United States Court of Appeals, Third Circuit
United States Court of Appeals, Third Circuit
2d 320
Peter S. Pearlman, Cohn & Lifland, Saddle Brook, N.J., for appellant.
Robert C. Epstein, Elizabeth A. Weiler, Hannoch, Weisman, Stern,
Besser, Berkowitz & Kinney, P.A., Newark, N.J., for W. George Gould.
James T. O'Halloran, Tompkins, McGuire & Wachenfeld, Newark, N.J.,
for Christopher J. O'Halloran; Robert J. Kelly, Washington, D.C., of
counsel.
Daniel L. Goelzer, Gen. Counsel, Jacob H. Stillman, Associate Gen.
Counsel, Rosalind C. Cohen, Asst. Gen. Counsel, Lawrence W. Koltun,
Atty., S.E.C., Washington, D.C., amicus curiae; Paul Gonson, Sol.,
Washington, D.C., of counsel.
Continental Import & Export, Inc., is an importer of wines and spirits. Joachim
Birkle is president of Continental and, until 1980, owned or controlled 100
percent of its stock. Ruefenacht, the plaintiff, alleges that early in 1980 he
purchased 2500 shares of Continental's stock for $250,000--said to represent 50
percent of the company--in reliance on financial documents and other oral
representations made by Birkle, Christopher O'Halloran, a certified public
accountant, and W. George Gould, Continental's corporate counsel.
In deposition testimony, Ruefenacht asserted that the consideration for the price
paid for Continental's stock included a promise by him to devote certain efforts
to the firm's business. In conformance with that promise, Ruefenacht engaged
in various activities on behalf of company. In the summer of 1980, for example,
he solicited contracts to import beverages on behalf of the firm. On other
occasions Ruefenacht participated in the hiring of company employees. He also
applied for and received a state liquor license (or solicitor's permit),
representing at that time that he would sell alcoholic beverages to wholesalers
After Ruefenacht paid $120,000 of the total $250,000 purchase price for
Continental stock, he began to doubt the accuracy of certain representations
made to him by Birkle and others. Soon thereafter he filed this action, alleging
violations of sections 12(2) and 17(a) of the Securities Act of 1933, 15 U.S.C.
Secs. 77l (2), 77q(a) (1982), section 10(b) of the Securities Exchange Act of
1934, 15 U.S.C. Sec. 78j(b) (1982), and Rule 10(b)(5), 17 C.F.R. Sec.
240.10(b)(5) (1983). Ruefenacht charges that financial statements prepared by
O'Halloran and signed by Birkle overvalued Continental's goodwill and
licenses by $243,000; that these financial statements assigned a $400,000 value
to import or contract rights with no substantial worth; that the firm reported a
surplus when in actuality it maintained a deficit; and that the defendants
represented that net profits on sales between 1980 and 1981 would be $848,000
under a nationwide distribution program, and $1.197 million in the New York
area, when in fact Continental was not seriously negotiating contracts for
nationwide distribution at all and could not reasonably project these net
earnings. In reliance on these representations, Ruefenacht alleges, he had
purchased 1000 shares of Continental's stock and had advanced $120,000 to
Birkle. The complaint seeks rescission and restoration of the amount paid.
Ruefenacht also pleads pendent state claims for fraud and breach of fiduciary
duties.4
The district court granted summary judgment for defendants, concluding that
the stock purchased by Ruefenacht was not a "security" within the meaning of
the 1933 and 1934 Acts. The court so concluded not because the instrument
purchased by Ruefenacht lacked any of the indicia of stock ownership; indeed,
the court conceded that the "stock which Ruefenacht received contains all the
attributes mentioned by the Forman5 Court as indicating that the transaction did
involve a security." App. at 220. Rather, the court held, the instrument was not
The 1933 and 1934 Securities Acts include within the definition of "security" a
series of specific terms--e.g., "note," "stock," "bond," and "debenture"--and
thereafter employ a number of more general phrases--e.g., "investment
contract," "any interest or instrument commonly known as a 'security.' "6 As
early as 1943 the Supreme Court held that certain novel economic transactions
were encompassed within these latter, more generic terms, even though not
embraced by their more specific provisions like "stock," "bond," or "note." See
SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 348-55, 64 S.Ct. 120, 122-25,
88 L.Ed. 88 (1943) (holding that leasehold interests in property adjacent to
exploratory oil wells were "securities"). The Court's leading opinion on this
point, SEC v. W.J. Howey Co., 328 U.S. 293 (1946), held that agreements for
the sale of a citrus crop coupled with optional service contracts were
"investment contracts." Howey propounded a definition of "investment
contract" derived from descriptions widely employed in state "blue sky" laws:
an investment contract, the Court held, is "a contract, transaction or scheme
whereby a person invests his money in a common enterprise and is led to
expect profits solely from the efforts of the promoter or a third party...." Id. at
298-99, 66 S.Ct. at 1102-03. This definition came to be known as the "Howey
test" and led many courts to classify a variety of novel economic schemes as
"investment contracts."7
While the courts were giving the term "investment contract" a broad compass,
the more specific term "note" was read narrowly, so as not to embrace every
instrument comporting with the Acts' terms that is technically a "note" under
state law. The first appellate holding that not every such "note" is a "security"
under the federal Acts is this court's decision in Lino v. City Investing Co., 487
F.2d 689 (3d Cir.1973).8 In Lino, this court held that a personal promissory
note tendered as partial consideration for rights under a franchise agreement
was not a "note" under the federal Acts. Id. at 693-96. Significantly, we did not
apply the Howey test to the notes in question, as Part I of the opinion pointedly
made clear by applying the Howey test to the franchise agreements themselves.
