The opinion of the court was delivered by: GOETTEL
This is an action
for violations of section 10(b) and rule 10b-5 of the Securities Exchange Act of 1934 (1934 Act), section 17(a) of the Securities Act of 1933 (1933 Act), and state common law. Before this Court is defendant Arthur Andersen & Co.'s (Andersen) motion to dismiss and for summary judgment.
The plaintiffs in this action are four commercial banks, Manufacturers Hanover Trust Company (MHT), First Pennsylvania Bank, N.A. (First Pennsylvania), Chemical Bank (Chemical), and Security Pacific National Bank (Security Pacific). (They will be referred to collectively as the Banks.)
The principal defendant
is Andersen, a public accounting firm with offices throughout the United States and the world. From 1973 until 1979, Andersen was the independent public accountant for the Frigitemp Corporation (Frigitemp), a New York corporation that is now in bankruptcy.
This lawsuit arises from a series of loans made by the Banks to Frigitemp and one of its wholly owned subsidiaries, Elsters, Inc. (Elsters). During the mid-1970's, Frigitemp, which had earlier embarked upon a course of rapid expension, required large amounts of capital, and it looked to the Banks for financing. The Banks obliged.
The money was advanced and the obligations of the parties defined in three transactions. The first will be called the Secured Credit Transaction. In a contract dated December 31, 1975 (the Secured Credit Agreement), the Banks agreed to provide Frigitemp with a line of credit up to $8 million. Beginning in 1976, the Banks advanced approximately $6.5 million to Frigitemp. These advances were secured by a pledge of Frigitemp's customer notes receivable and were evidenced by Frigitemp's promissory notes.
The second transaction will be called the Unsecured Loan Transaction. In September 1976, the Banks and Frigitemp began discussing the need to restructure Frigitemp's debt. Pending formal restructuring, which was expected to occur in 1977, Frigitemp asked for and received a $5 million short term loan from MHT, Chemical, and Security Pacific. The funding took place in two stages. In September 1976, the Banks advanced $1.5 million to Frigitemp, and Frigitemp gave a one month promissory note to each bank. In October 1976, the three banks advanced $3.5 million to Frigitemp, and Frigitemp gave each bank a three month promissory note that reflected the September 1976 financing and that matured on February 28, 1977. (The maturity of these notes was later extended to April 30, 1977.) In February 1977, Frigitemp received an additional $4 million unsecured loan from all four banks and gave each bank a promissory note that matured on April 30, 1977.
The final transaction occurred in August 1977. From March 1977 until August 1977, Frigitemp's management and members of the Banks' senior management discussed Frigitemp's future financial needs and the terms and conditions of the debt restructuring. The fruit of these negotiations was the August 1977 transaction, in which the Banks restructured Frigitemp's debt and provided $4 million in new financing to Elsters.
There were essentially three parts to this transaction, although the Banks maintain that "all three agreements (plus the Pledge and Guarantee) were structured as, and were intended to be, part of one single, integrated refinancing package." O'Neill Affidavit para. 26. First, the Banks extended the maturity date on the unsecured notes from April 30, 1977 to March 31, 1978. To reflect this change, Frigitemp executed new notes in substitution for the prior indebtedness. (These will be called the Replacement Notes.) Second, the Banks extended the maturity date on the notes issued pursuant to the Secured Credit Agreement from July 1, 1977 to July 1, 1978. See id. P 28. To reflect this change, the notes were amended by endorsements dated August 9, 1977. (These will be called the Note Endorsements.) Finally, the Banks advanced $4 million to Elsters. Elsters gave the Banks promissory notes that matured on March 31, 1978; Frigitemp guaranteed the loan and pledged 100% of Elsters common stock, 750 shares, pursuant to a Pledge and Security Agreement.
Thus, as of August 1977, Frigitemp and Elsters owed the Banks approximately $19.5 million. By the time that Frigitemp filed its bankruptcy petition in 1978, however, only approximately one-third of that amount had been repaid.
The Banks commenced this action in 1979 in what is essentially an attempt to hold Andersen liable for these losses. They allege that they entered into the transactions with Frigitemp and Elsters in reliance on Frigitemp's financial statements audited and certified by Andersen for the years 1973-1976 and that these statements were materially false and misleading.
According to the Banks, Andersen's conduct in preparing and certifying these statements amounted to violations of the securities laws: the first claim is that Andersen violated section 17(a) of the 1933 Act and section 10(b) and rule 10b-5 of the 1934 Act; the fourth claim is that Andersen aided and abetted violations of these provisions.
