Barker v. Henderson, Franklin, Starnes & Holt

• Decision Date: 30 July 1986
• Docket Number: No. 86-1143,86-1143
• Citation: 797 F.2d 490
• Parties: Fed. Sec. L. Rep. P 92,864 Pearl J. BARKER, et al., Plaintiffs-Appellants, v. HENDERSON, FRANKLIN, STARNES & HOLT, and Taylor, Edenfield, Gilliam & Wiltshire, Defendants-Appellees.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 490

797 F.2d 490

Fed. Sec. L. Rep. P 92,864

Pearl J. BARKER, et al., Plaintiffs-Appellants, v. HENDERSON, FRANKLIN, STARNES & HOLT, and Taylor, Edenfield Gilliam & Wiltshire, Defendants-Appellees.

No. 86-1143.

United States Court of Appeals Seventh Circuit.

Argued May 27, 1986.

Decided July 30, 1986.

Robert Plotkin, Plotkin & Jacobs, Ltd., Chicago, Ill., for plaintiffs-appellants.

Gary Kostow, Clausen, Miller, Gorman, Caffrey & Witous, P.C., Chicago, Ill., for defendants-appellees.

Before CUMMINGS, Chief Judge, and EASTERBROOK and RIPPLE, Circuit Judges.

EASTERBROOK, Circuit Judge.

For several years Michigan Baptist Foundation, Inc., built and operated a retirement village in Florida. It sold lifetime leases to the apartments in Estero Woods Village (the Project). In order to finance the Project until it could receive revenue from the leases, the Foundation issued bonds secured by its interest in the land and ongoing construction. Many of the bonds were sold in small amounts to people who, we assume, were unsophisticated and unable to afford losing their investments. In October 1976 Lee County Bank, the Trustee for the bonds, refused to participate in further issues. The Foundation then sold unsecured notes for another 17 months, until, at the request of state officials, a state court enjoined the sale of further instruments. The total sales exceed $7 million in principal. None of the bonds or notes were registered under the Securities Act of 1933, 15 U.S.C. Secs. 77a-77aa. We shall assume that the materials used to sell the bonds and notes omitted essential information about the risks involved in the Project.

The purchasers of bonds between January 1974 and October 1976, and of notes between November 1976 and March 1978, are the plaintiffs in this suit under Sec. 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. Sec. 78j(b), and the SEC's Rule 10b-5, 17 C.F.R. Sec. 240.10b-5. The Foundation issued notes before January 1974, but the interest and principal on these notes were paid in full. The original defendants include just about everyone who had any connection with the Project. A series of settlements, coupled with the sale of the Project, produced a fund from which the purchasers of the bonds have been paid between 120% and 125% of the face value of their instruments. The purchasers of the notes have recovered 35.79% of the face value. Because of the time value of money, even the bondholders have not been made whole. Six defendants did not settle, and a separate judgment under Fed.R.Civ.P. 54(b) has brought two of these before us.

Henderson, Franklin, Starnes & Holt (the Law Firm) furnished legal advice to the Foundation and its predecessors in interest (collectively the Foundation) from 1971 through 1976. Taylor, Edenfield, Gilliam & Wiltshire (the Accounting Firm) furnished accounting services during the same period. The district court reviewed the voluminous materials produced during discovery and wrote a lengthy opinion explaining why neither the Law Firm nor the Accounting Firm was sufficiently involved in the sale of the securities to be liable for any of the Foundation's sins. Barker v. Lee County Bank, 1985 Fed.Sec.L.Rep. (CCH) p 92,404 (N.D.Ill.1985). The district court's thorough opinion makes it unnecessary to repeat the facts. Instead we set out some typical examples of things a jury might find and that plaintiffs believe demonstrate the Firms' complicity.

William Graddy, a partner of the Law Firm, gave advice to the Foundation at the inception of the project. Julian Clarkson, another partner of the Law Firm, was a director of the Trustee and chairman of its Trust Committee. Fred Edenfield, a partner of the Accounting Firm, gave advice to the Foundation at the outset of the project. Edenfield and Graddy were good friends. The plaintiffs' case against the two Firms is essentially that (a) the Firms sent the Foundation down the wrong path, failing at the outset to insist that it register the securities and disclose the risks involved; (b) the Firms knew of the Foundation's continued solicitation of funds but did not "blow the whistle"; (c) the Firms induced the Trustee to lend implied support to the securities through October 1976 by acting as Trustee.