Id. at 691-93. Rather, we examined the entire context of the note transaction,
declining at that time to expound "a 'test' ... that would aid in determining
whether there has been a purchase or sale of securities when a personal
Following Lino 's lead, several courts strove to define the circumstances under
which a "note" should be considered a "security" under the Securities Acts. The
Fifth Circuit sought to determine whether a note comprised an "investment." 9
The Ninth Circuit approached the problem on a slightly different tack, seeking
to determine whether the lender supplies "risk capital" to the maker.10 In a
leading opinion written by Judge Friendly, the Second Circuit rejected both of
these approaches. See Exchange National Bank of Chicago v. Touche Ross &
Co., 544 F.2d 1126 (2d Cir.1976) (Friendly, J.). In part the Second Circuit
feared that the "investment" and "risk capital" tests obliterated Congress'
carefully drawn distinctions among those notes included within and excluded
from the Acts. Congress took care to provide that any note arising out of a
"current transaction" and having a maturity not exceeding nine months was
excluded from the registration provisions, but included in the anti-fraud
provisions, of the 1933 Act;11 and that any note with a maturity not exceeding
nine months was excluded from the 1934 Act.12 As the Fifth Circuit candidly
acknowledged, its "investment test" "virtually writes [these distinctions] out of
the law." McClure v. First National Bank of Lubbock, 497 F.2d 490, 494 (5th
Cir.1974), cert. denied, 420 U.S. 930, 95 S.Ct. 1132, 43 L.Ed.2d 402 (1975). In
addition, the Second Circuit expressed concern over the uncertainty that would
inevitably follow from a weighing of factors "without any instructions as to
[their] relative weights." Exchange National Bank, 544 F.2d at 1137. In lieu of
the "investment" and "risk capital" approaches, the Second Circuit enumerated
a family of note transactions presumptively excluded from the Act--all
concerning consumer financing or business financing of current costs--and held
that other notes not bearing the family pedigree were presumptively securities
under federal law.13
11
There matters stood when late in 1976 the Seventh Circuit held that the Howey
test for "investment contract" applies to determine whether a "note" is a
security under the Acts. Emisco Industries, Inc. v. Pro's Inc., 543 F.2d 38, 39-40
(7th Cir.1976). The extension of Howey into the note arena was problematical.
This application of Howey further obliterated the special statutory distinctions
drawn by Congress among notes included in and excluded from the Acts, and
injected into the note area the same uncertainty that pervades litigation over the
inherently vague term "investment contract." Moreover, the Seventh Circuit
doctrine seemed to ignore some important statutory policies underlying the
securities Acts. As the legislative history makes abundantly clear,14 one such
policy is the protection of "investors"; and to the extent that Howey maps the
entire set of "investors" marked for protection--not an obviously correct
assumption--then that policy may be satisfied. But a second policy of the Acts
13
First, at least in the note area there is, as we held in Lino, some necessity for
fine-tuning the definition of "note" to avoid sweeping within the coverage of
section 10(b) of the 1934 Act every consumer and business loan financing
current operational costs. But there is no such necessity in the stock area. Stock
is a well-defined term, is not issued by consumers, and is not ordinarily
employed by business to finance current transactions. While the importation of
the Howey test into the note arena might be justified as an expedient--albeit an
imperfect one--for limiting the definition of "note," no such expedient seems
necessary for the issue of stock.
