The opinion of the court was delivered by: NEAHER
Plaintiff Securities and Exchange Commission ("SEC") brought this action pursuant to § 20(b) of the Securities Act of 1933 ("the Securities Act"), 15 U.S.C. § 77t(b), and § 21(e) of the Securities and Exchange Act ("the Exchange Act"), 15 U.S.C. § 78u(e), alleging violations by defendants of the § 5 registration provisions of the Securities Act, 15 U.S.C. § 77 (e), and the anti-fraud provisions of both acts, § 17(a) of the Securities Act and § 10(b) of the Exchange Act, 15 U.S.C. § 77q(a) and 15 U.S.C. § 78j(b). Named as defendants are Galaxy Foods, Inc. ("Galaxy") and Arthur Lieberman, Ralph Avni, Charles Horowitz, Bruce Katz, Steven Roth, Mark Glazer, Irwin D. Kirschenblatt, George Padilla and Arthur Shevack, all of whom were either directors, officers or franchisees of Galaxy. The relief sought includes, inter alia, a permanent injunction against future violations of the securities laws and disgorgement of profits.
Prior to the hearing on the merits, defendants Lieberman, Avni, Horowitz, Katz, Roth and Glazer consented to the entry against them of a judgment, which included a broad permanent injunction against future violations of the securities laws and a provision for disgorgement of specified dollar amounts, without admitting or denying any of the substantive allegations of the complaint. During the hearing, which lasted eight days, Padilla also consented to the entry of a similar judgment against him and the matter proceeded to conclusion solely against Kirschenblatt and Shevack.
The following constitute the court's findings of fact and conclusions of law. Rule 52(a) F.R.Civ.P.
Galaxy was incorporated on September 2, 1971 by Lieberman, Avni and Rosenthal, each of whom acquired its issued and outstanding stock in approximately equal amounts in exchange for a total capital contribution of $100. Rosenthal became chairman of the board of directors and president; Avni became vice-president and Lieberman became secretary-treasurer.
In October 1971, Galaxy rented a large room on Flatbush Avenue in Brooklyn which served as its principal business office. This room was subdivided into compartments and used by Galaxy's executives as individual offices. In March 1972, Galaxy rented a warehouse on Stanley Avenue in Brooklyn.
Galaxy's proclaimed business objective was to provide a free home delivery service of supermarket items. Galaxy's retail customers would order name brand supermarket items at competitive prices from a catalog prepared by Galaxy and Galaxy would fill those orders from inventory.
In order to make possible this new concept in food retailing, two important requirements had to be met: (1) salespeople had to be recruited to attract retail customers, and (2) working capital had to be raised to rent a warehouse and trucks, purchase and maintain an inventory and finance the establishment of a delivery system capable of processing thousands of individual orders. The single solution to these twin problems employed by Galaxy, i.e., the sale of franchises, is at th heart of the SEC's complaint in this action.
Franchises came in two forms: distributorships and field manager positions. A distributorship originally cost $3,000 but was raised to $5,000 in March 1972, and to $7,000 in October 1972. Field manager positions sold initially for $1,000 but increased to $2,000 in March 1972, and to $3,000 in October 1972.
As explained at meetings held by Galaxy, about which more will be said later, and in manuals produced by the company, distributors and field managers could earn money through Galaxy in two ways, referred to respectively as the retail and wholesale ends of the business.
The retail end of the business involved the actual sale of food to consumers. Distributors were offered a 15% commission on initial customer orders and a 5% commission on reorders. Field managers, in turn, were offered a 10% discount on initial orders and 3% on reorders.
Both distributors and field managers were instructed to hire salespeople to recruit retail customers by offering the salespeople a 5% commission on initial orders and 1% commission on reorders. Franchisees could thus establish sales organizations consisting essentially of salespeople doing the actual "leg work" and yielding the franchisee the difference between the commission received from Galaxy and the lower commission paid the salesman.
The wholesale end of the business refers to the sale of franchises by existing franchisees. Distributors and field managers were encouraged to interest others, called "sponsoring," in purchasing distributorships or field manager positions. A distributor would receive a commission of $1,250, $2,000 or $2,450, depending on the prevailing selling price, for sponsoring a distributor, and $400, $750, or $1,050 for sponsoring a field manager. A field manager could earn $300, $500, or $750, depending on the prevailing franchise selling price, if he sponsored a distributor or field manager. Additionally, if a field manager sponsored a distributor, his distributor would receive the difference between the prevailing distributor commission, e.g., $1,250, and the commission received by the field manager, i.e., $300. Similarly, if a field manager sponsored another field manager, his distributor would receive the difference between the prevailing field manager commission, e.g., $400, and the commission paid the sponsoring field manager, i.e., $300.
