SECURITIES & EXCH. COM'N v. Diversified Indus.

• Decision Date: 05 February 1979
• Docket Number: Civ. A. No. 76-2114.
• Citation: 465 F. Supp. 104
• Parties: SECURITIES AND EXCHANGE COMMISSION, Plaintiff, v. DIVERSIFIED INDUSTRIES, INC., et al., Defendants.
• Court: U.S. District Court — District of Columbia

465 F. Supp. 104

SECURITIES AND EXCHANGE COMMISSION, Plaintiff, v. DIVERSIFIED INDUSTRIES, INC., et al., Defendants.

Civ. A. No. 76-2114.

United States District Court, District of Columbia.

February 5, 1979.

COPYRIGHT MATERIAL OMITTED

Michael F. Perlis, Adele R. Geffen, Washington, D. C., for plaintiff.

Daniel P. Levitt, Kramer, Lowenstein, Nessen, Kamin & Soll, New York City, William L. Borden, Washington, D. C., for defendant Aronoff.

Seymour Glanzer, Dickstein, Shapiro & Morin, Washington, D. C., for defendant Fox.

Donald J. Mulvihill, Cahill, Gordon & Reindel, New York City, for defendant Castle.

George P. Felleman, Paul, Weiss, Rifkind, Wharton & Garrison, New York City, Robert Loeffler, Isham, Lincoln & Beale, Washington, D. C., for defendant JDL Trust.

Harvey L. Pitt, Fried, Frank, Shriver & Kampelman, Washington, D. C., for defendant Penn-Dixie Industries, Inc.

MEMORANDUM OPINION

CHARLES R. RICHEY, District Judge.

In the Spring of 1975, the Securities and Exchange Commission (hereinafter, "the Commission") began investigating charges arising out of a proxy contest between Penn-Dixie Industries, Inc. (hereinafter, "Penn-Dixie") and Diversified Industries, Inc. (hereinafter, "Diversified"). The Commission's investigation resulted in the filing of this action on November 15, 1976, against Diversified, Penn-Dixie, Jerome Castle, Ben Fixman, Arnold Y. Aronoff, Sam Fox, Morris Lefton, Jack Kootman, E. Allen Payne, and Castle Bank and Trust, Ltd., as trustee for the JDL Trust.¹

The complaint in this action consists of seven counts. The first three counts pertain to the internal affairs and business practices of Diversified and include charges of short-weighting customers, commercial bribery, and fraudulent bookkeeping. All of the defendants charged in these counts have consented to the entry of final judgment.

Counts IV through VI relate to a fraudulent real estate transaction. Count IV charges the defendants Castle, Aronoff, Penn-Dixie and the JDL Trust with violations of section 10(b) of the Securities Exchange Act of 1934 (hereinafter, "the Act"), 15 U.S.C. § 78j(b) (1976) and Rule 10b-5, 17 C.F.R. 240.10b-5 (1978). The Commission alleges that Aronoff conspired with Castle, then President and Chairman of the Board of Penn-Dixie, to arrange for the purchase of undrainable Florida swampland by Penn-Dixie for over five million dollars from the JDL Trust, a trust set up by Aronoff for the benefit of his parents and children. According to the complaint, the defendants conspired to defraud the shareholders of Penn-Dixie by fraudulently inducing a public corporation to issue a security, the mortgage for the land, in connection with the acquisition of this investment property.²

Counts V and VI of the complaint allege violations of the reporting provisions of the federal securities laws. Count V charges that Castle, Penn-Dixie, and Aronoff violated section 13(a) of the Act, 15 U.S.C. § 78m(a) (1976) and Rules 12b-20 and 13a-1, 17 C.F.R. 240.12b-20 and 240.13a-1 (1978) by filing false and misleading Annual Reports which failed to disclose the allegedly fraudulent activities surrounding the purchase by Penn-Dixie of the Florida real estate. Count VI charges Castle and Penn-Dixie with violations of section 14(a) of the Act, 15 U.S.C. § 78n(a) (1976) and Rule 14a-9, 17 C.F.R. 240.14a-9 (1978) for filing false and misleading proxy statements which also failed to disclose the alleged swampland fraud.

Count VII of the complaint charges the defendants Castle, Penn-Dixie, and Fixman with violating section 13(d) of the Act, 15 U.S.C. § 78m(d) (1976) and Rule 13d-1, 17 C.F.R. 240.13d-1 (1978) for failing to file 13D schedules while beneficially owning more than five percent of the outstanding stock of Diversified.

On December 21, 1976, Arnoff filed a motion to dismiss and other relief and an alternative motion for severance and transfer. On January 11, 1977, the JDL Trust filed a similar motion for dismissal and other relief and an alternative motion for severance. Oral argument on these motions was held on June 15, 1977 before Judge Waddy.³ On October 6, 1977, Castle filed a motion to dismiss, for summary judgment, and to strike the complaint as sham. This case is currently before the Court on these motions.