14
Second, because the Howey test turns in part on whether the purchaser derives
profits "from the entrepreneurial or managerial efforts of others," see United
Housing Foundation, Inc. v. Forman, 421 U.S. 837, 852, 95 S.Ct. 2051, 2060,
44 L.Ed.2d 621 (1975), a central aspect of the test, when applied to stock,
requires a determination whether the purchaser exercises a controlling share of
the corporation.18 A controlling share may be exercised with less than 100
percent stock ownership--indeed, at times with far less than 50 percent
ownership. See Sutter v. Groen, 687 F.2d 197, 203 (7th Cir.1982). Thus an
instrument might be transformed from a security into a non-security by virtue of
a small increase in the number of shares traded. Instruments purchased by
multiple investors might be securities as to some purchasers and non-securities
as to others, or securities as to sellers but not as to purchasers.19 Instruments
might be securities if traded in a series of small transactions but non-securities if
the same transaction is effectuated in a single sale. To many judges and lawyers
with up to 50 years of experience with the securities laws, these seemed
extraordinary consequences.20
15
The case now before us illustrates just how far the extension of Howey from
investment contract to note to stock may be taken. Ruefenacht is the purchaser
of 50 percent of the stock of Continental. Had he purchased only 49 percent,
Ruefenacht would presumably have lacked corporate control, rendering the
instrument purchased (at least presumptively) a security. Had he purchased 51
percent, in contrast, the instrument would presumptively not have been a
security. Both presumptions, of course--at least under the Seventh Circuit
approach, see Sutter, 687 F.2d at 203--would have been subject to rebuttal.
Because Ruefenacht purchased exactly 50 percent, a more sophisticated
analysis would presumably be required--although just what that analysis should
be is less than obvious.
If Congress or the Supreme Court has mandated these results, then, regardless
of their deficiencies in logic, we would be bound to apply them. We turn,
therefore, to the language, history, structure, and policies of the 1933 and 1934
Acts. Then we consider the impact of recent Supreme Court decisions.
A.
Statutory Language, Structure, and History
1. The definition and exemption provisions
18
Section 2(1) of the 1933 Act as amended provides that the term "security"
19
means
any note, stock, treasury stock, bond, debenture, ... investment contract, ... or,
in general, any interest or instrument commonly known as a "security"....
20
15 U.S.C. Sec. 77b(1) (1982). The legislative history to section 2(1) indicates
that Congress cast the definition of security "in sufficiently broad and general
terms so as to include within that definition the many types of instruments that
in our commercial world fall within the ordinary concept of a security."
H.R.Rep. No. 85, 73d Cong., 1st Sess. 11 (1933).
21
Although Congress intended that the term "security" embrace those instruments
that "fall within the ordinary concept of a security," several important
qualifications limit this definition. Preceding all of the definitions in the 1933
Act is the clause "unless the context otherwise requires." The significance of
23
Any note, draft, bill of exchange, or banker's acceptance which arises out of a
current transaction ... and which has a maturity at the time of issuance of not
exceeding nine months....
24
25
The 1933 Act also empowers the Commission to grant additional exemptions.
Section 3(b) of the Act as amended provides that:
26
The Commission may from time to time by its rules and regulations, and
subject to such terms and conditions as may be prescribed therein, add any class
of securities to the securities exempted as provided in this section, if it finds that
the enforcement of this subchapter with respect to such securities is not
necessary in the public interest and for the protection of investors by reason of
the small amount involved or the limited character of the public offering; but
no issue of securities shall be exempted under this subsection where the
aggregate amount at which such issue is offered to the public exceeds
$5,000,000 [then $100,000].
27
28
The definition of "security" under the 1934 Act parallels that under the 1933
Act. Section 3(a)(10) of the 1934 Act provides that " 'security' means any note,
stock, treasury stock, bond, debenture, ... investment contract, ... or in general,
any instrument commonly known as a 'security.' " 15 U.S.C. Sec. 78c(a)(10)
(1982).22 One important distinction between the 1933 and 1934 Act definitions
pertains to short-term notes: generally speaking, short-term notes that would be
exempt from the registration provisions of the 1933 Act are exempted from the
antifraud provisions of the 1934 Act.23 And like the 1933 Act, section 3(a)(12)
of the 1934 Act authorizes the SEC to grant additional exemptions for classes
of securities either unconditionally or upon specialized terms and conditions.24
15 U.S.C. Sec. 78c(a)(12) (1982).
29
30
Second, Congress vested in the SEC the responsibility for identifying certain
securities for exemption. In addition, Congress empowered the SEC to attach
conditions to any exemptions granted in order to protect the investing public.
These decisions suggest that in the judgment of Congress the Commission, and
not the courts, has the expertise and practical experience required to ensure that
exemptions to the Act are prudently chosen, and that appropriate conditions are
attached to any exemptions granted. Needless to say, the SEC has never
exempted the purchase or sale of a controlling share of corporate stock from the
definition of security. Thus we look on the plea that this court do so with some
skepticism.
