Yoder v. Orthomolecular Nutrition Institute, Inc., 483

CourtUnited States Courts of Appeals. United States Court of Appeals (2nd Circuit)
Citation751 F.2d 555
Docket NumberD,No. 483,483
PartiesFed. Sec. L. Rep. P 91,898 Eileen R. YODER, Plaintiff-Appellant, v. ORTHOMOLECULAR NUTRITION INSTITUTE, INC., Healthful Living Company, Inc., Dr. David J. Henderson and Norman Rothstein, Defendants-Appellees. ocket 84-7686.
Decision Date07 January 1985

Lisa Kolb Liebert, New York City, for plaintiff-appellant.

Eli Feit, Heller, Horowitz & Feit, P.C., New York City, for defendants-appellees.

Before FRIENDLY, WINTER and PRATT, Circuit Judges.

FRIENDLY, Circuit Judge:

The principal issue on this appeal is whether a complaint alleging that a company knowingly misrepresented its financial condition when it undertook to issue its stock to a person, who, in reliance thereon, became an employee and also transferred certain assets as a part of the transaction, stated a claim under the federal securities laws. We hold that it did.

The complaint in this action in the District Court for the Southern District of New York alleged substantially as follows: Plaintiff, Eileen R. Yoder, is a nationally known specialist in the field of food allergies. In 1981, she established the Healthful Living Company ("Healthful Living"), a sole proprietorship which was registered to do business in Indiana, through which to conduct her professional activities. By 1983, as a result of her work as a consultant, author and lecturer, plaintiff had developed a mailing list with the names of over 2,000 doctors, other health professionals dealing with food allergies and individuals suffering from such allergies. By this time, plaintiff had also acquired certain proprietary information consisting of special recipes, sources of allergy-free ingredients that the plaintiff had tested extensively, special diet plans, programs for the physical and psychological management of multiple food allergies, and information and material required to develop an individual computerized allergy-free diet program. In the summer of 1983, plaintiff began to seek additional funds to expand Healthful Living, and particularly to enable her to implement and promote the computerized individual allergy-free diet program; she also sought to move from Indiana. She met defendant Henderson, president and chief executive officer of defendant Orthomolecular Nutrition Institute, Inc. ("Ortho-Nutrix"), a publicly held Delaware corporation having its principal place of business in New York City. Henderson expressed an interest in having Ortho-Nutrix purchase Healthful Living and employ plaintiff to assist in the development of the computerized diet program. After negotiations in New York with Henderson and defendant Rothstein, treasurer and a major shareholder of Ortho-Nutrix, an oral agreement was reached whereby Ortho-Nutrix would purchase from plaintiff the assets of Healthful Living, including its name and good will; the copyright and exclusive right to distribute and promote the book "Allergy Free Cooking" and other Healthful Living publications, including a subscription newsletter; allergy-free recipes developed by plaintiff; all materials and proprietary information necessary to develop and promote the computer diet program; and the exclusive right to publish, copyright and market all of plaintiff's writings during the period of her employment by Ortho-Nutrix. As consideration for the sale of Healthful Living, Ortho-Nutrix was to pay Healthful Living's debts, at that time approximately $82,560; to employ plaintiff for three years at a salary of $40,000 per annum plus insurance benefits; to pay 10% royalties on the sale of publications written by plaintiff after payment of the debts; and to issue to the plaintiff up to 30,000 shares of Ortho-Nutrix stock based on profits generated by the development of the computer diet program. Defendants were alleged also to have agreed to provide the necessary funds and support staff required to develop and promote the program. This oral agreement was to be reduced to writing by the defendants before plaintiff's return to New York.

The complaint alleged further that, at the conclusion of the negotiations in New York, Henderson requested a copy of plaintiff's mailing list for use by Ortho-Nutrix, and that she declined to furnish this prior to receipt of a written acknowledgement of the oral agreement. As a result, plaintiff received a two-page memorandum, signed by Henderson for Ortho-Nutrix, which was stated to constitute "a tentative agreement the spirit of which will remain but will be formally structured by our attorneys." This memorandum conformed generally to the allegations recited above except that the issuance of Ortho-Nutrix shares was tied to the company's gross sales rather than to profits generated by development of the computer diet program. The clause relating to plaintiff's receipt of Ortho-Nutrix stock is set forth in the margin. 1

