Kansas State Bank in Holton v. Citizens Bank of Windsor

• Decision Date: 31 July 1984
• Docket Number: No. 83-1315,83-1315
• Citation: 737 F.2d 1490
• Parties: Blue Sky L. Rep. P 72,049, Fed. Sec. L. Rep. P 91,554 The KANSAS STATE BANK IN HOLTON, Appellee, v. The CITIZENS BANK OF WINDSOR, J.W. Simmons, and William E. Simmons, Trustee of the Jean Simmons Trust Estate, Appellants.
• Court: U.S. Court of Appeals — Eighth Circuit

Page 1490

737 F.2d 1490

Blue Sky L. Rep. P 72,049, Fed. Sec. L. Rep. P 91,554

The KANSAS STATE BANK IN HOLTON, Appellee, v. The CITIZENS BANK OF WINDSOR, J.W. Simmons, and William E Simmons, Trustee of the Jean Simmons Trust Estate Appellants.

No. 83-1315.

United States Court of Appeals Eighth Circuit.

Submitted Dec. 14, 1983.

Decided June 29, 1984.

Rehearing and Rehearing En Banc Denied July 31, 1984.

Thomas W. Wagstaff, Penni L. Johnson, Blackwell, Sanders, Matheny, Weary & Lombardi, Kansas City, Mo., for appellants The Citizens Bank of Windsor, J.W. Simmons and William E. Simmons, Trustee of the Jean Simmons Trust Estate.

William L. Turner, Stephen B. Sutton, Gage & Tucker, Kansas City, Mo., for appellee.

Before McMILLIAN, JOHN R. GIBSON and BOWMAN, Circuit Judges.

JOHN R. GIBSON, Circuit Judge.

Appellee The Kansas State Bank in Holton purchased a $200,000 loan participation certificate from appellant The Citizens Bank of Windsor. The borrower, Oldham's Farm Sausage, Inc., subsequently went out of business. Holton Bank lost the entire $200,000 when its priority in collateral securing the loan proved to be junior to that of other lenders. Holton Bank then brought this suit alleging federal and Missouri securities laws violations (counts I and II) and common law fraud (count III). The jury returned a verdict in favor of Holton Bank on all three counts and awarded $200,000 in actual damages, $44,843 in interest and $104,212 in attorney's fees under count II, and $50,000 in punitive damages under count III. On appeal, Windsor Bank principally argues that a loan participation is not a security within the meaning of either federal or Missouri securities laws, that there was insufficient evidence on the issue of fraud, and that the district court should have required an election of remedies. We reverse the judgment on the securities laws counts and affirm on the fraud count. ¹

The crux of this lawsuit concerns the representations made by appellant William Simmons to Clarence Norris, President of Holton Bank, at a meeting of Oldham's creditors on November 29, 1979. Norris testified that he agreed to purchase the participation certificate only because he and the other lenders were told by Simmons at the meeting that their respective interests would be secured by a first priority in Oldham's accounts receivable and inventory except for the first $235,000. Within four months, however, Oldham's went out of business and Norris and the other lenders discovered that their secured positions were junior to approximately $827,000 in outstanding loans made to Oldham's by the parents of William Simmons. ²

The dispute is further illuminated by the events preceding the November 29 meeting. In 1978, Windsor Bank extended two loans to Oldham's and, due to its statutory lending limit, simultaneously sold both promissory notes to Traders Bank of Kansas City. The first was a $765,000 note secured by Oldham's equipment and machinery. The second was an $850,000 revolving line of credit secured by Oldham's accounts receivable and inventory. Both security agreements contained cross-collateralization provisions, whereby the collateral securing one note could be used to satisfy the amount due on the other note.

In 1979, Windsor Bank agreed to extend a third loan to Oldham's. This was an $850,000 participation loan and was secured by Oldham's accounts receivable and inventory. Windsor Bank funded $150,000 of this loan and two of its correspondent banks each agreed to purchase $250,000 participations. Oldham's President Michael Gibson hoped to sell the remaining $200,000 participation to Holton Bank.

In October, 1979, Traders Bank called both of the notes it held from Oldham's. Oldham's did not have the money to pay off the loans. To save Oldham's from foreclosure, the Simmons family personally borrowed $1,000,000 and purchased from Traders Bank both of the notes. ³

