The opinion of the court was delivered by: LASKER
Plaintiffs Robert Ingenito and James Cear (hereinafter jointly referred to as Ingenito), Martin Yarvis (Yarvis) and Morton Bickart (Bickart) are (or were) losing investors in the Black Watch Farms, Inc. (Black Watch) enterprise. Our earlier opinion, Ingenito v. Bermec Corporation, 376 F. Supp. 1154 (S.D.N.Y. 1974), describes the nature of Black Watch, which offered for sale herds of cattle. Purchased herds were maintained by Black Watch; under Black Watch's care, they increased and multiplied. Purchaser-investors hoped for gains in the form of tax avoidance and high resale prices for their animals. These plaintiffs gained nothing: Black Watch filed a petition in bankruptcy in September, 1970. Ingenito, Yarvis and Bickart allege that they consequently lost substantial sums of money.
In late 1970, these plaintiffs and others commenced suit against, among others, Herbert Meckler (Meckler), Eugene Freed (Freed) and State Mutual Life Assurance Company of America (State Mutual). More than a year later, certain plaintiffs amended their complaints and added Arthur Andersen & Co. (Andersen) as a defendant. Meckler and Freed sat on Black Watch's board. Freed was also, at one time, an officer of the corporation. State Mutual was a principal creditor of Black Watch. Andersen acted as Black Watch's independent public accountant.
The complaints alleged that the federal securities laws had been variously violated, by various defendants, in connection with a number of ill-defined transactions. Some of the claims did not survive defendants' motion to dismiss. See, Ingenito v. Bermec Corporation, supra, 376 F. Supp. at 1184. On certain of the claims that did survive the earlier motion (and, remarkably, on some that did not) plaintiffs now seek summary judgment against the defendants named above. State Mutual and Andersen cross-move for partial summary judgment against the plaintiffs, urging dismissal of a number of their claims. For reason stated below, the plaintiffs' motions are, in all respects, denied. Defendants' cross-motions are granted in part and denied in part.
Plaintiffs' Motions Against Meckler, Freed, and State Mutual
The factual and legal contentions of the plaintiffs' motions against the respective defendants are discussed in turn.
Yarvis purchased his herd in September, 1968. At the time he purchased, the Black Watch offering was unregistered. Yarvis saw no prospectus. He was contacted by a Black Watch salesman, who explained the Black Watch program and made representations concerning expected tax savings and profits. At least some of these representations were contained in a "projection sheet," which estimated the resale value of a herdowner's animals.
Completion of the underlying purchase did not mark the end of Yarvis' transactions with Black Watch. The purchase contract gave rise to mutual obligations (for example, in return for additional animals, Yarvis was bound to pay increased maintenance charges), some of which were played out over an extended period of time. In addition, the contract accommodated -- either expressly or implicitly -- the changing needs and desires of the individual investor. The modifications and periodic fulfillment of obligations are referred to as "late transactions."
Claims Arising From the Initial Purchase
Yarvis' motion for summary judgment is based on claims arising from both the initial purchase and the late transactions. With respect to the former set of claims, he alleges violations of § 10b of the Securities and Exchange Act of 1934, 15 U.S.C. § 78j and Rule 10b-5 thereunder, 17 C.F.R. § 240.10b-5. In sum, he alleges that: 1) he was not informed of his statutory right to rescind his original contract (which right existed because the herd offering had not been registered in accordance with the pertinent provisions of the Securities Act of 1933) and 2) he relied on a projection sheet that was materially false and misleading. Non-disclosure of the right to rescind needs no further mention in this opinion; it was earlier held that such an alleged non-disclosure did not give rise to a Rule 10b-5 claim. Ingenito v. Bermec Corporation, supra, 376 F. Supp. at 1177.
Like the other moving plaintiffs, Yarvis argues that his initial decision to participate in the Black Watch program, made in September, 1968, was induced by the use of a delusive, deceptively glowing projection sheet (para. 69 et seq., Yarvis Affidavit). The sheet represented profitable resale rates, which Yarvis claims were false. On this branch of his claim, he seeks summary judgment against Meckler only, on the theory that he was liable for the use of these misleading sheets, either as a control person, under § 20a of the Securities and Exchange Act of 1934, 15 U.S.C. § 78t, or as an aider and abettor.
The projection sheets were blank forms, apparently filled in by individual salesmen in the course of oral presentations made to prospective investors. (See Exhibit 62, Yarvis Class Action Affidavit; para. 19(f), Marshall Affidavit).
