SEC v. Wills

• Decision Date: 14 December 1978
• Docket Number: Civ. A. No. 77-0097.
• Citation: 472 F. Supp. 1250
• Parties: SECURITIES AND EXCHANGE COMMISSION, Plaintiff, v. S. Hayward WILLS et al., Defendants.
• Court: U.S. District Court — District of Columbia

472 F. Supp. 1250

SECURITIES AND EXCHANGE COMMISSION, Plaintiff, v. S. Hayward WILLS et al., Defendants.

Civ. A. No. 77-0097.

United States District Court, District of Columbia.

December 14, 1978.

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Irwin M. Borowski, New York City, Richard S. Kraut, Peter M. Sullivan, Richard J. Morvillo, Kathleen G. Gallagher, Richard O. Patterson, Robert J. Haft, Sp. Counsel, Washington, D. C., for plaintiff.

Burton H. Finkelstein, Douglas G. Thompson, Jr., John F. McCarthy, III, Washington, D. C., for Wills.

James E. Tolan and Richard A. Martin of Olwine, Connelly, Chase, O'Donnell & Weyher, New York City, for Stuken.

MEMORANDUM OPINION

GESELL, District Judge.

By this civil action the Securities and Exchange Commission ("SEC"), alleging violations of the federal security laws, seeks both injunctive relief and disgorgement against two former officers of a now-bankrupt land development corporate complex. The SEC has alleged that the defendants did not make disclosures as mandated by Sections 13(a) and 14(a) & (e) of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. §§ 78m(a) & 78n(a) & (e) (1976), and by Rules 13a-1, 13a-11, 13a-13, and 14a-9, 17 C.F.R. §§ 240.13a-1, 240.13a-11, 240.13a-13 & 240.14a-9. The SEC also contends that, in connection with such non-disclosures, the defendants violated the anti-fraud provisions of Section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b) (1976), Section 17(a) of the Securities Act of 1933 (the "Securities Act"), 15 U.S.C. § 77q(a) (1976), and Rule 10b-5, 17 C.F.R. § 240.10b-5 (1977), as well as the interstate prospectus rule of section 5(b)(1) of the Securities Act, 15 U.S.C. § 77e(b)(1) (1976).

Following a substantial bench trial, the submission of detailed proposed findings of fact and briefs, and oral arguments, the Court now enters its findings of fact and conclusions of law.

I. The Facts

A. The Business and Capitalization of Properties and Credit, and Credit's Public Filings.

The proof concerns the operations of GAC Corporation ("GAC"), a holding company; GAC Properties, Inc. ("Properties"), a wholly-owned subsidiary engaged in land sales; and GAC Properties Credit, Inc. ("Credit"), a wholly-owned subsidiary of Properties and financier of Properties' land sale operations. Defendants Wills and Stuken were major officers of each of the three companies.¹

GAC acquired Properties in 1969. Thereafter, Properties was engaged predominantly in subdividing and developing land for sale. The bulk of Properties' sales were made prior to completion of most of the necessary improvement work and on the installment basis, sometimes involving downpayments of as little as two and one-half percent. Properties' sales contracts uniformly required it to perform all related development work, meaning that it had to make substantial cash outlays prior to receiving the land's full purchase price. Consequently, it depended heavily on external sources to finance its operations.

Credit was created in 1970 to meet most of these financing needs. Credit was given the task of raising the cash needed to finance Properties' operations through public debt offerings, bank lines of credit, and collections on the installment land contract receivables which Properties' land sale operations generated.

Credit sold two issues of debentures. In November 1970, it issued $50 million of 12 percent Senior debentures due November 15, 1975 (the "1975 debentures"). In September 1971, it issued an additional $50 million Senior debentures, these with an interest rate of 11 percent and due September 1, 1977 (the "1977 debentures"). Both issues were registered under the Securities Act and under Section 12(b) of the Exchange Act. Each was also accompanied by the appropriate prospectus and indenture. The SEC does not now challenge either the accuracy or the completeness of the disclosures made in those initial documents.

The SEC's contentions center instead on the period between April 1974 and September 1975. During that time, Credit was obligated by law to file with the SEC one annual Form 10-K covering the calendar year 1974 and several quarterly 10-Q's. In addition, Credit in September 1975 sent an Exchange Offer to its 1975 debenture holders² and requested its 1977 debenture holders to consent to several indenture amendments.³ Accordingly, Credit had to prepare and file an Exchange Offer Prospectus and a Solicitation Statement. The SEC maintains that all of these documents contained material misrepresentations and omitted to state material facts.