Soon thereafter, Simmons arranged for the November 29 meeting of all persons involved in Oldham's financing. He wanted to disclose his family's recent purchase from Traders Bank of both notes and to persuade Holton Bank to purchase the remaining $200,000 participation. Norris testified, as we have discussed, that Simmons told the lenders that their participation interests would be secured by a first priority in Oldham's accounts receivable and inventory except for the first $235,000 worth of that collateral. Lanny Kimbrough, Vice-President of Holton Bank, corroborated Norris' testimony. Norris further testified that representatives of the other participating lenders, Bruce Kent and H.W. Harris, also were under the impression that they held a first position except for $235,000. Simmons asserts that he said nothing about the lender's priority in Oldham's accounts receivable and inventory. He argues that all he did was present the participating lenders with a "Subordination of Lien Agreement." Under its terms, the lenders would agree to subordinate their interests in Oldham's accounts receivable and inventory to the Simmons family's $850,000 interest which it held by virtue of its purchase from Traders Bank of the note secured by that collateral. Simmons explained to the lenders, however, that their actual subordination to the Simmons family would never exceed $235,000. This was because the Simmons family could loan Oldham's a total of no more than $1,000,000 on both notes. Of that amount, $765,000 was already due on the note secured by Oldham's equipment and machinery, and therefore only $235,000 could be loaned on the note secured by Oldham's accounts receivable and inventory. A follow-up letter sent by Simmons to Norris confirmed these representations. On December 3, Norris agreed to purchase the $200,000 participation.

Within four months, Michael Gibson informed Simmons that Oldham's could not continue in business. Simmons subsequently told Norris that his family intended to protect its position by invoking the cross-collateralization provision of the security agreement underlying the equipment and machinery note. By doing so, the Simmons family would be able to satisfy the $765,000 balance due on that note out of Oldham's accounts receivable and inventory. It was only then, Norris testified, that he realized that Holton Bank was subordinated not only to the maximum amount the Simmons family would loan Oldham's under the accounts receivable and inventory note ($235,000), but also to the full amount Oldham's owed under the equipment and machinery note ($765,000). ⁴ Norris claims that this was in direct contradiction to Simmons' representation that the lenders would be in a first position in Oldham's accounts receivable and inventory except for $235,000. Simmons counters that no such representation was made, and that his family never relinquished its right to invoke the cross-collateralization provision and satisfy the $765,000 balance due on the equipment and machinery note out of Oldham's accounts receivable and inventory. The proceeds from the eventual sale of Oldham's accounts receivable and inventory went entirely to the Simmons family. Holton Bank received nothing. This lawsuit resulted.

I.

The first issue is whether Holton Bank's participation interest is a security within the meaning of the Securities Exchange Act of 1934, 15 U.S.C. Secs. 78a-78kk (1982). Section 3(a)(10) of the Act defines security as follows:

(a) When used in this chapter, unless the context otherwise requires--

....

(10) the term "security" means any note, stock, treasury stock, bond, debenture, certificate of interest or participation in any profit-sharing agreement ... or in general, any instrument commonly known as a "security"; or any certificate of interest or participation in ... any of the foregoing....

15 U.S.C. Sec. 78c(a)(10) (emphasis added). The first court to address the issue literally applied the plain language of this definition and held that loan participations were securities. See Lehigh Valley Trust Co. v. Central National Bank of Jacksonville, 409 F.2d 989 (5th Cir.1969). Not only has the Fifth Circuit since repudiated this literalist approach, see Bellah v. First National Bank of Hereford, 495 F.2d 1109 (5th Cir.1974), but the Supreme Court has indicated that the broad statutory definition of security is limited by the phrase "unless the context otherwise requires" and by congressional intent "not ... to provide a broad federal remedy for all fraud." Marine Bank v. Weaver, 455 U.S. 551, 556, 102 S.Ct. 1220, 1223, 71 L.Ed.2d 409 (1982) (citations omitted). The Court has endorsed an approach to interpreting the federal securities laws that emphasizes "the economic realities underlying a transaction, and not on the name appended thereto." United Housing Foundation v. Forman, 421 U.S. 837, 849, 95 S.Ct. 2051, 2059, 44 L.Ed.2d 621 (1975).

Courts have since devised various tests to identify those commercial transactions involving notes and participations thought to be outside the intended scope of the federal securities laws. One is the "investment-commercial" test whereby promissory notes containing terms indicative of a commercial lending arrangement, e.g., collateralized, short-term, proceeds used for operating expenses, repayable at a fixed rate of interest, are not considered securities. See National Bank of Commerce v. All American Assurance Co., 583 F.2d 1295 (5th Cir.1978); C.N.S. Enterprises, Inc. v. G. & G. Enterprises, Inc., 508 F.2d 1354 (7th Cir.), cert. denied, 423 U.S. 825, 96 S.Ct. 38, 46 L.Ed.2d 40 (1975); Zabriske v. Lewis, 507 F.2d 546 (10th Cir.1974); Lino v. City Investing Co., 487 F.2d 689 (3d Cir.1973). Another is the "risk capital" test. Under this approach, notes representing loans of risk capital are considered securities while those subject only to the normal risks incident to commercial lending are not. See Great Western Bank and Trust v. Kotz, 532 F.2d 1252 (9th Cir.1976). Despite the different label, the risk capital test...