Underhill v. Royal
| Decision Date | 29 August 1985 |
| Docket Number | Nos. 84-6210,84-6211,s. 84-6210 |
| Parties | Fed. Sec. L. Rep. P 92,280, 13 Collier Bankr.Cas.2d 1198, Bankr. L. Rep. P 70,718 Herbert D. UNDERHILL, et al., Plaintiffs-Appellees, v. Carlos ROYAL, et al., Defendants-Appellants. Herbert D. UNDERHILL, et al., Plaintiffs-Appellants, v. NATIONAL MORTGAGE EXCHANGE, INC., et al., Defendants-Appellees. |
| Court | U.S. Court of Appeals — Ninth Circuit |
Matthew V. Herron, Meisenheimer & Herron, San Diego, Cal., for plaintiffs-appellees.
Gregory A. Akers, Akers & Williams, James F. Stiven, San Diego, Cal., for defendants-appellants.
Appeal from the United States District Court for the Southern District of California.
Before WALLACE, TANG, and WIGGINS, Circuit Judges.
California Mortgage Exchange, California Mortgage Exchange of Southern California and the principal shareholder of both companies, Carlos Royal, appeal from a judgment entered against them after a jury trial. These defendants were found liable for violations of federal and state securities laws. The plaintiffs cross-appeal the jury's finding that a director of one of the corporations, Max Hollis, was not derivatively liable for his company's participation in the illegal securities offering. We affirm.
Carlos Royal, a real estate businessman in Southern California, started a "loan agreement" program in the San Diego area in 1976 after purchasing the loan agreement concept from California Mortgage Exchange, a company in Central California. Previously, the attorney for California Mortgage Exchange had corresponded with the California Department of Corporations in response to Department inquiries regarding the character of the promissory notes sold pursuant to the loan agreement program. The attorney, Erling Kloster, gave the Department his opinion that the notes were not securities. No action was taken by the Department for the company's failure to qualify the program under the state securities laws.
Royal started two companies in Escondido, California. National Mortgage Exchange (NME) was formed in 1976 but was not active until early 1979 when it began to establish franchises for a mortgage brokerage business. These franchises would operate under the NME name and use its trademark. The other company started by Royal was National Mortgage Exchange of Southern California (NMESC). That company was also active as a mortgage broker, but also operated the loan agreement program. In 1980, NMESC entered a franchise agreement with NME, allowing use of NME's name and mark as part of its mortgage brokerage business.
Under the loan agreement program, NMESC would borrow money from lenders with promise of repayment according to the terms of a "collateral loan agreement/promissory note." The notes would mature in one to three years with a promised return of ten percent above principal. NMESC used the funds to buy at a discount third party promissory notes secured by deeds of trust. The company's beneficial interest in the purchased trust deeds would then be available to secure the obligations owed to the lenders. The lender's money would be placed in a segregated trust account pending the collateral assignment of a security interest in a trust deed owned by NMESC. The lender retained the right to reject the assignment. The program was advertised over radio and through newspapers. NMESC also distributed a brochure outlining the loan agreement plan. The brochure promised an annual return of 10 percent interest on the investment and called it "the Secured Contractual Loan Program of National Mortgage Exchange." The only reference in the brochure to National Mortgage Exchange of Southern California appears at the end of the brochure under the signatures of the Senior Vice President and Vice President of the company. All other references are to National Mortgage Exchange.
The plan was designed to restrict sales only to California residents to avoid the registration requirements of the federal securities laws through the intrastate offering exemption. Hundreds of people invested in the plan over a five-year period, however, and some of them were out-of-state residents. Relying on the correspondence between the California Mortgage Exchange attorney and the Department of Corporations, in addition to the inaction of the Department, NMESC did not qualify its sale of the promissory notes with the Department of Corporations. In 1980, however, the Department again raised questions regarding the sales of the notes and requested an explanation for nonqualification of the offering. NMESC's attorney responded that the operation did not involve the sale of securities.