Thus, approximately 35-40% of the selling price of franchises was paid as commissions to sponsoring franchisees.
The contract signed by Galaxy franchisees limited the number of distributorships Galaxy could sell to "60 per one million population per state" and specified a quota of 1,079 for New York State distributorships.
Sales of franchises were accomplished through the medium of sales presentations given at "Opportunity Meetings" held by Galaxy. These meetings were held three to four times a week at different hotels in the New York City and Long Island area. Group size at the meetings ranged from as few as 10 to as many as 200.
Lieberman, Horowitz, Roth and Katz were the regular and, for practical purposes, the exclusive speakers at these meetings. They always spoke from the same prepared text, which had been drafted by them, Rosenthal and Avni. Speakers were not permitted to deviate from the script.
The purpose of the presentation was to explain the Galaxy concept to prospective investors, called "prospects," whom sponsors had brought to the meetings. The speakers also explained in great detail the retail and wholesale commissions to be earned. A blackboard diagram was used to demonstrate how a distributor could earn as much as $60,000 per year from the retail end of the business after only three months in Galaxy.5 Statements by the speakers relating to how much money one could earn in Galaxy were greeted with cheers and applause by existing franchisees and Galaxy management.
After the first speakers explained the retail and wholesale ends of the business, there was a guest speaker, usually Lee Horowitz or one of the other top Galaxy officials, who promised that Galaxy would itself recruit and distribute to franchisees 8-10,000 retail customers when retail operations began.
Galaxy distributors and managers were instructed to invite prospects to these meetings but to tell them little or nothing about the Galaxy operation itself. The inducement to attend the meetings was to be simply the opportunity to earn large sums of money. Distributors and managers were told to drive new, expensive automobiles, to wear expensive clothing and to carry large amounts of cash, all to convey to the prospect an illusion of success attributable to association with Galaxy.
Once a prospect was lured to a meeting, Galaxy's management did the rest via their established sales presentation.
In addition to Opportunity Meetings, Galaxy held "Sunday Step-Up Meetings",
which were designed to obtain commitments, and checks, from the prospects. This process was referred to as "closing the deal" and "getting the check" ("GTC", in Galaxy parlance).
At these meetings, which after Marc 1972 were held in Galaxy's rented warehouse, one speech was given by either Lee, Horowitz, Katz or Roth. Another feature of these meetings, adopted around June 1972 and referred to as "Pay-Day", was the distribution of commission checks to existing franchisees. The one distributing the checks would either call out the amount or ask a prospect to come up and call out the amount. The speaker would usually emphasize that the franchisees receiving checks had just recently joined Galaxy.
Towards the end of the meeting, prospects were called to the front of the room and asked whether they wished to join Galaxy as a distributor or as a field manager, a question implicit with an assumption. The response was greeted with cheering and applause.
The tremendous exhibitions of enthusiasm at these Opportunity and Step-Up Meetings, the cheering and applauding and the check distributions, were all part of a conscious theme on the part of Galaxy's management to create a high-pressure atmosphere in which the prospect was enveloped and imbued with an almost irrational desire to join -- this process was referred to by Lieberman as "jack-up."
Bi-weekly or monthly training sessions were held for new franchisees from October 1971 until July 1973, either at Galaxy's offices or its warehouse. These training sessions were mandatory for distributors.
Katz was the principal instructor at these sessions.
The primary focus of the training sessions was the wholesale end of the business. Prospecting techniques such as advertising, approaching friends, relatives and associates and "cold canvassing"
were taught. Practice exercises were conducted and critiqued. Franchisees were taught always to think positively and to be enthusiastic. "Dare to be Great" tapes were played.
Franchisees were instructed not to go into any details concerning Galaxy with prospects but only to lure them to the controlled environment of the Opportunity Meetings and to rely on the sales ability of those giving the full organized presentation.
When at Opportunity or Sunday Step-Up Meetings, franchisees were directed to sit next to prospects they had brought there or, if they had come alone, to sit in the back of the room. They were told to applaud new speakers at the meetings, laugh at jokes and generally exhibit constant enthusiasm. Franchisees were encouraged to memorize the script read at Opportunity Meetings.
