Avenue Capital Management II, L.P. v. Schaden, 131 F. Supp. 3d 1118

Background

Avenue and Fortress (plaintiffs) agreed in January 2012 to fund an out-of-court debt restructuring of Quiznos (QCE entities) via a transaction that gave them at least 70% ownership in a new parent, QCE Parent, in exchange for forgiving/reducing debt and a $150 million equity investment.
The transaction documents included an Offering Memorandum (OM), a Restructuring Support Agreement, and a Subscription Agreement, and attached an Amended & Restated LLC Agreement for QCE Parent that governed governance and member rights.
Plaintiffs allege the OM and SA contained materially misleading financial projections and omissions that induced them to accept the out-of-court transaction instead of a Chapter 11 reorganization, and that actual post-transaction performance was materially worse.
Plaintiffs sued under §10(b)/Rule 10b-5 (securities fraud), §20(a) (control-person liability), and related New York common-law fraud/aiding-and-abetting and conspiracy claims; defendants moved to dismiss.
The threshold legal dispute was whether the LLC membership interests plaintiffs received are "securities" (investment contracts) under the Securities Exchange Act, because if not, the §10(b)/Rule 10b-5 claims fail.
The district court concluded the economic realities and the QCE Parent LLC Agreement show plaintiffs had controlling governance rights and access to information, so the membership interests were not investment contracts; it granted dismissal of federal securities claims with prejudice and declined supplemental jurisdiction over state-law claims, dismissing those without prejudice.

Issues

Issue	Plaintiff's Argument	Defendant's Argument	Held
Whether LLC membership interests are "securities" (investment contracts) under Howey	Memberships were in manager-managed LLCs where officers — not members — handled day-to-day management, creating a reasonable expectation of profits from others' managerial efforts	The QCE Parent LLC Agreement gave plaintiffs collective control (70% ownership), the right to appoint 8 of 9 managers (including chair), removal power, member voting, access to financials, drag-along and other protective rights — showing investors had control and information, not passive reliance	Held: Not investment contracts; securities claims dismissed because plaintiffs failed to plausibly plead the Howey third prong (profits derived from others' efforts)
Whether §20(a) control-person claims survive absent a primary securities violation	N/A (derivative of substantive securities claims)	§20(a) requires an underlying primary securities law violation; absent a primary violation, no control-person liability	Held: Dismissed because no primary §10(b) violation established
Whether the complaint pleaded material misrepresentation/scienter under §10(b)/PSLRA	OM contained unreasonable, baseless financial projections and omissions about operational impacts and a known gross profits gap; plaintiffs relied on those projections to invest	Defendants argued the complaint and incorporated documents do not show securities status and court need not reach PSLRA pleading if transaction did not involve securities	Held: Court did not reach PSLRA specifics because dispositive issue was absence of a security; securities claims dismissed on that basis
Whether the court should retain supplemental jurisdiction over state-law claims after dismissing federal claims	Plaintiffs sought to proceed on New York common-law claims in federal court	Defendants urged dismissal of remaining state claims if federal claims dismissed	Held: Court declined supplemental jurisdiction under 28 U.S.C. §1367(c)(3) and dismissed state-law claims without prejudice

Key Cases Cited

SEC v. W.J. Howey Co., 328 U.S. 293 (defining "investment contract" test)
Reves v. Ernst & Young, 494 U.S. 56 (statutory definition of "security" and focus on economic realities)
Amgen Inc. v. Connecticut Retirement Plans & Trust Funds, 568 U.S. 455 (elements of a §10(b) claim)
SEC v. Shields, 744 F.3d 633 (10th Cir.) (analysis of partnership/LLC interests and Howey factors)
Robinson v. Glynn, 349 F.3d 166 (4th Cir.) (LLC/member control and investment-contract analysis)
Maritan v. Birmingham Properties, 875 F.2d 1451 (10th Cir.) (factors relevant to Howey third prong)
United States v. Leonard, 529 F.3d 83 (2d Cir.) (diversity of LLC membership interests and securities analysis)
Maher v. Durango Metals, Inc., 144 F.3d 1302 (10th Cir.) (control-person liability requires primary securities law violation)