Appeals by plaintiffs from a judgment of the District Court for the Southern District of New York, Robert L. Carter, Judge, in favor of defendant Bankers Trust Company after a jury trial in an action for damages incurred in a securities transaction. Reversed and remanded.
Before Friendly, Oakes and Newman, Circuit Judges.
Appellants Samuel Mallis and Franklyn Kupferman brought this action in the District Court for the Southern District of New York to recover losses allegedly suffered as the result of a somewhat unusual securities transaction. In addition to appellee Bankers Trust Company, the original defendants included the Federal Deposit Insurance Corporation and the European American Bank as successor-in-interest to Franklin National Bank. The district court, Milton Pollack, Judge, dismissed appellants' claims against all defendants, Mallis v. F. D. I. C., 407 F. Supp. 7 (S.D.N.Y.1975), holding, inter alia, that appellants failed to state a claim against Bankers Trust under the Securities Act of 1933 because they were not purchasers of securities, and, for the same reason, denying appellants leave to amend their complaint to assert a claim under § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. On appeal, this court reversed the Securities Exchange Act holding and remanded with instructions to allow appellants leave to amend their complaint against Bankers Trust. Mallis v. F. D. I. C., 568 F.2d 824 (1977), cert. dismissed as improvidently granted, 435 U.S. 381, 98 S. Ct. 1117, 55 L. Ed. 2d 357 (1978) (hereafter Mallis I ).
Appellants' amended complaint, filed solely against Bankers Trust, asserted a claim under § 10(b) and Rule 10b-5 as well as pendent state law claims of fraud and negligent misrepresentation. Bankers Trust brought third-party complaints against Jerome B. Kates and Jack J. Arnold, a third-party appellee. The case was tried before Judge Carter and a jury which returned a verdict in favor of Bankers Trust on the Rule 10b-5 and fraud claims; the judge had declined to submit the claim of negligent misrepresentation. Mallis and Kupferman (sometimes collectively referred to as Mallis) appeal from the judgment in favor of Bankers Trust entered on this verdict, alleging, inter alia, error in the district court's treatment of their Rule 10b-5 claim and pendent common law fraud claim, and in its refusal to submit the pendent claim of negligent misrepresentation. Finding errors in the handling of all three claims, we reverse and remand for a new trial.
The case revolved around 40,384 unregistered "conditional" shares of stock of Equity National Industries, Inc. (Equity National) issued on August 7, 1970 to Jerome and Judith Kates as the result of a merger between Equity-Take Two, Inc., a wholly-owned shell subsidiary of Equity National, and Take Two, Inc., a corporation owned by the Kates. The merger plan and appended Escrow Agreement provided that if the surviving Take Two corporation failed to meet certain earnings requirements, the conditional Equity National shares issued to the Kates were subject to recall for cancellation in whole or in part. In particular, if Take Two failed to show any net earnings for the 1970 calendar year, the Kates' entire block of conditional Equity National stock must be returned. A typewritten legend on the back of the two certificates representing the Kates' shares of Equity National warned that they were
subject to the terms of an Escrow Agreement dated August 7, 1970 . . ., and may not be sold, transferred, pledged or hypothecated except in accordance with such Escrow Agreement, a copy of which may be examined at the office of the Corporation.
In fact, the surviving Take Two corporation showed a net loss for the 1970 calendar year and filed a petition in bankruptcy on February 18, 1971.
