Golden v. Garafalo

• Decision Date: 31 August 1981
• Docket Number: No. 81 Civ. 1987 (WCC).,81 Civ. 1987 (WCC).
• Citation: 521 F. Supp. 350
• Parties: Arthur GOLDEN and Gladys Golden, Plaintiffs, v. Anthony GARAFALO, Defendant.
• Court: U.S. District Court — Southern District of New York

521 F. Supp. 350

Arthur GOLDEN and Gladys Golden, Plaintiffs, v. Anthony GARAFALO, Defendant.

No. 81 Civ. 1987 (WCC).

United States District Court, S. D. New York.

August 31, 1981.

Kass, Goodkind, Wechsler & Labaton, New York City, for plaintiffs; Edward Labaton, John H. Riley, Richard Rosenblum, New York City, of counsel.

Warshaw, Burstein, Cohen, Schlesinger & Kuh, New York City, for defendant; William B. Aronstein, Milton Waxenfeld, New York City, of counsel.

OPINION AND ORDER

CONNER, District Judge:

Before the Court is the motion of defendant to dismiss the complaint for lack of jurisdiction over the subject matter, pursuant to Rule 12(b)(1), F.R.Civ.P. The issue presented is whether, after the decision of the United States Supreme Court in United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 95 S.Ct. 2051, 44 L.Ed.2d 621 (1975), the transfer of total ownership and control of a privately owned and operated business, accomplished by a sale of 100% of the stock of the corporation from defendant to plaintiffs, involves the purchase of a "security" under the Securities Act of 1933 ("1933 Act") and the Securities Exchange Act of 1934 ("1934 Act"). For the reasons which follow, the Court concludes that, on the facts of this case, it does not, and accordingly grants defendant's motion.

Background

This dispute centers around the transfer from defendant to plaintiffs of Mackey's Inc. ("Mackey's"), a ticket brokerage business. Prior to the transfer defendant owned 100% of the outstanding stock of Mackey's and was its Chief Operating Officer. Plaintiffs are engaged in the ticket brokerage business, and in or about November 1980 reached agreement generally with defendant for the purchase of Mackey's. The attorneys for the parties — the same attorneys who are appearing in this action —then entered into discussions as to how to structure the transaction; e. g., as a sale of assets or a sale of stock. Because the lease of the premises where Mackey's conducts business placed restrictions on any assignment of or subletting under the lease, it was agreed that the transfer would be structured as a purchase and sale of the stock of Mackey's.

A written agreement was signed on December 31, 1980. In it the purchase price of the stock is defined as an amount equal to the "Net Assets" of Mackey's, as defined in the agreement, plus $108,296. The purchase price is payable in three installments, the last two evidenced by promissory notes. The agreement provides for the transfer to plaintiffs of the resignation of all existing officers and directors of Mackey's, as well as its books and records, lease and contracts. By the agreement, defendant is prohibited from directly or indirectly engaging in any capacity in the ticket brokerage business in the United States for a period of five years.

The parties simultaneously executed a consulting agreement, which recites that defendant has sold his interest in Mackey's and is no longer employed by Mackey's; that defendant agrees to provide consulting and advisory services to Mackey's upon reasonable request for a fee of $100 per day; and that defendant is an independent contractor and not an employee of Mackey's.

Finally, also on December 31, 1980, counsel for plaintiffs wrote to defendant's attorney, confirming the agreement that "the new owners will have full operational control of the business and may change currently existing practices and policies."

The Lawsuit

Plaintiffs claim that defendant has made material misstatements, both in the contract of sale and in negotiations preceding the contract, regarding Mackey's, including the volume and nature of Mackey's sales.

The complaint is in five counts. The first count alleges violation of Section 17(a) of the 1933 Act, and Rule 10b-5, promulgated pursuant to Section 10(b) of the 1934 Act, and seeks rescission of the contract. Counts two through five are based upon the same factual allegations and plead claims of common law breach of contract, common law fraud, violation of a state securities statute and common law breach of the restrictive covenant agreement, respectively. Compensatory and punitive damages, as well as equitable relief, are sought. No diversity of citizenship exists, and thus jurisdiction over the latter four claims depends upon the application of principles of pendent jurisdiction.

