Frederiksen v. Poloway

• Decision Date: 08 January 1981
• Docket Number: No. 80-1292,80-1292
• Citation: 637 F.2d 1147
• Parties: Fed. Sec. L. Rep. P 97,815 Jeffrey E. FREDERIKSEN and Emerald City Corporation, an Illinois Corporation, Plaintiffs-Appellants, v. Edward T. POLOWAY, Defendant-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 1147

637 F.2d 1147

Fed. Sec. L. Rep. P 97,815

Jeffrey E. FREDERIKSEN and Emerald City Corporation, an Illinois Corporation, Plaintiffs-Appellants, v. Edward T. POLOWAY, Defendant-Appellee.

No. 80-1292.

United States Court of Appeals, Seventh Circuit.

Argued Oct. 31, 1980.

Decided Jan. 8, 1981.

Mark H. Schiff, Kaplan, Bernstein & Waller, Chicago, Ill., for plaintiffs-appellants.

Michael H. Moirano, Howington, Elworth, Osswald & Hough, Chicago, Ill., for defendant-appellee.

Before FAIRCHILD, Chief Judge, SPRECHER and CUDAHY, Circuit Judges.

SPRECHER, Circuit Judge.

This case involves the scope of the federal securities laws. The question we confront is whether alleged fraud regarding the sale of assets and stock in a corporation falls within the scope of those laws. Not all sales transactions which involve "stock" are necessarily covered by the securities laws. Rather, the test for coverage, in general is whether the purchaser is placing money in the hands of another who will control the funds and the business decisions. If, however, the purchaser is assuming control of the critical decisions of the corporation, then the transaction is not considered to involve "securities". Here, we find that the purchaser took control of the corporation. Therefore, this situation does not involve a "security" within the meaning of the federal securities laws.

I

During the months of August through October, 1978, Jeffrey E. Frederiksen and Emerald City Corporation ("ECC") negotiated for, and then purchased, the assets and stock of North Shore Marina, Inc. ("NSM"). NSM was in the business of selling, servicing and providing storage facilities for boats at its location in Waukegan, Illinois. The negotiations culminated on October 14, 1978, with the signing of four agreements. The agreements, signed by Mr. Frederiksen, in his capacity as president of ECC, and by Edward Poloway, in his capacity as president and sole shareholder of NSM and in his individual capacity, were as follows: (1) agreement by ECC to purchase assets of NSM; (2) stock purchase and voting trust agreement; (3) employment agreement between ECC and Mr. Poloway; and (4) management agreement between ECC and NSM.

The purchase agreement provided that NSM would sell its assets to ECC for $191,800. The purchase price was to be paid as follows: $160,000 was to be paid into an escrow account to be used to pay all existing debts of NSM and any unknown liabilities; the balance, $31,800, was to be paid in equal monthly installments over a three year period beginning October 14, 1979.

The stock purchase and voting trust agreement provided that in exchange for $10, Mr. Poloway would sell 10% of the issued and outstanding stock of NSM to ECC, and, for an additional $10 consideration, would transfer his remaining 90% of the issued and outstanding shares of NSM into a voting trust controlled by Mr. Frederiksen. The agreement also provided that after all debts of NSM were paid out of the escrow account, or earlier at the option of ECC, NSM would pay the balance of the funds to Mr. Poloway as the full price for redemption of his shares held in the voting trust.

The employment agreement provided that for a period of five years, ECC would employ Mr. Poloway to "assist, guide and give his expertise" in all areas of ECC'S business. Mr. Poloway was to perform within the "goals, guidelines, directives, policies and procedures" set forth by ECC in return for an annual salary of $32,000. As additional compensation, Mr. Poloway was to receive a consulting fee and a 20% commission on the sale of new boats, accessories, and brokerage sales.

The management agreement granted ECC authority to operate and manage the marina facilities. ECC was to receive as compensation 50% of the gross income derived from the operation of the pavilion at the Waukegan marina. All expenses ECC incurred in operating the pavilion were to be deducted from the remaining 50% of gross income, and the remaining balance was to be paid to NSM. It was the understanding of the parties, however, that the operational expenses together with the management fees to be paid to ECC under the agreement, would, in all probability, eliminate any income to NSM.

On or about May 11, 1979, ECC terminated its employment agreement with Mr. Poloway. On June 14, 1979, Mr. Poloway filed suit against ECC and Mr. Frederiksen in the Circuit Court of Lake County, Illinois for breach of contract and fraud.

