Kagan v. Edison Bros. Stores, Inc.

• Decision Date: 18 July 1990
• Docket Number: No. 89-3458,89-3458
• Citation: 907 F.2d 690
• Parties: , Fed. Sec. L. Rep. P 95,368, 13 UCC Rep.Serv.2d 1245 Marvin KAGAN, et al., Plaintiffs-Appellants, v. EDISON BROTHERS STORES, INC. and Edison Brothers Apparel Stores, Inc., Defendants-Appellees.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 690

907 F.2d 690

59 USLW 2083, Fed. Sec. L. Rep. P 95,368,

13 UCC Rep.Serv.2d 1245

Marvin KAGAN, et al., Plaintiffs-Appellants, v. EDISON BROTHERS STORES, INC. and Edison Brothers Apparel

Stores, Inc., Defendants-Appellees.

No. 89-3458.

United States Court of Appeals, Seventh Circuit.

Argued June 8, 1990.

Decided July 18, 1990.

Stephen C. Shamberg, Chicago, Ill., for plaintiffs-appellants.

Fred H. Bartlit, Jr., Ann M. Hamilton, Chaim T. Kiffel, Kirkland & Ellis, Chicago, Ill., for defendants-appellees.

Before CUDAHY and EASTERBROOK, Circuit Judges, and FAIRCHILD, Senior Circuit Judge.

EASTERBROOK, Circuit Judge.

The stockholders and debenture holders of Ringo, Inc., a closely held corporation that operated two apparel stores in Chicago, entered into negotiations with Edison Brothers Stores, Inc., for the sale of their shares (and derivatively of Ringo itself). Edison Brothers balked at signing a contract, and the deal collapsed. In the meantime, believing that Edison wanted Ringo to expand, Ringo had signed a lease for a third store, taking expensive space in a fancy new building on the Magnificent Mile of Michigan Avenue. The new store was too much for this little corporation, which filed a bankruptcy petition one month after Edison Brothers said it would not buy the shares. Ringo is being liquidated, and its creditors will receive only a few cents on the dollar. The investors want to do better for themselves. They demand that Edison Brothers pay them the full $950,000 they would have received had the deal been consummated.

Because the statute of frauds blocks any effort to obtain this relief under the law of contracts, the investors deploy two different theories: (1) that failure to complete the acquisition violated Sec. 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. Sec. 78j(b), and the SEC's Rule 10b-5, 17 C.F.R. Sec. 240.10b-5, and (2) Edison committed common law fraud by making a promise it intended to disdain. The district court dismissed the complaint under Fed.R.Civ.P. 12(b)(6), concluding that the shareholders could not establish the "loss causation" that is an essential ingredient of either claim. 1989 WL 134657, 1989 U.S. Dist. LEXIS 12176 (N.D.Ill.). Edison Brothers' withdrawal would not have caused the investors any injury had Ringo not folded under them. Edison Brothers might be responsible for that failure if, as the investors assert, Edison misled Ringo's board into signing the fateful lease. But that claim, the district court concluded, belongs to Ringo, not to the investors. The court added for good measure that the action under Rule 10b-5 must be dismissed in any event because there was neither a purchase nor a sale of securities. We start with this latter conclusion.

Section 10(b) and Rule 10b-5 apply only to fraud "in connection with the purchase or sale" of securities. Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 95 S.Ct. 1917, 44 L.Ed.2d 539 (1975). Section 2(3) of the Securities Act of 1933, 15 U.S.C. Sec. 77b(3), defines a sale as a "contract of sale or disposition of a security ... for value". The '34 Act provides that "sale" shall "include any contract to sell or otherwise dispose of", Sec. 3(a)(14), 15 U.S.C. Sec. 78c(a)(14). Although there was no "sale" in the sense of a transfer or disposition of the interests in Ringo, both statutes provide that sales include "contracts" for sale. Does "contract" include an oral agreement that is not enforceable because of the statute of frauds in Sec. 8-319 of the Uniform Commercial Code? The district court held, following Pelletier v. Stuart-James Co., 863 F.2d 1550 (11th Cir.1989), that a "contract" for purposes of the securities laws means an enforceable contract, a conclusion with which we agree.

"Contract" in the securities acts is a word of legal art. Without signed writings, consideration, and the other legal requirements for enforcement, there is no "contract"; there is only a promise. This is not mindless formalism. Blue Chip Stamps stressed the substantial problems of proof and high risk of error entailed in litigating claims that fraud prevented a sale from occurring. Statutes of frauds likewise are concerned with problems of proof. It is easy to say that there was an oral agreement. Section 8-319 of the UCC increases certainty in commercial life by preventing the enforcement of oral agreements to purchase or sell securities. The statute of frauds would be a hollow doctrine if disappointed sellers could convert their contract claims into actions under Rule 10b-5. The principles animating Sec. 8-319 and the doctrine of Blue Chip Stamps alike require a conclusion that an unenforceable oral agreement is not a "contract" to purchase or sell securities. ^* The district court properly dismissed the securities claim. Because diversity of citizenship provides an independent jurisdictional basis for the state-law claim of fraud, we turn to it.

The district court held that Ringo would be the only proper plaintiff. Two ways to get there come to the same thing: the court observed that any fraud committed against the investors did not cause the corporation's loss (the "loss causation" route, see Bastian v. Petren Resources Corp., 892 F.2d 680 (7th Cir.1990); LHLC Corp. v. Cluett, Peabody & Co., 842 F.2d 928, 931 (7th Cir.1988)), and that the investors seek recovery for an injury done the corporation (the "derivative injury" route). In either case, the nub of the problem is that the investors' injury flows not from what happened to them (Edison Brothers did not buy the stock) but from what happened to Ringo (it failed, making their stock worthless). Ringo's creditors in bankruptcy are entitled to the damages for injury done it, and the investors' effort to get 100cents on the dollar while the creditors get next to nothing is improper. See Mid-State Fertilizer Co. v. Exchange National Bank, 877 F.2d 1333, 1335-36 (7th Cir.1989). Recovery by the corporation ensures that all of the participants--stockholders, trade creditors, employees, and others--recover according to their contractual and statutory priorities. Direct recovery outside of bankruptcy defeats those priorities.

The investors recognize the venerable principle that stockholders and bondholders may not recover for the firm's injuries but say that it does not apply: Edison Brothers deceived them, and this direct injury entitles them to direct recovery. See, e.g., Spartech Corp. v. Opper, 890 F.2d 949, 954 (7th Cir.1989); Grogan v. Garner, 806 F.2d 829, 834 (8th Cir.1986); Zokoych v. Spalding, 36 Ill.App.3d 654, 344 N.E.2d 805 (1st...