Andrews v. Browne

Present: All the Justices

JOHN EDWARD ANDREWS

v. Record No. 071079 OPINION BY JUSTICE DONALD W. LEMONS
June 6, 2008
MICHAEL S. BROWNE, ET AL.

FROM THE CIRCUIT COURT OF PRINCE WILLIAM COUNTY
Leroy F. Millette, Jr., Judge

In this appeal, we consider whether a transaction in

which 100% of the stock of a closely held corporation was

transferred to a group of three purchasers is regulated by the

Virginia Securities Act, Code § 13.1-501 et seq.

I. Facts and Proceedings Below

Before August 31, 2004, Michael Browne ("Browne") and

James Stein ("J. Stein") were the sole shareholders of the

Manassas Health Club, Inc. ("MHCI"). MHCI operated a health

club facility in Prince William County. John Edward Andrews

("Andrews"), a patron of MHCI, expressed an interest in buying

MHCI from Browne and J. Stein. Browne and J. Stein provided

Andrews with a document entitled "Manassas Income & Expense

Report" ("the Report"), containing financial information

regarding the operations of MHCI. The Report was prepared by

Tina Stein ("T. Stein"), J. Stein's wife, who was responsible

for MHCI’s bookkeeping.

Relying on the information in the Report, Andrews,

Christopher Pownall (an MHCI employee), and Richard Pownall
(collectively "the Purchasers") decided to purchase MHCI.

They entered into a "Stock Purchase Agreement" ("SPA") with

Browne and J. Stein (collectively "the Sellers") under which

they agreed to pay $500,000 in exchange for all 2,000 shares

of MHCI stock. The Purchasers also agreed to "assume all

liabilities and obligations of the Corporation, including, but

not limited to, leases, build out, and any outstanding bonds

and payroll that was incurred by the Corporation prior to the

date of closing, in the ordinary course of business," and to

"indemnify Sellers against all liabilities and obligations

related to the Corporation or this transaction except as

described [in the SPA]." The sale price was to be paid by

transferring $200,000 cash to the Sellers at closing and a

$300,000 note (the "Note") to the Sellers payable over 60

months. The SPA did not specify how the 2,000 shares were to

be divided by the Purchasers. The “stock certificates,

documents, and monies” were to be “held in escrow by Lawrence

E. Fischer, Attorney at Law[,] until conditions precedent to

closing [were] fully satisfied and all the terms and

conditions of the Note [had] been fulfilled in his sole

discretion.”

Under the SPA, the Purchasers retained the exclusive

right to vote the stock as long as there were no breaches of

the SPA. The Purchasers agreed not to "sell, transfer, assign

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for whatever reason, gift or transfer with or without

consideration any shares of their stock in the Corporation to

another individual or entity until such time as the aforesaid

Note is satisfied in full, without first obtaining the written

consent of the Sellers."

The Sellers and Purchasers entered into the transaction

on August 31, 2004. After the transaction closed, Browne, J.

Stein, and T. Stein gave Andrews a computer disc containing

the income history of MHCI. The defendants told Andrews the

disc was “too damaged to be accessed.” Andrews was able to

access the disc, which contained different information than

what was in the Report provided to him before the closing.

In March 2005, Andrews, with the consent of the Sellers,

bought Christopher Pownall’s and Richard Pownall’s interest in

the MHCI stock. Andrews was then the sole shareholder of

MHCI.

On February 2, 2007, Andrews filed a second amended

complaint against the defendants, alleging that the Report

prepared by T. Stein and provided to Andrews by Browne and J.

Stein contained materially false information. Specifically,

Andrews alleged that the Report deliberately understated the

expenses and overstated the income of MHCI. Andrews also

alleged that the defendants made various untrue statements of

fact prior to the purchase regarding the number of members

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MHCI had, MHCI's assets and debts, and whether MHCI's tax

returns had been filed and its taxes paid when due. Andrews

alleged that if he had known these facts prior to the purchase

of the MHCI stock, it would have "significantly impacted [his]

deliberations on whether or not to purchase the corporation."

Andrews sought judgment against Browne and J. Stein under Code

§ 13.1-522 for making untrue statements of material fact and

omitting material facts in furtherance of the sale of a

security. Andrews also sought judgment against all three

defendants for actual fraud and common law civil conspiracy,

and against Browne and J. Stein for breach of contract.

