The opinion of the court was delivered by: MANSFIELD
MANSFIELD, District Judge.
In this action the Securities and Exchange Commission ("the Commission") seeks to plug up what some have treated as a loophole in the federal securities laws permitting a company, by "spinningoff" its subsidiary's shares to the parent's stockholders without registration, to convert the subsidiary into a public corporation whose unregistered shares would be actively traded on the market. The suit is brought under § 22(a) of the 1933 Securities Act, 15 U.S.C. § 77v(a), and § 27 of the 1934 Securities Exchange Act, 15 U.S.C. § 78aa. The Commission alleges violations of the registration requirement of § 5 of the 1933 Act, 15 U.S.C. § 77e, and of the antifraud provisions of both the above securities acts, § 17(a) of the 1933 Act, 15 U.S.C. § 77q(a) and § 10(b) of the 1934 Act, 15 U.S.C. § 78j(b), and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5. Preliminary injunctive relief is sought, Rule 65, F.R. Civ. P., § 20(b) of the 1933 Act, § 21(e) of the 1934 Act, against all 15 defendants on the basis of their participation in a series of transactions involving stock distributions by Harwyn Industries Corporation ("Harwyn") to its shareholders.
The scheme involved three coordinated steps: (1) the acquisition by the subsidiaries of assets of other corporations in exchange for issuance of controlling interests in the subsidiaries to those contributing such assets, (2) the "spin-off" distribution by the parent, Harwyn, to its stockholders of the unregistered shares of its subsidiary owned by it, and (3) the development of an over-the-counter trading market in the unregistered shares thus spun-off. Although the motion for a preliminary injunction was made many months ago, we deferred decision because of the pendency of settlement discussions. No such settlement, however, was reached, despite several conferences in open court. Because there is little dispute over the basic facts on which the litigation is based, our decision relies on undisputed facts appearing from the affidavits and other voluminous papers submitted by the parties. SEC v. Frank, 388 F.2d 486, 490 (2d Cir. 1968).
Harwyn was incorporated in 1958 under the name Harwyn Publishing Corporation and engaged in the printing business. In 1965 it changed its name by substituting "Industries" for "Publishing." On June 22, 1961, a registration statement filed pursuant to the requirements of the 1933 Securities Act, Form S-1, became effective, covering a public offering of 131,000 shares of its common stock. The stock is traded over-the-counter, and Harwyn has approximately 600 public shareholders. Harwyn is not a public reporting company in that it is not required to file reports with the Commission. Harvey R. Siegel ("Siegel") is its President and Chairman of its Board of Directors. Irving L. Gartenberg ("Gartenberg"), an attorney, is, and has been since 1962, its Secretary, a member of its Board of Directors, and general counsel.
The actions of which the Commission complains involved four corporations which were wholly-owned subsidiaries of Harwyn as of November 1968 -- Cleopatra Cosmetics Corporation ("Cleopatra"), NTRR, Inc. ("NTRR"), Motel Trailer Distributors, Inc. ("Motel"), and Prospectus Press, Inc. ("Prospectus").
Cleopatra was incorporated on May 13, 1963, and was an active subsidiary of Harwyn in the business of distributing cosmetics. Counsel for Harwyn inquired of the Commission, both in New York and in Washington, regarding the need for registering a "spin-off" distribution of Cleopatra stock to the Harwyn shareholders, but there is no indication that any view on the question was offered by the Commission in reply. On November 21, 1968, the Board of Directors of Cleopatra authorized a distribution of 127,500 Cleopatra shares held by Harwyn to its shareholders, one share of Cleopatra being distributed for every four shares of Harwyn held as of December 6, 1968. The distribution was payable December 30, 1968, and was effected on that date. Seventy-five thousand five hundred shares were distributed to Harwyn insiders (presumably Siegel and Gartenberg), and the remaining 52,000 shares were distributed to the public shareholders of Harwyn. A notice as to the source of the distribution, required by N.Y. Business Corporation Law, McKinney's Consol. Laws, c. 4, § 510(c), was sent to the shareholders of Harwyn.
