Burns v. Paddock

• Citation: 503 F.2d 18
• Decision Date: 04 October 1974
• Docket Number: No. 73-1243,73-1243
• Parties: Fed. Sec. L. Rep. P 94,789 Robert K. BURNS et al., Plaintiffs-Appellants, v. Stuart R. PADDOCK, Jr., et al., Defendants-Appellees.
• Court: United States Courts of Appeals. United States Court of Appeals (7th Circuit)

Page 18

503 F.2d 18

Fed. Sec. L. Rep. P 94,789

Robert K. BURNS et al., Plaintiffs-Appellants, v. Stuart R. PADDOCK, Jr., et al., Defendants-Appellees.

No. 73-1243.

United States Court of Appeals, Seventh Circuit.

Argued Jan. 25, 1974.

Decided Sept. 5, 1974, Rehearing Denied Oct. 4, 1974.

Edward L. S. Arkema, Robert Plotkin, Chicago, Ill., for plaintiffs-appellants.

Edward L. Foote, Chicago, Ill., for defendants-appellees.

Before PELL, STEVENS, and SPRECHER, Circuit Judges.

PELL, Circuit Judge.

Plaintiffs-appellants John R. Malone and George M. Hilgendorf appeal from the district court's dismissal of their first amended complaint (hereinafter designated complaint) and denial their motion for a preliminary injunction. ¹

The action arises from plaintiffs' purchase of a minority interest in the Paddock corporation, a close corporation engaged in the business of publishing community newspapers. ² The defendant Stuart R. Paddock, Jr., Robert Y. Paddock, and Margie Flanders (Paddock) are brothers and sister. During the period in question, the Paddocks were directors and the majority shareholders in the Paddock corporation. Defendant Andrew Lamb was not associated with the corporation at the time of plaintiffs' purchases but later became an officer and director of the company.

The complaint contained five counts, ³ each proposing an alternative theory of liability. Count I was based on section 10(b) of the Securities Exchange Act of 1934 (15 U.S.C. 78j(b)), Rule 10b-5 of the Securities Exchange Commission (17 C.F.R. 240.10b-5), and section 17 of the Securities Act of 1933 (15 U.S.C. 77q). ⁴ Counts II and III were based on the same federal statutes and rule as Count I plus the Illinois common law. Counts IV and V were based on the Delaware and the Illinois common law. Jurisdiction was based on section 22(a) of the Securities Act of 1933 (15 U.S.C. 77v(a)), section 27 of the Securities Exchange Act of 1934 (15 U.S.C. 78aa), and the doctrine of pendent jurisdiction. The plaintiffs sought damages as well as declaratory and injunctive relief.

The district court dismissed the complaint for failure to state a claim upon which relief could be granted. ⁵ At the same time the district court denied the plaintiffs' petition for a preliminary injunction. The plaintiffs appeal from these orders.

We note at the outset that, on a motion to dismiss, the allegations in the complaint must, of course, be taken as true with any reasonable inferences drawn in favor of the pleader. '(A) complaint should not be dismissed for failure to state a claim unless it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief.' Conley v. Gibson, 355 U.S. 41, 45-46, 78 S.Ct. 99, 102, 2 L.Ed.2d 80 (1975).

COUNT I.

Count I alleges that the defendants violated the federal securities fraud statutes and rules by inducing Malone and Hilgendorf to purchase securities in the Paddock corporation by means of promises which defendants did not intend to fulfill. In 1971, the Paddock corporation, according to the complaint, was in a 'desperate' financial condition. Malone and Hilgendorf were, at that time, officers and directors of the company but not shareholders. During 1971, they and a number of their friends purchased securities in the company. The Paddock family, however, retained the majority interest (53%) of the voting stock.

The complaint alleges that, in making their investments, the plaintiffs relied upon certain oral promises made to them by defendant Stuart Paddock, Jr., who was then president of the company. The alleged promises were:

'(a) That for a period of ten years, control of the Company would be placed in the Minority Investors through the device of a voting trust agreement establishing a voting trust in which was to be placed all of the Paddocks' stock and which would be effectively controlled by Minority Investors. (b) That no one would be permitted to become a director of the Company unless he owned at least one percent of the Company's stock. (c) That the plaintiffs would occupy certain important offices and positions with the Company and play important roles in the management of the Company. (d) That experienced outside professional management would be brought into the Company. (e) That the Company would form, participate in and vigorously promote a group advertising sales operation known as 'super group,' to which other publishers would be invited to join.'

