Pacific Dunlop Holdings Inc. v. Allen & Co. Inc., 91-2346

• Decision Date: 07 May 1993
• Docket Number: No. 91-2346,91-2346
• Citation: 993 F.2d 578
• Parties: , Fed. Sec. L. Rep. P 97,450 PACIFIC DUNLOP HOLDINGS INCORPORATED, a Delaware Corporation, Plaintiff-Appellant, v. ALLEN & COMPANY INCORPORATED, a New York Corporation, Defendant-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 578

993 F.2d 578

61 USLW 2703, Fed. Sec. L. Rep. P 97,450

PACIFIC DUNLOP HOLDINGS INCORPORATED, a Delaware Corporation, Plaintiff-Appellant, v. ALLEN & COMPANY INCORPORATED, a New York Corporation Defendant-Appellee.

No. 91-2346.

United States Court of Appeals Seventh Circuit.

Argued Sept. 11, 1992.

Decided May 7, 1993.

Peter J. Meyer, Michael J. Koenigsknecht (argued), Andrew C. Spiropoulos, John W. Raihala, Gardner, Carton & Douglas, Chicago, IL, for plaintiff-appellant.

Derke J. Price, Nick J. DiGiovanni, Lord, Bissell & Brook, Chicago, IL, James C. McMillin (argued), Kevin J. Toner, Werbel, McMillin & Carnelutti, New York City, for defendant-appellee.

Before BAUER, Chief Judge, MANION, Circuit Judge, and MOODY, District Judge. ^* , ^** MANION, Circuit Judge.

This case presents a single issue of law: the scope of section 12(2) of the Securities Act of 1933 (1933 Act), 48 Stat. 74, as amended, 15 U.S.C. § 77l, as it involves civil fraud in a security transaction. ¹ On October 1, 1987 Pacific Dunlop Holdings Inc. ("Pacific") entered into a stock purchase agreement with GNB Holdings Inc. ("GNB") and its other shareholders, Allen & Company Incorporated ("Allen"), Daniel E. Heffernan and thirteen other individuals. The defendants in this case, Allen, an investment banking firm, owned approximately 20 percent of the stock, and Heffernan owned 6.7 percent. ² Neither defendant is considered a management shareholder. A few months earlier GNB filed a registration statement with the Securities Exchange Commission in order to make an initial public offering of 5,800,000 shares of common stock, including some stock owned by Heffernan. No securities were ever sold pursuant to the registration statement. GNB abandoned the public offering once it entered into the private stock purchase agreement with Pacific, although the agreement did warrant and represent the truthfulness of the information in the registration statement.

Pacific's purchase of GNB brought its ownership to approximately 92 percent of the outstanding common stock for a total cost of $670 million. ³ GNB is a holding company whose subsidiaries engage in the manufacture and sale of industrial and lead acid batteries and the recovery, smelting and sale of lead. In pertinent part the stock purchase agreement represented that GNB and its subsidiaries were in compliance with environmental laws and regulations, were not subject to any pending or threatened governmental investigation and had disclosed all liabilities or obligations. But in reality, GNB was exposed to and now faces extensive environmental claims, liabilities regarding a government services contract, and occupational disease claims. In part to avoid the liabilities and to expunge itself from the plethora of problems GNB faces, Pacific seeks to rescind the deal. Allen is not interested; it prefers to keep the money rather than regain the stock.

Pacific's complaint asserts that Allen omitted material facts that rendered its representations in the stock purchase agreement false and misleading, constituting fraud in violation of the Securities Act, section 12(2), and the Illinois Securities laws. ⁴ Allen moved to dismiss the complaint for failing to state a claim upon which relief could be granted. The district court summarily dismissed the complaint, relying upon the Third Circuit opinion in Ballay v. Legg Mason Wood Walker, Inc., 925 F.2d 682 (3d Cir.), cert. denied, --- U.S. ----, 112 S.Ct. 79, 116 L.Ed.2d 52 (1991).

Section 12(2) prohibits fraud in a prospectus. However, there are many possible interpretations of "prospectus." Section 2(10) contains an explicit definition of prospectus; however, this definition may not control if the context of the securities laws and their legislative history require otherwise. Pacific wants the section 2(10) definition to apply in this case. Because of its broad wording, the definition of prospectus would include the stock purchase agreement and provide Pacific relief. Allen, however, wants a more narrow definition, arguing section 12(2) does not apply to secondary market transactions. Case law provides authority on each side of the dispute. Ultimately, we conclude that Pacific has a cause of action, based on the text of the 1933 Act, its legislative history, and the impact of section 12(2) on similar fraud provisions in the security laws.

