Lifemark Corp.
Nov 17, 1981

SEC-REPLY-1:

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

August 17, 1981

RESPONSE OF THE OFFICE OF CHIEF COUNSEL

DIVISION OF CORPORATION FINANCE

Re: Lifemark Corporation

Incoming letters dated August 10, 1981

You inquire whether a contractual provision in an Acquisition Agreement which involves cah payments that are contingent upon future net revenues of an acquired business (the "earn out right") constitutes a security as defined by Section 2(1) of the 1933 Act. While the question presented is not free from doubt, this Division will not recommend any enforcement action to the Commission if the Lifemark acquisition takes place as described without registration of the earn out right under the 1933 Act. In arriving at this position, we have particularly noted: (1) the earn out right is granted to the sellers as part of the consideration for the sale of their business and neither the purchasers nor the sellers view the right as involving an "investment" by the sellers; and (2) the earn out right represents no ownership interest in the purchaser, it cannot be transferred (except by operation of law), and does not entitle the owner to voting or dividend rights nor does it bear stated interest.

Because this position is based upon the representations made to the Division in your letter, it should be noted that any different facts or conditions might require a different conclusion. Further, this response expresses only the Division's position on enforcement action and does not purport to express any legal conclusion on the question presented.

With respect to your request that your letters and the staff's response thereto be accorded confidential treatment pursuant to 17 CFR 200.81, we have determined that confidential treatment would be appropriate. Consequently, your letters and our response will not be made available for public inspection until the earlier of (i) 90 days following the customary date of public availability, or (ii) the date the Acquisition Agreement is executed. In this regard, we note that you will advise the staff of the date of execution of the Acquisition Agreement. You should understand, however, that notwithstanding the staff's decision to grant confidential treatment to this correspondence, confidentiality cannot be maintained if the correspondence becomes subject to a request for information under the Freedom of Information Act, 5 U.S.C. § 552, unless an exemption under that Act is available.

Sincerely,

Michael R. Kargula

Attorney Adviser

INQUIRY-1:

FULBRIGHT & JAWORSKI

1150 CONNECTICUT AVENUE, N.W.

WASHINGTON, D.C. 20036

TELEPHONE (202) 452-6800

August 10, 1981

Peter Romeo, Esq.

Chief Counsel

Division of Corporation Finance

Securities and Exchange Commission

Washington, D.C. 20549

Re: Request for Confidential Treatment of No-Action

Request Letter of Lifemark Corporation dated

August 10, 1981 and Commission Staff Response

Thereto

Dear Mr. Romeo:

I. Request for Confidential Treatment

On behalf of our client, Lifemark Corporation, we hereby respectfully request that (i) the enclosed no-action request letter of Lifemark Corporation dated August 10, 1981; (ii) any Commission staff response thereto; and (iii) this letter (collectively, the "Documents") be treated as nonpublic and confidential matters pursuant to the provisions of Commission regulation 17 C.F.R. § 200.81, "Publication of Interpretative and No-Action Letters and Other Written Communications" and the Freedom of Information Act, 5 U.S.C. § 552, and applicable Commission regulations,and that these Documents and any information contained therein not be published or made available to any person, until the earlier of (i) 90 days after the expiration of 30 days after the Commission's response to the forestated no-action letter has been sent to Lifemark Corporation; or (ii) the date the Acquisition Agreement discussed in the enclosed no-action request letter is executed. In this regard, Lifemark Corporation undertakes to advise the Commission staff of the date of execution of the Acquisition Agreement as soon as is reasonably possible.

Pursuant to 17 C.F.R. § 200.81(b) and the Freedom of Information Act, 5 U.S.C. § 552, and applicable Commission regulations, we request that the Commission staff advise us if it determines to deny this request for confidential treatment and, further, we request, on behalf of Lifemark Corporation, the opportunity to submit additional material substantiating this claim, should the Commission staff not be satisfied with the information herein submitted.