It seems that -- and this can only be established at trial -- the salesmen used the sheets as a device to demonstrate the economics of herd ownership. Plaintiffs concede that the use of the projection sheets constituted only a part of the sales presentation that was routinely offered to investors. "The salesman," claims plaintiffs' counsel "gave his 'pitch' in the living room . . . and the projection sheet . . . was the keystone in a personalized sales talk." (Amended Brief at 142). Oral representations accompanied the "documentary" presentation. As was noted in our earlier opinion, the sheets had no meaning without the oral and written representations that an individual salesman made to the individual investor:
"As plaintiffs' supporting affidavits make clear, (and indeed, as the complaints claim on their face) a Black Watch salesman made his sales presentation in person. Consequently, not only the various figures embodied in the projection sheet, but also their context and significance would present individual issues of fact . . ." Ingenito v. Bermec Corporation, supra, 376 F. Supp. at 1166-7.
Some of the factual issues raised by claims arising from use of the projection sheets have already been mentioned:
"Quite apart from the fact that the sales were made over a period of time, while cattle prices (and consequently the accuracy of any projections) fluctuated, the precise quality of the representations -- which might range from a solid guarantee or representation of fact to a carefully hedged, highly contingent opinion -- would have to be separately proven at trial as to each plaintiff to establish liability." Id. at 1169.
None of the papers submitted subsequent to our earlier opinion obviates the need for a trial of this claim. Defendants' responsive papers raise a host of triable issues: the manner and context in which the projection sheets were used; what, if any, representations were made during the oral presentation; whether the projection sheets were in fact false; whether the information contained in those sheets was material; and whether Yarvis relied on that information. The list is meant to exemplify, not exhaust, the triable issues.
Other issues are open here. Liability of Meckler is said to attach by virtue of his being a control person. The determination of whether control person liability exists necessarily involves a series of factual inquiries. Under § 20(a) a control person may be liable for the misdeeds of those who act under his direction. However, § 20(a) does not impose liability automatically; it is not a statutory incarnation of the common law theory of respondeat superior. Only those "who are in some meaningful sense culpable participants in the fraud perpetrated by controlled persons," Lanza v. Drexel Co., 479 F.2d 1277, 1299 (2d Cir. 1973) (en banc), are meant to come within the ambit of the provision for vicarious liability. Accord, Gordon v. Burr, 506 F.2d 1080 (2d Cir. 1974). If this is not apparent from the affirmative language of § 20(a), it becomes clear upon a reading of the exculpatory provision of that section, which permits a control person to assert the defense that he or she "acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action." 15 U.S.C. § 78t(a).
Knowledge is the key to the assertion of good faith, and the existence of culpable knowledge perforce involves genuine questions of fact. Those who neither know nor have reason to know of an agent's misdeeds are not liable as control persons. Lanza v. Drexel & Co., supra, 479 F.2d at 1300-04. On the issue of constructive knowledge, the inquiry centers on whether adequate mechanisms were established to discover and prevent the alleged fraud. Barthe v. Rizzo, 384 F. Supp. 1063, 1069 (S.D.N.Y. 1974). If the perpetration of fraud went unnoticed because of willful or reckless disregard, the good faith defense is unavailable. Lanza v. Drexel & Co., supra, 479 F.2d at 1306.
Determination of liability as an aider-abettor also involves questions of fact. Such liability attaches only when one "has actual knowledge of another's improper scheme plus an intent to further that scheme (i.e., scienter), and he has given substantial assistance to the primary wrongdoer . . ." Rosen v. Dick [1974-75] C.C.H. Fed. Sec. L. Rep. P 94,786 at 96,604 (S.D.N.Y. 1974); accord, Landy v. Federal Deposit Insurance Corporation, 486 F.2d 139, 162-3 (3d Cir. 1973), cert. denied, 416 U.S. 960, 40 L. Ed. 2d 312, 94 S. Ct. 1979 (1974); Lanza v. Drexel & Co., supra, 479 F.2d at 1289, 1302-4, 1309. The showing required to establish actual knowledge, intent and substantial assistance obviously involves a parade of facts.
Application of the above principles to the claim that Meckler is secondarily liable for the fraudulent misstatements and omissions demands that the motion be denied. Before Meckler may be held liable for the use of the projection sheets, Yarvis would have to establish that Meckler knew, or should have known, that the sheets were being used as representations in connection with the sale of herds, that he knew they were false, and that he encouraged -- actively, or by way of culpable passivity -- their continued use. Plaintiff has proven none of this. Yet Meckler denies, by way of undisputed affidavit, that he was involved in the daily management of Black Watch (paras. 11, 12, Meckler Affidavit); specifically, he denies that he was aware of the sales techniques that were employed (para. 27, Meckler Affidavit). His liability, if any, as a control person or as an aider-abettor must be resolved at trial.
