Provident Nat. Bank v. Frankford Trust Co.

• Decision Date: 16 April 1979
• Docket Number: Civ. A. No. 78-4286.
• Parties: PROVIDENT NATIONAL BANK v. FRANKFORD TRUST COMPANY.
• Court: U.S. District Court — Eastern District of Pennsylvania

468 F. Supp. 448

PROVIDENT NATIONAL BANK v. FRANKFORD TRUST COMPANY.

Civ. A. No. 78-4286.

United States District Court, E. D. Pennsylvania.

April 16, 1979.

William A. Harvey, Fellheimer, Krakower & Eichen, Philadelphia, Pa., for plaintiff.

Frank D. Allen, Thistle, Moore & Rosser, Philadelphia, Pa., for defendant.

OPINION

LUONGO, District Judge.

This controversy centers around a loan participation agreement between the Provident National Bank (Provident) and the Frankford Trust Company (Frankford). The complaint enumerates five grounds for relief: (1) violations of the federal securities laws, specifically, sections 12 and 17(a) of the Securities Act of 1933 (15 U.S.C. §§ 77l, 77q(a) (1976)), sections 10(b) and 29(b) of the Securities Exchange Act of 1934 (15 U.S.C. §§ 78j(b), 78cc(b) (1976)), and Rule 10b-5 (17 C.F.R. § 240.10b-5 (1978)); (2) violations of the Pennsylvania Securities Act of 1972 (70 Pa.Stat.Ann. §§ 1-401 to -407 (Purdon Supp. 1978-79); (3) breach of contract; (4) intentional misrepresentation; and (5) negligence. Jurisdiction over the federal securities claim is premised upon 28 U.S.C. § 1331(a) (1976) (federal question) and sections 22 and 27 of the 1933 and 1934 acts respectively (15 U.S.C. §§ 77v, 78aa (1976)); jurisdiction over the remaining state securities and common law claims rests upon the doctrine of pendent jurisdiction. Arguing that the loan participation is not a "security" within the purview of the federal securities laws, the defendant Frankford has moved to dismiss the entire action.¹ I agree that the loan participation at issue here is not a security and I will grant the motion to dismiss.

I. THE FACTUAL BACKGROUND

Viewed in the light most favorable to the plaintiff, the essential facts with respect to the federal securities claim follow. In July 1977, Frankford proposed that Provident "purchase a share of and participate in a loan which Frankford had agreed to make to Olde Kensington Redevelopment Corporation" (Olde Kensington). Complaint ¶ 10. On August 8, 1977, Frankford and Provident signed an Agreement of Participation, under which each bank acquired a nonassignable 50% share in the interest accruing on the loan, in the mortgage and bond securing the loan, and in the repayment of principal. Id., Exhibit A ¶¶ 1, 2, 5.² The moneys to be loaned under the agreement were to finance the construction of 25 single family townhouses. Id. ¶ 11. The loan ceiling was set at $345,400 and the interest was to float at 1% above the Philadelphia prime rate with a floor of 10%. Id., Exhibit A at 1. The agreement contemplated that the loan would be made in periodic advances, with each party assuming its proportionate share of the loan commitment; the agreement further provided that Frankford might make advances "for the account of Provident Nat'l, thereafter requesting from Provident Nat'l its share in said loan." Id., Exhibit A ¶ 3. In its status as lead bank, Frankford was designated the mortgagee, and all documents executed in connection with the transaction were to be taken in the name of and delivered to Frankford. Id., Exhibit A at 1-2. Frankford also bore the responsibility of monitoring the status of the loan, undertaking to notify Provident of "any defaults by the mortgagor(s) or of any other matter which in its best judgment materially affects the joint or respective interests of the parties to the participation agreement." Id., Exhibit A ¶ 4.

Prior to negotiation of the participation agreement, Frankford made the following oral and written representations to Provident:

"(a) That Olde Kensington was a non-profit corporation formed in March of 1968 for the purposes of acquiring abandoned homes, rehabilitating them and making them available for moderate purchase prices or as rentals to low or moderate income families;

. . . . .

(c) That the general contractor which would perform and oversee the construction of the townhouses was Mango Construction Company, Inc., a contractor known and approved of by Frankford;

(d) That the general contractor, Mango Construction Company, Inc. had been bonded, in a manner satisfactory to Frankford, under a dual obligee performance, labor and material payment bond by the United Surety and Financial Guaranty Company;

(e) That Frankford would oversee the construction of the townhouses, inspect the premises from time to time, review invoices submitted by Mango and its subcontractors for payment, collect all amounts of principal and interest due from Olde Kensington, police the collateral generally and take all other steps necessary to assure the continued stability and viability of the loan;

. . . . .

