The opinion of the court was delivered by: TENNEY
This is an action tried to the Court for alleged violations of sections 12(1), 12(2) and 17(a)(2) of the Securities Act of 1933 ("Securities Act"), 15 U.S.C. §§ 77l (1), 77l (2) and 77q(a)(2), section 10(b) of the Securities Exchange Act of 1934 ("Securities Exchange Act"), 15 U.S.C. § 78j(b), New York General Business Law § 352-c, and other violations of state law. Such violations are alleged to have occurred on the sale by defendant Recognition Devices of certain of its common stock valued at $ 10,000 plus its $ 40,000 promissory note to plaintiff Sven Eriksson on September 13, 1973. However, it is necessary that we consider events occurring well prior to September 1973 in determining just what Eriksson's purpose, intent and knowledge were in making this "investment" in Recognition Devices.
Eriksson is a Swedish electronics engineer now living in Switzerland, who in 1956 started a company, Telekontroll, to manufacture and sell electronic "paging" equipment. In the summer of 1972 Eriksson learned of an inventor, Robert Lester in the United States who had invented "paging" or "localizing" equipment that used only ultrasonic, rather than electronic, transmissions. Lester referred to his system as Trakatron and had assigned it to his company, then named Recognition Devices a company distinct from the defendant in this action. Eriksson had a friend in the United States, Sten Persson who was also an engineer, and it was Persson who brought Lester to Eriksson's attention. Thereafter, in the summer of 1972 Eriksson called Lester and had discussions with him since Eriksson was interested in using Trakatron in connection with his electronic paging system. Indeed, in early October 1972 Lester conferred with Eriksson at the offices of Telekontroll in Sweden with a view to developing a patent licensing agreement between Telekontroll and Recognition Devices whereby Telekontroll would manufacture the Trakatron systems for the European market with further provision for Telekontroll to manufacture in all other parts of the world. Telekontroll was also given a temporary right to build a prototype of Lester's ultrasonic locating system and in late 1972 or early 1973 did just that. Letter from Eriksson to Lester, dated December 12, 1972, Defendants' Exh. B.
Before any action was taken to formalize such an agreement, Lester and Recognition Devices had transferred the Trakatron and other patents together with the right to use the name "Recognition Devices" to a new company bearing the name RCDS Enterprises, Inc. ("RCDS"). This transfer arose out of the following circumstances. One of the investors in Lester's Recognition Devices was an individual named Sanford Bronstein, who was the president of Cedars of Lebanon Hospital in Miami, Florida. As a hospital president, Bronstein had come into contact with defendant William Galvin, who was in the hospital consulting field. Bronstein told Galvin about Recognition Devices and, at Bronstein's request, Galvin went to see Lester in the fall of 1972 after Lester's conference with Eriksson in Sweden. Galvin himself was looking for a project to invest in, and reported back to Bronstein that all that was needed was money, management and sales, but that in the company's present state it would be advisable to form a new company. Bronstein indicated he would support such a project by way of a contract to install the Trakatron system at Cedars of Lebanon Hospital. Galvin, not being a money-raiser, contacted defendant Pierre LeLandais, whom he had previously known and through whom he met defendant Pierre Schoenheimer, for the purpose of forming the new company and of raising additional money. LeLandais and Schoenheimer were the original managing directors of Radix Organization Inc. ("Radix"), which was in the business of originating, structuring and implementing corporate development programs.
Galvin, LeLandais and Schoenheimer met with Lester in January 1973. They explained that they had formed or were in the process of forming a new company, RCDS, which would purchase Recognition Devices' name, patents, and sales leads, and would hire Lester for one year. Lester, enthusiastic about the proposal, obtained approval of his board of directors, and on April 2, 1973 the transfer of assets to RCDS was effected. The consideration for the transfer was (a) 1500 shares of RCDS (i. e., 15% of the number of shares originally issued) and (b) cash payments not to exceed $ 200 million, of which $ 5000 was paid at the time of transfer plus: 10% of cumulative sales above $ 50,000 but under $ 1 million; 5% of next $ 1 million of sales; and 3% on sales over $ 2 million but not to exceed 30% when added to cost of sales. In addition, RCDS retained the name Recognition Devices, Inc., the services of Intersonics Corporation ("Intersonics," the new name of the old Recognition Devices, Inc.), and, more particularly, the services of Lester for a period of not less than 12 months for a fee of $ 2000 per month or 5% of sales, whichever was higher. Finally, the assets acquired by RCDS were to revert to Intersonics if Intersonics had not received at least $ 100,000 by the third anniversary date of the agreement. The patents transferred consisted of the Trakatron patent, two other issued patents, and four pending patents. The certificate of incorporation of RCDS Enterprises was amended on April 2, 1973 (the day of the purchase of the assets of the Lester company), and a certificate was filed on April 17, 1973; thereafter the company became known as Recognition Devices, Inc. ("RD").