The defendants moved for partial summary judgment

concerning count one of Andrews' complaint in part on the

grounds that Code § 13.1-522, a provision of the Virginia

Securities Act, “is not intended to protect active purchasers

of a business.” After a hearing on defendants' motion for

summary judgment, the trial court held that “the terms of the

contract show [that the transaction was] a sale of business,

and . . . that the Virginia Securities Act is not intended to

protect the transaction herein under the facts and

circumstances of this case.” The trial court entered an order

on March 16, 2007, granting partial summary judgment and

dismissing count one of Andrews' complaint. Andrews nonsuited

his remaining claims pursuant to Code § 8.01-380. Andrews

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appeals the trial court's March 16, 2007 order granting

partial summary judgment on four assignments of error:

1. The Court erred in its conclusion that the securities
sold in this transaction did not have the traditional
characteristics of stock.

2. The Court erred in determining that the “sale of
business” doctrine was applicable to this stock transaction.

3. The Court erred by failing to apply the plain
language of the Virginia Securities Act.

4. The Court erred by ignoring material facts in dispute
and applied the incorrect standard for granting Summary
Judgment.

II. Analysis

Whether the MHCI stock transferred in this case is a

“security” within the meaning of the Virginia Securities Act

is a mixed question of law and fact, which we review de novo.

University of Va. Health Servs. Found. v. Morris, 275 Va. 319,

332, 657 S.E.2d 512, 518 (2008).

A. Similarity to Federal Securities Acts

The Virginia Securities Act defines “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
certification of subscription; transferable
share; investment contract; voting-trust
certificate; certificate of deposit for a
security; oil, gas or other mineral lease,
right or royalty, or any interest therein; or,
in general, any interest or instrument commonly

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 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. . . .

Code § 13.1-501. This definition of “security” derives almost

verbatim from the definition of “security” in the federal

Securities Act of 1933 (“1933 Act”). George D. Gibson, The

Virginia Corporation Law of 1956, 42 Va. L. Rev. 445, 483

(1956). The definition of “security” in the federal

Securities Act of 1933, 15 U.S.C. § 77b(a)(1) (2000 & Supp. V

2005), is “virtually identical” to the definition of

“security” in the federal Securities Exchange Act of 1934

(“1934 Act”), 15 U.S.C. § 78c(a)(10) (2000 & Supp. V 2005),

and is treated as such for purposes of determining the scope

of the term “security.” Landreth Timber Co. v. Landreth, 471

U.S. 681, 686 n.1 (1985).

The Virginia Securities Act, the 1933 Act, and the 1934

Act, are all intended to protect investors from fraud in the

investment market. See Gurley v. Documation, Inc., 674 F.2d

253, 259 (4th Cir. 1982) (“Virginia’s blue sky law shares with

§ 10(b) of the 1934 Act the central purpose of protecting

investors from fraud in the securities markets.”). “The

primary purpose of the Acts of 1933 and 1934 was to eliminate

serious abuses in a largely unregulated securities market.”

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United Housing Found., Inc. v. Forman, 421 U.S. 837, 849

(1975). Similarly,

[t]he object and purpose of [Virginia blue sky
laws is] to suppress an existing and growing
evil in this State. The investment market was
flooded with stocks of little or no value and
promoters and stock salesmen, well versed in
trade talk, preyed upon an unwary public by
inducing it to purchase this character of
stock.

Virginia Brewing Co. v. Webber, 167 Va. 67, 71-72, 187 S.E.

447, 449 (1936)) (interpreting the Securities Act of 1928,

which was replaced by the current Virginia Securities Act in

1956). The Virginia Securities Act, the 1933 Act, and the

1934 Act “achieve their ends in similar ways: the disclosure

of material information concerning issuers of stock and the

regulation of sellers of securities.” Pollok v. Commonwealth,

217 Va. 411, 413, 229 S.E.2d 858, 860 (1976). In light of

these parallels, we have previously held that the Virginia

Securities Act should receive “similar construction” as the

1933 and 1934 Acts. Id. When engaged in interpretation of a

term used in the Virginia Securities Act, it is appropriate to

look to the federal courts’ interpretation of the same term in

the context of the 1933 and 1934 Acts. See Tanner v. State

Corp. Comm’n, 266 Va. 170, 172, 580 S.E.2d 850, 852 (2003).

We have not previously addressed the use of the word

“stock” as part of the definition of “security” in Code

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§ 13.1-501. We will therefore look to federal interpretation

of the word “stock” as part of the definition of “security” in

the 1933 and 1934 Acts.