The plaintiffs allege in their complaint that they would not have made the purchases of Paddock securities if these promises had not been made. They also allege that Stuart Paddock, Jr. made these promises with the intention of breaching them. The other defendants, according to the complaint, although it is asserted on information and belief, either authorized the promises or ratified them after they were made, all with the intention of not fulfilling them. All of the promises, it is alleged, have, in fact, been breached. ⁶ Finally, the plaintiffs allege that the defendants conspired to induce the plaintiffs to invest in the company, intending then to oppress the plaintiffs in a minority position until the plaintiffs agreed to sell their securities to the Paddocks at a price below the actual value of the securities.

The condition of the Paddock corporation has, the plaintiffs admit, vastly improved since they made their investments. The company has, nonetheless, allegedly lost a large amount of profits due to the defendants' failure to fulfill the promises.

Rule 10b-5 prohibits, inter alia, the employment of 'any device, scheme, or artifice to defraud' in connection with the purchase or sale of any security. The district court dismissed count I on the ground that 'broken promises do not rise to the level of fraud or a violation of Rule 10b-5.' This was a misstatement of the law.

Where a promise is made with the intention of not keeping it, there is a scheme or artifice to defraud. Durland v. United States, 161 U.S. 306, 313, 16 S.Ct. 508, 40 L.Ed. 709 (1896). This court has specifically adopted the rule that a promise made with a deceptive intent violates the securities acts.

'The law has been long established that a scheme to defraud may consist of suggestions and promises as to the future, when not made in good faith but with deceptive intent.' United States v. Herr, 338 F.2d 607, 610 (7th Cir. 1964), cert. denied, 382 U.S. 999, 86 S.Ct. 563, 15 L.Ed.2d 487 (1966).

See also, Robinson v. Cupples Container Co., 316 F.Supp. 1362, 1366 (N.D.Cal.1970); 1 A. Bromberg, Securities Law: Fraud 4.2, at 72 (1973).

In the present case, Malone and Hilgendorf alleged, in their complaint, that the defendants never had any intention of fulfilling the promises made to plaintiffs. They further alleged that they relied on the promises in making their investments. Such assertions were, under the circumstances, sufficient to allege actionable fraud under the federal securities laws.

The defendants contend, however, that the dismissal of the complaint can be justified on other grounds. The complaint affirmatively establishes, the defendants argue, both a lack of reliance and a lack of damages.

We turn first to the question of reliance. The defendants' argument with respect to reliance is comprised of, essentially, two steps. First, the defendants argue that the only promise which this court need consider is the one concerning the voting trust. This is the crucial promise, it is argued, since the group controlling the voting trust would also control the performance of the other four promises. Second, the defendants contend that the facts stated in the complaint affirmatively establish that Malone and Hilgendorf did not rely on the promise that the minority investors would control the voting trust.

We disagree with both parts of the defendants' argument concerning the plaintiffs' reliance. First, we reject the contention that, in determining whether the plaintiffs relied on the five promises, we need only consider the promise concerning the voting trust. Initially, we note that the last three of the remaining four promises would be implemented by the board of directors not those voting the shares. While it may be ordinarily assumed that directors elected under circumstances such as the present ones will be puppetarily responsive to the will of those who placed them in office, this result does not always necessarily follow. Further, as many corporate directors are now aware there are fiduciary obligations imposed on board members, violation of which will result in exposure to individual liability. In any event, it could be anticipated that during certain time periods, e.g., when positions on the board became vacant by death or resignation, the board would not necessarily be responsive to the will of the voting trust.

Moreover, even assuming that minority control of the voting trust would, in most circumstances, be sufficient to guarantee fulfillment of the other four promises, these other four promises could, nevertheless, have been fulfilled by the defendants without giving the minority investors control of the voting trust. The defendants do not question the plaintiffs' allegation that they relied on these four promises.

Even assuming, arguendo, that the voting trust promise is the only relevant promise, we do not find that the complaint affirmatively establishes a lack of reliance on this promise. The facts regarding the voting trust, as disclosed by the complaint, are as follows. The trust agreement, which provided for five trustees, was signed prior to the actual investment by plaintiffs. The five persons originally designated to be trustees were: defendants Stuart Paddock, Jr. and Robert Paddock; plaintiff Malone; and minority investors Fred Goss and Norman Isaacs. However before the plaintiffs purchased the securities, Goss and Isaacs decided not to invest in the company. Defendant Flanders and plainti...