II. Basis for Request for Confidential Treatment

We request that the forestated Documents be treated as nonpublic and confidential matters for the requested period of time forthe reason that the proposed acquisition and proposed Acquisition Agreement discussed in the Documents constitute confidential and non-public business information. Moreover, the Documents contain confidential commercial and financial information within the meaning of 17 C.F.R. § 200.80(b)(4), disclosure of which would cause substantial harm to the competitive position of Lifemark Corporation.

If you have any questions or wish to discuss this matter, please call Alan B. Levenson (452-6839), Jean W. Gleason (452-6840), or Arthur H. Rogers (713-651-5421) for the firm.

Sincerely,

Fulbright & Jaworski

INQUIRY-2:

FULBRIGHT & JAWORSKI

1150 CONNECTICUT AVENUE, N.W.

WASHINGTON, D.C. 20036

TELEPHONE (202) 452-6800

August 10, 1981

Securities Act of 1933

Section 2(1)

Peter Romeo, Esq.

Chief Counsel

Division of Corporation Finance

Securities and Exchange Commission

Washington, D.C. 20549

Re: Lifemark Corporation

Dear Mr. Romeo:

I. Request

We request that the staff concur with our opinion that the contractual earn out or deferred payment right described in this letter is not a security for purposes of the federal securities laws and that the staff state that it would not recommend any enforcement action to the Commission if the acquisition described below takes place without registration under the Securities Act of 1933.

II. Facts

Lifemark Corporation, a Delaware corporation ("Lifemark"), is primarily in the business of owning and operating general acute care hospitals. Lifemark also offers a broad range of management services to the hospital industry, including total facility management and the management of specific ancillary service departments such as pharmacy, cardiopulmonary and physical therapy.

Lifemark's common stock and three classes of its debentures are traded on the New York Stock Exchange. For the 12 months ended June 30, 1981, it had revenues and net income of $ 250,238,000 and $ 16,147,000, respectively, and had total assets at June 30, 1981 of $ 309,771,000.

In the last two years, Lifemark has been very active in the public market, having had three equity offerings, two debenture offerings and a unit offering of equity and debentures. The purpose of these offerings was to raise capital for Lifemark's active construction and development and acquisition programs. Lifemark is committed to expanding its operations throughacquisitions. It now has pending a significant acquisition containing an earn out or deferred payment right in addition to the one discussed below. Lifemark is also actively pursuing other potential acquisitions and anticipates that an earn out or deferred payment right could be proposed in the future.

In the specific acquisition to which this letter relates, Lifemark proposes to acquire a 360-bed general acute care hospital owned by a general partnership made up of approximately 100 partners, all of whom are doctors practicing at the hospital. The acquisition would include a professional building currently under construction and approximately 48 acres of property adjacent to the hospital. In the year ended December 31, 1980, the hospital had revenues and net income (before taxes) of $ 42,278,602 and $ 7,024,944, respectively, and total assets at December 31, 1980 of $ 35,580,588.

Lifemark has entered into a nonbinding letter of intent to purchase the hospital for (1) $ 73,000,000 in cash (net of long term debt), (ii) the assumption of approximately $ 4,000,000 in current liabilities and (iii) the right of the sellers to receive four percent of net revenues of the hospitalfor 12 years. The obligations under the earn out or deferred payment right are contingent based solely on revenues of the hospital as they accrue. Payments under the earn out which have accrued will be secured until they are paid by a security interest in the hospital's accounts receivable. Among other things, the letter of intent provides that the definitive agreement will require that partners responsible for 70% of the hospital's admissions will agree not to compete with the hospital for 12 years and that the hospital's current board of directors will retain jurisdiction over all medical staff matters after the acquisition.

The earn out or deferred payment right was proposed by Lifemark during negotiations; the partnership had originally proposed cash only. Lifemark proposed the earn out or deferred payment right in this transaction and in previous ones both to defer a portion of the cost of acquisition and to encourage the continued interest and participation of the partners.