Franchisees were taught to suggest to prospects ways of raising the necessary funds to purchase a franchise, e.g., borrowing the cash value of insurance policies or taking loans from a bank or finance company. If the prospect was going to take out a loan, franchisees were told to drive the prospect to the lending institution and to tell them to put down furniture as the reason for the loan.
Training in the retail end of the business did not begin until the end of November 1971, and was then given in addition to training in prospecting.
Galaxy was run by two management groups, the board of directors and the executive board. The board of directors, which originally consisted of Lieberman, Avni and Rosenthal (who in June 1972 was replaced by Horowitz), actually established operational and management policy and made all important decisions, including the commission percentages to be paid. They were also Galaxy's only corporate officers. The executive board consisted of the three directors and five executive vice-presidents and was a subordinate body whose weekly meetings consisted of discussions of the events of the previous week and decision-making concerning the logistics -- location, frequency and speakers -- of the Opportunity Meetings and training sessions. The executive board also discussed the content, format and purpose of meetings and training sessions, e.g., the initiation of "pay-day", but it is unclear whether they actually voted on such matters. Only the board of directors could authorize any extraordinary expenditures or promote individuals in the organization. Also, the board of directors could veto any corporate action proposed by the executive board.
On occasion the three directors would leave an executive board meeting to vote on an issue and then report back their decision.
Each member of Galaxy's board of directors received a free distributorship and, from September 1971 until September 1973, an override commission of 3-4% based on total franchise sales.
Galaxy's executive vice-presidents apparently received a similar override commission but at a lower percentage rate, i.e., 1/2-1%. Altogether approximately 18% of gross franchise selling prices were distributed to members of the executive board as override commissions. Thus a total of approximately 53-58% of gross franchise sales was paid in various commissions, leaving only 42-47% actually to fund Galaxy.
The organizational arrangement and promotional nature of Galaxy -- particularly the concept of non-exclusive franchisees, the Opportunity Meetings and the commission structure -- was patterned in large part after that employed by a company called Koscot Interplanetary, Inc. ("Koscot").
Lieberman, as well as Galaxy founding fathers, e.g., Avni, Rosenthal and Katz, had been previously associated with Koscot.
Paul J. Deceglie was introduced to Galaxy in the fall of 1971 at a presentation given by Franz Quack to 20 or 30 people at the home of his future in-laws. He subsequently attended an Opportunity Meeting and a Sunday Step-Up Meeting, during which he gave a Galaxy executive a $1,000 check to come in as a field manager and filled out an application. After joining Galaxy, he went to another Opportunity Meeting in December 1971, which was held in the New York Hilton. No mention was made at any of the meetings attended by him that Galaxy franchises were available only to New York residents. Deceglie is and was during that period a resident of New Jersey and so indicated on the application he filled out. He received mail from Galaxy at his New Jersey address.
In May 1972, Horowitz called him at his home in New Jersey and informed him that there was a problem with his being a New Jersey resident and that he would either have to establish a New York residence or withdraw from Galaxy. He chose to withdraw and received back a check representing his investment.
In the third revision of the script read at Opportunity Meetings dated October 1972, the following sentence was inserted to be read last by the speaker immediately preceding the guest speaker: "Investments are available only to residents of New York State."
During the summer of 1972, Galaxy adopted a rule, proposed by Katz, which provided that:
Six months subsequent to the commencement of full scale retail operations, distributors and field managers, regardless of their date of entry into Galaxy's program, will be permitted to exercise Galaxy Foods "final buy-back option". Distributors and field managers will be notified of their option to sell their distributorship back to Galaxy Foods, Inc. at their original purchase price, less any commissions earned. Distributors will be given 30 days from the date of notification to respond to the company offer. A lack of response will be deemed by the company to be a decision to remain on active status with the company. A notification of the desire to exercise the option will be followed by an interview with the company. If the situation cannot be corrected to the satisfaction of both the company and the field manager or distributor, sixty days hence, the buy-back will be executed. The decision shall be binding and final on both parties.
Rule 25 of Galaxy's Rules and Regulations. In conjunction with the adoption of this rule, Galaxy caused to be published in several newspapers of general circulation in New York City advertisements directed at soliciting franchisees which read in part in bold print "A $2,000 or $5,000 guaranteed investment."
These advertisements were approved by Galaxy's executive board.
