Physician Networks and IPAs: Are you Selling Securities?

If you are considering forming a network or independent practice association ("IPA") and issuing stock or limited partnership interests to network or IPA participants, you must consider whether the stock or limited partnership interest is a security.

What is a Security?

Federal securities laws include stock and investment contracts within the definition of the term "security," "unless the context otherwise requires." The U.S. Supreme Court has stated that the fact that an instrument takes the form of stock does not alone make it a security. The Supreme Court delineated the following five characteristics usually associated with securities:

  • The right to receive dividends contingent upon an apportionment of profits
  • Negotiability
  • The ability to be pledged or hypothecated
  • The conferring of voting rights in proportion to the number of shares owned
  • The capacity to appreciate in value

Even if the traditional attributes of corporate stock are absent, an instrument denominated as "stock" may be an "investment contract" and, thus, a security. The most notable element of an investment contract is the expectation of a profit based solely on the efforts of others.

In response to ongoing inquiries as to whether an enforcement action would be recommended for failure to register stock or to qualify for an exemption under the federal securities laws, the U.S. Securities and Exchange Commission (the "SEC") has identified factors supporting the argument that a particular stock is not a security, including the following:

  • Each person is entitled to purchase only one share;
  • No dividends may be paid;
  • The stock is not transferable (other than to the issuing corporation), and may not be pledged or otherwise hypothecated;
  • There is no potential for capital appreciation (e.g., the stock may be redeemed at only the original purchase price);
  • There is no expectation of profit from the efforts of others;
  • The sole benefit the investor physician expects to receive is an enhancement in his ability to earn income in the practice of his profession;
  • Compensation is based on criteria related to the productivity of the investor physician;
  • The stock cannot be promoted on the basis that there will be a substantial return if the entity is sold to a third party. If that is what ultimately happens, the substantial return arguably not cause the stock to be classified as a security, provided the substantial return was not the expectation of shareholders when they joined the network or IPA;
  • Upon dissolution, the sums available for distribution to the shareholders must be distributed based on criteria unrelated to share holdings.

Compliance with Laws

If the stock is a security, the network or IPA must comply with federal and state securities laws. Securities must be issued pursuant to an exemption from registration or issued pursuant to a registration statement. The registration process is very costly and time consuming. The cost generally ranges from $60,000 to $200,000 or more. Audited financial statements are required. It takes at least 60 days to prepare a registration statement, 30 days for the SEC, state regulators and others to respond with comments, and up to 30 more days to respond to comments and (assuming there are no additional comments) to be declared effective. The process takes, at a minimum, about 120 days and can take six months or more.

The most commonly used exemption from federal securities registration is Regulation D. Offers and sales may be made to no more than 35 persons who are not "accredited investors" and to an unlimited number of accredited investors. Generally, an accredited investor is someone with a net worth of $1 million or more, or who had income of $200,000 or more ($300,000 with that person's spouse) during the last 2 years and has a reasonable expectation of earning such income in the current year.

If offers are made to any person who is not accredited, all offerees must receive a private placement memorandum, which is a detailed disclosure document similar to a prospectus. Even if a private placement memorandum is not required under Regulation D, it is still advisable to prepare one. This is because the issuer is still liable for misrepresentations and omissions of material fact, and a private placement memorandum is the best evidence of disclosures made.

Not-for-Profit Corporations

On a final note, not-for-profit corporations, by statute, have some of the features identified in SEC no-action letters. Payment of dividends and distribution of income to members is prohibited. However, compensation may be paid to members, directors and officers for services rendered. Upon dissolution, the assets must be distributed in accordance with the articles of incorporation or bylaws, with any remaining assets to be distributed as specified in the plan of distribution of assets (which, in the case of an IPA or network, should provide for distribution based on criteria unrelated to shareholdings). While not required to avoid the issuance of securities, the use of a not-for-profit corporation supports the argument, if challenged, that what is issued is not a security.

As noted above, if the stock or partnership interest sold is not a security, then there are no securities registration or disclosure requirements. Accordingly, it may be desirable to structure transactions whereby stock or limited partnership interests to be sold by a network or IPA do not constitute securities.