Golden v. Garafalo

• Decision Date: 05 May 1982
• Docket Number: No. 694,D,694
• Citation: 678 F.2d 1139
• Parties: Fed. Sec. L. Rep. P 98,656 Arthur GOLDEN and Gladys Golden, Plaintiffs-Appellants, v. Anthony GARAFALO, Defendant-Appellee. ocket 81-7693.
• Court: U.S. Court of Appeals — Second Circuit

Page 1139

678 F.2d 1139

Fed. Sec. L. Rep. P 98,656

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

No. 694, Docket 81-7693.

United States Court of Appeals, Second Circuit.

Argued Feb. 10, 1982.

Decided May 5, 1982.

Edward Labaton, New York City (John H. Riley, Richard K. Rosenblum, Kass, Goodkind, Wechsler & Labaton, New York City, of counsel), for plaintiffs-appellants Arthur Golden and Gladys Golden.

William B. Aronstein, New York City (Milton Waxenfeld, Warshaw Burstein Cohen Schlesinger & Kuh, New York City), for defendant-appellee Anthony Garafalo.

Before LUMBARD, NEWMAN and WINTER, Circuit Judges.

RALPH K. WINTER, Jr., Circuit Judge:

This appeal raises another of the recurrent and troubling questions ¹ as to the legal status of certain instruments under the Securities Act of 1933 (the " '33 Act") and the Securities Exchange Act of 1934 (the " '34 Act") (collectively, the "Acts").

Plaintiffs purchased 100% of the outstanding stock of a corporation engaged in the ticket brokerage business from defendant, the sole stockholder. Plaintiffs intended to manage the business directly. The corporation presumably had the customary assets, owned the corporate name, and had non-assignable leasehold rights to certain office space. We may assume the lease was decisive in determining that the transfer would be by way of a sale of shares rather than assets.

Alleging that defendant had made misrepresentations relating to the value of the business, and, therefore, the value of the shares of stock, plaintiffs brought this action under Section 17(a) of the '33 Act, 15 U.S.C. § 77q; Section 10(b) of the '34 Act, 15 U.S.C. § 78j(b); and Rule 10b-5 promulgated under Section 10(b), 17 C.F.R. 240.10b-5. Other counts of the complaint alleged a variety of common law and state claims.

Judge Conner dismissed the complaint. In a careful and thoughtful opinion, reported at 521 F.Supp. 350, he utilized what has come to be known as the "sale of business" test and concluded:

... where the reality of the transaction was the sale of an entire small business to be operated by the purchaser, the protective purpose of the federal legislation is not implicated. Here there is no publicly traded security nor any passive investor entrusting his capital to another in hopes of profit. To apply the federal securities laws to such a transaction simply because of the incidental transfer of stock would bring within the ambit of the Acts the transfer of any conceivable item, as long as the deal was structured as the purchase and sale of the stock of a corporation holding that item as an asset, even if the corporation held no other assets. The federal securities laws were not designed to usurp the common law where the reality of the transaction is the transfer of a tangible item for the use of the purchaser.

Id. at 358 (citations omitted).

Although that conclusion is not unreasonable, we disagree and reverse. We hold that conventional stock in business corporations is a security within the meaning of the '33 and '34 Acts whether or not the underlying transaction involves the sale of a business to one who intends to manage it.

THE SALE OF BUSINESS DOCTRINE

The sale of business doctrine finds its most explicit origins in Frederiksen v. Poloway, 637 F.2d 1147 (7th Cir.), cert. denied The statutory definition of "security" in each Act ² includes words such as "stock," "note," "treasury stock," "bond," "debenture," "voting trust certificate," "certificate of interest," "investment contract" or "any instrument commonly known as a 'security.' " Each definition, however, begins with the language " ... unless the context otherwise requires ...," words which the sale of business doctrine reads to limit the inclusion of the instruments subsequently named to "contexts" in which the principal protective purposes of the Acts are directly involved. Where, as Judge Conner argued, "there is no publicly traded security nor any passive investor entrusting his capital to another ...," 521 F.Supp. at 358, the "context otherwise requires," and there is no "security" within the meaning of the Acts.

451 U.S. 1017, 101 S.Ct. 3006, 69 L.Ed.2d 389 (1981), which held that a sale of a business effectuated by a transfer of stock does not involve a "security" within the meaning of the '33 or '34 Acts when the "economic reality" of the transaction is "commercial"-acquiring a business to manage-rather than "investment"-receiving income from capital without managerial effort. See also Chandler v. Kew, Inc., (1979 Transfer Binder) Fed.Sec.L.Rep. (CCH) P 96,966 (10th Cir. 1977).