On November 7, 1968, well before the distribution had been authorized, an attorney in Gartenberg's office wrote to the National Quotation Bureau to arrange for trading in the shares of Cleopatra. The letter set forth basic but somewhat skimpy information concerning Cleopatra, i.e., its name, address, state of incorporation, number of shares issued, etc., and did not reveal anything about the business of the company. Beginning on January 6, 1969, Cleopatra stock was quoted on the over-the-counter listings, or "pink sheets," published by the National Quotation Bureau.
The Harwyn insiders who received Cleopatra shares were prevented by law from trading their Cleopatra shares without registering them pursuant to § 5 of the 1933 Securities Act. Stop transfer orders with respect to such shares were placed with Cleopatra's transfer agent, Bankers Trust Company.
On approximately January 13, 1969, negotiations were commenced concerning the possibility of an exchange of investment stock between Harwyn and certain individuals who were to become, after completion of the exchange, the principals of Cleopatra, the name of which was to be changed to Academic Development Corporation ("Academic"). These individuals included Hyman Temkin ("Temkin"), who became President and Chairman of the Board of Academic, James W. Feeney ("Feeney"), who succeeded Temkin as President and a director of Academic, and Ramon D'Onofrio ("D'Onofrio"), who was to become Secretary-Treasurer and a director of Academic. It appears that D'Onofrio may have been the most active in conducting these negotiations. A 16-page agreement was signed on January 18, 1969, embodying the terms of the exchange. Cleopatra was to issue 872,500 new shares of common stock (amounting to 87% of the stock in Cleopatra after issuance) in exchange for stock in two publicly traded companies -- 49,000 shares of Educational Science Programs ("ESP") and 53,000 shares of Academic Systems and Management Corp. ("Systems"). Of the 872,500 Cleopatra shares, 254,000 were to go to Temkin, 254,000 to Feeney, and 253,500 to Xanadu Properties, Inc. ("Xanadu"), a corporation engaged primarily in holding securities. Xanadu's President, Muriel Barter, is D'Onofrio's wife. D'Onofrio acted as " attorney-in fact" for Xanadu and all of the parties who participated in the above transaction. Sixty-nine thousand shares were paid to Hill, Thompson, Magid & Co., Inc. ("Hill, Thompson") as a finders fee. The remaining 42,000 Cleopatra shares were distributed among three associates of the D'Onofrio group.
The agreement, Art. 3(d), recognized that the shares of ESP and Systems obtained by Cleopatra were to be acquired for investment, and Cleopatra consented to their being legended with the statement that they were not registered under the 1933 Securities Act. The agreement further provided, Art. 4(c), that the Cleopatra shares newly issued in exchange for the ESP and Systems stock were acquired for investment and would be similarly legended. There is no evidence that the restriction implicit in the legending has been violated in any way. Temkin has, however, made certain transfers which are allegedly exempt.
Article 9 of the agreement provided that if Cleopatra were to register any stock for sale to the public, e.g., stock held by D'Onofrio and his group, the Harwyn insiders could register up to 40,000 shares of their Cleopatra stock. After two years, Cleopatra agreed to file a registration statement covering the shares held by Harwyn insiders and those held by Hill, Thompson. In the event of any such registration, each selling shareholder was to pay his pro rata portion of the underwriting and registration costs.
Cleopatra was required to adopt a name other than Cleopatra pursuant to the agreement, Art. 8, Harwyn reserving to itself "all right, title and interest" in the name Cleopatra Cosmetics. As a result of the "spin-off" distribution to Harwyn shareholders, the letter from Gartenberg's office to the National Quotation Bureau, and the listing of Cleopatra shares on the pink sheets, described above, Cleopatra stock became publicly traded. Although the name "Cleopatra" was reserved by Harwyn, the advantages of being a public corporation remained with the "spun-off" company. On January 9, 1969, the price of Cleopatra was $3 bid per share. By February 28, 1969, the price had risen to $15 1/2 bid per share, and on March 28, 1969, the price reached $22 bid per share. On June 30, 1970, the price of Cleopatra (then known as Academic) was $1 bid per share. Approximately five broker dealers made the market in Cleopatra stock.
In March 1969, Cleopatra changed its name to Academic. Since then it has been active in the field of education. The controlling persons have assertedly lent Academic amounts of money and have guaranteed as yet unpaid bank loans in substantial amounts.
