocent seller would not be subject to a technical rescission action, by its terms demonstrates that a sale of stock in a business is a sale of a security. What section 4 O exempts is securities. Securities are what each subsection deals with. And section 4 O deals with a sale in which five or fewer persons end up owning 50% or more of the equity interest in the corporation, assuming the entity is incorporated. But this is the typical situation in which Illinois courts like Condux and Doherty had held that a security was not involved. In fixing the situation that had concerned Justice Simon, the legislature also made clear that the sale of a controlling interest in a corporation to a small number of purchasers was the sale of a security, but that such sale was a transaction exempt from registration but not from the anti-fraud provisions.
Finally, the courts that applied the economic realities test did not understand economic reality. When someone buys stock in a closely held corporation, they are buying an intangible -- not dead assets. The stock represents a right to a stream of income in the future. The economic realities test assumed that the buyer of a controlling interest would be responsible for the stream of income in the future. What was not appreciated is that the price that was paid for the stock was predicated in large part on the stream of income that the business had generated in the past. What the buyer is buying is the continuation of that stream of income, hopefully enhanced by the buyers future efforts.
There are two prototypical pieces of litigation that can arise under the Illinois Securities Act. One deals with rescission for failure to register; the other deals with anti-fraud. The impetus for Illinois courts adopting the economic reality test was to preclude an innocent seller being victimized by a harsh and technical application of the registration provisions. But this problem has been mooted by legislation.
But there still remains the problem of the innocent buyer being victimized by a seller's misrepresentations in connection with the sale of stock. The Trecoli case is a good example. Plaintiff paid $30,000 for a 50% interest in the corporation and became its vice-president. According to the economic realities test, plaintiff was an active investor and thus could not sue under the securities laws because there would be no security under the economic realities test. But the reason that plaintiff purchased the stock was the misrepresentations of defendant. It was not until after the sale that plaintiff obtained access to company's books and accounts of operations and found that the company was insolvent. This is the type of situation at which the anti-fraud provisions of the securities laws are aimed.
In effect, the stream of income prior to sale is a predictor of future streams of income. This is an intangible about which full disclosure needs to be made. If misrepresentations are made about the status of the business at the time of sale, the calculus by which the buyer determines how much he will pay is flawed. A buyer to whom misrepresentations are made is entitled to rescission, not because of failure to comply with a technical registration requirement, but because the misrepresentation undercuts the basic ethic of the securities laws -- full and honest disclosure.
_______________
1 815 ILCS 5/2.1.
2 132 N.E.2d 78, 78 (1956).
3 15 U.S.C.A. §77(b)(1). The federal act omits "investment fund share" and face-amount certificate and, with respect to oil and gas interests, refers to "rights" rather "lease, right or royalty," as does the Illinois Act.
4 328 U.S. 293 (1946).
5 83 Ill.App.3d 575 (1980).
6 283 N.E.2d 115 (1982) and 313 N.E.2d 180 (1974).
7 815 ILCS 5/2.4.
8 815 ILCS 5/4A (transactions not involving an issuer, underwriter, dealer or controlling person).
9 815 ILCS 5/4G (sales to less than 25 purchasers--now 35).
10 421 U.S. 837, 849 (1975).
11 470 F.Supp. 7 (E.D.Va. 1977), rev'd 596 F.2d 1202 (4th Cir. 1979).
12 637 F.2d 1147 (7th Cir. 1981).
13 See Kaiser v. Olson, 435 N.E.2d 113 (1981) and Torres v. Divia, 494 N.E.2d 1227 (1956).
14 471 U.S. 683 (1985).
15 Id. at 691.
16 Id.
17 Torres v. Divia, 494 N.E.2d 1227 (1986); Boatmen's Bank of Benton v. Durham, 561 N.E.2d 206 (1990) (which actually left the issue open); Doherty v. Kahn, 682 N.E.2d 163 (1997).
18 514 N.E.2d 767 (1987).
19 514 N.E.2d at 772 (citations omitted).
20 Brit Corp. v. R.V. Acquisition Corp., 1987 WL 11359 (N.D. Ill. 1987).
21 See supra note 6.
22 404 N.E.2d at 531.
23 815 ILCS 5/40.
Confidentiality agreements for a corporate acquisition
By Thomas N. Jersild, Mayer Brown & Platt, Chicago
[Note: An agreement of this kind might be used by a potential seller (or its agent) when providing financial and other proprietary information to a prospective buyer. Agreement A below can be used or adapted when the potential seller is dealing directly with prospective buyers; Agreement B could be appropriate where the seller is dealing with an agent or broker.]
AGREEMENT A
[Editor's note: The ^ denotes insertion point for person or entity name, or date.]
^[Letterhead of ^ABC Inc.]
^, 19^
^XYZ Inc.
^
Attention: ^
Gentlemen:
You have stated to us that you have a serious interest in acquiring the stock or substantially all of the assets of our subsidiary ^ Inc. In order to facilitate discussions relating to such a possible acquisition, we are furnishing you with certain information (the "Information") which includes but is not limited to financial and other proprietary data. All of the Information is confidential.
In consideration of our furnishing the Information to you, you agree to keep confidential all of the Information and all other information you may obtain from us or from any subsidiary, parent or affiliate of us in the course of your investigation, except only for information which (i) at the time of disclosure to you is generally available to the public, (ii) was available to you on a non-confidential basis prior to its disclosure to you in connection with the present investigation, or (iii) becomes lawfully available to you on a non-confidential basis from a third party provided that such third party is not in breach of an obligation of confidentiality to us or any affiliate of us.
You agree (i) to take all precautions necessary to safeguard the Information from disclosure to anyone other than employees, officers, directors and agents (including counsel and financial advisors) of your company who are directly engaged in the evaluation or negotiation of the possible acquisition described above and who, in addition, otherwise normally have access to information of such nature under your established internal confidentiality procedures, (ii) not to use the Information for any purpose other than to assist you in your evaluation of the possible acquisition described above, and (iii) not to disclose to any person the fact that we or any affiliate of us is soliciting potential purchasers.
You further agree that if you decide not to undertake the proposed acquisition you will promptly return to us all of the Information that is in documentary or other tangible form, including all copies thereof.
You also agree that you will not disclose to any third party the existence or substance of any present or future negotiations relating to the possible acquisition contemplated hereby without our permission, except for disclosures required by law, government agencies or departments, securities regulations or financial reporting requirements, and that in any such event you shall first consult with us as to the timing and content of any such disclosure.
Please confirm your agreement with all of the foregoing by signing the enclosed copy of this letter in the space provided below and returning the copy to us.
Very truly yours,
^ABC Inc.
By:
Agreed to and accepted as of the
^ day of ^, 19^.
^XYZ Inc.
By:
AGREEMENT B
^[Letterhead of ^ABC Inc.]
^, 19^
^
Attention: ^
Re: Confidentiality
Gentlemen:
We propose to retain you to provide us with confidential advice relating to the possible sale of the stock or substantially all of the assets of ^ Inc. (the "Company"). In connection with such retention we and our accountants,