31
32
33
In the Securities Act the term "security" was defined to include by name or
description many documents in which there is common trading for speculation
or investment. Some, such as notes, bonds, and stocks, are pretty much
standardized and the name alone carries well-settled meaning. Others are of
more variable character and were necessarily designated by more descriptive
terms, such as "transferable share," "investment contract," and "in general any
interest or instrument commonly known as a security." We cannot read out of
the statute these general descriptive designations merely because more specific
ones have been used to reach some kinds of documents. Instruments may be
included within any of these definitions, as a matter of law, if on their face they
answer to the name or description. However, the reach of the Act does not stop
with the obvious and commonplace. Novel, uncommon, or irregular devices,
whatever they appear to be, are also reached if it be proved as [a] matter of fact
that they were widely offered or dealt in under terms or courses of dealing
which established their character as "investment contracts," or as "any interest
or instrument commonly known as a 'security.' "
34
320 U.S. at 351, 64 S.Ct. at 123 (emphasis added). Thus, the Supreme Court
recognized that instruments like "stock," "bonds," and "notes" answer "on their
face ... to the name or description." The Acts' latter phrases, intended to
supplement these common instruments, were devised to capture "[n]ovel,
uncommon, or irregular devices" that were not so readily classified. This
construction is consistent with the fact that the terms "stock," "bond," and
"note" had well-defined meanings under state corporate law that Congress
obviously had incorporated by reference, and that Congress did not intend the
reach of the Act to stop with these well-defined terms alone.
35
The Court's next bout with the definition of security confirmed that the phrase
"investment contract" also drew on state law for its content. In SEC v. W.J.
Howey Co., 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946), the Supreme
Court held that in the words "investment contract" Congress had employed a
term "common in many state 'blue sky' laws." Id. at 298, 66 S.Ct. at 1102.
Despite Justice Frankfurter's position in dissent that the phrase " 'investment
contract' is not a term of art," id. at 301, 66 S.Ct. at 1104 (Frankfurter, J.,
dissenting), the Court held that by "including an investment contract within the
scope of [the Act], Congress was using a term the meaning of which had been
crystallized by [state] judicial interpretation[s]." Id. at 298, 66 S.Ct. at 1102.
These state definitions, the Court held, "had been broadly construed by state
courts so as to afford the investing public a full measure of protection." Id.
36
Thus, by 1946 it was plain that the definitions in the 1933 and 1934 Act drew
on state law for their content, and that in order to embrace novel or unusual
investment schemes within the salutary provisions of the Acts, Congress
supplemented standard state-law definitions of "stock," "note," etc., with more
general phrases, including "investment contract," drawn from state law. Joiner
and Howey make plain that Congress did not intend to circumscribe the scope
of the standard terms--"stock," "note," "debenture"--to that of the more
generous phrases. To the contrary, that construction would turn the history of
the Acts and the state-law definitions on their heads. Congress never intended
that "stock" that did not also satisfy the definition of "investment contract"
would not be within the Acts' terms. Rather, Congress intended that
"investment contracts" that did not also satisfy the definition of "stock" would
be within the Acts' terms. See Tcherepnin v. Knight, 389 U.S. 332, 343, 88
S.Ct. 548, 556, 19 L.Ed.2d 564 (1967) (Joiner "rejected the respondents'
invitation to 'constrict the more general terms substantially to the specific terms
which they follow' ").
37
The language of the definition itself makes this consideration clear. As the
Second Circuit recently noted, there would have been little reason for the
drafters to have employed words like "stock," "bond," and "note"--which had
clear definitions under state law--if their intention had been to include only
those instruments that satisfied an "economic reality" test appropriate to the
latter terms. If an economic reality test appropriate to these subsequent terms
were intended, "a substantial portion of each class of instrument would, in fact,
not be within the definition." Golden v. Garafalo, 678 F.2d 1139, 1144 (2d
Cir.1982).
38
To be sure, the Howey Court also admonished that "[f]orm was [to be]
disregarded for substance" and that "emphasis was [to be] placed upon
economic reality." 328 U.S. at 298, 66 S.Ct. at 1102. Those words were written,
however, in the context of disregarding the absence of a label like "stock" or
"note" when novel schemes nonetheless constitute "investments" earning
profits from the labor of others. They did not direct us to ignore the presence of
an instrument that, as a matter of economic reality, is "stock" simply because it
is not purchased by one who also entered into an "investment contract."
39
In summary, neither the language, the history, the structure, nor the Acts' early
interpretations suggest that the transfer of stock to effectuate the sale of all or
part of a business is not the purchase or sale of a "security." And several
considerations--particularly Congress' express treatment of notes and its
conferral on the SEC of the power to specify exempt securities--suggest the
contrary. We now consider the impact of the "context clauses" on our analysis.
40
41
Each of the definitional sections of the 1933 and 1934 Acts begins with the
words, "When used in this [sub]chapter, unless the context otherwise requires-." 15 U.S.C. Secs. 77b, 78c(a) (1982). These clauses, the defendants maintain,
authorize us to narrow the definition of "stock" as the "economic realities"
require. In considering this position, we turn to the history and function of the
clauses.