On September 14, 1979, ECC and Mr. Frederiksen filed this suit in the United States District Court for the Northern District of Illinois. Plaintiffs allege that the interests they acquired in NSM are "securities" within the meaning of the federal securities acts and that, in connection with the sale of those interests, Mr. Poloway failed to disclose or misrepresented certain material facts. Plaintiffs claim that Mr. Poloway's conduct violates the 1933 and 1934 securities acts, and they seek to recover $1,250,000 in actual damages and lost profits. Plaintiffs also have asserted pendent claims for breach of the Illinois securities laws, common-law fraud, and breach of contract.

Mr. Poloway moved to dismiss the complaint, arguing that the acquisition of NSM did not involve a "security" within the purview of the federal securities laws. He argued that since there was no diversity of citizenship, there was, thus, no basis for subject-matter jurisdiction. Alternatively, Mr. Poloway argued that the complaint failed to allege fraud with particularity, and that Mr. Frederiksen was not a proper party to the action. The district court granted Mr. Poloway's motion and dismissed the suit. The plaintiffs now appeal that dismissal. We affirm the district court's dismissal on the ground that this transaction does not involve a "security" within the meaning of the federal securities laws.

II

The critical legal issue in this case is whether the plaintiffs' acquisition of North Shore Marina involves a "security" within the meaning of the 1933 and 1934 securities acts. We begin the analysis of this issue with a review of the purpose of the securities laws.

The purposes of and policies behind the securities laws were examined by the Supreme Court in the leading case of United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 95 S.Ct. 2051, 44 L.Ed.2d 621 (1975). In Forman, residents of a cooperative housing project, who had been required to purchase "stock" in the housing corporation in order to acquire coop units, filed an action for fraud under the federal securities laws. The Supreme Court held that the shares of stock involved did not constitute "securities" within the meaning of those laws. The Court recognized that:

The primary purpose of the Acts of 1933 and 1934 was to eliminate serious abuses in a largely unregulated securities market. The focus of the Acts is on the capital market of the enterprise system: the sale of securities to raise capital for profit-making purposes, the exchanges on which securities are traded, and the need for regulation to prevent fraud and to protect the interest of investors.

Id. at 849, 95 S.Ct. at 2059. The Court emphasized that the securities laws do not apply when the goal of a purchaser is not investment but is a desire to "use or consume the item purchased." Id. at 852-53, 95 S.Ct. at 2060.

Recent decisions of this court recognize that the key to defining the scope of the securities laws is whether the transaction is primarily for commercial (i, e., motivated by a desire to use, consume, occupy or develop), or for investment purposes. See Canadian Imperial Bank of Commerce Trust Co. v. Fingland, 615 F.2d 465, 470 (7th Cir. 1980) (complaint regarding bank certificates of deposit did not plead securities fraud where it "simply describes a victim whose currency was being held in a commercial transaction and not a victim-investor aspiring for profits"); Emisco Industries, Inc. v. Pro's Inc., 543 F.2d 38 (7th Cir. 1976) (note given as part of sale of all assets of a corporation not an investment where there was no reliance on efforts of others to produce profit).

III

We now turn to plaintiffs' claim that the interest they acquired in NSM constitute "securities" within the meaning of the federal securities laws. ¹ First, plaintiffs argue that ECC's purchase of NSM stock falls under the literal wording of the federal securities laws and, for that reason, a legal presumption exists that a security was sold. There are several problems with this "literal application" theory.

The first problem is that the language in the securities acts is not as broad as the plaintiffs contend. Although 15 U.S.C. § 78c(a)(10) ("1934 Act") provides that, "(t)he term security means any ... stock," that definition, as are all the definitions in § 78c(a), is preceded by the phrase "unless the context otherwise requires." 15 U.S.C. § 78c(a). The definition of "security" in the Securities Act of 1933 is prefaced by the same phrase. 15 U.S.C. § 77b(1).

The second problem is that it is not the case that any conduct within the theoretical reach of a statute is necessarily governed by that statute. In Church of the Holy Trinity v. United States, 143 U.S. 457, 459, 12 S.Ct. 511, 512, 36 L.Ed. 226 (1892), the Supreme Court stated:

It is a familiar rule, that a thing may be within the letter of the statute and yet not within the statute, because not within its spirit, nor within the intention of its makers.

The third problem with the plaintiffs' "literal application" argument is that the Forman decision and its progeny have specifically rejected that argument. The Forman Court stated:

We reject at the outset any suggestion that the present transaction, evidenced by the sale of shares called "stock," must be considered a security transaction simply because the statutory definition of a security includes the words "any ... stock." Rather we adhere to the basic principle that has guided all of the Court's decision in this area:

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