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Securities and Exchange Commission v. Commonwealth Chemical Securities Inc.

decided: March 3, 1978.


Appeal from a judgment of the District Court for the Southern District of New York, Lloyd F. MacMahon, Judge, finding that appellants had violated various sections of the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act and the Investment Advisers Act of 1940, and rules issued thereunder, issuing an injunction, and directing disgorgement of profits. In the main the judgment is affirmed; however, it is modified in minor respects and the cause is remanded for the correction of mathematical errors in the computation of profits to be disgorged.

Friendly, Smith and Meskill, Circuit Judges.

Author: Friendly

FRIENDLY, Circuit Judge:

This action by the Securities and Exchange Commission (SEC) in the District Court for the Southern District of New York arises from an offering of 50,000 units of common stock and redeemable purchase warrants of Beneficial Labs, Inc. (BL) made by Commonwealth Chemical Securities, Inc. (CCS) on a "best efforts -- all or none basis," and an additional 50,000 units on a "best efforts" basis in the go-go market of late 1971 and early 1972. The offering circular, issued pursuant to SEC Regulation A under the Securities Act of 1933, must be read to be believed. It described CCS as having 250,000 outstanding shares of common stock, 236,000 of which were owned by officers and directors.*fn1 In contrast to this impressive capitalization BL had net tangible assets of $4,750 or 2 cent per share. If the minimum of 50,000 units had been sold at the offering price of $2.25 per share, BL, after paying underwriting commissions to CCS and other expenses, would have had net tangible assets of $83,500 or 28 cent per share. The result, all clearly stated in the Offering Circular, would have been to increase the equity of existing shareholders from 2 cent to 28 cent per share, whereas the purchasers' investment of $2.25 per unit would have dwindled to the same amount. The rare opportunity offered as an inducement was that BL, which had engaged in no business and had no corporate headquarters aside from Feldman's residence, intended "to own and operate pharmacies and to operate drug departments in larger units such as department stores and supermarkets" and also "to sell in its pharmacies certain items which it will purchase at wholesale and bottle and sell under its own label." To that end, approximately $25,000 would be allocated to working capital "including officer's salary and general overhead," with $53,750 left available "to make cash down payments on the purchase of pharmacies." The circular did not claim any originality in BL's concepts; on the contrary it conceded, with elaborate detail, that BL "will be faced with very strong competition in its proposed operations." Executives of the many great drug chains of the country or owners of established neighborhood drugstores would hardly have stirred in their sleep at the threat of BL's prospective entry.

The SEC's complaint had three main facets. The first was that although the Offering Circular dated December 20, 1971 had stated:

At least 50,000 units offered hereby must be sold and paid for or all subscription payments shall be promptly refunded in full without interest.

CCS closed the transaction on the basis of a declaration that 50,650 units had been sold and paid for by March 8, 1972 when in truth and fact they had not been. Here the SEC's major item of evidence was the purported sale of 2,000 units each to four friends of a CCS employee avowedly as nominees for one David Massad in Boston; the units were not paid for before the closing and Drucker repurchased them from Massad two or three weeks thereafter. The second facet was that thereafter the defendants embarked on a course of manipulating BL stock by a campaign of buying and selling which drove the price of BL common stock up to a range of 14-15 by the end of September 1972 and a high of 24 1/2 on January 15, 1973 -- representing a market value of $7,365,925.

Here the SEC's principal item of evidence was the testimony of a SEC analyst that accounts controlled by the defendants participated in extraordinarily large percentages of all transactions in BL stock, warrants and units -- plus the fact that prices rose astronomically although BL reported no earnings through September 1972 and the offering circular had conceded that BL could commence business only on a small scale if only 50,000 units were sold and that failure to sell all 100,000 units might severely limit "the potential of the Company." On March 5, 1973, the SEC suspended trading. When it allowed trading to be resumed on October 31, 1973, there were no reported bids for the stock; in November 1973, two of the mutual funds hereafter mentioned sold their BL stock at prices which, after giving effect to a 100% stock dividend, were less than $1 per share.