42
Perhaps the most notable feature about the "context clauses" is that they do not
appear in the paragraphs defining "security" at all. Instead, these clauses
precede all fifteen definitions in the 1933 Act and all forty definitions in the
1934 Act. Plainly, the "context clauses" were not directed particularly at the
definition of "security." This lack of particular application is underscored by the
legislative history of the definitions of "security." In neither the House nor the
Senate reports, for example, did the drafters allude to the clauses or indicate
that particular kinds of stock, notes, or debentures are embraced by the Act
"only when the context requires." If the drafters had indeed intended that the
context clause exempted certain named securities from coverage, they certainly
made no mention of it.
43
The legislative evolution of the 1933 Act suggests even more strongly that the
context clauses had no such purport. Section 2 of the Senate version of the 1933
Act provided, "When used in this Act the following terms shall, unless the text
otherwise indicates, include the following respective meanings." H.R. 5480,
73d Cong., 1st Sess. 39 (1933) (emphasis added) (as enacted by the Senate on
May 10, 1933); S. 875, 73d Cong., 1st Sess. 1 (1933). This Senate bill tracked
the language of an early House bill, H.R. 4314, which had also opened with the
phrase "unless the text otherwise indicates." H.R. 4314, 73 Cong., 1st Sess. 2
(1933). Early in the legislative process, however, the House Committee on
Interstate and Foreign Commerce substituted the language "unless the context
otherwise requires" for the phrase "unless the text otherwise indicates." See
H.R. 5480, 73d Cong., 1st Sess. 1 (1933) (as enacted by the House on May 5,
1933). Ultimately the Conference Committee adopted the House version.
Although the Conference Committee Report discusses a number of significant
distinctions between the House and Senate definitions, the Report makes no
mention of the difference between these prefatory clauses. See H.Conf.Rep.
No. 152, 73d Cong., 1st Sess. 24-25 (1933).
44
It seems evident that the drafters did not attribute particular significance to the
distinction between these House and Senate phrases. The "text" to which the
Senate had adverted was obviously the text of the statute itself. Similarly, the
"context" to which the House referred was obviously the context in which the
defined words appear in the statute itself. Both the House and Senate
provisions were intended to direct that the ensuing definitions were to be used
throughout the statute unless the text of the Act expressly, or another section of
the statute implicitly, made them inapplicable to that section.27
45
IV.
A.
Policy Considerations
47
48
l. Uncertainty of application
49
The Seventh Circuit acknowledges the uncertainty that would flow from this
investigation, but discounts it. To interpret the Acts as creating private rights of
action in favor of "entrepreneurs," the Seventh Circuit has reasoned, "is to go
awfully far for the sake of having to make some distinctions." Sutter, 687 F.2d
at 202. We are not as placid about this prospect as is the Seventh Circuit. After
all, the costs of legal rules accrue not only to the courts but to those members of
the public who must structure their affairs accordingly. Counsel must be hired
to predict whether the purchase of a large block of stock will render it a
security or a non-security. Doubts will be created over whether registrations are
necessary. All of this uncertainty has real economic costs. It is one thing, if the
sale-of-business doctrine were capable of clear application, to say "caveat
emptor" and let the market price reflect that the purchaser no longer has federal
protection from fraudulent representations. But it is another thing if the buyer
and seller are unable to predict readily whether their instruments are
"securities" at all. That uncertainty raises the cost of economic transactions,
inhibits the flow of capital, spawns litigation, and in general benefits neither the
parties nor the courts. 30
51
52
54 are special risks involved in the sale of stock in a corporation that might justify
there
special protection. Generally speaking, one who purchases the assets of a business is
not liable for its debts and liabilities, while one who purchases the stock in a
corporation--a separate legal entity--assumes ownership of a business with both
assets and liabilities.... Liabilities, alas, are often the subject of inaccurate or
incomplete disclosures.
55
Daily v. Morgan, 701 F.2d 496, 504 (5th Cir.1983). 31 Of course, the buyer can
reduce these risks by employing professionals to comb through the most
intricate details of the seller's business. But such an investigation is costly and
inefficient: the seller controls this information and is already in possession of it;
and the buyer's investigation is time-consuming and expensive, thereby raising
transaction costs and inhibiting the flow of capital. One of Congress' purposes
in singling out the named instruments in the Act was to facilitate such
transactions without the ensuing delays, duplication of effort, and expenses
associated with the "caveat-stockholder" era of deregulation. See H.R.Rep. No.
1383, 73d Cong., 2d Sess. 4-5 (1934). Denial of the Acts' protection in these
circumstances would undermine this Congressional policy.32
56
57
reasonable when the stock purchased has the traditional attributes commonly
associated with stock ownership. In United Housing Foundation, Inc. v.
