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Tenth Circuit Affirms Dismissal Of Securities Fraud Claims Against Quiznos
12/19/2016On December 13, 2016, the United States Court of Appeals for the Tenth Circuit affirmed the dismissal of a securities fraud action against the manager-managed limited liability company and individual managers and officers of fast-food chain Quiznos. Avenue Capital Management II, L.P., et al. v. Schaden et al., No. 15-1389, 2016 WL 7210052 (10th Cir. Dec. 13, 2016). Plaintiffs, a pair of private equity firms, alleged Quiznos executives violated Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Securities and Exchange Commission Rule 10b-5 by fraudulently misrepresenting to plaintiffs the financial condition of Quiznos in a 2012 restructuring deal in which plaintiffs obtained an 80% equity interest in the company. The Tenth Circuit affirmed that because plaintiffs collectively controlled the profitability of their investments, the underlying equity purchase did not constitute an “investment contract” and was thus not subject to the Exchange Act.
Plaintiffs entered into a restructuring deal with Quiznos after the company could no longer satisfy its loan commitments due to a profitability plunge between 2007 and 2011, when Quiznos lost roughly 3,000 franchise restaurants. Plaintiffs, who were creditors of the fast-food chain, could have foreclosed on their collateral, but opted instead to restructure Quiznos’ debt. As part of the restructuring, plaintiffs invested $150 million into Quiznos, reduced Quiznos’ debt, became members of the manager-managed limited liability company (“LLC”) that operated Quiznos, and acquired 80% of the LLC’s shares. Plaintiffs brought their action against Quiznos’ former executives when the value of their shares plummeted after Quiznos filed for bankruptcy shortly after the restructuring deal.
The Tenth Circuit upheld the ruling of the United States District Court for the District of Colorado, finding that plaintiffs’ control of the LLC meant that their expected profits did not “come solely from the efforts of others” as required to constitute an “investment contract” under the Exchange Act. Plaintiffs had argued that they “did not intend to exercise control because they continued to expect the board and the officers to operate Quiznos.” The Court, however, citing the Fourth and Ninth Circuits, held that “the test of control is an objective one,” and focused on “the measure of control that [plaintiffs] could exercise over Quiznos, not the control that they intended to exercise.” In upholding the lower court’s determination that plaintiffs did not enter into an investment contract with Quiznos, the Court emphasized the following three factors as establishing plaintiffs’ control over Quiznos’ profitability: (i) their ability to amend the LLC agreement; (ii) their option to select eight of the nine managers of the LLC; and (iii) plaintiffs’ backgrounds as sophisticated and informed investors who, pursuant to the LLC, could receive audited and unaudited financial statements and designate non-voting members to attend board meetings. The Tenth Circuit also rejected plaintiffs’ arguments that, even if it did not constitute an investment contract, the purchased equity constituted “stock” or “securities” and was thus nevertheless subject to the Exchange Act. The Court held that plaintiffs had waived these arguments by failing to raise them in the lower court, and declined to consider them at the Court’s own discretion because they presented several issues of first impression.
The decision serves as a warning to sophisticated investors who obtain control positions over a company wherein those investors arguably could be deemed to have control over the company’s profitability. In addition, the decision serves as an important reminder to raise potential arguments before the trial court in order to avoid having those arguments waived on appeal.