Andersen filed this motion in 1982, after extensive discovery. It contends that this Court lacks jurisdiction because the alleged fraud was not "in connection with" the purchase or sale of a security and that the complaint fails to state a claim against Andersen as either a primary violator of the securities laws or as an aider and abettor.
For the reasons stated below, Andersen's motion is denied.
I. Jurisdiction Under the Securities Laws
The sine qua non of a federal court's jurisdiction to hear a claim under section 10(b) of the 1934 Act is a misrepresentation "in connection with the purchase or sale of [a security]," 1934 Act § 10(b), 15 U.S.C. § 78j(b) (1976); under section 17(a) of the 1933 Act, it is a misrepresentation "in the offer or sale of [a security]," 1933 Act § 17(a), 15 U.S.C. § 77q(a) (1976). The Banks assert that these requirements are satisfied by virtue of the notes issued in connection with the August 1977 transaction and the pledge of Elsters stock. Andersen, on the other hand, argues that the notes are not securities
and that the alleged fraud was not "in connection with" the pledge of Elsters stock.
A. The Notes As Securities
Three types of notes were issued in connection with the August 1977 transaction. First, there were the Replacement Notes issued by Frigitemp to the Banks in substitution for the prior unsecured indebtedness. These notes were issued on August 9, 1977 and matured on March 31, 1978, a period of approximately eight months. They provided for a definite rate of interest tied to the prime rate of the lending bank, and they were unsecured. Second, there were the Note Endorsements that amended the notes issued pursuant to the Secured Credit Agreement. The endorsements were dated August 9, 1977 and extended the maturity date on the notes to July 1, 1978. The notes, as amended, provided for a definite rate of interest tied to the prime rate of the lending bank, and they were secured by Frigitemp's customer notes receivable. Third, there were the notes issued by Elsters to reflect the $4 million advance. These notes were issued on August 9, 1977 and matured on March 31, 1978, a period of approximately eight months. They provided for a definite rate of interest tied to the prime rate of the lending bank, and they were secured by Frigitemp's pledge of Elsters common stock. Moreover, the underlying loan agreement provided that the proceeds of the loan were to be added to Elsters' working capital for use in the ordinary course of business.
Whether these notes are securities is not an easy question. The 1933 Act provides that, unless the context otherwise requires, "the term 'security' means any note." 1933 Act § 2(1), 15 U.S.C. § 77b(1) (1976). Although "any note . . . which arises out of a current transaction or the proceeds of which have been or are to be used for current transactions, and which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited," is exempt from the 1933 Act's registration requirements, 1933 Act § 3(a)(3), 15 U.S.C. § 77c(a)(3) (1976), it is clear that this exemption does not apply to the Act's antifraud provisions. Exchange National Bank v. Touche Ross & Co., 544 F.2d 1126, 1131 (2d Cir. 1976) (quoting Zeller v. Bogue Electric Manufacturing Corp., 476 F.2d 795, 799 (2d Cir.), cert. denied, 414 U.S. 908, 94 S. Ct. 217, 38 L. Ed. 2d 146 (1973)); Sonnenschein, Federal Securities Law Coverage of Note Transactions: The Antifraud Provisions, 35 Bus. Law. 1567, 1572, 1574-75 (1980); see 1933 Act § 12(2), 15 U.S.C. § 77l(2) (1976); id. § 17(c), 15 U.S.C. § 77q(c) (1976). The 1934 Act provides that unless the context otherwise requires, "the term security means any note . . . but shall not include any note . . . which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited." 1934 Act § 3(a)(10), 15 U.S.C. § 78c(a) (10) (1976). Thus, a literal reading of the statutes would mean that all notes are securities for purposes of section 17(a) of the 1933 Act and all notes with a maturity of greater than nine months are securities for the purposes of section 10(b) of the 1934 Act.