This "guarantee" apparently supplemented or superseded a previous "guarantee", which read:
Galaxy will do all in its power to commence retail operations. Should the "operating retail territory", (consisting of from 8,000 to 12,000 customers) not have begun operations by June 30, 1973, Galaxy agrees to:
A. If feasible, continue in the effort to establish the first retail foot hold.
B. Give the option to those individuals who wish to sell their distributorships back to Galaxy, at their original purchase price less commissions paid against it, less ten (10%) percent for handling and interim operating expenses. Those individuals wishing to sell, must notify the company, in writing, after the above-mentioned date. The company will complete the purchase within sixty (60) days after receiving such notification.
Rule 21 of Galaxy's Rules and Regulations.
Lieberman testified that the language of Rule 21 "less commissions paid against it" meant that an investor could get back his original investment less that amount paid as commissions, presumably 53-58%, less 10% for handling or in effect 32-37% of the original amount.
No steps were ever taken, e.g., establishing a sinking fund, to ensure that funds would be available to satisfy either of these "guarantees."
As far back as the fall of 1971, Galaxy announced June 1972 as a target date for the beginning of retail operations,
but the target dates were continually readjusted backward as they approached. In a similar fashion, the projected designated retail territory continually shrank. In 1971, prospects and new franchisees were told at Opportunity Meetings and training sessions that the retail territory would consist of a 30-mile radius around each warehouse. In 1972, after the warehouse was actually rented, the operative radius was reduced to ten miles and later in 1972 to three miles.
An article appeared in a local Brooklyn newspaper around September 1972, describing Galaxy in glowing terms and indicating that retail operations were to begin in October. The article also contained the patently false statement that Galaxy then had operations in Long Island, Poughkeepsie, Buffalo and Montreal. Although Galaxy was not responsible for the article's publication, no attempt was made to correct the erroneous statement.
The procedure contemplated by Galaxy when full retail operations began was as follows: A retail customer, living within a three-mile radius of a Galaxy warehouse, would be contacted by a salesperson (or franchisee) on a door-to-door basis or through advertising. If the retail customer was interested in buying from Galaxy, he or she would be given a catalog and asked to place a minimum $15 order. The initial order would be phoned in to the warehouse by the salesperson (or franchisee). At the warehouse, a Galaxy employee would fill out a form which would be tied into a computer system. The orders would be accumulated in the computer until the end of the day when a high-speed printer would print out copies of the order, one for the "picking" area, one for the truck, one for the distributor, and one for inventory. The computer would also deduct the ordered items from inventory. The orders would be physically filled from shelves in the warehouse and loaded on trucks for delivery. The computer was also to establish a routing sheet for the truck drivers. Finally, the computer was to credit the appropriate franchisees and salespeople with commissions and to cut checks for them. After the initial order, retail customers were to phone in their orders directly to the warehouses.
Galaxy's management estimated a need for twenty warehouses to service the New York City area, assuming only 10% of the population ordered from Galaxy. In addition, it was hoped that each franchisee would maintain an office as a place to hold meetings with his salespeople to monitor their performance.
In November 1972, Galaxy began what is called a "pilot program" to test its retail operation, although none had been mentioned at the time franchises were originally sold. At about this time, Galaxy's management altered the stated retail commission policy by requiring a "cushion" of 8,000 retail customers before paying any commissions on retail sales. Although it appears that Galaxy never acquired more than 4,800 customers, some commissions were paid beginning in March 1973, after vigorous protesting by the franchisees.
In conjunction with the "pilot program" and the expectation of beginning full retail operations, Galaxy purchased over $200,000 worth of food, rented ten delivery trucks, hired as many as ninety-eight employees and spent $150,000 for computer equipment on a lease-purchase basis. During the "pilot program", which lasted from November 27, 1972 until March 31, 1973, Galaxy sold $160,000 worth of goods.
Although the "pilot program" apparently terminated in March 1973, Galaxy continued, and in fact increased its efforts, to recruit new franchisees. The guarantees of Rule 21 and 25 were deleted for franchisees joining after July 1, 1973. The sale of field manager positions ended as of August 1, 1973.
On November 28, 1973, Galaxy filed a voluntary petition in bankruptcy, listing assets of $30,000 and liabilities of $200,000. During the two-year period prior to bankruptcy, Galaxy sold in excess of 800 franchises, raising more than $2.4 million. Aside from the "pilot program", sales of franchises accounted for all of Galaxy's income from inception to demise.
Kirschenblatt was approached concerning employment with Galaxy by Rosenthal and Avni, who offered him a "salaried position." He joined Galaxy in August 1971, and continued until January 12, 1973, when he resigned effective February 1, 1973. He testified that his resignation was prompted by dissatisfaction with Galaxy management, their handling of the retail end of the business, their decision not to pay commissions on retail sales until ...