UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK
September 6, 1973
Milton and Ellen FORMAN et al., Plaintiffs,
COMMUNITY SERVICES, INC., et al., Defendants
Pierce, District Judge.
The opinion of the court was delivered by: PIERCE
OPINION AND ORDER
PIERCE, District Judge.
This action has been commenced by 57 residents of Co-op City,
a low-middle income cooperative housing project located in the Borough of the Bronx, New York City. They sue on behalf of themselves and all other residents of Co-op City, alleging, among other things, violations of the anti-fraud provisions of the Securities Exchange Act of 1934,
and of the Securities Act of 1933,
in connection with the sale to plaintiffs of shares of the common stock of the cooperative housing corporation.
The amended complaint also asserts violations of the plaintiffs' civil rights by one of the government defendants,
premised upon the protections afforded by the federal securities laws; and it further sets forth several claims, pendent to the federal claims, based on New York State law, including an asserted derivative cause of action on behalf of the cooperative corporation.
The corporate defendants constitute the amalgam which conceived, built, promoted and, at this time, controls the management of Co-op City. United Housing Foundation (UHF) initiated and sponsored the project.
UHF was organized under New York's nonprofit corporation statute
and is comprised of housing cooperatives, civic groups and labor unions. Community Services Inc. (CSI) is the general contractor and sales agent for the project. CSI was organized under New York's business corporation statute
and is a wholly owned subsidiary of UHF. Riverbay Corporation (Riverbay) is the cooperative housing corporation in which plaintiffs purchased shares, and which owns and operates the project. Riverbay was organized by UHF as a "mutual company" under New York's Mitchell-Lama Act,
and is named as a defendant here only to facilitate the derivative aspects of the action.
The individual defendants are officers or directors, or both, of some, and in some cases all, of the corporate defendants.
Pursuant to the Mitchell-Lama Act, the defendant New York State Housing Finance Agency (the Agency) provided the bulk of the financing for the project through long-term, low-interest mortgage loans; and the defendant New York State Division of Housing and Community Renewal (the State Division) is responsible for the supervision of the development, construction, promotion and operation of the project.
The question before this Court, raised by defendants' motion to dismiss for lack of subject matter jurisdiction, is narrow, but dispositive: Is a "share" of a state-financed and supervised, nonprofit cooperative housing corporation a "security" within the meaning of the federal securities laws ?
If so, plaintiffs are properly in federal court; if not, each of the alleged bases for federal jurisdiction must fail, and with them, the pendent state claims.
For the reasons set forth herein, this Court holds that the shares involved in this action are not "securities" within the meaning of the federal securities laws, and dismisses the complaint in its entirety pursuant to Fed. R. Civ. P. 12. Such ruling has no bearing on the merits of plaintiffs' grievances, which may well deserve to be fully aired in appropriate New York State forums.
Co-op City is no ordinary enterprise. Reputed to be the largest cooperative housing development in the United States, the project was conceived in 1964, completed in 1972, and presently houses some 45,000 people. The complex is located on a 200-acre site, includes more than 30 high-rise buildings and more than 230 townhouses, which in total provide about 15,400 apartment units ranging from three to seven rooms.
The project was facilitated by New York's salutary Mitchell-Lama Act, the express purpose of which is to address critical housing problems in New York's urban areas by encouraging private enterprise to participate with the state and municipalities
in the creation of nonprofit housing cooperative undertakings for persons with low incomes.
Toward that goal, the Agency is empowered to provide low-interest financing through the issuance of loans secured by first mortgages on the projects;
and tax exemptions,
and certain other inducements are provided for corporate participants from the private sector.
State regulation and supervision of the housing enterprises built under the Mitchell-Lama Act is mandated by law. The cooperative corporation cannot be created without the approval of the Commissioner of the State Division.
The statute mandates that no directors or subscribers to its stock may profit from the resale of such stock,
and provides that the tenant may not sublet at a price greater than approved by the Commissioner.
