Home Guar. Ins. v. Third Financial Services, Inc.

• Decision Date: 19 August 1987
• Docket Number: No. 3-86-0869.,3-86-0869.
• Citation: 667 F. Supp. 577
• Parties: HOME GUARANTY INSURANCE CORPORATION v. THIRD FINANCIAL SERVICES, INC., and Peoples Federal Savings and Loan Association.
• Court: U.S. District Court — Middle District of Tennessee

667 F. Supp. 577

HOME GUARANTY INSURANCE CORPORATION v. THIRD FINANCIAL SERVICES, INC., and Peoples Federal Savings and Loan Association.

No. 3-86-0869.

United States District Court, M.D. Tennessee, Nashville Division.

August 19, 1987.

Boult, Cummings, Conners & Berry, Robert S. Patterson, Patricia Head Moskal, Nashville, Tenn., Raymond F. Scannel, Sr., Warren E. Zirkle, Robert T. Billingsley, McGuire, Woods & Battle, Richmond, Va., for plaintiff.

H. Naill Falls, Jr., Katherine Simpson Allen, Farris, Warfield & Kanaday, Nashville, Tenn., for Third Financial Services, Inc.

Wallace Dietz, Nashville, Tenn., William G. Merchant, Papernick & Gefsky, P.C., Pittsburgh, Pa., for Peoples Federal Sav. and Loan Ass'n.

MEMORANDUM

WISEMAN, Chief Judge.

This is a civil action in which the plaintiff Home Guaranty Insurance Corporation (HGIC) seeks to rescind its mortgage insurance policies on the grounds of material misrepresentations and omissions made in the applications for insurance. Defendant, Third Financial Services (Third), the originator of certain mortgage loans, has sold and assigned these mortgage loans and accompanying mortgage guarantees to defendant Peoples Federal Savings & Loan Association (Peoples). In Count VI of its Counterclaim, Peoples alleges violations by HGIC of federal securities laws under Section 17(a) of the Securities Act of 1933, as amended, 15 U.S.C. § 77q(a); Section 10 of the Securities Exchange Act of 1934, 15 U.S.C. § 78j, and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10-b-5.

The determinative issue for the purpose of this motion is whether these mortgage loans and guarantees, taken together, are "securities" under the federal statutes.

When ruling on a motion to dismiss, a court must take as admitted the material allegations of the claim and must construe the claim liberally in favor of the claimant. Jenkins v. McKeithen, 395 U.S. 411, 421, 89 S.Ct. 1843, 1848, 23 L.Ed.2d 404 (1969). In this case, the counterclaim at issue rests upon the following facts.

I. Factual Background

In June 1982 HGIC executed and issued to Third a "Master Policy" providing 100 percent mortgage insurance coverage for mortgage loans originated by Third. In December 1982, Third submitted to Peoples a proposal for financing a townhouse project consisting of nine townhouse units located in Destin, Florida, and known as the "Shoreline Gardens Townhomes" (Shoreline Phase I). Under this proposal Third would loan the sum of $1,485,000.00 to a Georgia limited partnership known as Shoreline Gardens Townhomes II, Ltd., which loan would be secured by nine first mortgages on the respective townhouse units. Third further proposed that these mortgage loans, to be purchased by Peoples, would be serviced by Third and would enjoy 100 percent private mortgage insurance provided by HGIC. In January 1983 HGIC, being aware of the ongoing negotiations between Peoples and Third for the purchase of Shoreline Phase I, reviewed and approved the applications of Third for private mortgage insurance and issued nine individual commitments/certificates to Third. In January 1983 Third closed the Shoreline Phase I mortgage loans with the borrower. In February 1983 these mortgage loans were sold and assigned by Third to Peoples, along with the mortgage insurance issued by HGIC on these loans.

During this period Third was also negotiating the sale of Shoreline Phase II to Peoples. Phase II comprised 12 additional units. Peoples agreed in February, 1983 to purchase from Third the construction/permanent mortgage loans on these 12 additional units with the proviso that HGIC issue mortgage insurance on these loans.

In April 1983 Third closed the construction loan with the borrower in the amount of $2,500,000; this loan was collaterized by 12 individual mortgages on these units. In the meantime HGIC provided mortgage insurance on each loan; the sale by Third to Peoples of the construction/permanent mortgage loans on Phase II was closed in August 1983.