III. Opinion and Bases of Opinion

In our opinion, the contractual earn out right described is not a security under the federal securities laws. It does not come within the language or the intentof the statutes, nor does it come within the concept of a "security" when viewed in terms of economic reality and common sense. The instrument in question is the contractual right to receive in cash a percentage of net revenues over a period of twelve years. The earn out right is granted in the context of a business acquisition of a closely held business and is payable to the sellers as part of the consideration.

A. Language of the Statutes and Legislative History

The definition of a security under the Securities Act is set forth in section 2(1) of the Act n1 The section provides that "unless the context otherwise requires," a security is:

[A]ny note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trustcertificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, or, in general, any interest or instrument commonly known as a "security," or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

Congress stated that the Act defines "the term security in sufficiently broad and general terms so as to include within that definition the many types of instruments that in our commercial world fall within the ordinary concept of a security." n2 The Congressional debates demonstrate that the legislators assumed that the ordinary concept of a security connoted some form of investment. The intent of the Act was seen as "regulat[ing] the sale of investment securities to the innocent public." n3

Earn out rights are thus notspecifically identified in the definition of a "security," nor is there any indication in the legislative history that they were specifically intended to be covered. However, the breadth of the term "security" requires that one look beyond the terms of the statute.

B. Scope of Relevant Terms in Statutory Definition of "Security"

There are several general terms in the definition of a security that might be read to include an earn out right: an investment contract, an evidence of indebtedness, or an interest in a profit-sharing agreement. The earn out right is not an investment contract because under the circumstances here, it does not come within the court developed definition of that term. In addition, the earn out right is not a security in the nature of an evidence of indebtedness or an interest in a profit-sharing agreement because under the circumstances here, the economic realities and common sense require that the earn out right not be viewed as a security.

1. The Earn Out Right Is Not an Investment Contract

The Supreme Court defined an investment contract in SEC v. W.J. Howey Co., stating that an investment contract is a "scheme [which] involves an investmentof money in a common enterprise with profits to come solely from the efforts of others." n4 The three-part Howey test continues to be the first step in any analysis of whether a particular financial interest constitutes an investment contract. n5

a. Investment of money in a common enterprise

The earn out right in this case does not involve the investment of money by those receiving the earn out right; rather it is received as part - and not the primary part -of the purchase price for a business operated in the form of a general partnership. The sellers of the hospital are in effect trying to take their investment out of the hospital, not make an investment in it.

Although there is considerationgiven - i.e., the business as a whole, the Daniel case suggests that this type of consideration is not what Howey meant by an "investment of money." In the Daniel case, the Supreme Court held that an employee's participation interest in a compulsory non-contributory pension plan does not constitute a security. In analyzing whether the employee's interest was an investment contract, the Court found that no investment of money occurs in a non-contributory plan and rejected the argument that an employee's contribution is his labor:

Only in the most abstract sense may it be said that an employee exchanges some portion of his labor in return for these possible benefits. He surrenders his labor as a whole, and in return receives a compensation package that is substantially devoid of aspects resembling a security. His decision to accept and retain covered employment may have only an attenuated relation, if any, to perceived investment possibilities of a future pension. Looking at the economic realities, it seems clear that an employee is selling his labor primarily to obtain a livelihood, not making an investment (at 560).

The Court stated that "[i]n every decision of this court recognizing the presence of a 'security' under the Securities Acts, the person found to have been an investor chose to give up a specific consideration in return for a separable financial interest with the characteristics of a security" (at 559).

In this case, the earn out right is an integral part of the purchase price for a business. It is not anticipated that it will represent a substantial percentage of the entire purchase price, the bulk of which will be the cash payment and the assumption of current liabilities. It is not possible to sort out which assets are being bought for the earn out right and which for the rest of the price. The sellers of the business are clearly interested primarily in selling their business as a whole, not in making an investment.

b. Expectation of profits from the efforts of others

Although there is a right to receive a percentage of revenues in this case, that is not, in our view, the type of profit contemplated by the definition of investment contract involved in the earn out rights. In the Forman case, the Supreme Court held that profits mean "either capital appreciation resulting from the development of the initial investment...or a participation in earnings resulting from the use of investors' funds..." (at 852).