Claims Arising From the Late Transactions
Regarding his late transactions, some of which were earlier held to be sales of securities (see, Ingenito v. Bermec, supra, 376 F. Supp. at 1178-1184), Yarvis alleges that material information was withheld from him. He was not told that State Mutual was, as he claims, an underwriter and promoter of Black Watch. He was not informed that Black Watch was in the midst of serious financial difficulties. For these claimed violations of Rule 10b-5, Yarvis seeks summary judgment against Meckler, Freed, and State Mutual. They are said to be liable as participants, abettors, or "control" persons within the meaning of the '34 Act. In addition to the general assertions of liability, there is an allegation that State Mutual is liable, as an underwriter, for nondisclosure of its own underwriter-promoter status.
The late transactions in issue here are, at first, broadly referred to by Yarvis as "investment decisions" that were made during the period October, 1969 through September, 1970. Specifically, these transactions consisted of: payments by Yarvis on promissory notes by which he had originally prepaid his maintenance charges; a cash payment of maintenance in December, 1969; the receipt of "free," additional animals, in fulfillment of Black Watch's promise that herds would reproduce at a specified rate; and receipt of replacement animals for those that did not live up to the quality that Black Watch had earlier warranted. There is no need to deal further with any claims arising out of the payments on the promissory notes. Those monthly installments cannot be characterized as sales of securities, for they involved not "the creation or assumption of new obligations, but the fulfillment of those [obligations] previously created." Ingenito v. Bermec, supra, 376 F. Supp. at 1184. As for the rest of the late transaction claims, Yarvis' motion is denied, for reasons discussed below.
To begin with, the dates and circumstances of the late transactions are not clearly pleaded (in fact, they are not pleaded at all, but rather, are casually adverted to in counsel's supporting memoranda). Certainly, they have not been established with the degree of specificity that would be required, as a preliminary matter, for a grant of summary judgment. Where, as here, liability is claimed to exist by virtue of a defendant's attainment of a particular status, the necessary inquiry cannot even begin if the dates of attainment cannot be measured against the dates of the claimed violations.
More fundamental reasons compel denial of this aspect of Yarvis' motion. Insofar as Yarvis contends that the defendants were implicated in the culpable misrepresentation of Black Watch's financial condition, he implies that they knew what that condition was. Putting aside the state of each defendant's mind, it is apparent that Black Watch's actual financial condition, in late 1969 and 1970, was controversial. For example, State Mutual read Black Watch's 1969 financial statement (Ex. 6, Yarvis Class Action Affidavit) as a positive report. In partial reliance on it, they committed $3,000,000. to Black Watch in November, 1969 (paras. 92-96, Sterling Affidavit). Plaintiffs, on the other hand, point to this very financial statement as proof of Black Watch's bleak expectations (Amended Brief, passim).
What each defendant knew about Black Watch's condition poses substantial questions of fact. State Mutual and Meckler offer evidence that they knew neither of the bleak financial picture that Yarvis alleges nor of any misrepresentations thereof. On the contrary, both defendants claim that they thought Black Watch was an essentially sound organization in the middle of a temporary cash flow crisis (para. 21, Meckler Affidavit; para. 14, Wilson Affidavit; para. 19, Sterling Affidavit). Each loaned substantial sums of money to Black Watch during the very period that Yarvis claims Black Watch was on its way down (para. 22, Meckler Affidavit; paras. 20, 21 Sterling Affidavit; paras. 13, 14, 18, Wilson Affidavit). State Mutual, for example, advanced three million dollars to Black Watch in November, 1969, and continued, during 1970, to pump money in. It was apparently relying on the '69 financial statements, which showed that Black Watch was operating at a profit. It cannot be concluded on the present record that Meckler would lend hundreds of thousands of dollars, and State Mutual millions, to a company that each believed to be on the verge of bankruptcy. At the least, the making of these loans raises a question as to what the defendants knew and in good faith believed about Black Watch's actual financial position.
Secondary liability (claimed as an alternative basis for holding the defendants responsible for the alleged misdeeds) raises several factual issues. We have adverted to these matters above (see supra, slip op. at 6-8) and need not reiterate the elements of control person or aider-abettor liability, or the defenses available to such persons. All defendants have created issues of fact as to whether they knew what Black Watch's financial condition actually was, whether they knew or should have known that it was being misrepresented, and whether they encouraged any misrepresentations.
Yarvis also contends that nondisclosure of State Mutual's "underwriter-promoter" role amounted to a violation of Rule 10b-5 (Amended Brief at 120, et seq.). At this reading, the underwriter claim is a fanciful machination, advanced with frightening nonchalance. In its articulation, plaintiffs' counsel misstates the law and misrepresents reported cases.