The statute requires the Commissioner's approval before the corporation can contract for operation of the project.
In fact, from the initiation of a project and continuing thereafter state control is pervasive.
It is contemplated that a Mitchell-Lama cooperative project thus subsidized and supervised will be owned by a mutual company formed under the Act whose stock is held almost exclusively by persons who actually live in the project.
In accord with the purposes of the Act, the legislature has declared that no one may live in the project whose probable aggregate income exceeds six times the rental fees
and further, the legislature has indicated that preference shall go to the aged, the handicapped and to veterans.
Thus by definition, the tenants of Co-op City are persons of limited, and in some cases, fixed incomes. They secured their right to occupancy by completing a Subscription Agreement and Apartment Application form, wherein they agreed to subscribe to 18 shares of Riverbay common stock -- at $25 par value per share -- for each room in the apartment they selected. After their applications were screened and accepted by the State Division, they signed a three-year, non-proprietary Occupancy Agreement (lease), paid for or financed the purchase of their stock, and moved in as the buildings were completed and their apartments were ready for occupancy.
Beyond the face value of $25 per share and the right to occupancy, the Riverbay shares carry little, if any independent value or meaning. The Riverbay By-Laws provide that they may not be pledged or otherwise encumbered; the shares may descend intact, with the right to occupancy, only to a surviving spouse. The stock transaction is rescindable by either party. The shares may not be owned separate and apart from actual occupancy in Co-op City, and a tenant who wishes to move out -- or who is forced out for violation of the lease, or because his income has increased beyond income limits -- is required to divest himself of the stock. He must first offer the shares to the cooperative corporation for repurchase, and the By-Laws provide that he will be compensated for these shares with exactly the amount he paid for them. In the unlikely event that the corporation does not repurchase the shares,
only then is he free to sell the shares elsewhere and then the Mitchell-Lama Act provides that he may not sell them for more than the original purchase price, plus a fraction of the mortgage amortization which he has paid during his tenure at Co-op City.
It is implicit in the By-Laws and the Act that he may not sell to a person who does not meet the income and credit requirements for occupancy. Voting rights in the affairs of the cooperative corporation are not tied to the number of shares owned, which could vary greatly according to apartment size. Rather, to facilitate the democratic cooperative ideal, each apartment is allotted one vote.
The obligations of the Co-op City residents flow from the lease, not the stock. In addition to the usual landlord/tenant covenants with respect to services and care of the premises, the lease provides that the resident's financial commitment is to pay annual carrying charges, prorated in advance monthly payments. The apportionment is not based on the number of shares owned, but rather on other factors such as size, type and location of apartment. This monthly payment is, for all practical purposes, rent. It represents a proportionate allocation of all the expenses of Riverbay in connection with the construction, ownership, maintenance, operations and activities associated with the housing corporation. These include such items as taxes, mortgage indebtedness, repairs, improvements and wages for Riverbay
employees. It is the amount of these carrying charges for Co-op City apartments which is the stress-point in this litigation.
In May of 1967, CSI as sales agent for Riverbay began promoting the sale of shares which carried with them the concomitant right to reside in Co-op City. Construction was then underway, but nowhere near completion. The Information Bulletin circulated through the mails to prospective tenant/stockholders set forth an estimated average monthly carrying charge of $23.02 per room. Thus, assuming he met the income eligibility requirements, the prospect for a three-room apartment could expect to pay about $1,350 for stock in Riverbay and a monthly rent thereafter of $69.06. Persons familiar with the cost of housing in New York City can appreciate the incredible bargain Co-op City must have seemed to prospective tenant/stockholders. However, by the time the project was near completion, the bargain had somewhat diminished. In 1968, while the project was still under construction, the Information Bulletin estimate was revised to $25 per room, per month. Then in an unremitting upward spiral, the estimate was revised to $29.39 for 1970-72; to $35.27 for 1973-74; and it is now estimated that the charge will be $39.68 effective July 1, 1974. Thus, the $69.06 monthly rental bargain for a three-room apartment will soon cost $119.04 a month.