In addition, the Supreme Court has indicated that the possibility for "profit" from the financial instrument must be a significant aspect of the overall "investment." In Daniel, the Court stated:

When viewed in light of the total compensation package an employee must receive in order to be eligible for pension benefits, it becomes clear that the possibility of participating in a plan's assets earnings "is far too speculative and insubstantial to bring the entire transaction within the Securities Acts." Forman, 421 U.S. at 856 (at 562).

The "profits" are a part of the purchase price for the assets, and they come primarily from the efforts of the holders of the earn out rights rather than from "use of" their "funds" that they have "invested."

The Howey test requires that the profit "come solely from the efforts of others", although Daniel suggests that "primarily from the efforts of others" may be a more pertinent test. In the case of a proprietary hospital such as Palmetto, the revenues come primarily from the activities of the doctors who use the hospital -- not only from thecare of the patients who the doctors bring to the hospital, but from the various departments of the hospital such as the pharmacy, the x-ray department and laboratory, use of which require the authorization of the doctors.

In the case of the Palmetto hospital, Lifemark is purchasing the hospital from a group of doctors who use the hospital now. In fact, their general partnership was responsible for the building of the hospital to satisfy their professional needs by affording them the ability to practice medicine and provide health care in an environment they could control and in a manner consistent with their professional ethics and responsibilities. It is these same doctors who will receive the earn out right--the right to receive a percentage of the net revenues (before expenses) of the hospital for the next 12 years. Although the doctors are not required to continue using the hospital, those responsible for 70% of the admissions in the first part of 1981 will be required to agree not to take a proprietary stake in a competing hospital during the period of the earn out. Obviously, in addition, if the doctors with the earn out rights do not make any efforts, they will receive little in the way of a percentage of revenues because they are primarily responsible for the revenues. They are not expected to be passive participants. n6 In fact, so long as the earn out remains in effect, the doctors will control the board of the hospital which has significant influence over medical and staff matters at the hospital. The efforts that Lifemark will commit to the enterprise are to run the hospital as efficiently as possible. Although the business side of the hospital will have an impact on the revenues in that a badly run hospital will not attract doctors or patients, revenues depend ultimately on the professional competence of the doctors who use the hospital. This right should be distinguished from an interest in net profits where the efforts of Lifemark would be of much greater significance to the doctors.

2. The Earn Out Right Is Not an Evidence of Indebtedness or an Interest in a Profit-Sharing Agreement

It could be argued that theearn out right is an evidence of indebtedness in that it represents Lifemark's contractual obligation to pay four percent of revenues over a period of twelve years to the sellers of the Palmetto. However, we believe that the context of the issuance of the earn out right requires that it not be considered to be a security. The same is true with regard to whether the earn out right represents an interest in a profit-sharing agreement.

In rejecting the literal approach to statutory construction, the Court has stated that it adheres to the basic principle:

[I]n searching for the meaning and scope of the word "security" in the Act[s], form should be disregarded for substance and the emphasis should be on economic reality (Forman at 848, quoting 389 U.S. at 336).

Further, the Court noted in this regard:

[I] construing these [federal securities] Acts against the background of their purpose, we are guided by a traditional canon of statutory construction: "A thing may be within the letter of the statute and yet not within the statute, because not within its spirit nor within the intention of its makers" (Forman at 849, quoting 143 U.S. 457, 459).

In holding the cooperativestock not to be a security, the Court stated that "common sense" suggested that purchasers of the stock would not likely believe or expect that they were purchasing securities covered by the federal securities laws. The Court noted in Daniel that an employee covered by the pension plan in that case did not really believe that he was contributing his labor in order to purchase an investment security: "Looking at the economic realities, it seems clear that an employee is selling his labor primarily to obtain a livelihood, not making an investment" (at 558).