The Frederiksen Court based its holding on United Housing Foundation v. Forman, 421 U.S. 837, 95 S.Ct. 2051, 44 L.Ed.2d 621 (1975), and SEC v. W. J. Howey Co., 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946), which are said to establish a three-part "economic reality" test to determine what is a "security" in particular "contexts." The elements of the test area: (1) an investment in a common venture, (2) premised on a reasonable expectation of profits, (3) to be derived from the entrepreneurial or managerial efforts of others. Forman, 421 U.S. at 852, 95 S.Ct. at 2060; Howey, 328 U.S. at 301, 66 S.Ct. at 1104.

Although the sale of business doctrine has been relied upon in a growing number of cases, ³ its contours remain uncertain. See generally Seldin, When Stock is Not a An unresolved issue is whether the purchase of 100% of the shares of a corporation by one who delegates management to others comes within the doctrine. While element (3) of the "economic reality" test is arguably met, the power to change managers or assume direct control is ever present, as is the power to "suggest" managerial decisions. Element (1) would not be present because there is no investment "in common" with others, although there would seem to be little difference in principle between this case and one in which one person held 80% of the stock while several others shared the remaining 20%.

Security: The "Sale of Business" Doctrine Under the Federal Securities Laws, 37 Bus.Law 637 (1982). A transaction involving a transfer of 100% of the shares of a business corporation between old and new managers is clearly within the doctrine since elements (1) and (3) of the "economic reality" test cannot be met. The Seventh Circuit has also stated that an instrument may be a "security" as to some parties to a transaction but not as to others. An example is the purchase of 100% of shares by a new manager from a number of persons including passive investors. The protection of the Acts would continue to extend to the passive investors who sold the stock, but not to the new managers. McGrath v. Zenith Radio Corp., 651 F.2d 458, 467-68 n.5 (7th Cir. 1981). One District Court appears to have held that purchase of a control block of stock by a new manager is within the doctrine even though the transaction involved less than 100% of the outstanding shares. Oakhill Cemetery of Hammond, Inc. v. Tri-State Bank, 513 F.Supp. 885 (N.D.Ill.1981). That holding seems logical since, as to the new manager, the purchase is a purchase of a business. Element (3) of the "economic reality" test, moreover, cannot be met as to the purchaser.

The effect of the sale of business doctrine is also unclear in cases involving a purchase of a large block of shares from a corporation by one intending to manage jointly with another. See Coffin v. Polishing Machines, Inc., 596 F.2d 1202 (4th Cir. 1979) (rejecting sale of business doctrine); Frederiksen, 637 F.2d at 1151 (distinguishing Coffin on the grounds that the sale of stock raised capital for the corporation).

The doctrine has not been limited to closely held corporations. See Zilker v. Klein, (1981 Transfer Binder) Fed.Sec.L.Rep. P 97,992 (N.D.Ill.1981); Reprosystem v. SCM Corp., 522 F.Supp. 1257, (1981 Transfer Binder) Fed.Sec.L.Rep. P 98,207 (S.D.N.Y.1981), involving an acquisition or divesting of another corporation by a publicly held company.

Nevertheless, whatever the full scope of the sale of business doctrine, there is no doubt that, if it is valid, it would apply to the present case, involving as it does 100% of outstanding shares and an intent to manage.

A number of courts have rejected the doctrine. E.g., Coffin, supra; Occidental Life Insurance Co. v. Pat Ryan & Associates, Inc., 496 F.2d 1255 (4th Cir.), cert. denied, 419 U.S. 1023, 95 S.Ct. 499, 42 L.Ed.2d 297 (1974). ⁴ They have argued that the "economic reality" test applies only to instruments which are not securities in the ordinary or conventional sense of the term or which contain unusual or unique features and are thus difficult to classify under statutory or common law standards. See Bronstein v. Bronstein, 407 F.Supp. 925, 929 (E.D.Pa.1976). Those cases hold that where, as in the present case, the shares of stock qualify under local corporation and commercial law as ordinary stock, no further examination of the underlying transactions is necessary absent some reason to think they are not what they seem. See Coffin, 596 F.2d at 1204. Those cases have also argued that allowing the application of the anti-fraud provisions of the securities laws to turn upon the percentage of shares involved in a transaction would lead to "capricious" results. Occidental Life Ins. Co., 496 F.2d at 1263.

SUPREME COURT PRECEDENT

Although Howey, Forman and the recent decision in Marine Bank v. Weaver, --- U.S. ----, 102 S.Ct. 1220, 71 L.Ed.2d 409 (1982), are not dispositive as to the validity of the sale of business doctrine, they do support its rejection.

Howey involved the sale of citrus acreage in small plots along with a "service contract" which leased the land back to the original owner who grew and sold the crops, a share of the profits going to the purchaser. This unusual arrangement raised an obvious legal issue as to the applicability of the securities laws and the "economic reality" test...