We now turn to the second transaction involving the Harwyn subsidiary known as NTRR and J. Kevin Murphy ("Murphy"), which followed closely the pattern of the Cleopatra (Academic) arrangement. NTRR, the Harwyn subsidiary, was incorporated on October 16, 1962, as a sales agency for radio and television time. Until early 1969 Murphy was the sole stockholder and chief executive officer of two California corporations engaged in the business of general construction and leasing of construction machinery -- J.K. Murphy Associates and M & S Equipment Company. He had operated these companies profitably for about three years, but in late 1968 he concluded that it would be advantageous to have public shareholders and an active trading market for his stock in order to expand the business of his companies. He was advised that a legitimate method of achieving this goal without the expense of registration with the Commission might be to acquire a controlling interest in an inactive corporation which had public stockholders.
In late 1968, through the assistance of a consultant, Alvin K. Sweitzer ("Sweitzer") of AKS Consultants, Murphy learned of NTRR. A meeting was arranged by Sweitzer at which Murphy, his California counsel, and Siegel were present. A deal was discussed whereby Murphy would transfer all the shares of his corporations to NTRR, receiving in exchange a controlling interest in NTRR. Beset by a lingering concern about the legality of the proposed transaction, Murphy then consulted New York counsel and was assured that, although the Commission was concerned that the "spin-off" device not be used by unscrupulous persons to defraud the public, no Commission release or prior litigation indicated that the proposed transaction would be unlawful.
On the basis of the foregoing legal advice, as well as the advice of other experienced businessmen, on February 12, 1969, Murphy entered into a 22-page agreement with Harwyn for the purchase of 650,000 shares of common stock to be issued by NTRR, for which NTRR was to receive all the stock in the two abovementioned California corporations (J.K. Murphy Associates and M & S Equipment). In Art. 3.12 of the agreement, Murphy warranted that he was taking the NTRR stock for investment and not with a view to its distribution, and Art. 5.2(vi) set forth explicitly the legend which such stock was to bear. There is no evidence that Murphy has sold or otherwise transferred or encumbered any of his NTRR stock.
On February 29, 1969, as had been expressly covenanted in Art. 7.1 of the agreement, the Board of Directors of Harwyn authorized the "spin-off" distribution of Harwyn's 200,000 shares of NTRR to Harwyn shareholders of record as of March 14, 1969, payable April 7, 1969. The Harwyn shareholders were to receive one share NTRR for each four shares of Harwyn. The distribution was effected April 7, with Harwyn insiders receiving 125,000 shares and Harwyn public shareholders receiving 75,000 shares. Under the terms of the agreement, Art. 7.4, the Harwyn insiders (in this case, Siegel and one Garson Reiner) were required to give Murphy irrevocable proxies on their shares of NTRR for a period of two years and were prohibited from selling their shares during that period without the consent of NTRR. In Art. 8.2, NTRR agreed that, after two years had elapsed, it would file a registration statement with the Commission covering all shares held by any insider at the request of such insider. The expenses of such registration and of underwriting were to be shared pro rata by the insiders whose shares were being registered. Pursuant to Art. 8.1 of the agreement, NTRR changed its name to J.K.M. Industries, Inc. ("JKM") in May 1969. Under that same provision Harwyn retained all right, title and interest in the name NTRR.
A release was sent to Harwyn shareholders on March 7, 1969, informing them of the impending dividend and describing enough of the contract with Murphy to indicate that after the transaction closed on March 21, 1969, Murphy would become the controlling stockholder of NTRR. Another release, undated but apparently mailed out with the distribution of NTRR shares to Harwyn stockholders on or about April 7, paralleled the Cleopatra release in form but stated that the distribution would not affect the stated capital, capital surplus, or earned surplus of Harwyn, as NTRR had no assets or liabilities.
NTRR (JKM) shares were listed on the pink sheets for March 18, 1969, more than two weeks before the distribution of NTRR (JKM) shares. NTRR (JKM) stock was quoted in the pink sheets by 10 broker dealers. The price of the stock was $7 bid per share on April 30, 1969, rising to $9 bid per share on May 30, 1969, then falling to $4 bid per share on November 21, 1969, and finally reaching $1/2 bid per share on June 30, ...