Economic realities, the context in which the earn out rights are given, and common sense all lead to the conclusion that the earn out right is not a security. In analyzing these factors, the intent of the "purchasers" of the right (the sellers of the hospital) and the "sellers" of the right (Lifemark, the purchaser of the hospital) is critical. In this case, the economic transaction is the sale of a hospital and related assets--a business, in effect--by a general partnership consisting of doctors who built the hospital with their own capital and efforts. They were not passive investors in the hospital before the Lifemarktransaction; it was their hospital. The buyer of the hospital business, Lifemark, has an interest in purchasing the entire business on the terms most favorable to itself, including, if possible, incentive for the doctors who are now the owners to continue to use the hospital after they sell it. Lifemark recognizes that hospitals are basically only as good as the doctors who practice in them and that a successful hospital economically must be a successful one professionally. Thus, as part of the negotiated purchase price, Lifemark offered cash and assumption of certain debt, plus a percentage of the revenues in the future. Their intent was to buy the hospital business on the most favorable terms. The intent of the sellers was to sell their business as a whole on the best terms for themselves. They negotiated and arrived at the final price.

Neither the purchasers nor the sellers view the transaction as involving an "investment" by the doctors. If anything, they are removing themselves from investment in the hospital and taking their money elsewhere. They are getting in effect a deferred cash payment for an undefined proportion of the purchase price. n7

There obviously has been no promotion by Lifemark of the type associated with a security. The sellers of the hospital certainly did not need Lifemark to tell them about the revenues in the future. If anyone knows about the significance of the percentage of revenue, it is the sellers themselves since they have had years of experience operating the hospital. Where the "purchasers" of the earn out rights are a preselected group (the general partnership), there is also no question about widespread solicitation or marketing of interests.

Moreover, the earn out right has none of the characteristics of a security--it cannot be transferred (except by operation of law); it represents no equity or ownership interest in Lifemark and no possibility of such an interest; it has no intrinsic value so that it can be pledged or otherwise used as an ordinary security; it entitles the owner to no voting or dividend rights nor does it bear stated interest. The earn out right has no relation to the capital markets, to the raising or capital or to other common notions of a "security."

C. SEC Staff Advisory View in 1971

Although it is our opinion that there is no security involved in the earnout right in this instance, we are aware that in 1971 the staff took a contrary position in a fact situation not too dissimilar from this one, Newell National Company (June 14, 1971). In that case, which involved a stock purchase agreement with an undertaking to make future cash payments contingent on earnings of an acquired business, the staff was unable to concur in the attorney's opinion that the undertaking did not constitute a security as defined in Section 2(1) of the Act. There are factual differences between the Newell situation and the Lifemark situation but, except for the fact that certain of the payments in Newell were based on earnings rather than revenues, they are not significant for purposes of our analysis as to whether a security is present. We are aware of no no-action or other positions taken by the staff or the Commission since that time that specifically withdraw the Newell letter or its conclusion.

However, we believe that the Newell position should not be controlling in this case. Although there have been no specific staff or Commission actions withdrawing that letter, we are aware of no other suggestion by the staff, and no practice by the staff or byindustry, that a cash earn out right in an acquisition situation is by itself a security. Where securities are to be delivered to satisfy an earn out obligation, these securities have been registered, but we have not seen the right itself registered. n8 Thus common sense and practice seem to suggest that earn out rights in situations similar to Lifemark's are not generally treated as securities by the parties involved or the staff.

In legal terms, the framework for analyzing whether an instrument is a security has changed quite drastically since 1971. The Supreme Court has spoken in Forman and Danieland has made clear that literal readings and broad brush approaches to the analysis of when an instrument or arrangement is a security are not appropriate. The criterion is the economic reality of the transaction. In addition, other courts have begun to take a somewhat stricter view of when it is appropriate to apply the federal securities laws to what are essentially straightforward business transactions rather than traditional investment transactions. The recent line of cases on the sale of a business and whether that involves a security is typical of this approach. n9 The cases over the past decade that develop the concept of commercial versus investment transaction in the context of when a note is a security suggest that one must look beyond the literal application of the statutes.