Forman, 421 U.S. 837, 95 S.Ct. 2051, 44 L.Ed.2d 621 (1975), the Court
reasoned:
58
There
may be occasions when the use of a traditional name such as "stocks" or
"bonds" will lead a purchaser justifiably to assume that the federal securities laws
apply. This would clearly be the case when the underlying transaction embodies
some of the significant characteristics typically associated with the named
instrument.
59
Id. at 850-51, 95 S.Ct. at 2059-60. In the case of stock, the Court held, those
characteristics include the right to receive dividends contingent upon an
apportionment of profits; negotiability; capacity for use as collateral; voting
rights in proportion to the number of shares owned; and share appreciation. Id.
at 851, 95 S.Ct. at 2060.
60
The district court concluded that the stock purchased by Ruefenacht bears these
characteristics, and we accept that conclusion for the purposes of this appeal.
Consequently, Ruefenacht would have been justified in agreeing on a purchase
price that did not include a premium reflecting the risk of fraud. This savings to
Ruefenacht represented part of the value of the bargain; and to withhold the
Acts' protection in these circumstances would be to deprive the purchaser of
that part of the value of the bargain.
61
4. Protection of "investors"
62
64
of securities, depending on how the doctrine is applied;37 and the very same
transaction consummated in a single purchase, rather than as a series of step
transactions, would presumably not constitute the sale of securities.
65
66
Moreover, in focusing on terms like "stock," "bond," and "note" in the early
part of the definition of security, Congress drew on well-known state-law
definitions. See Part III A 2 supra. These terms had a consistency of meaning
under state law that did not vary with who owned the instrument at any
particular moment, and did not admit of asymmetries between buyer and seller.
Rather, they focused on the essential attributes of the instrument: voting rights,
redemption rights, the right to participate in dividends, the right to participate in
assets upon dissolution, etc. E.g., 8 Del.Code Ann. Sec. 151 (1983); 11 W.
Fletcher, Cyclopedia of the Law of Private Corporations Secs. 5083-5085
(1971). Fluctuations in the identity of the instrument were foreign to the notion
of stock. The chameleon-like quality of stock under the sale-of-business
doctrine is wholly arbitrary with respect to the state-law definitions that are the
source of the terms in the 1933 and 1934 Acts.
67
Nor are we persuaded that economic affairs have magnified in complexity since
the Seventy-Third Congress, thereby rendering these distinctions any less
arbitrary. Of course, affairs of commerce are more sophisticated now than fifty
years earlier; but the transaction at issue here is not one that the appellees seek
to steer clear of the securities laws because of its peculiar sophistication, and
they do not argue that the transaction was unknown in earlier days. This is the
simple purchase of 50 percent of a business by means of stock, a transaction as
old as the concept of stock itself and certainly known to the drafters of the 1933
and 1934 Acts. If the increased sophistication of today's markets now renders
appropriate a variety of distinctions that would have been rejected by the
Seventy-Third Congress--an argument whose truth is hardly self-evident--we
68
69
B.
Recent Supreme Court Authority
70
In United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 95 S.Ct. 2051, 44
L.Ed.2d 621 (1975), the Supreme Court held that "stock" held by a tenant in a
cooperative apartment building is not a security under the federal Acts. The
Court's analysis of the term "stock" admonished us to attend to substance over
form:
71
We reject at the outset any suggestion that the present transaction, evidenced by
the sale of shares called "stock," must be considered a security transaction
simply because the statutory definition of a security includes the words "any ...
stock." Rather we adhere to the basic principle that has guided all of the Court's
decisions in this area:
"[I]n searching for the meaning and scope of the word 'security' in the Act[s], form
72
421 U.S. at 848, 95 S.Ct. at 2058 (footnote omitted). The instruments held by
the tenants, the Court concluded, lacked the attributes commonly associated
with stock: the right to participate in dividends, negotiability, capacity to serve
as collateral, voting rights in proportion to the number of shares owned, and
appreciation in value. Consequently, the Court concluded, as a matter of
economic reality the shares in issue were not "stock" within the meaning of the
Acts. Id. at 851, 95 S.Ct. at 2060. As we noted earlier, the Supreme Court
acknowledged that occasions may arise when the use of a particular name
would lead a purchaser justifiably to assume that the federal securities laws
apply, adding that "[t]his would clearly be the case when the underlying
transaction embodies some of the significant characteristics typically associated
with the named instrument." Id. at 850-51, 95 S.Ct. at 2059-60.