The complaint next alleged that in reliance on defendants' representations, plaintiff furnished Ortho-Nutrix with the mailing list and other proprietary information and assets of Healthful Living and, with her two children, came to New York to commence working for Ortho-Nutrix. In late August, 1983, Ortho-Nutrix had the "Healthful Living Company, Inc." incorporated as a wholly-owned subsidiary. However, plaintiff soon discovered that "defendants were without funds to meet their obligations pursuant to the agreement for the purchase of Healthful Living." In particular, insufficient funds were provided with which to fill orders for Healthful Living publications received from plaintiff's former customers or to enable plaintiff to develop the computer-diet program. On October 14, 1983, defendants terminated plaintiff's services.

The complaint alleged as a first cause of action for violation of the antifraud provisions of the Securities Act and the Securities Exchange Act that defendants made fraudulent representations as to the assets, liabilities and earnings of Ortho-Nutrix. The complaint also alleged pendent state law causes of action for fraud, breach of contract and conversion.

Along with her complaint, plaintiff moved for a preliminary injunction restraining defendants from using Healthful Living's name, mailing lists, publications, or proprietary information and other assets. Defendants countered with a motion for an order pursuant to F.R.Civ.P. 12(b)(6) dismissing the complaint for failure to state a claim upon which relief can be granted, or, in the alternative, for an order pursuant to F.R.Civ.P. 56 granting defendants summary judgment. A supporting affidavit submitted by Rothstein alleged that the arrangement with plaintiff was simply an employment agreement and not the purchase of a business, and that plaintiff's employment had been terminated because she had been unproductive. After this, plaintiff's attorney submitted an affidavit in support of the motion for a preliminary injunction to the effect that examination of Ortho-Nutrix' quarterly reports to the SEC for the periods ending November 30, 1982, and May 31, August 1 and November 30, 1983, disclosed that when "the negotiations between Plaintiff and defendants took place, [Ortho-Nutrix] was operating at a significant loss and experiencing major liquidity problems." The reports give this assertion considerable support. As early as November 30, 1982, when the working capital ratio was 1.8, the company reported that

given the present level of operating expenses and the lack of significant operating revenues to date, management believes that the Company may face a serious liquidity problem during the next year unless significant revenues can be achieved from the orthomolecular practice assistance program, operating expenses can be reduced and additional sources of financing can be found.

The later reports reveal an increasingly deteriorating financial situation. The May 31 report showed a current working capital ratio of 1.3 and a quarterly loss of $142,515; the August 31 report showed a current ratio of 1.2 and a loss for the quarter of $160,145; the November 30, 1983 report showed a working capital ratio of 1:1 and a $145,859 loss for the quarter. In the May 31 report management repeated its observation that "the Company may face a serious liquidity problem during the next year unless significantly greater revenues can be achieved, operating expenditures can be reduced and additional sources of financing can be found." Statements to the same effect may be found in the other reports as well; indeed, the November 30, 1983 report went so far as to include the observation that "[t]here can be no assurance that the Company will have sufficient working capital to fund its needs during the next year." Plaintiff also submitted an affidavit in support of her motion and in opposition to defendant's motion. This contradicted many of the allegations made in Rothstein's affidavit. In particular, plaintiff averred that Ortho-Nutrix' claim that its stock "was to be issued to me as merely an employment benefit" was untrue. Rather, plaintiff alleged: "The stock was to have constituted a deferred payment for the acquisition of my assets, and was a major inducement to me to enter into the initial agreement with [Ortho-Nutrix]."

Judge Griesa granted defendants' motion to dismiss, holding that the complaint failed to state a cause of action under the federal securities laws and that the pendent jurisdiction claims should therefore be dismissed. Not unreasonably in light of its inept drafting, Judge Griesa construed the complaint as predicating the applicability of the federal securities laws only on the basis that the agreement constituted an "investment contract" under Sec. 3(a)(10) of the Securities Exchange Act, 15 U.S.C. Sec. 78c(a)(10). He held that the arrangement described above did not constitute an "investment contract" as that term has been defined in SEC v. W.J. Howey Co., 328 U.S. 293, 298-99, 66 S.Ct. 1100, 1102-03, 90 L.Ed. 1244 (...

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