I. THE PURCHASE MONEY MORTGAGE PENN-DIXIE ISSUED TO THE JDL TRUST IS A "SECURITY" WITHIN THE MEANING OF THE FEDERAL SECURITIES LAW.

The defendants in their papers in support of their motion to dismiss and in their oral argument before Judge Waddy have tried to characterize this case as an attempt by the Commission to convert the securities laws into a general remedy for real estate fraud. The defendants contend that if the Court finds that the securities laws apply in this case every homeowner who sells his or her home would be subject to the anti-fraud provisions of the 1934 Securities Exchange Act. The Commission distinguishes this situation from the average homeowner's case by pointing to three factors: (1) the note was issued for the acquisition of an investment asset, (2) the note was issued by a public company, and (3) the note was not initially issued to a bank or other party in the business of making loans.

To render the Securities Exchange Acts of 1933 or 1934 applicable to a transaction, a "security" must be exchanged. The Commission relies on the ten-year purchase money mortgage note Penn-Dixie issued to the JDL Trust as part payment for the Florida real estate to satisfy this requirement.

Although there are slight differences in wording between the 1933 and 1934 Acts, the definitions of "security" in the two acts have been treated as functionally equivalent. See Tcherepnin v. Knight, 389 U.S. 332, 335-336, 88 S.Ct. 548, 19 L.Ed.2d 564 (1967); National Bank of Commerce v. All American Assurance Co., 583 F.2d 1295 (5th Cir. 1978); United California Bank v. THC Financial Corp., 557 F.2d 1351, 1356 (9th Cir. 1977); Great Western Bank & Trust v. Kotz, 532 F.2d 1252, 1255 (9th Cir. 1976).

The definitional section of the Securities Exchange Act of 1934, 15 U.S.C. § 78c(a)(10) (1976), provides that, "unless the context otherwise requires— . . . (10) The term `security' means any note . . . but shall not include . . . any note . . . which has a maturity date at the time of issuance of not exceeding nine months . . . ." The definitional section of the 1933 Act has a similar definition of "security" with the exception of the nine-month limitation. 15 U.S.C. § 77b(1) (1976). Although the statutes on their faces are readily discernible, judicial interpretation has clouded their clarity. In the words of a recent commentator:

The courts have recently made it clear that despite the apparently contrary language of (the definitional statutes), (1) not all notes of more than 9 months' duration are "securities" and not all notes of less than such duration are not "securities," (2) the decisive factor in the determination of whether notes fall within the 1933 or 1934 Act is the type of note, and not its duration, and (3) this decisive factor is itself not readily determinable.

Kaplan, Promissory Notes as Securities Under § 2(1) of Securities Act of 1933 (15 U.S.C. § 77b(1)), and § 3(a)(10), of Securities Exchange Act of 1934, 39 A.L.R.Fed. 357, 365 (1978).

Unfortunately, the U.S. Circuit Courts of Appeals that have confronted this issue have devised somewhat different tests to determine whether a note constitutes a "security," and the judges of this circuit court have yet to address this problem. Accordingly, the Court must examine the varying approaches taken by the different circuits to the problem before the Court.

A. The Commercial/Investment Dichotomy Test of the Third, Fifth, Seventh, and Tenth Circuits.

The "investment/commercial dichotomy test," which has been followed in the Third, Fifth, Seventh, and Tenth Circuits, is premised on the view that Congress' concern in enacting the securities laws was with practices associated with investment transactions and that the securities laws were not designed to regulate commercial transactions. See C.N.S. Enterprises, Inc. v. G. & G. Enterprises, Inc., 508 F.2d 1354, 1359 (7th Cir.) cert. denied 423 U.S. 825, 96 S.Ct. 38, 46 L.Ed.2d 40 (1975). The decision of the U.S. Court of Appeals for the Seventh Circuit in C.N.S. Enterprises, Inc. contains a helpful description of the investment/commercial test:

The ultimate question is whether the plaintiffs are simply borrowers in a commercial transaction who are not protected by the 1934 Act or investors in a securities transaction who are protected.

In one sense every lender of money is an investor since he places his money at risk in anticipation of a profit in the form of interest. Also in a broad sense every investor lends his money to a borrower who uses it for a price and is expected to return it one day.

On the other hand, the polarized extremes are conceptually identifiable: buying shares of common stock of a publicly-held corporation, where the impetus for the transaction comes from the person with the money, is an investment; borrowing money from a bank to finance the purchase of an automobile, where the impetus for the transaction comes from the person who needs the money, is a loan. In between is a grey area which, in the absence of further congressional indication of intent or Supreme Court construction, has been and must be in the future subjected to case-by-case treatment.

Id. at 1359. (citations omitted).

Although a case-by-case approach has been adopted under the commercial/investment dichotomy approach, courts have focused on certain factors to guide the application of the test. Despite the defendants' contentions to the contrary, one of the factors the courts have focused on in applying the test is the nature of the assets acquired in exchange for the notes. The defendants are correct in pointing out that every time an investment asset is acquired, the notes have not been determined to be...