Smith v. Manausa

• Decision Date: 22 November 1974
• Docket Number: Civ. No. 1639.
• Citation: 385 F. Supp. 443
• Court: U.S. District Court — Eastern District of Kentucky
• Parties: A. E. SMITH, Plaintiff, v. C. E. MANAUSA et al., Defendants.

385 F. Supp. 443

A. E. SMITH, Plaintiff, v. C. E. MANAUSA et al., Defendants.

Civ. No. 1639.

United States District Court, E. D. Kentucky, Covington Division.

November 22, 1974.

COPYRIGHT MATERIAL OMITTED

Stites, McElwain & Fowler, Frankfort, Ky., James G. Apple, Louisville, Ky., for plaintiff.

Robert F. Barrett, Florence, Ky., for Manausa.

Truett R. DeMoisey, pro se.

Harry L. Riggs, Jr., Erlanger, Ky., for all other defendants.

MEMORANDUM

SWINFORD, District Judge.

This action seeks recovery of amounts expended and profits lost as a result of the defendants' alleged noncompliance with federal and state securities and corporate legislation. Securities Act of 1933, 15 U.S.C. § 77a, et seq.; Securities Exchange Act of 1934, 15 U.S.C. § 78a et seq; KRS Chapters 271 and 292. Trial was held on May 6-9, 1974, and the parties accorded an opportunity for the submission of briefs. The record is now before the court for decision.

Although presenting complex questions of law, the facts of the case are uncomplicated and largely uncontested. Frontier Enterprises, Inc., was organized in 1969 by the eight defendants and two nonparties to operate a chain of restaurants, motels, and food marts. In January, 1970, the plaintiff purchased lease-hold interests in three "fast food" restaurants in Columbus, Ohio, operated by the failing Kettle Fried Chicken of America. The transactions giving rise to this action occurred in March, 1970, with negotiations addressing the sale of Frontier stock and the plaintiff's three Ohio restaurants. Smith had transacted business with Frontier in the past and his interest in consummating an agreement was heightened by a "balance sheet" purporting to represent the assets and liabilities of the offering corporation. Although unsigned, the evidence indicated that the sheet was discussed by the directors and furnished by the Frontier president on behalf of the corporation. Plaintiff's Exhibit 61. Relying on the balance sheet, Smith purchased 10,000 shares of stock outright and agreed to exchange all of his Ultra stock for 160,000 Frontier shares and $120,000 in corporate notes payable first upon the passage of nine months or completion of a public stock issue. See Plaintiff's Exhibit 10. The understanding was embodied in an April 26, 1970, contract signed by the president and approved by Frontier's board of directors. Plaintiff's Exhibits 11, 62. Although a certificate for 10,000 shares was furnished, Plaintiff's Exhibit 9, Smith did not receive the remaining stock or promissory notes; indeed, the evidence indicated that in April, 1970, Frontier had already dispensed stock far exceeding that authorized in its Articles of Incorporation. See Plaintiff's Exhibit 17.

Frontier took possession of the three restaurants, but defaulted on lease payments in the fall of 1970. A public stock offering was precluded by the inability to secure registration and the corporate obligations to the plaintiff were never satisfied. It is contended that the balance sheets contained misrepresentations prohibited by the disclosure provisions of federal and state statutes, Sections 12 and 17 of the Securities Act of 1933, 15 U.S.C. §§ 77l, 77q; Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), KRS 292.480; KRS 292.320; and that the stock was not registered as required by Section 5 of the Securities Act of 1933, 15 U.S.C. § 77e, and KRS 292.340. The defendants' personal liability is predicated upon (1) the "controlling person" and/or "aiders and abettor" responsibility engrafted in the securities regulation, 15 U.S.C. §§ 77o, 78t; KRS 292.480(2); (2) noncompliance with the statutory prerequisites to doing corporate business specified in KRS 271.095. Damages sought include $29,532.54 paid out by the plaintiff on behalf of Frontier in an effort to prevent cessation of the Ohio operations, $200,000.00 in lost profits from the three restaurants occasioned by the abandonment of the leases, attorneys' fees, and interest.

I

The defendants peripherally argue that the court lacks subject matter jurisdiction over the state law elements because the claims involve dissimilar causes of action. Hurn v. Oursler, 289 U.S. 238, 53 S.Ct. 586, 77 L.Ed. 1148 (1933). Although not expanding federal jurisdiction, the philosophy embodied in the Federal Rules of Civil Procedure has diminished the importance of the "cause of action" criterion applied in Hurn. Mine Workers v. Gibbs, 383 U.S. 715, 724-725, 86 S.Ct. 1130, 16 L.Ed.2d 218 (1966). In Lewis v. Pennington, 6th Cir., 400 F.2d 806, 816 (1968), cert. denied 393 U.S. 983, 89 S.Ct. 450, 21 L.Ed. 2d 444 (1968), the Court outlined the requirements for the exercise of pendent jurisdiction:

"(1) that the federal claim have `substance' so as to confer jurisdiction of the subject matter on the court in which the action is commenced and (2) that the `state and federal claims must derive from a common nucleus of operative fact'."

