Rekant v. Desser

• Citation: 425 F.2d 872
• Decision Date: 20 April 1970
• Docket Number: No. 25872.,25872.
• Parties: Kenneth REKANT on behalf of himself as an individual, etc., Appellant, v. Arthur A. DESSER et al., Appellees.
• Court: United States Courts of Appeals. United States Court of Appeals (5th Circuit)

425 F.2d 872 (1970)

Kenneth REKANT on behalf of himself as an individual, etc., Appellant, v. Arthur A. DESSER et al., Appellees.

No. 25872.

United States Court of Appeals, Fifth Circuit.

April 20, 1970.

Lawrence Feingold, Miami Beach, Fla., for appellant.

E. David Rosen, Miami, Fla., Moses Krislov, Cleveland, Ohio, Gerald M. Higier, Miami Beach, Fla., for appellees.

Philip A. Loomis, Jr., Gen. Counsel, SEC, Washington, D. C., as amicus curiae.

Before WISDOM and AINSWORTH, Circuit Judges, and JOHNSON, District Judge.

WISDOM, Circuit Judge.

The plaintiff appeals from the district court's dismissal of the complaint for failure to state a private right of action under Sections 10(b) and 15(d) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) and § 78o(d). We hold that the plaintiff has a derivative action under Section 10(b)¹ and Rule 10b-5² against the president of a corporation, directors, and co-conspirators who fraudulently caused the corporation to issue to the president and others in league with him treasury shares and a note for grossly inadequate consideration.

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On August 17, 1967, Kenneth Rekant sued Arthur A. Desser, president and a director of World-Wide Realty and Investing Corporation (formerly Lefcourt Realty Corporation) and others for damages resulting from an alleged fraud and deceit upon the corporation and its stockholders.³ The plaintiff sued (1) derivatively, on behalf of the corporation, (2) individually, and (3) on behalf of all similarly situated shareholders of World-Wide.⁴ In the original complaint Rekant charged Desser and the directors with "fraudulent mismanagement" of the corporation and described the other defendants as "co-conspirators". The complaint is based on two transactions — one involving the Henry Hudson Hotel in New York City and the other involving Desser's River Oaks Farm in Montgomery County, Maryland.

In November 1965, in its annual report for the fiscal year ending April 20, 1965, World-Wide included a letter to the stockholders from Desser containing the following statement regarding the corporation's contract to purchase the Henry Hudson Hotel:

Recently, we contracted to purchase the 1000 room Henry Hudson Hotel on West 57th and 58th Streets across from the New York Coliseum and close to the new Lincoln Center. The purchase was made at very favorable terms which includes the Seller subordinating its second mortgage (not yet committed) which would include a $2,000,000 fund for renovation and modernization. Our engineers are presently working on plans for this modernizing program and we are hopeful that the hotel will provide the company with large revenues.

The complaint alleges that the corporation assigned the Henry Hudson Hotel contract to Desser and to Joseph Goumont, partners or joint venturers, for a nominal consideration, depriving the stockholders of "the large revenues" promised in the 1965 report. Moreover, so the plaintiff avers, Desser converted even this nominal consideration to his own use.

The 1965 report also included a letter to the stockholders from Desser relating to the River Oaks Farm. This letter states:

For several years, I have owned a 167 acre parcel of land called the River Oaks Farm. Demand for estate homesites in this exclusive suburb of Washington, D. C. has reached the point where subdivision of this property should increase its value. In order to obtain the $5,000,000 financing concluded in May, I had to make this parcel of land available as part of the collateral to secure the indebtedness. Subsequently, I sold this property to the Company for the then market price, giving the Company the opportunity to subdivide it and reap the profits from the sales of homesites and home construction. The portion of the purchase price in excess of the existing encumbrance, $782,674, is represented by an unsecured note payable to me when the Company has funds available. The note finally matures in 1972. $250,000 was reserved from the $5,000,000 borrowing for land improvements for this parcel and our engineers are presently working on a master plan.

Rekant says that Desser paid $100,000 for the farm, but that it was worth no more than $150,000 at the time World-Wide bought it for $1,100,000. The complaint also alleges:

that the unsecured Note payable to Desser in the amount of $782,674 was continually reduced any time the corporation received any substantial monies, thereby leaving World-Wide with a continuing operating loss and a continuous shortage of working capital; all of which acts were part of a device, scheme and artifice wherein World-Wide and its stockholders were defrauded of substantial benefits that would have been incurred had the property been purchased at market value; or, in the alternative, this $5,000,000.00 financing to which this property was mortgaged was never properly utilized for normal business uses because the effect of the sale of the Montgomery County, Maryland property by Desser to World-Wide was to divert 1/5th of the proceeds of a $5,000,000.00 loan to purchase a farm owned by Desser and valued under $150,000.00.

