Sale of securities versus sale of business

Is the sale of a controlling interest in a corporation necessarily a sale of securities governed by the Securities Regulation Code (SRC)?

The question appears simple as the sale invariably involves sale of shares, which are included in the definition of the term “securities” under the SRC.

The question has not yet been decided in the Philippines, but it is not unlikely that it will crop up one of these days considering the number of corporate mergers and acquisitions now happening in our midst.

Why is the question important?

If the transaction is a sale of security, it is governed by the SRC. As such, it is governed by anti-fraud provisions (e.g., liability for making materially false or misleading statements under Section 26) which, in turn, exposes the guilty party to liability for actual damages—triple the amount of the transaction to the aggrieved party.

Also, here in the Philippines, there may be tax implications. According to my tax partner, Eric Recalde, the Bureau of Internal Revenue may challenge the valuation of the shares if goodwill can be imputed in a sale of business situation and there may be donor’s tax implications.

Investor vs entrepreneur

The issue has actually cropped several years ago in the United States where our securities laws were patterned, at least in the context of securities regulation.

In resolving the issue, some circuit courts have adopted the sale of business doctrine. The courts ruled that purchasers who acquire controlling or one hundred percent of a corporation’s stock with intent to manage or direct the management of the business have not purchased a “security” under the federal securities laws.

The courts ruled that the transaction is a sale of business and not a sale of securities. They emphasized the importance of distinguishing between an investor and entrepreneur.

An investor entrusts his money to others expecting to profit from their efforts, but an entrepreneur seeks to profit primarily from his own efforts. These courts ruled that the securities laws were envisioned to protect investors and not entrepreneurs.

Courts espousing the sale of business doctrine favor an economic realities test, which examines the transaction to determine whether it is an investment or a sale of the underlying business. According to these courts, if the economic substance of the transaction is that the purchaser bought and the seller sold a business, then the transaction is not a sale of security although structured as a stock transaction.

Ordinary stock as security

Some of these courts went further by maintaining that Congress enacted the securities laws to protect investors in public markets who are not in a position to inspect the business prior to the purchase of the shares. According to this school of thought, the securities laws were not intended to protect persons who can demand material information from the seller prior to the purchase of the shares.

On the other hand, there are circuits that reject the dichotomy between investors and entrepreneurs. These courts adopt a literal approach on the issue, stating that ordinary stock is a security because “stock” is a term specifically listed in the statutory definition of a security.

This line of thinking also maintains that a purchaser of a business is also an investor in a corporation. As such, he deserves the protection of the securities laws regardless of whether he purchased the stock of the corporation for the purpose of personally managing or operating the business. Hence, a person who makes materially false or misleading statements or representations in connection with the stock purchase is liable under the securities laws.

While the conflicts among the circuits appear to have been resolved to a certain extent by the US Supreme Court in Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985), the fact remains the decision was rendered in the context of the purchasers not having the intention of running the business they purchased.

At any rate, US Supreme Court decisions have only persuasive effect in the Philippines and the resolution of the issue will ultimately depend on how our Supreme Court will interpret the SRC.

Let’s wait and see how our Supreme Court will resolve the issue if and when it is brought up for its consideration.

(The author is a professor of Securities Regulation Code in the Ateneo Law School and a senior partner in ACCRALAW. The views in this column are exclusively his. He may be contacted at: [email protected])