75
80
The defendants now maintain that the foregoing passages direct that the Howey
80
The defendants now maintain that the foregoing passages direct that the Howey
test is to be applied to all of the defined terms in the Act, including the
definition of stock. We do not agree. In its discussion of stock, the Court's
admonition to attend to economic reality simply instructed that the label "stock"
is not dispositive if the instrument lacks the traditional elements associated with
stock ownership. The Court's analysis was clearly not intended to, and did not,
apply the Howey test to stock. Nor did the Court direct that an economic reality
test be applied to stock other than to determine whether, as a matter of
economic reality, the instrument was in fact "stock" as that term has historically
been understood. The label of the instrument may be pierced in order to
determine whether it indeed bears the indicia of stock ownership. In this case
the district court has done so, holding that the "stock which Ruefenacht
received contains all the attributes mentioned by the Forman Court as
indicating that the transaction did involve a security." App. at 220.
81
82
share," and only then turned to whether the separate agreement was an
"investment contract" under the Howey test. 455 U.S. at 556-60, 102 S.Ct. at
1223-25. Weaver therefore reinforces our interpretation of Forman.
VI. Conclusion
83
84
Thus, we hold that the sale of all or part of a business effectuated by the
transfer of stock bearing the traditional incidents of stock ownership is the sale
of a "security" under the 1933 and 1934 Acts. The judgment of the district court
will be reversed and the case remanded for further proceedings consistent with
this opinion.
JAMES HUNTER, III, Circuit Judge, concurring:
85
Following Lino, I reach the same conclusion as the majority regarding the
particular transaction at issue here. The court below found that Ruefenacht
acquired no more than joint control over Continental, that Ruefenacht and
Birkle exercised absolute veto power over each other in all important business
matters, and that Ruefenacht continued to be a full-time employee of Autobern
Trading Co., Inc. "The commercial context of this case," see Lino, 487 F.2d at
685, persuades me to conclude that the district court erred in dismissing
Ruefenacht's claims for lack of federal jurisdiction under the securities acts.
Accordingly, I join the majority in ordering a remand.
Honorable Sylvia H. Rambo, United States District Judge for the Middle
District of Pennsylvania, sitting by designation
The Second, Fourth, Fifth, and Eighth Circuits have rejected the sale-of-
business doctrine. See Daily v. Morgan, 701 F.2d 496, 497-504 (5th Cir.1983);
Cole v. PPG Indus., Inc., 680 F.2d 549, 555-56 (8th Cir.1982); Golden v.
Garafalo, 678 F.2d 1139, 1140-47 (2d Cir.1982); Coffin v. Polishing Machs.,
Inc., 596 F.2d 1202, 1204 (4th Cir.), cert. denied, 444 U.S. 868, 100 S.Ct. 142,
62 L.Ed.2d 92 (1979)
The Seventh Circuit has taken the lead in applying the doctrine to the purchase
of all or part of the stock of a business. See Sutter v. Groen, 687 F.2d 197, 199204 (7th Cir.1982); Canfield v. Rapp & Son, Inc., 654 F.2d 459, 463-66 (7th
Cir.1981); Frederiksen v. Poloway, 637 F.2d 1147, 1150-54 (7th Cir.), cert.
denied, 451 U.S. 1017, 101 S.Ct. 3006, 69 L.Ed.2d 389 (1981). The Ninth,
Tenth, and Eleventh Circuits have followed the Seventh Circuit's lead. See
Landreth Timber Co. v. Landreth, [1984] Fed.Sec.L.Rep. (CCH) p 99,705 (9th
Cir.1984); Christy v. Cambron, 710 F.2d 669, 672 (10th Cir.1983); Kaye v.
Pawnee Constr. Co., 680 F.2d 1360, 1366 n. 2 (11th Cir.1982); King v.
Winkler, 673 F.2d 342, 344-46 (11th Cir.1982). See also Chandler v. KEW,
Inc., 691 F.2d 443, 443-44 (10th Cir.1977).
On one occasion this court applied the federal securities laws to the sale of 50
percent of the common stock of a close corporation without expressly
addressing the applicability of the sale-of-business doctrine. Glick v.
Campagna, 613 F.2d 31, 35 (3d Cir.1979). See also Cramer v. General Tel. &
Elec. Corp., 582 F.2d 259, 270-73 (3d Cir.1978) (sale of controlling stock
interest in corporate subsidiary constitutes sale of securities).
On the morning of oral argument in this case, the Supreme Court granted
certiorari in a Second Circuit case rejecting the sale-of-business doctrine. See
Seagrave Corp. v. Vista Resources, Inc., 710 F.2d 95 (2d Cir.1983) (per
curiam) (following Golden v. Garafalo, supra ), cert. granted, --- U.S. ----, 104
S.Ct. 2341, 80 L.Ed.2d ---- (1984).