At the time of the purchase of the Lester patents and for some months thereafter, those connected with RCDS and thereafter with RD appear to have been in error as to the capitalization of RCDS and, consequently, of RD. The original funding of RCDS of $ 25,000 was subscribed to by Galvin, Mrs. Galvin, Radix (i. e., LeLandais and Schoenheimer), and by Robert Feldstein and two other principals of Scientific Prototype Corporation ("Prototype") which, under Feldstein, was to prepare a prototype of the Trakatron system. Actually the Galvins and Radix went in on a 50/50 basis, but Radix allocated 426 of its 4250 shares to Prototype and the Galvins subscribed to 4250 shares equally. At $ 1 per share this accounted for $ 8500 of the initial funding. The balance was covered by $ 16,500 of 8% three year Subordinated Notes. With the transfer of 1500 shares to Intersonics, the total shares outstanding were 10,000, out of a total of 15,000 shares that it was mistakenly believed constituted the capital structure of the company. Actually, the certificate of incorporation authorized only the issuance of 200 shares of common stock. The defendants rectified this oversight as soon as it was discovered by amending the certificate.
There was no further solicitation of funds at the time of the initial $ 25,000 investment. It was contemplated, however, that at an appropriate time the company would attempt to raise an additional $ 250,000 from a group of sophisticated investors known to Radix. Indeed, one potential investor was on the scene prior to July 1973, but the deal fell through. The defendants hoped that the product could be developed and that the engineers at Prototype would construct a model that would, in turn, attract investors.
On May 1, 1973 the contract with Cedars of Lebanon Hospital and RD was signed. Exh. A to Plaintiffs' Exh. 2. It called for the sale and the installation of a Trakatron 300 (Locating) System, a purely ultrasonic system. Two phases were prescribed: Phase I, which involved a survey by RD of the hospital buildings, ultrasonic propagation studies, wiring diagrams, field testing and general planning as to equipment, was not to cost more than $ 50,000 and was to be completed by September 1, 1973; Phase II called for delivery by RD of the hardware and was to be completed by March 1, 1974. The estimated cost for Phase II was set at $ 187,500 or a total cost for both phases not to exceed $ 237,500.
In the spring of 1973 after the contract with Cedars of Lebanon had been signed, work was commenced on the preparation of a brochure to crystallize how RD was going to function in the market areas it was eventually going to enter. Both LeLandais and Galvin worked on this material, which was prepared in the office of Radix where RD was situated. The document was completed on the letterhead of RD late in June or early July 1973 and was entitled "History Current Operations & Business Plan For The Future." It was dated July 19, 1973 and marked "confidential." Plaintiffs' Exh. 2. It is referred to hereinafter as the "Report." Fifteen copies of this document were prepared. The Report consisted of (1) an introduction; (2) a general description of The Trakatron System and its applications including a more detailed description of Trakatron's first application to be installed at Cedars of Lebanon Hospital; (3) a description of the business acquired, i. e., the assets acquired from Intersonics and the contract for the services of Intersonics; (4) the business plan, including engineering and product development, marketing and sales, and finances; (5) budgeted operating expenses for the fiscal year 1973 showing total expenses of $ 115,150; (6) a description of management, including biographical data on Galvin, LeLandais, Schoenheimer, Feldstein, and Martin; (7) capitalization, listing the issuance of 10,000 shares to Mr. and Mrs. Galvin, Radix, Intersonics and certain personnel of Prototype; (8) balance sheet as of July 15, 1973 (unaudited and on a cash basis); and (9) profit and loss statements as of July 15, 1973, one of which reflected no revenues and expenses of almost $ 31,000, the other incorporating the revenue to be received from Cedars of Lebanon Hospital on the contract, showing net revenue from that source of $ 100,000 and total net income of $ 69,159.90. Attached and made part of the Report as exhibits were: A) the contract with Cedars of Lebanon Hospital Corporation, Miami, Florida; B) the patents granted to date; C) new products, represented by reprints of magazine and advertising literature relating to Trakatron; D) a list of countries where Trakatron might be introduced; E) Radix: an overview, including its services to business enterprises, its services to private and institutional investors, its investments, examples of Radix at work, and its organization, including biographical data on LeLandais, Schoenheimer, and a Daniel Presser, identified as a director and consultant; and F) a description of the activities and principal officers of Prototype.
Nowhere in the Report is any mention made of any proposed sale of the stock of RD. According to LeLandais, the purpose of the Report was to crystallize how RD was going to function in the market area. However, it was recognized that the Report might be useful in future financing, although LeLandais did not consider it to be a "prospectus."