D. Policy Considerations

Our conclusion that the earn out rights are not securities is supported by the fact that registration of these earn out rights would serve no purpose in this case. The sellers of the hospital, the ones receiving the earn out rights, are intimately familiar withthe Stream of revenues into the hospital. Lifemark is not in a position to tell them anything that they don't already know. And, although those holding the earn out rights will be interested in Lifemark's financial stability and administrative efficiencies, this information is readily available.

IV. Conclusion and Request

We believe that the mode of analysis of transactions such as the one involved here has changed significantly since 1971 and that the staff should not, under the circumstances here, be bound by a position taken in 1971, particularly where there is not benefit to be obtained. Therefore, we request that the staff concur with our opinion that the earn out right in this cae is not a security for purposes of the federal securities laws and that the staff state that it would not recommend to the Commission any enforcement action if the Lifemark acquisition takes place as described without registration of the contractual earn out right under the Securities Act of 1933.

If you have any questions or wish to discuss this matter, please call Alan B. Levenson (452-6839), Jean W. Gleason (452-6840), or Arthur H. Rogers (713-651-5421) of the firm.

Sincerely,

Fulbright& Jaworski

_____________________________

n1 The definition of the term "security" under the Securities Act, the Exchange Act and the Investment Company Act are, for all practical purposes, identical. See, e.g., International Brotherhood of Teamsters v. Daniel, 439 U.S. 551, 556 (1979); United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 847 n.12 (1975); Tcherepnin v. Knight, 389 U.S. 332, 336 (1967).

n2 H.R. Rep. No. 85, 73d Cong., 1st Sess., 11 (1933).

n3 77 Cong. Rec. 2940 (1933) (remarks of Rep. McFadden). See also, id. at 2912 (remarks of Rep. Mapes).

n4 328 U.S. 293, 301 (1945).

n5 The Howey test has been reaffirmed in two recent Supreme Court cases. In Forman, the Court used this test to find that shares of "stock" entitling a purchaser to purchase an apartment in a housing cooperative were not securities for purposes of the federal securities laws. In Daniel, the Court applied the Howey test and held that an employee's interest in a compulsory, non-contributory pension plan did not constitute a security.

n6 See Klein v. Arlen Realty, 410 F. Supp. 1261 (E.D. Pa. 1976) in which a real estate lease calling for payment of a percentage of the lessee's revenues to the shopping center developer was held not to be a security.

n7 In Sea Pines of Virginia, Inc. v. PLD, Ltd., 399 F.Supp. 708 (M.D. Fla. 1975), the Court found that a note calling for five installment payments given as partial payment for an interest in a limited partnership was not a security within the meaning of the federal securities laws because it was used merely as a cash substitute. The primary motivation of the purchase was receipt of the purchase price, not acquisition of an investment note. Similarly, in Oliver v. Bostetter, 426 F. Supp. 1082 (D. Md. 1976), where a controlling stockholder bought the stock of other stockholders by issuance of a note, the Court found that, by the sale of stock in exchange for the note, the stockholders had sought to terminate, not continue, their investment. The interest on the note was not considered to be the type of profit that was significant under the securities laws, particularly in light of the intentions of the parties--neither side had investment in mind as a motivation for the issuance or purchase of the note.

n8 Lifemark itself has recently registered deferred payment rights similar to those described in this letter and undertaken in connection with an acquisition. Reg. No. 2-72679. However, in that instance, securities (notes) may be issued as part of the consideration for the business being acquired and these notes had to be registered in any event. Because of the uncertainty engendered by the Newell letter and the exigencies of time, Lifemark decided to be conservative and register the deferred payment rights also, despite its opinion that they were not securities.

n9 See, for example, Canfield v. Rapp & Son, Current FED. SEC. L. REP. (CCH) P98,227 (7th Cir. 1981).