When the recession hit hard in 1981, NMESC's cash flow suffered because many of the notes in its portfolio went into default. NMESC filed for Chapter 11 reorganization. The holders of the notes in the loan agreement program were classified as unsecured creditors because their security interests in the notes were deemed unperfected as they lacked actual or constructive possession of the assigned notes or trust deeds. Their claims totaled nearly $4.5 million.
After the bankruptcy filing, the Underhills in September, 1981, commenced this action against the defendants for securities law violations. They claimed violations for failure to file a registration statement under federal law and a qualification statement under California law. They also alleged violations of the anti-fraud provisions of state and federal law.
In the bankruptcy proceedings, a proposal was made to repay 100 percent of the amounts owing to the unsecured creditors over a five-year period, but the creditors rejected the plan. Royal proposed an alternative method of repayment. He offered to exchange NMESC's notes for property held by a third party financial institution (Central Savings & Loan). The company would then use the property to secure a loan with the loan's proceeds going into the fund to pay off the creditors. Under this plan, the creditors would immediately get 50 percent of their principal returned. Royal also sought to obtain a release from the participants in the loan agreement plan of all claims against the debtor, "any affiliate of the Debtor, and any insider of the debtor." 89 percent of the creditors approved the plan. The Underhills, however, raised objections to the release provision on June 25, 1982. The plan was confirmed by the bankruptcy court on July 7, 1982, but only after a stipulation was entered which left the scope of the release and its enforceability subject to the district court's ruling in the Underhill class action.
The plan was executed, but the amount raised to fund the plan fell short of the $2.5 million goal. Royal then obtained a personal loan of $350,000 from Escondido Bank to fund the plan and secured it with his personal assets. The fund was then sufficient to cover the plan.
On October 14, 1982, the district court conditionally certified the class for a separate trial on the validity of the release contained in the reorganization plan. The class was certified as 295 investors in the loan agreement program. Subsequently, the plaintiffs moved for summary judgment on the validity of the release. In April, 1983, the district court ruled that the release was invalid.
The plaintiffs later moved for partial summary judgment seeking a determination that the promissory notes under the loan agreement program were "securities" under the federal securities laws. The defendants cross-motioned on the same issue. The motion was granted in favor of the plaintiffs in April, 1984.
In March, 1984, the defendants moved to decertify the class. The plaintiffs moved to bifurcate the trial and this motion was granted. The case continued with a separate trial on the failure to file registration and qualification statements against NMESC and NME. Carlos Royal, the principal shareholder of both companies, was a defendant in this separate trial in order to determine his derivative liability on a control person theory. Max Hollis, who was a director of NME, and Jeffrey Stoffel, who served as counsel for both companies, were also defendants on the same theory.
In June, 1984, the jury returned a special verdict finding that NMESC and NME were liable for the offer and sale of unregistered and unqualified securities. Royal was found vicariously liable, but Hollis and Stoffel were not found liable. The district court entered the judgment on July 6, 1984, and certified the action for appeal pursuant to Fed.R.Civ.P. 54(b).
In a grant of partial summary judgment, the district court concluded that the contractual loan agreements/promissory notes were securities under the federal securities laws. The appellants contend that the trial court erred by ruling on the matter before trial, and that genuine factual disputes exist as to certain subsidiary aspects of this circuit's "risk capital" test for determining whether a particular instrument is a "security" under the federal securities laws.
The Securities Act of 1933 and the Exchange Act of 1934 include notes within the definition of a security "unless the context otherwise requires." 15 U.S.C. Sec. 77b(1); 15 U.S.C. Sec. 78c(a)(10). The central distinction to be made is whether the particular transaction is an "investment" or a commercial lending situation, the latter of which is outside the scope of the federal securities laws. United California Bank v. THC Financial Corp., 557 F.2d 1351, 1356-1358 (9th Cir.1977). "The focus of the Acts is on the capital market of the enterprise system: the sale of securities to raise capital for profit-making purposes, the exchanges on which securities are traded, and the need for regulation to prevent fraud and to protect the interest of investors." United Housing Foundation, Inc v. Forman, 421 U.S. 837, 849, 95 S.Ct. 2051, 2059, 44 L.Ed.2d 621 (1975). Thus, the Supreme Court has...
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