Some of the allegedly manipulative transactions were with investment companies to which some defendants were "affiliates" as defined in § 2(a)(2), (3) of the Investment Company Act or an investment adviser as defined in § 2(a)(20) of that Act and § 202(a)(11) of the Investment Advisers Act. These transactions, along with several others, form the basis for the third facet of the SEC complaint, alleging violations of §§ 17(a), 36(a), 37, and 48(a) of the Investment Company Act and § 206(1) and (2) of the Advisers Act. The funds to which some of the defendants were affiliates and advisers were induced to purchase 22,100 shares of BL common and 3,000 warrants at a total cost of $220,137.50 and an ultimate loss of $158,345.

The appellants here are CCS; Robert Drucker, vice president and a director of CCS and owner of 1/4 of its shares as well as 1/3 of the shares of a corporation owning 1/2 of the CCS stock, who at the time of the alleged violations was an officer and director of Vanguard Fund, Inc. (Vanguard) and New York Hedge Fund (Hedge) and president and a director of DK&B Management, Inc. (DK&B); Julius Kleinman, president, treasurer and chairman of the board of directors of CCS, who at the time of the alleged violations was an officer and director of Hedge and Vanguard and vice president, secretary and a director of DK&B; DK&B, which was the registered investment adviser of Hedge from October 24, 1972 to September 22, 1973 and of Vanguard from March 22, 1972 to July 16, 1973; Mary Sharpe, CCS's bookkeeper from August 1970 to June 1974; and Marlene Kleinman, Kleinman's wife. The district court ruled in favor of the SEC on all three of its claims. Specifically it found that the minimum of 50,000 units provided for in the offering had not in fact been sold and that in consequence CCS, Drucker and Kleinman had violated § 17(a) of the 1933 Act, § 10(b) of the 1934 Act and Rules 10b-5*fn2 and 10b-6, § 15(c)(2) of the 1934 Act and Rule 15c2-4,*fn3 and with DK&B, §§ 17(a), 48(a), 36(a) and 37 of the Investment Company Act; that the same defendants and DK&B had violated § 17(a) of the 1933 Act and § 10(b) of the 1934 Act and Rule 10b-5 for manipulating the market in BL shares; that CCS, aided and abetted by Drucker, Kleinman and Sharpe violated SEC bookkeeping rules under the 1934 Act, notably Rule 17a-3(a)(9), since the record reflected fictitious ownership of securities; that DK&B, aided and abetted by Drucker and Kleinman, violated § 206(1) and (2) of the Investment Advisers Act; that Sharpe also violated § 17(a) of the 1933 Act and § 10(b) of the 1934 Act and Rule 10b-5 for her role in the fraudulent closing and the market manipulation; and that Mrs. Kleinman violated these same provisions for her role in the market manipulation. Accordingly it granted the SEC's prayers for an injunction and disgorgement of profits.

Appellants attack these rulings on innumerable grounds. Some of these raise important and recurring issues of law and two raise arguable questions of the sufficiency of evidence. We shall limit ourselves to the points which we believe to merit discussion by us; for the balance we rest on the excellent opinion of Judge MacMahon.


I. Defendants' asserted right to a jury trial.

Defendants had made the jury demand required by F.R. Civ.P. 38(b). The judge struck it sua sponte. This, appellants claim, was error.

The claim seems surprising since it has been assumed for decades that a suit for an injunction, whether by the Government or a private party, was the antithesis of a suit "at common law" in which the Seventh Amendment requires that the right to trial by jury "shall be preserved." In 1791, when the Seventh Amendment became effective, injunctions, both in England and in this country, were the business of courts of equity, not of courts of common law. Although the entitlement to a jury trial extends to many rights that were not recognized in 1791, e.g., the special liability of the seller of a product for physical harm to a user or consumer, see ALI, Restatement of Torts 2d, § 402A (1965), or an action for damages based upon a statute creating a tort unknown to the common law, see, Curtis v. Loether, 415 U.S. 189, 195 & n.10, 39 L. Ed. 2d 260, 94 S. Ct. 1005 (1974), the test remains "whether the action involves rights and remedies of the sort traditionally enforced in an action at law, ...

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