Accord, Kayser-Roth Corp. v. Textile Workers Union of America, 6th Cir., 479 F.2d 524 (1973), cert. denied 414 U.S. 976, 94 S.Ct. 292, 38 L.Ed.2d 219 (1973). The "power" to exercise pendent jurisdiction must be coupled with a discretionary finding that "judicial economy, convenience and fairness to litigants . . ." dictate its implementation. Mine Workers v. Gibbs, supra, 383 U.S. at 726, 86 S.Ct. at 1139; Johnson v. Miller, E.D.Ky., 367 F.Supp. 541, 543 (1973). There is little doubt of either the substantiality of the federal question or the factual identity of the respective claims; the propriety of a single resolution is reflected in the decisions joining allegations of common law fraud and state securities acts violations with claims under corresponding federal legislation. See Vanderboom v. Sexton, 8th Cir., 422 F.2d 1233, 1241-1242 (1970), cert. denied 400 U.S. 852, 91 S.Ct. 47, 27 L.Ed.2d 90 (1970); Strahan v. Pedroni, 5th Cir., 387 F.2d 730 (1967).

II

The initial predicate of liability is found in the Securities Act of 1933, 15 U.S.C. § 77a et seq., the Securities Exchange Act of 1934, 15 U.S.C. § 78a et seq., and the Kentucky Securities Act, KRS Chapter 292.¹ The Acts generally employ comparable language to proscribe fraudulent securities transactions. Thus, Section 17(a) of the Securities Act of 1933 sanctions the employment of manipulative devices in the interstate offer or sale of any security:

"It shall be unlawful for any person in the offer or sale of any securities by the use of any means or instruments of transportation or communication in interstate commerce or by the use of the mails, directly or indirectly —

(1) to employ any device, scheme, or artifice to defraud, or

(2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser."

15 U.S.C. § 77q(a).

Rule 10b-5 promulgated under Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), outlaws in similar language the conduct proscribed in Section 17(a), of the Securities Act of 1933, 15 U.S.C. § 77q(a), but extends the proscription to the purchase as well as the sale of securities. 17 C.F.R. 240.10b-5. The Kentucky "Blue Sky" legislation essentially parallels the federal acts. KRS 292.480(1) prohibits the offer or sale of a security through a knowingly untrue statement or omission of a material fact, while KRS 292.320(1) duplicates Rule 10b-5.

The alleged nondisclosure violations generally relate to the representations of the balance sheet furnished the plaintiff by the corporation. Examination of the document reveals several irregularities tending to inflate the corporation's recited worth. Although formally valid, the obligors on the claimed $170,000.00 in notes receivable were corporations controlled by the Frontier directors; further, the notes were given not for cash or property but apparently for future restaurant franchises. Plaintiff's Exhibits 27-31. The plaintiff maintains that the loans were uncollectible for lack of consideration and that the failure to disclose the interlocking ownership of the debtors and creditor induced an inflated representation of the corporation's worth. Transcript, p. 117-120. Also listed as an asset was certain Northern Kentucky realty valued on the sheet at $207,000.00. Aside from the diminished equitable ownership attributable to pending mortgages the evidence indicated that Frontier at no time possessed legal title over the property: the stock recited as the sale price for the land was never transferred and the vendor, Eight, Inc., did not itself own one of the parcels "purchased" by Frontier. The above misrepresentations were coupled with the corporation's failure to disclose sales in excess of the shares authorized in the Articles of Incorporation.

While the inaccuracies and nondisclosures of the balance sheet ostensibly fall squarely within the legislative prohibitions, the transaction must be examined to determine whether the plaintiff was a statutory "purchaser" or "seller" of a "security" in response to a statement containing a "material" fact or omission. There is little doubt that the contract was a "security" as defined by the Acts.² The term "security" is defined as "any note, stock, . . . evidence of indebtedness, . . . investment contract . . . or, in general, any interest or instrument commonly known as a `security' . . .." 15 U.S.C. § 77b(1). The defendants' promise to deliver shares of stock at a stated time clearly reveals a "note" or "evidence of indebtedness" under the 1933 Act. See Lawrence v. Securities and Exchange Commission, 1st Cir., 398 F.2d 276, 279 (1968); Llanos v. United States, 9th Cir., 206 F.2d 852, 854 (1953), cert. denied 346 U.S. 923, 74 S.Ct. 310, 98...