B. The Relationship Between Credit and Properties.

Comprehension of the SEC's allegations requires some familiarity with the framework within which Credit operated by agreement with its debenture holders. This framework was created by an Operating Agreement into which Credit and Properties entered on November 15, 1970 (the "Operating Agreement"), by the indentures which underlay the company's two debenture issues (respectively the "1970 indenture" and the "1971 indenture"), and the two prospectuses which accompanied those issues (respectively the "1970 prospectus" and the "1971 prospectus").

The Operating Agreement provided that Credit was to enjoy first rights to Properties' Eligible Receivables⁴ (Section 2), prices to be negotiated from time to time (Section 3). Correspondingly, Credit was obliged to purchase all such Receivables as Properties tendered to it (Section 2), so long as Credit was able to finance the purchases on a "reasonable basis" (Section 6).

With respect to all Eligible Receivables which Properties sold to Credit, Properties promised to perform or have performed "all acts and things for which Properties or any Real Estate Affiliate is committed under the terms of, or in connection with, any item of Receivables . . .." (Section 12(a); see also Section 9). In addition, Credit "at all times" was to maintain "reserves" against the Receivables it purchased (Section 4), these reserves to be based, among other things, on percentages of Properties' own reserves, Properties' development costs, and the Receivables' gross principal amount. These "reserves" were not cash, but simply the partial nonpayment by Credit of what it owed Properties for the Eligible Receivables it undertook to purchase.⁵

The 1970 and 1971 indentures required that Credit and Properties "duly and punctually perform all of the terms, agreements and conditions of the Operating Agreement." (Section 1008). Neither corporation could "terminate, cancel, assign, or materially amend, modify or supplement the Operating Agreement" (id.), except with the permission of those holding at least two-thirds of the outstanding debentures. (Section 1013; Section 1012). Violation of this covenant would amount to an "event of default" (Section 501(6)).

The 1970 and 1971 indentures defined with particularity the contours of the "business" in which Credit could engage:

Neither Credit nor any Subsidiary will engage in any business other than dealing in Eligible Receivables or activities incidental thereto, or invest a material part of its assets in properties, assets or securities other than Eligible Receivables, Short Term Debt of the United States of America, any agency thereof, any State of the United States of America or any political subdivision thereof, certificates of deposit, prime or equivalently rated commercial paper of non-affiliated issues and securities of Subsidiaries.

(Section 1004(b)).

Credit, therefore, enjoyed a flow of income which depended heavily on Properties' customers continuing to make payments on the Eligible Receivables Credit held. These customers were not legally bound to make such payments, although upon default they generally did forfeit all previously paid sums. Whether or not they would default largely depended on Properties meeting its development obligations under the installment land contracts, on overall economic conditions, and on the nature of the publicity which surrounded the installment land contract business as a whole. As to Properties' ability to continue to meet its development obligations, this rested on its success in obtaining new installment land contract receivables (to sell to Credit for cash), on not having to buy back cancelled Eligible Receivables from Credit, and, of course, on the soundness of its initial development cost predictions. Customer defaults did not proportionately reduce development costs which were largely geared to projects rather than individual lots.

The inherent weaknesses in this structure were highlighted by both the 1970 and 1971 prospectuses. There, the debenture holders were informed that Credit's Eligible Receivables "may become uncollectible" if Properties defaults on its development obligations and these obligations are not assumed by Credit.⁶ The debenture holders were further warned that:

Performance of the development obligations of Properties under instalment land contracts will require Properties to expend substantial sums of cash over the terms of such contracts . . .. Cash expenditures to date have exceeded the total cash generated by sales, and, therefore, Properties' operations have required, and it is anticipated that they will continue to require, substantial funds in addition to cash generated from sales . . ..

In conjunction with this disclosure, the prospectuses made clear that Properties' customers were not legally bound to continue to make payments on Credit's Eligible Receivables and that "no significant resale market for instalment land contracts" existed. In short, Credit's financial posture was highly dependent on "the continued ability of Properties to operate as a going concern" and on "general economic conditions." Any adverse trend in the latter could "induce substantial numbers of contract purchasers to discontinue making installment payments . . .."

The debenture holders...