249 F.3d 115 (2nd Cir. 2001), 99-9374, Morales v Quintel Entertainment Inc.

Docket Nº:Docket No. 99-9374
Citation:249 F.3d 115
Party Name:RICHARD MORALES, PLAINTIFF-APPELLANT, v. QUINTEL ENTERTAINMENT, INC. AND PETER STOLZ, DEFENDANTS-APPELLEES.
Case Date:May 02, 2001
Court:United States Courts of Appeals, Court of Appeals for the Second Circuit
 
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249 F.3d 115 (2nd Cir. 2001)

RICHARD MORALES, PLAINTIFF-APPELLANT,

v.

QUINTEL ENTERTAINMENT, INC. AND PETER STOLZ, DEFENDANTS-APPELLEES.

Docket No. 99-9374

United States Court of Appeals, Second Circuit

May 2, 2001

Argued September 25, 2000

Plaintiff appeals from a judgment entered on October 28, 1999 in the United States District Court for the Southern District of New York (Conner, J.), denying summary judgment to plaintiff and granting summary judgment to defendants on plaintiff's claim of short-swing trading in securities in violation of 15 U.S.C. § 78p(b) (1994). The district court ruled plaintiff failed to produce sufficient evidence to infer the existence of an agreement giving rise to beneficial ownership of ten percent or more of the securities in question.

Affirmed in part, vacated in part, and remanded.

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David Lopez, Southampton, New York (Albert D. Barnes, Southampton, New York, of counsel), for Plaintiff-Appellant.

Bruce E. Clark, New York, New York (Mark E. Coyne, Sullivan & Cromwell, New York, New York, of counsel), for Defendant-Appellee Peter Stolz.

Allan A. Capute, Washington, D.C. (David M. Becker, Eric Summergrad, Meyer Eisenberg, Securities and Exchange Commission, Washington, D.C., of counsel), filed a brief for the Securities and Exchange Commission, Amicus Curiae, in support of appellant.

Before: Cardamone, Jacobs, and Sack, Circuit Judges.

Cardamone, Circuit Judge

This appeal presents important issues relating to "short-swing" trading under § 16(b) of the Securities Exchange Act of 1934 (Exchange Act), 15 U.S.C. § 78p(b) (1994).1 Because defendant Peter Stolz concededly does not own in his name ten percent or more of the stock in which he, as an insider, is alleged to have traded, our discussion necessarily focuses on whether defendant owns ten percent as a "beneficial owner." The Exchange Act did not at the time of its enactment define the term "beneficial owner." That obvious gap was filled in over many years by case law which, as it now turns out, incorrectly defined the term. Although the statute and regulations in existence prior to the decisional

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law failed to give even a few faint hints as to the meaning of "beneficial owner," the Securities and Exchange Commission (Commission) in its 1991 regulations defining the phrase nonetheless rejected existing case law. We construe those regulations on this appeal.

Plaintiff Richard Morales appeals a judgment entered on October 28, 1999 in the United States District Court for the Southern District of New York (Conner, J.), granting summary judgment to defendants Stolz and Quintel Entertainment, Inc. (Quintel). Morales claims Stolz realized illegal profits on short-swing trades in shares of Quintel common stock, in violation of § 16(b) of the Exchange Act. He contends the district court erred in finding Stolz exempt from § 16(b) on the ground that, as a matter of law, he was not a "beneficial owner" of ten percent or more of Quintel stock. Because in our view a trier of fact could find that Stolz' concerted activities with two other Quintel shareholders rendered him a beneficial owner of their Quintel stock, thereby placing him above the ten-percent threshold, we vacate the judgment appealed from, in part, and remand.

BACKGROUND

Although the events leading up to this lawsuit are generally not in dispute, they are somewhat complex. Hence, as a guide to the reader, we set forth the principal corporations and individuals who figure in this litigation. Four corporations are involved, one of which, Quintel, is the issuer of the stock that is the subject of this litigation. Quintel, a nominal defendant-appellee in the appeal before us, is a publicly-traded Delaware corporation. The other three corporations are Psychic Reader's Network (Psychic), New Lauderdale, LLC, and Calling Card Co., Inc., each of which at one time played a more minor role. Psychic is a closely-held Florida corporation providing psychic consultations to persons calling in by telephone. New Lauderdale is a limited liability Florida corporation (formed by Psychic and Quintel), which develops and markets theme-related clubs and telephone entertainment services. Calling Card is a subsidiary owned by Quintel. Quintel, through Calling Card, and Psychic each held 50 percent of the stock of New Lauderdale. Psychic and Quintel had joined forces to form New Lauderdale in 1995.