(j) That Frankford would insure that the property was properly secured and protected."

Complaint ¶ 24.

In reliance upon Frankford's representations, Provident agreed to participate in the loan, and from August to November 1977, paid to Frankford $41,850 as its proportionate share of the loan advances pursuant to the agreement. Id. ¶¶ 27, 39.

In early November 1977, Provident attempted, without success, to ascertain from Frankford the status of the loan. Id. ¶ 30. Provident's visit to the construction site in mid-November confirmed that work on the project had ceased. Id. ¶ 31. Subsequently, Provident discovered that Frankford had failed to perform the duties that it had represented it would assume in its role as lead lender. Id. ¶¶ 33(c)-(1), 34-37. Provident also determined that, contrary to Frankford's representations,

"(a) the general contractor, Mango Construction Company, Inc., which had been approved by Frankford, lacked the necessary financial ability and expertise from the inception of the project to see the project through to completion; and

(b) the dual obligee performance, labor and material payment bond allegedly issued by United Surety and Financial Guaranty Company was, in fact, a forgery, and despite Frankford's assurance to the contrary, there was no valid and enforceable bond in effect. . . ."

Id. ¶ 33.

To date, the loan has not been repaid and the security for the loan has not yielded any proceeds. Id. ¶ 38.

II. THE EXISTENCE OF A SECURITY

Since there is no diversity of citizenship between the parties, the plaintiff may prosecute this action in federal court only if there is a federal question claim under the federal securities laws, that is, only if it can be said to have purchased a security when it agreed to participate in the loan to Olde Kensington.³ Both the 1933 and the 1934 acts provide that "unless the context otherwise requires . . . `security' means any note . . . investment contract . . . or any certificate of interest or participation in . . . any of the foregoing." 15 U.S.C. §§ 77b(1), 78c(a)(10) (1976).⁴ Accordingly, the participation agreement at issue here will be cognizable under the federal acts if either (1) the underlying transaction — in this instance, the note or bond exchanged for the loan — is itself a "security" or (2) the participation interest acquired by the plaintiff falls within the catch-all category of investment contract. See generally Comment, Bank Loan Participations as Securities: Notes, Investment Contracts, and the Commercial/Investment Dichotomy, 15 Duquesne L.Rev. 261, 267-86 (1976-77).

In its memorandum opposing the motion to dismiss and again at oral argument, Provident conceded that the underlying instrument was not a security. This obviates consideration of the first alternative, despite Provident's argument that because "the plain language of the statutes covers the situation described in the complaint, . . . Defendant must demonstrate a statutory exclusion." Document No. 8 at 13-14. This literal approach with its presumption of inclusion that is urged by plaintiff stems from the Second Circuit rule announced in Exchange National Bank v. Touche, Ross & Co., 544 F.2d 1126 (2d Cir. 1976). There, Judge Friendly, having considered the Supreme Court's antiliteral stance in United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 849, 95 S.Ct. 2051, 44 L.Ed.2d 621 (1975), nevertheless concluded that "the best alternative . . . may lie in greater recourse to the statutory language," and advised that the plain terms of the acts control unless the party opposing the application of the securities laws demonstrates that "the context otherwise requires." 544 F.2d at 1137-38. Even if I were to disregard the questionable validity of this literal approach,⁵ I would nevertheless conclude that plaintiff's argument is unavailing, given plaintiff's disavowal of reliance on the underlying transaction. Although a few courts have intimated that the "plain language" of the acts comprehends a participation notwithstanding the nonsecurity status of the underlying instrument,⁶ as I read the definitions the "plain language" covers only participations in one of the statutorily enumerated items that merit security status. In my view, therefore, in order for plaintiff's "plain language" argument to apply, the underlying instrument must be a security. Provident's concession that the loan to Olde Kensington did not generate a security therefore effectively defeats any argument based on a literal reading of the acts.

As to the second alternative, the Supreme Court has consistently counseled that "application of the securities laws turns on the economic realities underlying the transaction . . .." United Housing Foundation, Inc. v. Forman, supra, 421 U.S. at 849, 95 S.Ct. at 2059; accord, International Brotherhood of Teamsters v. Daniel, ___ U.S. ___, ___, 99 S.Ct. 790, 58 L.Ed.2d 808 (1979); Tcherepnin v. Knight, 389 U.S. 332, 336, 88 S.Ct. 548, 19 L.Ed.2d 564 (1967); S. E. C. v. Howey, 328 U.S. 293, 298, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946). The security status of this loan participation depends upon whether the "economic realities" satisfy the Howey investment contract test.⁷ As the Supreme Court stated in United Housing Foundation v. Forman, the Howey test

"embodies the essential attributes that run

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