B. Federal “Economic Reality” Test

Both the federal Acts and the Virginia Securities Act

define “security” to include, “unless the context otherwise

requires,” “any . . . stock.” Code § 13.1-501, 15 U.S.C.

§ 77b(a)(1), 15 U.S.C. § 78c(a)(10). In interpreting the term

“security” in the 1933 and 1934 Acts, the United States

Supreme Court has repeatedly stated that “form should be

disregarded for substance and the emphasis should be on

economic reality.” Tcherepnin v. Knight, 389 U.S. 332, 336

(1967); see also Securities & Exch. Comm’n v. W.J. Howey Co.,

328 U.S. 293, 298 (1946).

In the context of “stock,” the United States Supreme

Court has rejected the suggestion that a transaction is

regulated by the 1933 and 1934 Acts simply because the

transaction is evidenced by the sale of an instrument called

“stock.” Forman, 421 U.S. at 848. Noting that “[t]he focus

of the Acts is on the capital market of the enterprise system:

the sale of securities to raise capital for profit-making

purposes, the exchanges on which securities are traded, and

the need for regulation to prevent fraud and to protect the

interest of investors,” the Court held that an instrument may

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be “stock,” and therefore “within the letter of the [1933 and

1934 Acts,] yet not within the [Acts] because not within

[their] spirit, nor within the intention of [their] makers.”

Id. at 849. The Court further noted in Landreth that where an

instrument called “stock” is exchanged, there “is no need

. . . to look beyond the characteristics of the instrument to

determine whether the Acts apply.” 471 U.S. at 690.

Rather than apply a “plain language” approach to the 1933

and 1934 Acts, the United States Supreme Court applies an

“economic reality test.” In Forman, the Court identified five

common features of traditional stock: (1) the right to receive

dividends contingent upon an apportionment of profits; (2)

negotiability; (3) ability to be pledged or hypothecated; (4)

conferring of voting rights in proportion to the number of

shares owned; and (5) ability to appreciate in value. 421

U.S. at 851. The Court reasoned that in some instances, the

use of the traditional name “stock” was likely to “lead a

purchaser justifiably to assume that the federal securities

laws apply.” Id. at 850. This is most likely when the

instrument exchanged in the underlying transaction possessed

some of the five common features of traditional stock. Id. at

851. The touchstone of the analysis is “the presence of an

investment in a common venture premised on a reasonable

expectation of profits to be derived from the entrepreneurial

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or managerial efforts of others.” Id. at 852. Under this

test, if “the investor is ‘attracted [to a purchase] solely by

the prospects of a return’ on his investment,” the underlying

“stock” is more likely to be a security; the 1933 and 1934 Act

would then apply. Id. (quoting Howey, 328 U.S. at 300). “By

contrast, when a purchaser is motivated by a desire to use or

consume the item purchased . . . the securities laws do not

apply.” Id. at 852-53.

C. “Sale of Business” Doctrine

Following the Supreme Court’s decision in Forman, some

federal courts applied the Court’s reasoning from Forman to

exclude from coverage under the 1933 and 1934 Acts

transactions in which 100% of the stock of a business was

sold. See, e.g., Chandler v. KEW, Inc., 691 F.2d 443, 444

(10th Cir. 1977) (holding that the federal securities law did

not apply because the economic reality of the transaction was

that the purchaser was receiving 100% of the stock of the

company); Bula v. Mansfield, [1979 Transfer Binder] Fed. Sec.

L. Rep. (CCH) ¶ 96,964 (D. Colo. May 13, 1977) (holding that

the sale of “stock” does not transform the purchase of a

business into a security transaction). These courts declined

to apply the 1933 and 1934 Acts when a purchaser sought to

acquire a business in its entirety. In such cases, the

“stock” that was exchanged in the transaction was considered

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to be only a method of vesting ownership of the business, and

was “passed incidentally as an indici[um] of ownership of the

business assets.” Frederiksen v. Poloway, 637 F.2d 1147,

1151-52 (7th Cir. 1981). This application of the “economic

reality test” was ultimately referred to as the “sale of

business” doctrine, providing that

under certain circumstances, the transfer of
100 percent of the stock of a corporation
incident to the sale of an ongoing business to
a purchaser who will manage or direct the
management of the business does not constitute
the sale of a security within the meaning of
the federal securities laws.

Irving P. Seldin, When Stock is Not a Security: The “Sale of

Business” Doctrine Under the Federal Securities Laws, 37 Bus.

