No Way, Amending an Agreement Can Violate State Securities Laws?

In drafting contract amendments, some lawyers may neglect to consider whether the amendment is subject to the California Corporate Securities Law (CSL). However, there is no such thing as benign neglect of the CSL. Failure to take the CSL into account can result in rescission of the amendment, an award of damages, and even civil or criminal penalties. Thus, lawyers who undertake to draft a contract amendment should consider whether the amendment runs afoul of the CSL.

The CSL makes it unlawful for anyone to offer or sell a security in this state unless the sale has either been qualified with the Commissioner of Corporations or the security or transaction is exempt. Qualification involves a determination by the Commissioner of whether a proposed offer and sale of a security is fair, just and equitable. Another key feature of the CSL is its anti-fraud provisions. These apply even when the security or transaction is exempt from qualification.

Lawyers are most likely to think of the CSL when a security is first offered for the direct or indirect benefit of the issuer of that security (i.e., the corporation, limited partnership, note issuer or limited liability company). However, the CSL's qualification requirement is not limited to the initial offer and sale of securities. In fact, Corporations Code Section 25017(a) defines "sale" to include any change in the rights, preferences, privileges, or restrictions of or on outstanding securities. In other words, an issuer can "sell" a change to a security even after it has sold that security. This principle is reinforced by Corporations Code Section 25120(a)(2), which declares in no uncertain terms that it is unlawful to offer or sell a security in this state in an issuer transaction in connection with any change in the rights, preferences, privileges, of or on outstanding securities, unless that offer or sale is qualified or exempt.

The CSL applies to offers and sales of more than just shares of stock in a corporation. Under the CSL, the term "security" includes a variety of different contractual arrangements, including interests in limited partnerships, evidences of indebtedness and, in most cases, interests in limited liability companies. Because the terms of these securities are established by contract, a change to the contract constitutes a sale of a security even though the issuer is not raising additional capital or issuing additional securities.

For example, the amendment of a limited partnership agreement to impose, change or delete restrictions on transfer of partnership interests is unlawful unless that change is qualified or exempt from qualification. Similarly, an amendment changing the interest rate on an outstanding note may be subject to qualification.

Although the CSL's approach is to treat most changes to outstanding securities as sales subject to qualification, most changes are not qualified with the Commissioner. The reason is that in many, but not all cases, an exemption from qualification is available. Thus, having thrown nearly every contract amendment affecting a debt or equity security into the "sale" basket, the CSL pulls most of these changes from the qualification basket.

For many issuers, a key source of exemptions is Corporations Code Section 25100, which lists a variety of
different securities that are exempt, regardless of the type of transaction, from qualification under the CSL. This list includes, among others, any security listed or approved for listing on the New York Stock Exchange or NASDAQ Global or Capital Markets. In addition to exempt securities, the CSL includes a number of different transactional exemptions. Moreover, some of these transactional exemptions apply specifically to changes in outstanding securities. For example, Corporations Code Section 25103(e) exempts any change (other than a stock split or reverse stock split) in the rights, preferences, privileges, or restrictions of or on outstanding equity securities unless the change is one of 13 changes listed in the statute and the change materially and adversely affects any class of equity security. Thus, an amendment to a limited partnership agreement to impose, change or delete restrictions on transfer is not exempt if that change materially and adversely affects any class of equity security (i.e., not simply the class of security that is amended).

In the case of outstanding debt securities, Corporations Code Section 25103(g) similarly exempts any change in the rights of outstanding debt securities unless that change substantially and adversely affects any class of securities and is one of eight changes listed in the statute. For example, a change in the maturity date of outstanding debentures would not be exempt if that change substantially and adversely affects any class of securities.

A common misconception is that the CSL's qualification requirement applies only to issuers that are organized under California law. However, the application of CSL depends not on where the issuer was organized but on where the offer or sale is made. Thus, the fact that a limited liability company was organized in Delaware is irrelevant.

The good news is that the CSL includes a special jurisdictional exemption in the case of changes to outstanding securities. Under Corporations Code Section 25103(b), a change is exempt unless the holders of at least 25 percent of the outstanding shares or units of any class of securities that will be directly or indirectly affected substantially and adversely by that change have addresses in California according the issuer's records. When applying this exemption, it is important to take into account the effect of Corporations Code Section 25103(d) which provides, among other things, that any securities controlled by any one person who controls directly or indirectly 50 percent or more of the outstanding class are not to be considered outstanding.

If the foregoing exemptions are not available, counsel should not despair. The CSL and the Commissioner's rules include numerous other exemptions that may be available. Therefore, it is usually worthwhile to continue the hunt for an exemption.

Finally, it must be remembered that even when a security or change to a security is exempt from qualification, the CSL's anti-fraud rules still apply. Thus, materials soliciting an amendment, such as a "Dear Partner" letter, can result in liability for securities fraud when those materials contain an untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.

The CSL may be the last thing on the mind of some lawyers when they undertake to draft an amendment to a
note, limited partnership agreement or operating agreement. It should, however, be one of the first things on
their minds because neglecting the CSL can lead to some very unpleasant surprises.
In most cases, counsel may find that a review of the CSL and the Commissioner's rules reveals an available
exemption from qualification. The trick is to find the exemption before some disaffected security holder comes
knocking with a securities claim in hand.
Keith Paul Bishop is a partner in the Irvine office of Allen Matkins Leck Gamble Mallory & Natsis and adjunct
professor at Chapman University School of Law. He previously served as California's Commissioner of
Corporations.