Before the facts with respect to Take Two's 1970 performance were known, Bankers Trust accepted the Kates' conditional Equity National shares as collateral on several short-term loans to them aggregating $65,000. The first of these loans was made with a copy of the Escrow Agreement in hand, but was concluded in reliance on a rosy letter from Jerome Kates' attorney. By early 1971 these loans began to sour. Beginning in February or March of 1971, Bankers Trust assigned the Kates' account to a house attorney, Nathan Silverman, for collection purposes. In letters dated March 1, March 4, and April 14, 1971, Bankers Trust received increasingly urgent requests from Equity National demanding the return of the Kates' stock pursuant to the terms of the Escrow Agreement because of Take Two's 1970 loss. On the other side, in a letter dated April 21, 1971, the Kates through their attorneys threatened legal action if Bankers Trust returned the disputed stock to Equity National. In a letter dated May 21, 1971, Silverman formally denied Equity National's request. On June 3, 1971, however, Bankers Trust brought an action against the Kates for repayment of the three overdue notes, and on July 15, 1971, it obtained a confession of judgment for $68,000 and an agreement from the Kates to a "workout" that permitted gradual repayment of their notes over a period exceeding ten years. Bankers Trust continued to hold the certificates for the Kates' Equity National shares.
Plaintiffs were not involved in any of the transactions recited up to this point. On February 3, 1972, John Fowler, a broker specializing in the placement of unregistered securities, learned that Jerome Kates possessed a large block of Equity National stock and was also said to hold a block of unregistered shares in Merck & Co., the blue-chip international pharmaceutical manufacturer. Fowler testified by deposition that he was informed that Kates was willing to sell his unregistered shares in both companies, but that the sale of the Equity National shares, by far the less attractive, would have to close first. In early February 1972, Fowler contacted Kates to confirm the availability of the two blocks of stock; he also contacted Jack J. Arnold, the third-party defendant-appellee in this case, who was an associate and an experienced attorney. Arnold expressed interest in the Kates' stock, and, on February 24, 1972, after several conversations with Kates, entered into two contracts: an agreement to purchase the entire block of Equity National shares for $181,000 (of which he paid $25,000 immediately), and a 30-day option to purchase 110,000 unregistered shares of Merck & Co. at 60% of market price. Arnold testified that he and Fowler had planned to split the profits from the resale of the Merck stock. In addition, Arnold testified that he did not learn of the restrictive legend on the back of the Equity National certificates until the closing of the Equity National purchase. Several calls that Fowler and Arnold placed to the National Bank of Georgia, Equity National's transfer agent, apparently failed to reveal any encumbrances on the Equity National stock other than those stemming from its unregistered status under the Securities Act of 1933. Arnold also testified that he saw only a Xerox copy of the front side of the Equity National certificates during the negotiations with Kates that led to the purchase agreement (the certificates themselves being held by Bankers Trust), but was assured by Kates that the reverse side contained nothing unusual. Arnold's continued ignorance of any restrictions on the Equity National stock after he signed the purchase agreement was contested by a portion of Fowler's deposition, introduced by Bankers Trust, in which Fowler claimed to have phoned the president of Equity National on February 25, 1972, to have learned that Equity National would not honor the Kates' stock certificates, and to have informed Arnold of this unsettling conversation on the same day. Appellants objected to the introduction of this portion of Fowler's deposition at trial, and the district court instructed the jury to consider it only "to determine whether or not (Fowler's) telephone call or the telephone calls were in fact made." Arnold, it should be added, denied any knowledge of a telephone conversation between Fowler and the president of Equity National.