We turn now to the actors in the suit: Thomas H. Lindsey and Steven L. Feder each owned in equal proportion a total of 89 percent of the stock of Psychic. Feder was the chief executive officer (CEO) of Psychic. Stolz owned the remaining 11 percent of the common stock of Psychic. Quintel's CEO, Jeffrey Schwartz, proposed to Feder in 1995 that Quintel buy Psychic's 50-percent interest in New Lauderdale in exchange for Quintel stock. Feder agreed.

In September 1996 Psychic and Quintel executed a sales agreement ("Sales Agreement") to sell Psychic's interest in New Lauderdale to Quintel in exchange for the issuance of new shares of Quintel common stock to Psychic's shareholders. Pursuant to the Sales Agreement, Stolz received 352,000 shares of Quintel common stock (in proportion to his 11 percent interest in Psychic), and Feder and Lindsey each received 1,424,000 shares (which combined were in proportion to their 89 percent interest in Psychic). While Stolz owned less than 2.5 percent of the outstanding Quintel common stock, his stock holdings when added to those of Feder and Lindsey totaled over 18 percent.

The Sales Agreement included several "lock-up" provisions restricting the ability of Stolz, Feder, and Lindsey to dispose of their new Quintel shares. Aside from formally consenting to these specific provisions,

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Stolz and Lindsey are said to have played no role in negotiating the Sales Agreement, which was handled by Schwartz for Quintel and by Feder for Psychic, with the help of Psychic's counsel, Donn A. Beloff. According to Feder, the lock-up provisions were included at Quintel's request because of its concern subsequent to its purchase of Psychic's interest in New Lauderdale that rapid sales of large blocks of Quintel stock could depress its price. Pursuant to § 3.3 of the Sales Agreement, therefore, the former Psychic shareholders were barred for two years from selling their Quintel stock, except to pay taxes or if a principal of Quintel sold shares. In addition, § 3.2 of the Sales Agreement limited the number of shares that could be sold in any three- month period and treated the three Psychic shareholders, within certain bounds, as "affiliates" within the meaning of Commission Rule 144(a)(1).

Psychic and Quintel also executed a number of ancillary agreements including a registration agreement, an escrow agreement governing the newly issued shares of Quintel common stock, and a covenant not to compete. Calling Card and Feder entered into an agreement by which Feder would perform managerial services for Calling Card and be able to serve as a director of either Calling Card or Quintel, if elected. In addition, Psychic, Quintel, and Calling Card executed a service agreement, pursuant to which Psychic would provide live operator services to Calling Card. The service agreement further acknowledged that Feder's continuing control of Psychic (he later bought out Lindsey's interest in that corporation) was an essential condition to Quintel's purchase of Psychic's interest in New Lauderdale.

In December 1996 Stolz, Feder, and Lindsey jointly executed and filed a Schedule 13D with the Commission reporting their acquisition of Quintel stock pursuant to the Sales Agreement. The Schedule reflected, by a check in the appropriate box, that Stolz was a member of a "group" under § 13(d) of the Exchange Act. The Schedule also indicated that a § 13(d) group "may be formed" which "may be deemed to be the beneficial owner" of the 18 percent of Quintel stock owned in the aggregate by the three joint filers. The Schedule stated that the sole purpose of the acquisition of Quintel stock was "for investment," and the Schedule explicitly disclaimed any beneficial ownership by Stolz, Feder, and Lindsey of each other's Quintel stock, except for certain shares owned by Feder and Lindsey as joint tenants. Four subsequent amendments to the Schedule contained similar disclaimers.

Further, between February 1997 and September 1998, Stolz filed one Form 5 and six Form 4s with the Commission. Each form stated that the "Relationship of [the] Reporting Person to [the] Issuer" was that of a "Member of [a] 13(d) group owning more than 10%." The cover letter accompanying each form similarly stated that Stolz was a member of a § 13(d) group owning more than ten percent of Quintel stock. According to Stolz, the Schedule 13D and the Forms 4 and 5 were prepared by his attorney, and he signed them without taking note of these particular statements.

Between November 1996 and August 1998, Stolz made 40 purchases and 51 sales of Quintel common stock. These transactions ranged anywhere from 100 to 26,300 shares, and averaged slightly less than 5,400 shares per transaction, which equals 1.5 percent of Stolz' personal holdings in Quintel. The other two Psychic shareholders, Feder and Lindsey, also sold small percentages of their Quintel stock on the open market, but made no purchases. On December 24, 1997 Stolz, Feder, and Lindsey

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transferred their respective Quintel shares to a short-term trust; each trust had the same terms and the same trustee. In April or May 1999, Quintel offered to redeem the Quintel stock it had issued to Stolz, Feder, and Lindsey. They accepted, and the redemption of their remaining Quintel stock took...

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