World-Wide filed no annual report for the period ending April 20, 1966, a violation of § 15(d)⁵ and Rule 15d-1.⁶ This omission apparently was part of the alleged scheme to defraud (at least, it facilitated the scheme): failure to file the 1966 report avoided the necessity of the defendants' disclosing in the annual report what had happened in the Henry Hudson and River Oaks transactions after the favorable prospects were set forth in the 1965 report.

In 1959 Rekant paid the total sum of $56.45 for six shares of Lefcourt Realty Corporation (now World-Wide).⁷ He still owns these six shares which, he says, are now "practically worthless" as a result of Desser's schemes to defraud the corporation.

The district court dismissed the original complaint, without prejudice, for lack of federal jurisdiction over the subject matter. Rekant then filed an amended complaint alleging that Desser and the other directors had caused World-Wide to issue treasury shares to the "participants" in the Henry Hudson Hotel and River Oaks transactions for no consideration. The defendants sold the stock on the open market shortly after receiving it.⁸

In the district court Rekant strongly emphasized that the failure of Desser and other directors to file the 1966 annual report gave rise to a private cause of action. On appeal he shifted the emphasis to § 10(b) and Rule 10b-5.

The district court gave these reasons for the order of dismissal:

violations of Rule 15-d do not give the plaintiff a private right of action, and furthermore the plaintiff does not have a cause of action under Rule 10 (b) (5) in that internal corporate matters or mishandling of corporate transactions is not within the purview of this Rule. Furthermore, the issuance of World-Wide\'s treasury stock, as alleged in the Amended Complaint, is not in connection with the purchase or sale of securities so as to give this plaintiff an action under Rule 10(b) (5).

I. Standing to Sue: The Buyer-Seller Requirement.

We take up, first, the question whether the plaintiff must be a buyer or seller to have standing to sue.

Rule 10b-5, promulgated under § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j, makes unlawful the employment of "manipulative and deceptive devices" "in connection with the purchase or sale of securities". Since 1946 courts have construed the rule as providing an implied private right of civil recovery for its violation.⁹ Kardon v. National Gypsum Co., E.D.Pa.1946, 69 F.Supp. 512.¹⁰ In recent years, the rule has been applied in such a variety of situations that one can scarcely find an issue of the advance sheets of the Federal Supplement and Federal Reporter that does not contain an opinion on § 10 (b). This extraordinary expansion of subject-matter coverage by § 10(b) and Rule 10b-5, coupled with the possibility of extraordinarily great liability, has moved courts to limit the class of persons who may recover to purchasers or sellers of securities. In the leading case of Birnbaum v. Newport Steel Corp., 2 Cir., 1952, 193 F.2d 461, cert. denied 343 U.S. 956, 72 S.Ct. 1051, 96 L.Ed. 1356, the court construed the language "in connection with the purchase or sale of any security" as limiting standing to sue to buyers or sellers of securities. See also City National Bank of Fort Smith v. Vanderboom, 8 Cir., 1970, 422 F.2d 221.

Birnbaum has been shot at by expert marksmen. The buyer-seller requirement for standing has been criticized as too strict a reading of the rule.¹¹ Commentators have said that Birnbaum has been significantly eroded in a variety of later cases, even in the Second Circuit.¹² Cf. Crane Co. v. Westinghouse Air Brake Co., 2 Cir., 1969, 419 F.2d 787. See also Kahan v. Rosenstiel, 3 Cir., 1970, 424 F.2d 161 (injunctive relief). Bloody but unbowed, Birnbaum still stands. Iroquois Industries, Inc. v. Syracuse China Corp., 2 Cir., 1969, 417 F.2d 963; Greenstein v. Paul, 2 Cir., 1968, 400 F.2d 580. See also Vanderboom v. Sexton, 8 Cir., 1970, 422 F.2d 1233.

A. The derivative action. The amended complaint alleges that World-Wide issued treasury shares to Desser and his alleged co-conspirators for grossly inadequate consideration. The rule in this Circuit and other Circuits is that a corporation issuing its own treasury shares is a seller of securities for purposes of Rule 10b-5. Schoenbaum v. Firstbrook, 2 Cir., 1968, 405 F.2d 215; Pappas v. Moss, D.N.J.1966, 257 F. Supp. 345, 363, reversed on other grounds, 3 Cir., 1968, 393 F.2d 865; Dasho v. Susquehanna Corp., 7 Cir., 1967, 380 F.2d 262; Ruckle v. Roto American Corp., 2 Cir., 1964, 339 F.2d 24; Hooper v. Mountain States Sec. Corp., 5 Cir., 1960, 282 F.2d 195, cert. denied, 365 U.S. 814, 81 S.Ct. 695, 5 L.Ed.2d 693 (1961).

In Hooper this Court permitted the trustee in bankruptcy to bring a derivative action alleging that the former officers of...