After the conclusion of the purchase agreement and option contract between Arnold and Kates, Arnold and Fowler began to search for a way to raise the funds to close the Equity National deal. It was this search that brought Mallis and Kupferman into the transaction. Arnold was attorney for Mallis, a dentist, in an unrelated securities matter. On March 1, 1972, during the course of a meeting about this, Arnold revealed to Mallis the broad outlines of the pending deal with Kates. He informed Mallis that he stood to lose his $25,000 deposit on the Equity National purchase agreement unless he could raise $156,000 for the closing of the agreement scheduled two days later; he indicated that he or his clients would soon be in a position to make some $800,000 (without mentioning the Merck shares by name); and he offered a $50,000 fee for short-term financing of his Equity National purchase. Mallis conveyed this information to his brother-in-law, Kupferman, also a dentist, who in turn contacted John Murfitt, then an Assistant Vice President of Franklin National Bank and manager of the Uniondale branch of the Bank. Murfitt testified to having explored the possibility of lending Kupferman and Mallis the requisite funds by contacting Arnold and Silverman on March 2, 1972. Of these alleged conversations, the most critical was between Murfitt and Silverman. Murfitt claimed to have informed Silverman that appellants were interested in borrowing funds to finance the Equity National closing and, as the prospective lender, to have inquired about the availability, negotiability and registration of the Equity National stock. According to Murfitt, Silverman's reassuring response was that the stock was available, that it was "saleable," that the closing of the sale would be a brief and routine affair, but that the deal had to be closed within twenty-four hours. Silverman denied any such conversation. After this brief investigation, Murfitt agreed that Franklin National would advance Mallis and Kupferman the necessary $156,000 providing that they alone would assume total responsibility for its repayment. Murfitt, with appellants' knowledge, falsely characterized the purpose of Franklin National's loan to appellants as financing for a real estate transaction.
On the morning of March 3, the day set for the closing, appellants obtained their loan from Franklin National. In addition, Arnold telephonically communicated to Mallis and Mallis approved a letter purporting to confirm the understanding between Arnold and Fowler as to appellants' "participation" in the Equity National transaction.*fn1
Appellants did not attend the closing but were represented by Arnold, Murfitt, or both Arnold and Murfitt, depending on whose testimony is credited. Murfitt arrived at the closing with three checks representing the funds lent to appellants by Franklin. Besides Murfitt, the other participants in the closing included Arnold, Fowler, Kates and Silverman. The closing was held on the premises of Bankers Trust in a conference room near Silverman's office.
The trial testimony as to what transpired during the closing was contradictory on all but a handful of major points. Acting for Bankers Trust, Silverman produced the Equity National certificates from a file that contained some or all of the correspondence addressed by Equity National to Bankers Trust and that may have contained a copy of the Escrow Agreement, see note 2 infra. Upon reading the typewritten legend on the back of the Equity National certificates, Arnold inquired about the Escrow Agreement mentioned in the legend. Kates could not produce a copy of the Agreement. A discussion about the meaning of the legend then ensued. Kates assured Arnold that the requirements of the Escrow Agreement had been met and no restrictions on the stock remained; someone suggested that Kates sign an affidavit to that effect; an affidavit was dictated to Silverman's secretary by either Arnold alone or Arnold and Silverman jointly; Kates signed the affidavit; and Murfitt handed over the checks to Kates, including a check for $45,000 which Kates endorsed to Bankers Trust in partial satisfaction of the Kates' outstanding debt. During the closing Silverman never mentioned the Equity National correspondence that he kept in the same file with the stock certificates.*fn2 At issue during the trial were the extent of Silverman's knowledge of the terms and significance of the Escrow Agreement; the extent of his participation in dictating the affidavit signed by Kates; and whether, as Arnold and Murfitt alleged, Silverman affirmatively represented the Equity National stock as unencumbered apart from restrictions imposed by lack of registration. The closing ended with Bankers Trust having been repaid $45,000, or the bulk of its then outstanding loan to the Kates, with the Kates receiving the balance of $111,728, and with Mallis and Kupferman holding the 40,384 shares of Equity National as collateral for the payment by Arnold and Fowler of their "investment" of $156,728 and a $50,000 profit. Unknown to the other participants in the transaction, Fowler subsequently received a $10,000 fee from Kates for his services.
It soon developed that Kates never possessed the 100,000 unregistered shares of Merck & Co. specified in his option contract with Arnold, the sale of which was to generate the funds to reimburse appellants, and that the Equity National conditional shares were worthless. After the discovery of his fraud, Kates paid Arnold $50,000 which Arnold then paid over to appellants. Arnold and Fowler also contributed an additional $5,135 toward appellants' interest payments on their Franklin National loan. Apart from this, appellants remain out-of-pocket on their payment to Kates, $106,000. In this action they sought ...