Galvin had first heard of Eriksson in March 1973 from correspondence between Lester and Persson relating to a grant by Lester to Eriksson of a license in Europe in 1972. Galvin called Persson and was reassured that although a license agreement had been forwarded by Lester to Eriksson following Eriksson's letter of October 12, 1973, Defendants' Exh. B, nothing had come of it. Indeed, nothing concrete appears to have occurred with respect to Eriksson and the defendants until July 2, 1973 when Persson and Lester wrote a joint letter to Eriksson on the letterhead of Elenex, Inc., Persson's employer, to bring Eriksson up to date on Recognition Devices, Defendants' Exh. G. In this letter Persson advised Eriksson, in part, as follows:
Bob (Lester) recently sold Recognition Devices, the patents and trade marks to Radix, 375 Park Avenue, New York City, for which Bob received royalties and 15 percent of their stock. Radix is a mini-conglomerate with an annual business of between $ 15-$ 20 million a year.
Radix presently desires to purchase from you, Sven, if ready at this time, a RF/Ultrasonic locating system for demonstration purposes in that they feel they have potential customers lined up for you in this area.
I will let Bob take over this letter from here.
Id. Lester then continued the letter as follows:
I hope you answer this letter, Sven, because I am beginning to wonder.
I have enclosed a letter from the new Recognition Devices, for which I am now acting as a consulting engineer. I have told them that Mr. Sten Persson is their representative and we can negotiate through him prior to either a meeting with you here or our coming to Sweden with the new president, Mr. William Galvin sometime at the end of September or beginning of October.
Meanwhile, your thoughts for a working arrangement regarding pricing of units for our marketing in the United States and other parts of the world are desired and also an indication of a formula for your marketing in Scandinavia and for the Eastern Bloc as per the original discussions or possibly even more extensively in Europe.
It is difficult in a letter to go into all the ramifications and facets so I feel that your initial reply should indicate what the status is at the moment and how fast you can move.
There is also the possibility of your having the rights to the all ultrasonic unit which we have finally finished and are now packaging for production. We solved the problem by using pulse with coating of the sonic frequency, tell Veine.
I am very much looking forward to seeing you soon either here or there, but at least let me hear from you one way or the other.
Warmest personal regards.
Although Persson testified that he first met Galvin "in the late summer of 1973," T. 280, he had certainly been in contact with him in July, since he gave him Eriksson's address, and Galvin wrote Eriksson on July 13, 1973, Plaintiffs' Exh. 1. Furthermore, the tentative date for a meeting at the end of September or beginning of October referred to by Lester in his letter of July 2, 1973 to Eriksson, Defendants' Exh. G, must have been known to Galvin on July 13, 1973 when he wrote:
By the time you receive this letter, we trust that you will have heard directly from Mr. Persson.
We are moving ahead rapidly in the development of a working model of the pure ultrasonic paging and locating system and we have already sold one such system to a hospital in Miami, Florida. In addition, we have made substantial progress in formulating our plans for distribution and sale domestically and abroad.
We look forward to your visit with us here in New York in order that we may demonstrate our ultrasonic system and discuss our plans for the future. In view of the advanced stage of our negotiations with some other European firms interested in our program, we hope that you share our sense of urgency in this matter, in the event you would like to develop a working relationship with us.
In any event, on August 13, 1973 Galvin wrote Persson confirming that RD would demonstrate the ultrasonic locating system for Eriksson and Persson "during the week of September 3rd in New York City." Apparently this date was changed thereafter, and the initial meeting between Eriksson and the defendants did not take place until September 12, 1973.
The meeting of September 12, 1973 was held at the Radix office at 375 Park Avenue, New York City, which was also the office of RD. Eriksson arrived around 2:00 P.M. accompanied by Persson, who had met Eriksson at the airport. Awaiting them were Galvin, Schoenheimer and LeLandais. Feldstein from Prototype was there with the demonstration equipment. Irving Kram, a potential investor, was also present. The meeting lasted until late in the evening. Apparently Galvin and his associates had incorrectly identified and associated Eriksson with L. & M. Eriksson of Sweden, a very substantial enterprise, and Eriksson corrected this misapprehension and explained that it would be easier to deal with him as the sole owner of a company than with a huge corporation. He gave his general background and his success in the manufacture of paging equipment in Europe, pointing out that he was a member of the European Selective Paging Association (ESPA) formed by all the large paging equipment companies in Europe, which membership would give him the opportunity to market Trakatron to all that group. He also told them that he was familiar with the field of ultrasonics and had had dealings with Lester in the past.
