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Avenue Capital Management II, L.P. v. Schaden

Court of Appeals for the Tenth Circuit
843 F.3d 876 (2016)
ELI5:

Rule of Law:

An investment in a limited liability company (LLC) does not constitute an 'investment contract' under federal securities law when the investors collectively acquire sufficient ownership and contractual power to control the company's profitability, regardless of whether they intend to exercise that control.


Facts:

  • From 2007 to 2011, Quiznos experienced a sharp business decline, losing roughly 3,000 franchise restaurants and seeing its profitability plummet.
  • Due to its financial condition, Quiznos could no longer satisfy its loan covenants, putting it at risk of foreclosure.
  • To avoid this, Quiznos underwent a debt restructuring transaction with multiple investment funds, including Avenue and Fortress.
  • Through the transaction, Avenue acquired approximately 70% and Fortress acquired approximately 10% of the shares in a new manager-managed LLC that would operate Quiznos.
  • The LLC agreement empowered Avenue and Fortress, with their collective 80% stake, to amend the LLC agreement as they wished.
  • The agreement also gave Avenue the power to appoint seven of the nine managers on the board and Fortress the power to appoint one manager.
  • Avenue and Fortress also possessed the authority to remove the managers they had appointed without cause.
  • The agreement granted the funds the right to receive regular audited and unaudited financial statements and to inspect Quiznos's records.

Procedural Posture:

  • Avenue and Fortress sued former Quiznos managers and officers in the U.S. District Court for the District of Colorado, alleging securities fraud under § 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5.
  • In the district court, Avenue and Fortress argued their interests in Quiznos constituted 'investment contracts.'
  • The district court granted the defendants' motion to dismiss the securities fraud claims, ruling that the interests were not investment contracts because Avenue and Fortress had acquired control over Quiznos.
  • Avenue and Fortress, as appellants, appealed the district court's dismissal to the U.S. Court of Appeals for the Tenth Circuit.

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Issue:

Does an investment in a manager-managed limited liability company (LLC), where the investors collectively acquire an 80% ownership stake and the power to appoint and remove a majority of the managers, constitute an 'investment contract' under the Securities Exchange Act of 1934?


Opinions:

Majority - Bacharach, Circuit Judge.

No. The interests acquired by Avenue and Fortress do not constitute investment contracts because the investors retained ultimate control over the profitability of their investment. An interest is an 'investment contract' under the Howey test only when profits are expected to come 'solely from the efforts of others.' Here, Avenue and Fortress were not passive investors dependent on others. First, their collective 80% ownership gave them the power to freely amend the LLC agreement, allowing them to change the management structure or dissolve the company. Second, they had the power to appoint and remove eight of the nine managers, giving them direct supervisory authority over those running the day-to-day operations. Third, as sophisticated investors with contractual rights to detailed financial information, they could intelligently exercise their control. The court applies an objective test for control; the investors' subjective intent not to exercise their power is irrelevant. Because they possessed the objective power to control Quiznos's profitability, their interests were not investment contracts.



Analysis:

This decision refines the application of the 'investment contract' test from SEC v. W.J. Howey Co. in the context of sophisticated investors acquiring interests in an LLC. The court emphasizes that the objective power to control a venture, through contractual rights like appointing managers and amending governing documents, prevents an interest from being classified as a security. This holding serves as a caution to sophisticated investment funds that acquire controlling stakes in companies; they cannot later seek protection under federal securities fraud laws by claiming to be passive investors. The ruling solidifies the principle that actual, exercisable control, rather than the investor's intent or day-to-day involvement, is the determinative factor.

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