At the same time, of course, the maximum income eligibility limit, related as it is to carrying charges, has increased proportionately; and it may be assumed that to the extent the increases in carrying charges reflect the inflationary trend of the period, wages and salaries should have also risen proportionately. Thus, for tenants in the work force, it is possible that no real hardship has occurred.
But all of this is of little solace to the elderly and the handicapped, or anyone on a fixed or sluggish income, or indeed, anyone who arranged his affairs based on a belief that the earlier Co-op City estimates would remain unaffected by changes in the economy. The gravamen of the plaintiffs' complaint is that this is precisely what they were led to believe by misrepresentations and material omissions in the Information Bulletins. They point to the earliest Bulletin which indicated that there was a "lump sum" price of $258,678,000 fixed for the construction of the project, to be financed with a $250,000,000 mortgage from the Agency. The bulletin further stated that "the risk of completing the construction within the lump sum price is on the contractor." The final construction bill for Co-op City was $340,500,000, and the tenant/stockholders absorbed the impact, chiefly through a $125,000,000 increase in the mortgage loan from the Agency which consequently contributed greatly to the increase in carrying charges.
In addition to this alleged misrepresentation, plaintiffs assert that a number of other material facts were omitted from the Information Bulletins, all of which would have influenced their decision to purchase or not to purchase shares in the cooperative corporation.
Since this Court is not called upon to rule on the merits here, and particularly in view of the conclusion this Court reaches as to this motion to dismiss, further detail with respect to the plaintiffs' specific charges or the defendants' answers would serve little purpose. But the Court is constrained to say that if ever there was a group of people who need and deserve full and careful disclosure in connection with proposals for the use of their funds, it is this type of group. By law, they would not be eligible for occupancy in Co-op City unless their financial resources were limited. The housing selection decision is a critical one in their lives. The cost of housing demands a good percentage of their incomes. Their savings are most likely to be minimal, and they probably don't have lawyers or accountants to guide them. Further, they are people likely to put a great deal of credence in statements made with respect to an offering by reputable civic groups and labor unions, particularly when the proposal is stamped with the imprimatur of the state.
However, the question before this Court is not whether the plaintiffs should be protected; rather, the question is whether or not they are protected by the federal securities laws.
The Legal Principles
Any analysis of this issue must begin with the language of the statutes which define the scope of the federal securities laws.
Section 3(a) (1) of the Securities Exchange Act of 1934 provides:
3. (a) When used in this title, unless the context otherwise requires -- (10) The term "security" means any note, stock, treasury stock, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit, for a security, or in general, any instrument commonly known as a "security"; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker's acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.
The Securities Act of 1933 contains a definition of a "security" almost identical to that contained in the 1934 Act, and the Supreme Court has indicated that the definitions under either Act are, for these purposes, interchangeable.
Beyond the bare itemization contained in each definitional section, the statutes themselves yield little in the way of elaboration as to the characteristics of an instrument intended to be covered by the securities acts. Legislative history directly to the point is sparse and somewhat circular, confirming, for instance, that the definitional sections define "the term 'security ' in sufficiently broad and general terms so as to include within that definition the many types of instruments that in our commercial world fall within the ordinary concept of security. ..."
However, there is a landmark Supreme Court case which sets forth a number of principles and tests which light this Court's way. The Court in S.E.C. v. Joiner Corp., 320 U.S. 344, 64 S. Ct. 120, 88 L. Ed. 88 (1943), did not attempt to rigidly classify the oil leases at issue there, rather it stated that the courts should construe the legislation in conformity with its dominating general purposes, Id. at 350-351, 64 S. Ct. 120 and decide whether these documents had the evils inherent in the securities transactions which it was the aim of the Securities Act to end. Id. at 349, 64 S. Ct. 120. Then, the Court went on to explain the definitional sections:
In the Securities Act the term "security" was defined to include by name or description many documents in which there is common trading for speculation or investment. Some, such as notes, bonds, and stocks, are pretty much standardized and the name alone carries well-settled meaning. Others are of more variable character and were necessarily designated by more descriptive terms, such as "transferable share," "investment contract," and "in general any interest or instrument commonly known as a "security." . . . Instruments may be included within any of these definitions, as matter of law, if on their face they answer to the name or description. However, the reach of the Act does not stop with the obvious and commonplace. Novel, uncommon, or irregular devices, whatever they appear to be, are also reached if it be proved as a matter of fact that they were widely offered or dealt in under terms or courses of dealing which established their character in commerce as "investment contracts," or as "any interest or instrument commonly known as a 'security. '" Id. at 351, 64 S. Ct. at 124.