Despite the broad statutory language, however, not every note is a security. Oliver v. Bostetter, 426 F. Supp. 1082, 1085 (D. Md. 1977); see Exchange National Bank v. Touche Ross & Co., supra, 544 F.2d at 1133-37; Zeller v. Bogue Electric Manufacturing Corp., supra, 476 F.2d at 800. Perceiving that Congress, in passing the securities laws, intended to protect investors, see Tcherepnin v. Knight, 389 U.S. 332, 336, 19 L. Ed. 2d 564, 88 S. Ct. 548 (1967), and not "to regulate commercial loan transactions that would have no impact on the securities markets," American Fletcher Mortgage Co. v. U.S. Steel Credit Corp., 635 F.2d 1247, 1254 (7th Cir. 1980), cert. denied, 451 U.S. 911, 68 L. Ed. 2d 300, 101 S. Ct. 1982 (1981), most courts have held that, regardless of maturity, a note is a security only if it evidences an investment transaction; if it merely reflects a commercial loan transaction, the provisions of the securities laws do not apply. Id. at 1254; National Bank of Commerce v. All American Assurance Co., 583 F.2d 1295, 1301 (5th Cir. 1978); Great Western Bank & Trust v. Kotz, 532 F.2d 1252, 1256 (9th Cir. 1976); C.N.S. Enterprises, Inc. v. G. & G. Enterprises, Inc., 508 F.2d 1354, 1359 (7th Cir.), cert. denied, 423 U.S. 825, 46 L. Ed. 2d 40, 96 S. Ct. 38 (1975); McClure v. First National Bank, 497 F.2d 490, 493-95 (5th Cir. 1974), cert. denied, 420 U.S. 930, 43 L. Ed. 2d 402, 95 S. Ct. 1132 (1975); Briggs v. Sterner, 529 F. Supp. 1155, 1167 (S.D. Iowa 1981); Robbins v. First American Bank, 514 F. Supp. 1183, 1187-88 (N.D. Ill. 1981); see Exchange National Bank v. Touche Ross & Co., supra, 544 F.2d at 1134-37; Sonnenschein, supra, at 1587-89. This is known as the commercial-investment dichotomy. See National Bank of Commerce v. All American Assurance Co., supra, 583 F.2d at 1301; Great Western Bank & Trust v. Kotz, supra, 532 F.2d at 1256; Sonnenschein, supra, at 1588.
Courts utilizing the commercial-investment dichotomy judge a particular note transaction "against the attributes of an 'investment' and [accord antifraud coverage only to those transactions that sufficiently] display those attributes." Sonnenschein, supra, at 1588. The Ninth Circuit, for example, has noted that factors such as the term of the note,
the nature and extent of collateralization,
the form of the obligation,
the circumstances of issuance,
the relationship between the amount borrowed and the size of the borrower's business,
and the contemplated use of the proceeds
can be useful in determining whether a given note transaction represents an investment. Great Western Bank & Trust v. Kotz, supra, 532 F.2d at 1257-58.
If these factors were applied to the present case, a result that the notes did not represent an investment worthy of protection under the securities laws would certainly seem defensible. First, the notes were for a short term: the Replacement Notes and the Elsters notes had a maturity of less than nine months, the Note Endorsements had a maturity of eleven months. Second, the Note Endorsements and the Elsters notes were fully secured: the Note Endorsements by Frigitemp's customer notes receivable, the Elsters notes by 100% of Elsters common stock. Third, the notes were for a fixed amount, had a fixed maturity, and had a stated rate of interest. Thus, repayment did not depend solely upon the profit or productivity of Frigitemp and Elsters. See National Bank of Commerce v. All American Assurance Co., supra, 583 F.2d at 1301. Finally, a large class of investors was not involved. The obligations evidenced by the notes and the underlying agreements resulted from months of negotiations between the parties and were tailored to meet the needs of both Frigitemp and the Banks. In sum, the notes had the essential characteristics of an instrument representing a commercial loan. See generally Great Western Bank & Trust v. Kotz, supra, 532 F.2d at 1260 ("A note given to a bank in the course of a commercial financing transaction is not generally a security within the meaning of the federal securities [laws]."); Sonnenschein, supra, at 1581 ("in most cases in which institutional lenders have made federal antifraud claims, [coverage has been] denied").
Application of the commercial-investment dichotomy, however, is inappropriate in the Second Circuit. Rather, determination of whether a note is a security is governed by the test enunciated by Judge Friendly in Exchange National Bank v. Touche Ross & Co., supra. See Banco Nacional de Costa Rica v. Bremar Holdings Corp., 492 F. Supp. 364, 368 (S.D.N.Y. 1980); SEC v. Garfinkle,  Fed. Sec. L. Rep. (CCH) P 96,465, at 93,700 (S.D.N.Y. 1978); Altman v. Knight, 431 F. Supp. 309, 311-12 (S.D.N.Y. 1977). In that case, Judge Friendly, after reviewing the decisions that applied the commercial-investment dichotomy, concluded that "the efforts to provide meaningful criteria for decision under 'the commercial-investment' dichotomy do not seem to us to carry much promise of success." Id. at 1136.
He therefore adopted what has been termed a literalist of neo-literalist approach to the subject of notes as securities. Union Planters National Bank v. Commercial Credit Business Loans, Inc., 651 F.2d 1174, 1180 n.7 (6th Cir.), cert. denied, 454 ...