Law. 637, 637-38 (1982).

The United States Supreme Court rejected the “sale of

business” doctrine in Landreth and its companion case, Gould

v. Ruefenacht, 471 U.S. 701 (1985). The Court reaffirmed its

holding from Forman that “the fact that instruments bear the

label ‘stock’ is not of itself sufficient to invoke the

coverage of the Acts.” Landreth, 471 U.S. at 686. However,

if an instrument is called “stock” and bears the usual

characteristics of “stock” as identified in Forman, a

purchaser would be justified in assuming that federal

securities law applies. Id. Therefore,

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 where an instrument bears the label “stock” and
possesses all the characteristics typically
associated with stock, a court will not be
required to look beyond the character of the
instrument to the economic substance of the
transaction to determine whether the stock is a
“security” within the meaning of the [1933 and
1934] Acts.

Gould, 471 U.S. at 704 (citation omitted).

Although the “sale of business” doctrine is no longer

applicable under the federal Acts, there continues to be a

split of authority among the states as to whether the doctrine

should apply to individual state Securities Acts that define

“security” to include “any . . . stock,” as the Virginia

Securities Act does. Some of the state courts that have

followed Landreth have done so because they adopt the

reasoning of the United States Supreme Court in that case.

See Fong v. Oh, 172 P.3d 499, 508-09 (Haw. 2007); Banton v.

Hackney, 557 So.2d 807, 824 (Ala. 1989); Cohen v. William

Goldberg & Co., Inc., 423 S.E.2d 231, 232-33 (Ga. 1992). Some

courts have done so without explicitly agreeing with the

Supreme Court’s reasoning, but because the language of the

1933 and 1934 Acts is substantially similar to the wording of

the particular state securities statute. Barnes v. Sunderman,

453 N.W.2d 793, 796 (N.D. 1990); Carver v. Blanford, 342

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S.E.2d 406, 407 (S.C. 1986). * These courts apply the “stock

characterization test” from Landreth.

Some state courts that have not followed Landreth have

done so because they have reasoned that their state

legislatures have intended the state securities statutes to

cover sales in the securities market, not commercial

transactions when a closely held corporation is sold. See

White v. Solomon, 732 P.2d 1389, 1391 (N.M. Ct. App. 1986);

Doherty v. Kahn, 682 N.E.2d 163, 169-70 (Ill. App. Ct. 1997);

Anderson v. Heck, 554 So.2d 695, 700 (La. Ct. App. 1989).

These states continue to apply the principle the United States

Supreme Court applied in Forman, that “form should be

disregarded for substance and the emphasis should be on

economic reality.” People v. Figueroa, 715 P.2d 680, 694 n.26

(Cal. 1986) (quoting Tcherepnin, 389 U.S. at 336). As such,

these states apply the “sale of business” doctrine so that

state securities laws do not apply to transactions in which

100% of the stock of a closely held corporation is

transferred.

*
One state supreme court has followed Landreth while
explicitly disagreeing with the decision. In following
Landreth, that court noted that “we are required to coordinate
our interpretation of state securities laws with its federal
equivalent” under a provision of the state securities statute.
Kovatovich v. Barnett, 406 N.W.2d 516, 518 (Minn. 1987).

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 Like many of the states that have either chosen to follow

Landreth or not to follow it, our state securities statute

defines “security” to include, “unless the context otherwise

requires,” “any . . . stock.” Code § 13.1-501. There are

sound policy reasons for following Landreth and rejecting the

“sale of business” doctrine. As noted above, the definition

of “security” in the Virginia Securities Act derives from the

definition of “security” in the 1933 and 1934 Acts. Gibson,

42 Va. L. Rev. at 483. The Virginia Securities Act and the

federal Acts “achieve their ends in similar ways.” Pollok,

217 Va. at 413, 229 S.E.2d at 860. We have previously held

that the Virginia Securities Act should receive “similar

construction” as the federal Acts. Id. It is therefore

appropriate for the word “stock” as a part of the definition

of “security” in the Virginia Securities Act to be interpreted

in the same manner as the 1933 and 1934 Acts.

As the United States Supreme Court noted in Landreth, the

definition of “security” in the federal Acts is “quite broad.”

471 U.S. at 686. “The face of the definition shows that

‘stock’ is considered to be a ‘security’ within the meaning of

the Acts.” Id. Though bearing the label “stock” alone is not

sufficient to invoke the coverage of the securities laws, the

label does make it more likely that an investor purchasing

“stock” would believe he was covered by the securities laws.