The Court then stated that the "test . . . is what character the instrument is given in commerce by the terms of the offer, the plan of distribution and the economic inducements held out to the prospect", Id. at 352-353, 64 S. Ct. at 124, noting that while in some cases a document might be proved a security by proving the document itself, "in others proof must go outside the instrument itself. . . ." Id. at 355, 64 S. Ct. at 125.
In a later case, S.E.C. v. Howey Co., 328 U.S. 293, 66 S. Ct. 1100, 90 L. Ed. 1244 (1946) the Court stated explicitly what was implicit in Joiner, that in searching for the meaning and scope of the word "security" in the securities laws, form should be disregarded for substance and the emphasis should be on economic reality. Id. at 298, 66 S. Ct. 1100. See also, Tcherepnin v. Knight, 389 U.S. 332, 336, 88 S. Ct. 548, 19 L. Ed. 2d 564 (1967).
The Riverbay Shares
What this means in the context of the Riverbay shares is that this Court must first determine whether or not the identifying characteristics of the Riverbay instruments, and the economic realities of the Riverbay transaction -- the plan of distribution and the economic inducements held out to the prospective purchasers -- fit any of the items set forth in the statute; and, if not, then determine if Congress intended, nonetheless, to cover this type of transaction.
Plaintiffs urge, in one branch of their argument, that inasmuch as "stock" is explicitly set forth as a "security" in the plain language of the statute, and the instruments purchased by the residents of Co-op City are called "shares of stock," they are, a fortiori, securities. They rely on the language set forth in S.E.C. v. Joiner Corp., supra, 320 U.S. at 351, 64 S. Ct. 120, where the Court notes that some instruments may be included as a matter of law if they answer to the name or description of a category in the securities law. Plaintiffs also cite the alternate holding in Tcherepnin v. Knight, supra, 389 U.S. at 339, 88 S. Ct. 548, which relies on the Joiner language to point out that the investment contract in Tcherepnin could have also qualified as "stock." This Court believes that a reading of the entire paragraph from Joiner, set forth in full, supra, along with the Howey refinement, makes it clear that this Court must, at a minimum, look through the name of an instrument to its essential characteristics and determine whether it fits the standardized, well-settled meaning of "stock." This is, in fact, what the Court did in Tcherepnin, and only after noting that the instrument was evidenced by a certificate and that payment of dividends were contingent upon an apportionment of profits did it identify the instrument as a "stock." Accepting the definition set forth in Tcherepnin as the well-settled meaning, it is clear that Riverbay shares do not fit because they do not represent any right to any apportionment of tangible profits.
Therefore, this Court rejects plaintiffs' argument.
The Court in Joiner indicated that in cases where the instrument could not be proved a security on its face, "proof must go outside the instrument itself. . . ." S.E.C. v. Joiner Corp., supra, 320 U.S. at 355, at 125 of 64 S. Ct. Since this is the case here, the next area of inquiry is into the substance of the transaction. It is to this area that the bulk of the arguments are directed.
Defendants urge first that the severe restrictions surrounding the owner's use of the stock are such that the shares fit none of the categories of instruments or transactions which Congress intended to be covered by the securities laws. Further they argue that the nonprofit economic realities surrounding it, and the public policy underlying it, coalesce to produce a unique transaction, far removed from the commercial world that Congress intended to regulate with the federal securities laws.