In developing the claim, counsel makes no reference to the relevant statutory provision, § 2(11) of the '33 Act, 15 U.S.C. § 77b(11). Section 2(11) provides, in pertinent part, that:
"The term 'underwriter' means any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking . . ."
It is apparent that to be an underwriter within the meaning of the '33 Act, one must participate, in some manner, in the distribution of securities to the public. But neither plaintiffs nor their counsel have alleged that State Mutual ever purchased a Black Watch security -- either from Black Watch or an intermediate underwriter -- with an eye to public redistribution. Nor has it been argued (much less pleaded) that State Mutual ever sold a Black Watch security, or acted on behalf of Black Watch by paving the way for a public sale. In short, it emerges that counsel has confused the colloquial meaning of the word "underwriter" -- a backer or lender -- with the statutory definition of that term. Counsel's claim rests entirely on a Joycean -- and largely incorrect -- analysis of a loan agreement dated November 22, 1968 (Ex. O, Katz Class Action Affidavit). Pursuant to that agreement State Mutual and others lent $5,400,000. to Black Watch ($4,400,000. was advanced to the Black Watch partnership; the other money went to Black Watch, Inc., which ultimately absorbed the partnership) and secured the loan with herd-owner notes.
Even if counsel's characterization of the loan agreement were correct -- it is not
-- his underwriter allegation would fail as a matter of law. He has not alleged any activity by State Mutual that would bring it within the meaning of the term, as it appears in the statute and as it has been interpreted by case law. An underwriter buys securities directly or indirectly from the issuer and resells them to the public, or he performs some act (or acts) that facilitates the issuer's distribution. He participates in the transmission process between the issuer and the public. See, Securities Exchange Commission v. Management Dynamics, Inc., 515 F.2d 801, 810 (2d Cir. 1975); Securities Exchange Commission v. North American Research and Development Corporation, 424 F.2d 63, 72, 81 (2d Cir. 1970); United States v. Wolfson, 405 F.2d 779, 782 (2d Cir. 1968); Securities Exchange Commission v. Culpepper, 270 F.2d 241, 246 (2d Cir. 1959); Securities Exchange Commission v. Chinese Consol. Benev., 120 F.2d 738, 739, 741 (2d Cir. 1941).
At the very best, counsel's allegations amount to a charge that, as a lender; State Mutual stood behind Black Watch. Every creditor stands behind his debtor; but to prove that someone is a creditor cannot -- in and of itself -- suffice to establish a claim that someone is an underwriter.
State Mutual, by way of cross-motion, asks for dismissal of the underwriter claim pursuant to Rule 56 of the Federal Rules of Civil Procedure. It has not been factually established that State Mutual was not an underwriter. However, plaintiff's claim, "pleaded" for the first time by way of memorandum, comes without a shred of evidence. Moreover, as our discussion indicates, the claim is insufficient as a matter of law. Therefore, pursuant to Rule 12(b) of the Federal Rules of Civil Procedure, plaintiff's claims against State Mutual are dismissed insofar as they allege liability for failure to disclose underwriter status, and plaintiff's motion for summary judgment on this aspect of his claim is denied.
It follows that Yarvis' further request for summary judgment, based on his contention (again by way of memorandum) that as an underwriter, State Mutual was obliged to reveal that it was a promoter of Black Watch, is also denied. This would be true even if Yarvis had established that State Mutual was an underwriter, because we find that State Mutual was not a promoter of Black Watch.
The definition of a promoter is set forth in S.E.C. Rule 405, 17 C.F.R. § 230.405. (The pertinent part of the definition is reprinted here):
"(q) Promoter. The term "promoter" includes:
(1) Any person who, acting alone or in conjunction with one or more other persons, directly or indirectly takes initiative in founding and organizing the business or enterprise of an issuer;
(2) Any person who, in connection with the founding and organizing of the business or enterprise of an issuer, directly or indirectly receives in consideration of services or property, or both services and property, 10 percent or more of any class of securities of the issuer or 10 percent or more of the proceeds from the sale of any class of securities . . ."
Plaintiff's argument that State Mutual was Black Watch's promoter is made in these words: "The 10% or more interest in proceeds of an offering (promoter definition) in SEC Rule 405 . . . also fits State Mutual -- the proceeds here were investor notes and well over 10% went to State Mutual (some $8 million ultimately went to it), with all cash proceeds thereon funneled through it -- all undisclosed." (Reply Brief at 90). No citation to the record is offered in support of the promoter theory and no legal authority is cited. Counsel, relying entirely on the November, 1968 loan agreement, simply asserts: 1) that State Mutual's status as a lender was sufficient to establish its status as a promoter under 17 C.F.R. § 230.405 (q)(1) and 2) that herdowner notes held as collateral were proceeds, remitted to State Mutual (See, 17 C.F.R. § 230.405(q)(2)). State Mutual asks for dismissal of this branch of plaintiff's claim and their request is granted.