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Id. at 686-87. 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. In such a case, the Virginia

Securities Act should apply, regardless of whether control of

a business is changing hands.

Additionally, application of the “sale of business”

doctrine invites many practical difficulties in determining

whether a transaction is regulated by the Virginia Securities

Act. The doctrine presumably applies whenever “control” of a

business is sold. Whether “control” has passed to the

purchaser is often difficult to determine.

Control . . . may not be determined simply by
ascertaining what percentage of the company’s
stock has been purchased. To be sure, in many
cases, acquisition of more than 50% of the
voting stock of a corporation effects a
transfer of operational control. In other
cases, however, even the ownership of more than
50% may not result in effective control. In
still other cases, de facto operational control
may be obtained by the acquisition of less than
50%. These seemingly inconsistent results stem
from the fact that actual control may also
depend on such variables as voting rights, veto
rights, or requirements for a super-majority
vote on issues pertinent to company management,
such as may be required by state law or by the
company’s certificate of incorporation or its
bylaws.

Gould, 471 U.S. at 705. Whether “control” has passed to the

purchaser may not be determinable until a court has made a

15
factual determination, which may follow “extensive discovery

and litigation.” Id. The parties may therefore not know at

the time of the transaction whether the transaction is

regulated by the Virginia Securities Act.

The determination of whether “control” has passed to a

purchaser may also invite absurd results. For example,

a corporation’s stock could be determined to be
a security . . . as to some purchasers but not
others. Likewise, if the same purchaser bought
small amounts of stock through several
different transactions, it is possible that the
Acts would apply as to some of the transactions
but not as to the one that gave him “control.”

Id. at 705-06. These potential results are inconsistent with

the purpose of the Virginia Securities Act, to “protect[]

investors from fraud in the securities markets.” Gurley, 674

F.2d at 259; see also Virginia Brewing Co., 167 Va. at 71-72.

For the foregoing reasons, we hold that the “sale of

business” doctrine does not apply in Virginia. We therefore

apply the Landreth “stock characterization” test to the

transaction at issue in this case.

D. Application of the “Stock Characterization” Test

If an instrument “bears the label ‘stock’ and possesses

all of the characteristics typically associated with stock,”

it is a “security” within the meaning of the Virginia

Securities Act. Gould, 471 U.S. at 704. As stated above, the

characteristics typically associated with stock are: (1) the

16
right to receive dividends contingent upon an apportionment of

profits; (2) negotiability; (3) ability to be pledged or

hypothecated; (4) conferring of voting rights in proportion to

the number of shares owned; and (5) ability to appreciate in

value. Forman, 421 U.S. at 851.

The trial court erred in holding that the MHCI stock “did

not have the indicia of traditional stock.” First, there is

no dispute that Andrews had a right to receive dividends

contingent upon an apportionment of profits. As the owner of

the shares of MHCI “stock,” Andrews was entitled to receive

dividends payable on that stock if any were ever paid.

Second, the MHCI “stock” is negotiable. Although the

Purchasers agreed not to sell, transfer, assign, or gift their

shares without the Sellers’ permission until the Note was

satisfied, this was a limitation on the parties by agreement,

not a limitation on the instruments themselves. As previously

noted, Andrews purchased Pownall’s shares of stock in MHCI.

For the same reason, the MHCI “stock” has the ability to be

pledged or hypothecated. The parties’ agreement to hold the

instruments in escrow until the Note was satisfied does not

change the characteristics of the instruments.

Similarly, the MHCI “stock” conferred voting rights on

the Purchasers. The parties placed a limitation in the SPA on

the Purchasers’ right to vote, such that the Purchasers did

17
not retain the exclusive right to vote the shares if they

breached the SPA. Again, this is a limitation on the parties

by the agreement, not a limitation on the instruments.

Finally, it is not disputed that the MHCI “stock” had the

ability to appreciate in the future if the value of the

business increased. Because the MHCI “stock” has all the

characteristics of traditional stock as outlined in Forman and

bears the label “stock,” we hold that it is a “security”

within the meaning of Code § 13.1-501. Therefore, the

Virginia Securities Act applies to the sale of the MHCI stock

in this case.

III. Conclusion

For the reasons stated, the judgment of the trial court

will be reversed and the case remanded for further proceedings.

Reversed and remanded.

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