After this preliminary discussion the matter of an agency or a licensing agreement was explored. Galvin, knowing nothing about licensing, limited himself to his own field, salesmanship, and dwelt on what he, Schoenheimer, and LeLandais envisioned for RD. Thereafter, most of the conversation emanated from LeLandais and Schoenheimer, particularly LeLandais, who was a hard bargainer and experienced in licensing. During the course of the meeting Eriksson was furnished with one of the copies of the Report discussed above. He examined the Report, and at the conclusion of the meeting he took it back to his hotel where he read it in its entirety, including all the financial material. But the most interesting thing to Eriksson about the Report was "to see what people I had to deal with." T. 17. This was because his interest was in licensing or a sales agency, not in an investment.
Although Eriksson and Persson were somewhat evasive in their testimony, it is abundantly clear that the Trakatron was demonstrated by Feldstein at the meeting and that Feldstein also participated in the general conversation on a technical level. The attempt by Eriksson and Persson to fix the date of the demonstration at some time after Eriksson's investment in RD cannot survive scrutiny. There is abundant testimony and documentary evidence to support the finding of a demonstration on September 12, 1973. The Trakatron was demonstrated and proved that it was possible to send and receive a pure ultrasonic sound, but it was far from a complete success. Eriksson testified that he "thought it was a far way to go before anything could be delivered." T. 45.
It cannot be disputed that the sole purpose of the meeting on September 12, 1973 was a demonstration of Trakatron nor is it disputed that Eriksson came to New York without the slightest intention of investing in RD. As he testified at the trial, "I was not coming here for investment in that company at that time. I was coming to get a sales agency or a licensing for Europe. That was my purpose." T. 18. His sole purpose was to secure the right to market Trakatron in Europe and, incidentally, to sell in America his radio frequency (RF) system in combination with the ultrasonic system invented by Lester and owned by RD. Persson had written to him on July 2, 1973 that Radix, i. e., RD, was ready to purchase from Eriksson "a RF/Ultrasonic locating system for demonstration" if it was available, Defendants' Exh. G, and Eriksson was aware that time was running out on the Cedars of Lebanon contract. Indeed, the time limitations of that contract were discussed, and Eriksson brought up the possible use of an RF/Ultrasonic system at this first meeting because of this time problem.
After the meeting had concluded in the evening of September 12, 1973, Galvin, LeLandais, Schoenheimer and Kram met downstairs in 375 Park Avenue at the Brasserie Restaurant. The RD group was in a quandary as to how they should proceed. Eriksson wanted an exclusive agency or licensing agreement for Europe, but did not want to pay any fee or royalty. They were greatly impressed with Eriksson; they had been looking for a "real live, interested, knowledgeable person," T. 256; and they had to act promptly since he was returning to Europe to attend a meeting of ESPA at which he desired to disclose his acquisition of the European rights to Trakatron. Although an investment by Eriksson was not discussed at the meeting on September 12, 1973, there had been talk generally about the possibility of Radix getting financing for RD, and Kram was probably introduced to Eriksson as a potential investor. It is also probable that Eriksson was shown a copy of RD's financing plan which called for raising $ 250,000 through the sale of 2,500 shares at $ 20 per share plus $ 200,000 of 8% Subordinated Notes payable in five years. Plaintiffs' Exh. 25. After Eriksson and Persson had left and Schoenheimer, Galvin, LeLandais and Kram had gone down to the Brasserie, LeLandais suggested they they ask Eriksson to "join the team" on a similar basis to their own initial investment in "the ball club" and using the same form of investment. T. 257. A figure of $ 50,000 was suggested as not unreasonable since Eriksson would not be going in at the same time as the original investors. Moreover, this amount was what they had hoped Kram would invest.
The next morning, on September 13, 1973, by prearrangement Galvin met Eriksson and Persson for breakfast at the Brasserie. When Eriksson had left the building the prior evening he did not know whether he would get the agency or not. At breakfast they reviewed the meeting of the prior day, and Eriksson said he felt that they were close to a worthwhile association, but that the problem was LeLandais who was insisting on a minimum guarantee. Galvin told Eriksson that he would have an opportunity to purchase stock in RD in a fashion similar to Galvin's original investment, that it would be an indication of good faith on the part of Eriksson and that they would make him a member of the team. Following breakfast they went up to the Radix offices, Schoenheimer arriving at about the same time. LeLandais was not present since he was attending a directors' meeting in Connecticut. Schoenheimer and Galvin again suggested that if Eriksson wanted an agency he should show his sincerity and good faith by investing in RD. Galvin showed Eriksson a letter addressed to Eriksson on RD's letterhead which advised him that RD had accepted his offer to subscribe to 500 shares at $ 20 per share and a $ 40,000 8% three-year Subordinated Note at face value. Plaintiffs' Exh. 6. This letter had been prepared by Galvin earlier that morning after talking with LeLandais on the phone. The letter contained the following statement.
As you are aware, at this time, our Company is accepting subscriptions from other investors upon the same terms and conditions for an aggregate of 2,500 shares of common ...