Graddy and other attorneys at the Law Firm assisted the Foundation in organizing the Project under state law, drawing up its bylaws, and negotiating the purchase of the land. The purchase was complex, with the seller financing much of the sale and releasing the mortgage in strips as the Foundation paid installments. Graddy and Edenfield were among the incorporating directors of the Foundation, although they were immediately replaced by the permanent directors. Graddy knew of the plan to finance the Project through bonds, and he asked the Trustee to serve in that role. Graddy prepared the trust indenture. The indenture, although legally sufficient, did not contain controls sufficient to prevent the losses that ensued.

The Foundation raised its first money in 1972. Graddy and Edenfield reviewed a draft of the proposed selling document in 1971. Edenfield reviewed a draft projection in 1973, the same year Graddy reviewed a draft letter of solicitation. Neither asked the Foundation to make substantial changes. We assume that both men should have realized that there were substantial risks--that the Project was thinly capitalized, and that repayment of the bonds would require sales of further bonds, leases, or both, and that even a small problem could scuttle the Project. Both Graddy and Edenfield knew that other retirement villages had run into trouble--both financial difficulties and problems under the securities laws. Graddy knew that some of the directors of the Foundation had purchased an option on land in which the Foundation was interested and later sold their interest to the Foundation in exchange for some of the Foundation's bonds. Self-dealing could imperil the Foundation's exemption from the requirement of registration. See Sec. 3(a)(4) of the '33 Act, 15 U.S.C. Sec. 77c(a)(4). (It is uncontested, however, that these bonds were cancelled and that the Foundation never lost its status as a tax-exempt religious or charitable organization, and that no court has held that the securities should have been registered under the '33 Act.)

In September 1973 Graddy prepared the papers to increase the maximum amount of bonds the Foundation could sell. Edenfield received a pro forma balance sheet prepared by the Foundation. In 1976 Graddy participated in meetings at which an officer of the Trustee explored doubts about the Project. After these meetings, and other exchanges, the Trustee remained on the job until October. Graddy was aware of the possibility that the Foundation's failure to secure timely releases of the seller's interest in the land could imperil the security for the bonds. (As it turned out, the releases were late in coming, but the bonds still ended up with liens superior to those of the life-lease holders, the potentially competing claimants.)

The Law Firm and the Accounting Firm received the Foundation's selling documents during 1974-78 but did nothing to stop the sale of the securities and facilitated their sale by answering the Trustee's inquiries in a fashion that led the Trustee not to drop out until October 1976. We will assume that some of the answers to the Trustee's questions concealed legal difficulties. For example, the Law Firm allowed the Trustee to conclude that there were "[n]o known defaults" under the indenture, meaning that the Foundation had not "defaulted" in the payment of principal or interest; but a jury might conclude that the Law Firm should have known that the Trustee was interested in whether any legal problems, such as potential liability under the securities law, had arisen.

The following is also undisputed:

--Neither Firm reviewed or approved any of the materials used to sell the securities between 1974 and 1978. None of the drafts that the Firms saw in 1971 and 1973 was used to sell securities during 1974-78.

--Neither Firm received any of the proceeds of the sales. Neither Firm had a representative on the Foundation's board.

--Neither Firm's name appeared on any document used to sell the securities at any time.

--At Graddy's request, the Foundation retained two other law firms to review the promotional materials and give advice about the securities laws. One or both of these firms reviewed the materials used during 1974-78. Graddy told the Foundation that he had no expertise in securities matters.

--During 1974-75 the Law Firm billed the Foundation a total of $125. It ceased representing the Foundation in any way before the first note was sold.

--The Accounting Firm prepared the Foundation's financial statements through 1975, but none of these statements was used in any promotional material. The Foundation requested Edenfield to sign a pro forma balance sheet in 1973 for use in the promotional materials; he refused. During the audit for 1975 the Accounting Firm found that officers of the Foundation had drawn unauthorized sums and qualified its opinion of the financial statement. The Foundation then fired the Accounting Firm.

The district court held, and we agree, that these undisputed facts require summary judgment for the two Firms, even taking other inferences in the light most favorable to the plaintiffs.

I

The Securities Act of 1933 has an intricate set of rules establishing who is liable when securities are sold by the use of false or misleading documents. Section 11, 15 U.S.C. Sec. 77k, creates presumptive liability for the issuer, all members of its board, and all who sign the prospectus or are named as preparing it. Members of the board and other signers can use a series of "due diligence" and "reliance on expertise" defenses. Section 12, 15 U.S.C. Sec. 77 l, imposes liability on those who offer or sell the security, but if the problem was in the selling documents...