Once again, plaintiff's counsel has confused the colloquial meaning of "promoter" with its statutory import. As a matter of law, State Mutual's loan to Black Watch does not constitute taking "initiative in founding and organizing the business or enterprise" of Black Watch. See C.F.R. § 230.405(q)(1). To be found a promoter within the meaning of that subsection, one must either be active in the issuer's business, see, e.g., Shawnee Chiles Syndicate, 10 S.E.C. 109, 115 (1941); American Tung Grove Developments, Inc., 8 S.E.C. 51, 56 (1940), or actively engaged in the formation of the issuer. The latter form of promoter activity invariably involves more than a general loan to an issuer (which is all that plaintiffs have offered in support of this branch of their promoter claim), c.f., Doris Ruby Mining Company, 4 S.E.C. 427, 433 (1939); to be an active participant in formation, one must be involved either in the transactions by which the issuer acquires the properties essential to the conduct of its business, National Lithium Corporation, 40 S.E.C. 746, 749-50 (1961); Resources Company International, 7 S.E.C. 689, 732 (1940); Platoro Gold Mines, Inc., 3 S.E.C. 872, 875-76 (1938); Ypres Cadillac Mines Limited, 3 S.E.C. 41, 46-49 (1938), or in the mechanics of the underwriting and registration processes. Shawnee Chiles Syndicate, supra, 10 S.E.C. at 115; Resources Company International, supra, 7 S.E.C. at 732; Ypres Cadillac Mines Limited, supra, 3 S.E.C. at 46-49.
As for State Mutual's claimed receipt of proceeds, the terms of the loan agreement are clear; herdowner notes were held as collateral, and they were held by Black Watch, not State Mutual:
"Section 5.01. The Secured Notes shall be secured by Partnership Notes as follows: To State Mutual a Partnership Note in the sum of $4,048,000; to Citizens $176,000; to Worcester $132,000; and to Beacon $44,000. The Partnership hereby consents to the pledge of the Partnership Notes and the consequent pledge of the collateral security for the Partnership Notes, hereinafter referred to, being the collateral security for the Secured Notes.
Section 5.02. As collateral security for the Partnership Notes, the [Black Watch] Partnership agrees to pledge to the [Black Watch, Inc.] Company notes receivable of the Partnership which shall at all times have an aggregate unpaid principal amount due and to become due thereunder of at least one hundred and twenty-five (125%) per cent of the unpaid principal amount of the Partnership Notes. Such notes receivable are hereinafter referred to as "'Notes Receivable.'" (Ex. O, Katz Class Action Affidavit)
Accordingly, State Mutual's request to dismiss the promoter claim is granted.
B. Bickart's 10b-5 Claims
Claims Arising from the Initial Purchase
Bickart bought his herd in June, 1969. By then the Black Watch offering had been registered. Before he purchased his herd, Bickart saw both a May 26, 1969 prospectus (hereinafter, the May prospectus) and a projection sheet. He claims that the May prospectus was misleading in its failure to reveal both the precarious position of Black Watch as well as State Mutual's underwriter-promoter status. He claims that the projection sheet deluded him by falsely representing the resale value of his animals. He seeks summary judgment against State Mutual on the theory that its failure to reveal its true status amounted to a violation of Rule 10b-5, for which State Mutual is liable as a participant, aider-abettor, and underwriter.
Bickart also seeks summary judgment against Meckler, on the theory that he was liable both for the failure to disclose adverse data in the May prospectus and for the use of the misleading projection sheet.
Claiming fraud in connection with his original purchase, Bickart raises factual issues similar to those raised by Yarvis. For the reasons stated above, Bickart's request for summary judgment on claims arising from his initial purchase is denied. See, supra, slip op. at 4-6 (the projection sheet); slip op. at 10-12 (determination of Black Watch's "true" financial position); and slip op. at 6-8 (direct and vicarious liability).
Claims Arising from the Late Transactions
Like Yarvis, Bickart made "investment decisions" from the time of his initial purchase to the date of Black Watch's demise. Specifically, he alleges: 1) maintenance payments under a "split progeny" program, in which Bickart gave calves instead of cash to cover maintenance charges (the dates and circumstances of these in-kind payments are not provided) and 2) an exchange of ...