Plaintiffs contend that this Court, by applying some flexibility, could find that the major motivation for the purchase of Riverbay shares is the economic benefit to be gained and that such creates a securities transaction, if not as stock qua stock, then in some other form. Further they argue that the major thrust of Congress was to protect the investor and that it makes little difference whether or not the enterprise which induces him to part with his money is commercial or nonprofit.
For all the arguments set forth by both plaintiffs and defendants -- technical, substantive, emotional, policy -- it is well to note at the outset of this inquiry that it is the fundamental nonprofit nature of this transaction which in this Court's view is the insurmountable barrier to plaintiffs' claims in this federal court.
Plaintiffs attempt to overcome this hurdle by tacitly recognizing that if the Riverbay transaction is a securities transaction at all, it is more likely to be an investment contract than any other. An investment contract is one of the few items on the statutory list which has a developed definition. The oft-cited test enunciated in S.E.C. v. Howey Co., supra, has been used in a line of Supreme Court cases finding that such a contract does exist. See S.E.C. v. Variable Annuity Co., 359 U.S. 65, 79 S. Ct. 618, 3 L. Ed. 2d 640 (1959); S.E.C. v. United Benefit Life Ins. Co., 387 U.S. 202, 87 S. Ct. 1557, 18 L. Ed. 2d 673 (1967); Tcherepnin v. Knight, supra. The Howey definition of an investment contract contains three elements. First, there must be a transaction whereby a person invests his money in a common enterprise; second, he must invest with the expectation of profits; and third, the profits must come solely from the efforts of the promoter or a third party. S.E.C. v. Howey Co., supra, 328 U.S. at 298-299, 66 S. Ct. 1100.
With respect to the Riverbay shares there can be no serious argument as to the first and last requirements. The first, a common enterprise, is self-evident because the corporation is a cooperative. The third could be questioned in a small cooperative where the ideal of joint venture was a reality, but given the massive size of a Co-op City it would be specious to argue that the cooperative ideal precludes the notion of management by third parties. Furthermore, the By-Laws of Riverbay clearly vest absolute control in the hands of the promotors until the tenants receive their stock certificates. These have not yet been distributed, see note 33. Thus, at this time, the third element of the Howey test is met in fact, as well as in spirit.
It is on the second element -- the expectation of profit -- where plaintiffs' argument founders. Joiner instructs that this Court should look to the economic inducement offered by the promotor; Howey instructs that this Court should look go the expectation of the purchaser for profits. This Court has examined both and finds that none of the documents involved in this transaction -- the Information Bulletins, the Subscription Agreement and Apartment Application, or the Occupancy Agreement -- ever, once use material, tangible profits as an inducement.
In fact, the Information Bulletins assert the contrary, impressing upon the potential purchaser the stability of environment to be achieved because the shares can not be used for speculation.
They also point out that a departing tenant is required to resell his shares to the corporation for no more and no less than the purchase price, thus assuring no gain and no loss.
Further, since these shares pay no dividends, contemplate no apportionment of any profits or assets or earnings of any kind, it is clear that the Co-op City residents did not purchase the shares with any expectation of profits, as the word is generally used in commerce. These shares are incapable -- by law and by-law -- of producing any monetary or fungible return. It would go against the fundamental purpose of the cooperative ideal and the Mitchell-Lama Act if it were otherwise.
And, the state law is replete with provisions to guard against the possibility of profits from these shares or from occupancy in Co-op City.
Finally, of course, because both the cooperative corporation, Riverbay, and its sponsor UHF, are organized on nonprofit structures, there could be no monetary gain from the operations of the corporations to distribute, even if it were allowed by law.
Plaintiffs, fully cognizant of the legal problem, advance two bases upon which this Court might find the "profit" element satisfied in this transaction.
First, they suggest that this Court follow Silver Hills Country Club v. Sobieski, 55 Cal. 2d 811, 13 Cal. Rptr. 186, 361 P.2d 906 (1961) and read the tangible profit motive out of the Howey test.