I. Conflict of Authority

The 1933 Act was passed by Congress during an era in our country's history marked by grave concern over the securities market. Since that time numerous district courts have applied section 12(2) of the 1933 Act to similar facts yielding different results. E.g., Bank of Denver v. Southeastern Capital Group, Inc., 763 F.Supp. 1552, 1558-59 (D.Colo.1991) (and cases cited therein); see 17A J. William Hicks, Civil Liabilities: Enforcement and Litigation Under the 1933 Act, § 6.01, pp. 12-34 (1992). In Ballay, which the district court relied on in this case, investors had purchased outstanding securities of Wickes Corporation from stockbrokers employed by Legg Mason. 925 F.2d at 684. A jury found for the investors and against the brokerage firm for oral misrepresentations concerning the actual value of the stock. Id. at 686. The Third Circuit reversed, holding that section 12(2) applies only to initial distributions, not to after-market trading, based on "the language and legislative history of section 12(2), as well as its relationships to sections 17(a) and 10(b) within the scheme of the 1933 and 1934 Acts." Id. at 693. ⁵ Cf., Louis Loss, Commentary, The Assault on Securities Act Section 12(2), 105 Harv.L.Rev., 908 (1992).

Although the Supreme Court has not specifically addressed whether section 12(2) applies solely to initial offerings, the Supreme Court assumed to the contrary in Wilko v. Swan, 346 U.S. 427, 74 S.Ct. 182, 98 L.Ed. 168 (1953). In Wilko, investors sued their brokerage firm, Hayden, Stone & Co., pursuant to section 12(2) for misrepresentations concerning the value of the common stock of Air Associates, Incorporated (based on a merger contract with Borg Warner Corporation), and for omitting to state that an Air Associates director was also selling his stock. Id. at 429, 74 S.Ct. at 183-84. The brokerage firm moved to stay the district court proceedings pending arbitration in accordance with their margin agreements with the investors. The district court denied the motion, concluding that arbitration was contrary to the remedies afforded by the 1933 Act. Wilko v. Swan, 107 F.Supp. 75, 79 (1952). The Second Circuit reversed, holding that the congressional policies under the United States Arbitration Act permitted arbitration of the dispute, overriding the 1933 Act. Wilko v. Swan, 201 F.2d 439, 445 (1953). The Supreme Court reversed the Second Circuit, holding that an arbitration agreement could not waive the provisions of section 12(2) of the 1933 Act, notwithstanding the Arbitration Act. Wilko v. Swan, 346 U.S. at 438, 74 S.Ct. at 188-89.

Although in Wilko the arbitration provision of the margin agreements between the investors and their brokerage firm was the only issue raised in the motion to dismiss the complaint, ⁶ the posture of the case included the facts that no registration statement had been filed, and the securities involved common stock on the after-market, not an initial offering. On these facts the Supreme Court stated:

In response to a Presidential message urging that there be added to the ancient rule of caveat emptor the further doctrine of "let the seller also beware," Congress passed the Securities Act of 1933. Designed to protect investors, the Act requires issuers, underwriters, and dealers to make full and fair disclosure of the character of securities sold in interstate and foreign commerce and to prevent fraud in their sale. To effectuate this policy, § 12(2) created a special right to recover for misrepresentation which differs substantially from the common-law action in that the seller is made to assume the burden of proving lack of scienter.

Wilko, 346 U.S. at 430-31, 74 S.Ct. at 184-85 (emphasis added; footnotes omitted). Although dicta, the Supreme Court's recognition that section 12(2) applies to dealers ⁷ stands in opposition to the Third Circuit's holding in Ballay, 925 F.2d 682. This reasoning survived Rodriguez De Quijas v. Shearson/American Express, Inc., 490 U.S. 477, 109 S.Ct. 1917, 104 L.Ed.2d 526 (1989). ⁸

Also contrary to the Third Circuit's holding in Ballay stands the Tenth Circuit's opinion in Woodward v. Wright, 266 F.2d 108 (1959). Wright had assigned the majority of his interest in an oil and gas lease to Forrest and Hanna, who decided to sell the lease to Woodward and some fellow businessmen. The district court found that the sellers had mailed a prospectus to the purchasers that contained material false statements, but that the transaction did not violate sections 12(1)-(2). Id. at 112. The Tenth Circuit first ruled that the oil and gas lease involved a security sale within the meaning of the 1933 Act. Id. at 114. Second, "[t]he whole transaction was a closely knit arrangement among friends and acquaintances, and was conducted on a personal basis. All of the purchasers apparently entered into the transaction with sophisticated discernment." Id. at 115 (emphasis and citation omitted). Thus, the court concluded that the single transaction was not a public offering and did not violate section 12(1) ⁹ by failing to file a registration statement. Finally, on the question of section 12(2) liability, the Tenth Circuit reversed the district court in favor of the purchasers.

[T]he [s]ection [12(2) ] remedy is applicable to the sale of all securities (with exceptions not here material) whether exempt from the registration requirements or not, or whether the sellers were issuers for the purpose of public offering or not.

Woodward, 266 F.2d at 116. As in the Wilko decision, in Woodward neither the parties nor the court directly...