July 2008
Authors: Edward B. Stevenson, Irwin A. Kishner
Second Circuit Clarifies Test for Analyzing LLC Interests as Securities
On June 11, 2008, in U.S. v. Leonard, the Second Circuit Court of Appeals adopted a position already held by other circuits in determining that a "totality of circumstances" test should prevail over a literal reading of a limited liability company's organizational documents in determining the status of a limited liability company (LLC) interest as a "security."
Section 3(a)(10) of the Securities and Exchange Act of 1934, as amended (the "Exchange Act"), defines the term "security" to mean "any note, stock, treasury stock, security future…investment contract…or in general, any instrument commonly known as a 'security.'" LLC membership interests are not a specifically enumerated category in this definition. Rather, LLC membership interests typically resist categorical classification due to the sheer diversity of LLCs and their corresponding ownership structures. Generally, LLC interests are analyzed under the catch-all Exchange Act category of "investment contract."
In order for an instrument to be deemed an "investment contract," the courts require that there be a transaction or scheme whereby a person invests his or her money in a common enterprise and is led to expect profits solely from the efforts of the promoter of such enterprise or a third party. In Leonard, the Court employed a "totality of circumstances" test in deciding whether the LLC interests at issue were passive investment instruments, and therefore, a form of an investment contract. The Court concluded that, notwithstanding the language in the company's organizational documents regarding active participation by the LLC's investors, there could be no reasonable expectation of investor control in connection with the LLC interests. The Court thus found the LLC interests at issue to be securities.
In its decision, the Court held that the determination of whether an LLC interest is a security requires "case-by-case analysis" of the "economic realities" of the transaction underlying the transfer of such interest. This language is instructive as to the process the Second Circuit will follow in the future in conducting securities law analyses of LLC interests.
Restrictive Employee Stock Purchase Plan Blessed by NJ Supreme Court
In Rosen et al. v. Smith Barney Inc. et al, the New Jersey Supreme Court ruled that a voluntary employee incentive compensation plan, which required participants to forfeit any unvested funds if they resign or are terminated prior to the expiration of a two-year vesting period, did not violate New Jersey's Wage and Hour Law.
Smith Barney offered its capital accumulation plan to its employees on a voluntary basis upon employment with the company. Through the plan, Smith Barney used a percentage of participating employees' pre-tax compensation to purchase Citigroup Inc. stock (Smith Barney's parent company) at a price 25% below market. Pursuant to the plan, the stock ownership fully vested only after a period of two years. Participants who quit or were terminated prior to the end of the two-year vesting period would forfeit all unvested shares. The plaintiffs in Rosen resigned from Smith Barney within the two-year vesting period and forfeited all unvested shares under the plan. They subsequently filed a complaint, alleging that the plan violated the Wage and Hour Law because it required the forfeiture of earned wages.
The trial court's ruling granted the plaintiffs summary judgment, but a divided Appellate Division reversed it. The Appellate Division found that because the plan was voluntary in nature, all plan terms—including the forfeiture provisions—were fully and unambiguously disclosed to participants prior to enrollment and the plan provided immediate beneficial tax treatment and stock ownership benefits, it neither violated the Wage and Hour statute nor the underlying public policy. The Supreme Court affirmed the Appellate Division's decision.
This case highlights some of the complex issues surrounding employee incentive compensation plans, including proper plan structuring and unambiguous disclosure of plan details to participants.
SEC Issues New Guidance on Form 8-K and Forms 4 and 5
The SEC's Division of Corporate Finance (the "Division") has published guidance that clarifies reporting requirements regarding Form 8-K and Forms 4 and 5.
The SEC clarified disclosure requirements for section 5.02(b) of Form 8-K regarding resignations of directors. Generally, Form 8-K requires a company to disclose a director's resignation within four business days, even if the resignation is tendered as a result of compliance with a reporting company's internal governance policies. The new interpretations clarify that the Form 8-K filing requirement is triggered only upon the board's acceptance of a director's resignation, not merely when the resignation is tendered in compliance with the company's internal governance policies.
The SEC also published a no-action letter, on June 25, 2008, reversing its previous interpretation requiring same-day trades listed on a Form 4 or 5 at different prices to be reported on separate lines. The SEC's no-action letter recommends against taking action against a reporting person who, through a trade order executed by a broker-dealer, effects multiple same-way open market purchase or sale transactions on the same day at different prices, so long as the reporting person satisfies certain enumerated reporting requirements.
Proposed Reform of Credit Rating Agencies Regulation
The SEC voted to formally propose a series of credit rating agency reforms to increase transparency, accountability and competition in the credit rating agency industry.
The proposed rules would, among other things, limit a credit rating agency from issuing a rating of a structured financial product unless the rating agency has detailed information on the underlying asset pool. The SEC also proposed rules to bolster the independence of a credit rating agency from the financial products it is rating, including prohibiting the amount of gifts a rating agency or its employees may receive from the entities they are reviewing, and also prohibiting anyone who participates in determining a credit rating from negotiating the fee that the issuer pays for such rating.
The SEC also proposed a host of public disclosure requirements and a set of rules to inform investors of the role that credit rating agencies play, and the inherent risks in a structured financial products review.
For more information on these issues or other corporate matters, please contact:
Irwin Kishner at 212.592.1435 or ikishner@herrick.com
Edward Stevenson at 973.274.2025 or estevenson@herrick.com
Copyright © 2008 Herrick, Feinstein LLP. Corporate Alert is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.
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