The Silver Hills case has come to stand for the theory that the requisite profit motive should be replaced with a "risk capital" approach which holds that the investor is protected by the securities laws if he risks capital, whether or not he expects a monetary return on the capital. In Silver Hills the risk was for a lifetime membership in a country club, but it was a large risk in a shaky enterprise devoted to making a profit. Given the pervasive state support and supervision of Riverbay in the transaction at issue here, and the resultant zero capital risk because of the guarantee of a complete refund on the stock purchase price, and the essentially nonprofit nature of the enterprise, this would not seem to be the case for the first federal application of this California state securities theory.
Alternatively, plaintiffs suggest that even though no monetary profit was envisioned or possible from the Riverbay shares, the shares were sold and purchased with economic benefits in mind. They ask this Court to expand the definition of "profit" to include savings of money that might have otherwise gone for more expensive housing; or the social gain to be had in quality housing for minimal expense. Put another way, the profit expected by Co-op City residents was the invaluable hedge against the skyrocketing real estate market in New York City.
This argument is most appealing to this Court, particularly when made on behalf of people with limited incomes who are not free economically to allocate a portion of their money to ordinary capital producing securities, however safe, and who are not in a position to risk their money in speculative schemes. But, of the few cases which counsel and this Court have managed to find where this concept of profit was a possible factor, only one on close analysis is near the point.
And its point, with respect to a medical cooperative, was simply, "money saved is money earned." State ex rel. Troy v. Lumberman's Clinic, 186 Wash. 384, 58 P.2d 812, 816 (1936). As attractive as that reasoning may be, Supreme Court cases and the lower federal court cases which follow them closely, and legislative documents concerning the federal securities laws convince this Court that the weight of authority is against it. This Court has attempted to follow the guiding principle that federal securities laws, as remedial legislation, must be read liberally to effectuate the purpose of Congress. Tcherepnin v. Knight, supra, 389 U.S. at 336, 88 S. Ct. 548, and is mindful that to further the objectives of Congress, the securities laws must be viewed as embodying a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of money of others on the promise of profits. S.E.C. v. Howey Co., supra, 328 U.S. at 299, 66 S. Ct. 1100. Yet, it seems certain that Congress never intended to stretch the scope of the securities acts outside the commercial world and its fungible valuables, to the uncharted and unchartable realm of intangible, elusive personal values where one man's balm may very well be another's bane.
The legislative history of these acts, on the contrary, indicates that the intentions of Congress were focused on the powerful inducement of cold, hard cash and anything which could be converted to it through the commercial ingenuity of man. It is the abuse of this inducement, this motive, from which Congress believed investors needed protection, both for their well-being and for the health of the nation's commercial enterprises and its economy.
Congress did not intend to sweep into the ambit of the federal securities laws, state-encouraged, nonprofit transactions made pursuant to a state emergency housing law and available only to state residents. And the mere fact that the state legislature chose to provide a form of organization common to the commercial world, in order to achieve critical public welfare goals, does not change that basic finding.
Clearly, the beneficiaries of the state legislation should be protected from abuses, but it is this Court's view that in this instance, such protection must come from the state.
It is the plaintiffs' affirmative burden to show that their action has been properly brought in federal court. They have not met that burden with respect to this Court's jurisdiction under the federal securities laws. There being no other basis for federal jurisdiction, the counts of the amended complaint alleging violations of the federal securities laws are dismissed as to all defendants named therein. Further, since the federal securities allegations represent the only well-pleaded underlying basis for jurisdiction under the Civil Rights Act, count nine is dismissed as against the Agency. The remaining counts are dismissed as against the defendants named therein, inasmuch as they set forth pendent claims asserted pursuant to state law. United Mine Workers v. Gibbs, 383 U.S. 715, 726, 86 S. Ct. 1130, 16 L. Ed. 2d 218 (1966). The complaint is therefore dismissed in its entirety for lack of subject matter jurisdiction.