The Motion

Defendant argues that the subject of the agreement between the parties was the outright sale of Mackey's, in which the purchase of stock was a mere indicium of ownership, and thus that the transaction did not involve the purchase of a "security" triggering application of the 1933 and 1934 Acts. Thus, argues defendant, there is no federal question presented and no basis for the exercise of pendent jurisdiction over the state law claims.

Forman

As indicated above, resolution of the issue in this case turns upon the proper interpretation to be given to the Supreme Court's decision in 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 state subsidized and supervised nonprofit low-income housing cooperative were required to purchase shares of stock in order to acquire their apartments. The sole purpose of acquiring the stock was to enable the purchaser to occupy an apartment, the number of shares being proportionate to the number of rooms in an apartment. The stock could not be transferred to a nontenant pledged or encumbered. Each apartment owner was entitled to one vote, regardless of the number of shares held. Any tenant terminating his occupancy had to resell the stock back to the issuer at its initial selling price, or, under limited circumstances, sell to a qualifying replacement tenant at virtually the same price.

The question before the Court was whether the shares of stock held by the housing cooperative residents were "securities" under the 1933 and 1934 Acts. The definitional sections of the Acts¹ define a "security" as "any ... stock, ... or investment contract ...," "unless the context otherwise requires." The Court of Appeals had found the "stock" in Forman to be securities both because it was denominated "stock" and because it possessed the characteristics of an investment contract. The Supreme Court reversed, holding that

"well-settled principles enunciated by this Court establish that the shares purchased by respondents do not represent any of the `countless and variable schemes devised by those who seek the use of the money of others on the promise of profits,' SEC v. W. J. Howey Co., 328 U.S. 293, 299, 66 S.Ct. 1100, 1103, 90 L.Ed. 1244 (1946), and therefore do not fall within the `ordinary concept of a security.'" Id. at 848, 95 S.Ct. at 2058.

The Court began its analysis by rejecting the proposition that the use of the term "stock" automatically qualified the shares as securities under the Acts. Quoting from its previous opinion in Tcherepnin v. Knight, 389 U.S. 332, 336, 88 S.Ct. 548, 553, 19 L.Ed.2d 564 (1977), the Court reiterated

"the basic principle that has guided all of the Court's decisions in this area:

`In searching for the meaning and scope of the word "security" in the Acts, form should be disregarded for substance and the emphasis should be on economic reality.'

"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. Because securities transactions are economic in character Congress intended the application of these statutes to turn on the economic realities underlying a transaction, and not on the name appended thereto. Thus, in construing these Acts against the background of their purpose, we are guided by a traditional canon of statutory construction:

`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.' Church of the Holy Trinity v. United States, 143 U.S. 457, 459 12 S.Ct. 511, 512, 36 L.Ed. 226 (1892)."

Forman, supra, at 848-49, 95 S.Ct. at 2058-59.

The Court did caution that

"in holding that the name given to an instrument is not dispositive, we do not suggest that the name is wholly irrelevant to the decision whether it is a security. There may be occasions when the use of a traditional name such as `stocks' or `bonds' will lead a purchaser justifiably to assume that the federal securities laws apply. This would clearly be the case when the underlying transaction embodies some of the significant characteristics typically associated with the named instrument." Id. at 850-51, 95 S.Ct. at 2059-60.

However, the Court found no basis for any argument that the purchasers in Forman were misled by the use of the word "stock." The Court identified the following five "common features of stock" which the shares purchased by the cooperative tenants lacked —

(1) the right to receive dividends contingent upon an apportionment of profits,

(2) negotiability,

(3) the ability to be pledged or hypothecated,

(4) voting rights in proportion to the number of shares owned, and

(5) the potential to appreciate in value— and concluded that "in short, the inducement to purchase was solely to acquire subsidized low-cost living space; it was not to invest for profit." Id. at 851, 95 S.Ct. at 2060.

The Court then turned its attention to the alternative ground of the Court of Appeals decision that the shares were securities; i. e., that they constituted an "investment contract." In Howey, supra, the Court had set down the following test for determining whether shares in an enterprise constitute an "investment contract":

"The test is whether the scheme involves an investment of money in a

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