In December 1984 the Borrower defaulted on the Phase I and Phase II mortgage loans; Peoples instituted foreclosure proceedings against the Borrower in the Circuit Court of Okaloosa County in Florida. The foreclosure sale resulted in Peoples assuming title to the 21 units in March 1986. Subsequently, Peoples submitted the titles of the 21 units to HGIC along with 21 claims for loss in the amount of $4,805,356.86. HGIC refused to pay; on October 8, 1986 it filed an action in this Court for a declaratory judgment seeking to rescind the insurance certificates based on its view that Third made material factual misrepresentations in its applications for mortgage insurance coverage, thus rendering the insurance certificates on Phase I and Phase II void.

Accompanying its Answer, Peoples made a seven-count counterclaim against HGIC. Before the Court at this juncture is HGIC's rule 12(b)(6) motion to dismiss Peoples' federal claims (Count VI) alleging violations of the anti-fraud provisions of the Securities Act of 1933, the Securities Exchange Act of 1934 and Rule 10b-5. Peoples argues that it was induced by HGIC's mortgage insurance coverage to purchase the Shoreline Loan Packages from Third, and that HGIC in effect operated as a broker for the mortgage loan packages.

II. Discussion

In order for this Court to reach the question of an alleged violation of the antifraud provisions of the Securities Acts, the transaction at issue must involve a "security" as defined in either the 1933 and 1934 Acts. Section 2(1) of the 1933 Act provides:

When used in this subchapter, unless the context otherwise requires —

(1) The term "security" means any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, or in general, any interest or instrument commonly known as a "security," or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

15 U.S.C. § 77b(1).

Although Section 3(a)(10) of the 1934 Act, 15 U.S.C. § 78c(a)(10), has been read by the Supreme Court to be "virtually identical" to Section 2(1) of the 1933 Act, Tcherepnin v. Knight, 389 U.S. 332, 335-36, 88 S.Ct. 548, 552-53, 19 L.Ed.2d 564 (1967), there are, however, two differences. First, the 1934 Act definition deletes the term "evidence of indebtedness." Second, the language of Section 3(a)(10) excludes from the 1934 Act definition of "security" the following: "any note, draft, bill of exchange, or banker's acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited."

Although these statutes plainly enumerate a list of instruments, this list has not been dealt with literally by the courts. The Supreme Court, stressing that the intent of Congress in enacting the securities laws was the protection of investors, has generally favored the notion that the courts broadly construe the Acts,¹ disregard form for substance, and emphasize the economic realities of a transaction in determining whether an instrument, regardless of the name given to it,² is a "security."

As a result, courts generally have taken a broad approach to the statutory wording and used the "flexible" principle outlined in Howey to examine the "substance" or "economic reality" of all alleged securities transactions without relying solely on the particular form of the instrument in order to determine whether a transaction falls within the purview of the Act.³

This process began with the Supreme Court's definition of an "investment contract":

An investment contract for purposes of the Securities Act means a contract, transaction, or scheme whereby a person 1 invests his money 2 in a common enterprise and 3 is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.

Howey, 328 U.S. at 298, 66 S.Ct. at 1102.

This definition, known as the "Howey test," was later used by many courts to define a "security" in general.⁴ Not until recently did the Supreme Court reveal any inclination to constrain the "economic reality" approach. In this recent development, the Court took a "characteristics of the instrument" approach to a statutory category in the Acts, warning against universal application of the Howey test to determine whether a particular instrument "fits within any of the examples listed in the statutory definition of a security." See Landreth Timber Co. v. Landreth, 471 U.S. 681, 691, 105 S.Ct. 2297, 2305, 85 L.Ed.2d 692 (1985) (emphasis original). Although the Landreth Court applied the new approach only to the term "stock," it expressly left open the question of what other instruments listed in the Acts, including notes, are to be governed by a "characteristics of the instrument" approach.⁵ In light of the above and of the fact that the transaction at issue involves mortgage notes, this Court has examined the issue in this case using both an "economic reality" and a "characteristics of the instruments" approach.

A. Analysis as a "Note"

In assessing the economic realities of a note transaction, the United States Circuit Courts of Appeal have devised somewhat different approaches for determining whether a note transaction involves a "security."

An approach that draws a distinction between "investment" and "commercial" notes has been followed in the First, Third, Fifth, Seventh and Tenth Circuits. This...