4
United Housing Found., Inc. v. Forman, 421 U.S. 837, 95 S.Ct. 2051, 44
L.Ed.2d 621 (1975)
E.g., Smith v. Gross, 604 F.2d 639, 642-43 (9th Cir.1979) (per curiam)
(earthworms); Miller v. Central Chinchilla Group, Inc., 494 F.2d 414, 416-18
(8th Cir.1974) (chinchillas); SEC v. Koscot Interplanetary, Inc., 497 F.2d 473,
478-85 (5th Cir.1974) (cosmetics); SEC v. Glenn W. Turner Enters., 474 F.2d
476, 480-83 (9th Cir.) (self-improvement courses), cert. denied, 414 U.S. 821,
94 S.Ct. 117, 38 L.Ed.2d 53 (1973)
8
See Exchange National Bank of Chicago v. Touche Ross & Co., 544 F.2d 1126,
1134 (2d Cir.1976) (Friendly, J.) (acknowledging Lino as first appellate
holding to narrow the breadth of "note" under the federal Acts)
10
Great Western Bank & Trust Co. v. Kotz, 532 F.2d 1252, 1257 (9th Cir.1976).
Six factors bore on the Ninth Circuit's analysis: (1) "time," (2)
"collateralization," (3) "form of the obligation," (4) "circumstances of
issuance," (5) "relationship between the amount borrowed and the size of the
borrower's business," and (6) "contemplated use of the proceeds." Id. at 125758 (emphasis omitted)
11
12
13
member to this family: notes evidencing loans by commercial banks for current
operations. See Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930, 939
(2d Cir.1984) (Friendly, J.).
14
15
The SEC regards commercial paper as exempt from the registration provisions
of the 1933 Act, see 15 U.S.C. Sec. 77c(a)(3) (1982), only if the paper is:
prime quality negotiable paper of a type not ordinarily purchased by the general
public, that is, paper issued to facilitate well-recognized types of current
operational business requirements and of a type eligible for discounting by
Federal Reserve Banks.
Securities Act Release No. 4412, 26 Fed.Reg. 9158, 9159 (1961); see 17 C.F.R.
Sec. 231.4412 (1983). Commercial paper is not exempt from the antifraud
provisions of the 1933 Act. See 15 U.S.C. Sec. 77q(c) (1982); Part III A infra.
Most courts have applied the criteria of Release 4412 to the 1934 Act
exemption as well. E.g., Mallinckrodt Chem. Works v. Goldman, Sachs & Co.,
420 F.Supp. 231, 240 (S.D.N.Y.1976); Alton Box Board Co. v. Goldman,
Sachs & Co., 418 F.Supp. 1149, 1157 (E.D.Mo.1976) (citing Levy infra ), rev'd
on other grounds, 560 F.2d 916 (8th Cir.1977); Franklin Savings Bank v. Levy,
406 F.Supp. 40, 43-44 (S.D.N.Y.1975), rev'd on other grounds, 551 F.2d 521,
527-29 (2d Cir.1977); Welch Foods v. Goldman, Sachs & Co., 398 F.Supp.
1393, 1397-98 (S.D.N.Y.1974). See generally Sonnenschein, Federal Securities
Law Coverage of Note Transactions: The Antifraud Provisions, 35 Bus.Law.
1567, 1574 & nn. 27-28, 1586-87 & n. 86 (1980); Note, The Commercial Paper
Market and the Securities Acts, 39 U.Chi.L.Rev. 362, 380-401 (1972)
[hereafter Note, Commercial Paper ].
16
See Sonnenschein, supra note 15, 35 Bus.Law. at 1595 & n. 131; Coffey, supra
note 2, 18 Case W. Res.L.Rev. at 381-403; Hannan & Thomas, supra note 2, 25
Hastings L.J. at 219-53
17
E.g., Daily v. Morgan, 701 F.2d 496 (5th Cir.1983); Cole v. PPG Indus., Inc.,
680 F.2d 549 (8th Cir.1982); Golden v. Garafalo, 678 F.2d 1139 (2d Cir.1982);
Coffin v. Polishing Machs., Inc., 596 F.2d 1202 (4th Cir.), cert. denied, 444
U.S. 8868, 100 S.Ct. 142, 62 L.Ed.2d 92 (1979). For incisive academic
commentary, see Note, Sale-of-Business Doctrine, supra note 2, 83
Colum.L.Rev. 1718 (1983); Comment, A Criticism of the Sale of Business
Doctrine, 71 Calif.L.Rev. 974 (1983)
18
See McGrath v. Zenith Radio Corp., 651 F.2d 458, 467-68 n. 5 (7th Cir.), cert.
denied, 454 U.S. 835, 102 S.Ct. 136, 70 L.Ed.2d 114 (1981)
20
Until recently, courts expressed little doubt that the sale of 100 percent of the
stock of a business (and a fortiori less than 100 percent) constituted the sale of a
"security" under the Acts. See Occidental Life Ins. Co. v. Pat Ryan Assocs.,
Inc., 496 F.2d 1255, 1261-63 (4th Cir.), cert. denied, 419 U.S. 1023, 95 S.Ct.
499, 42 L.Ed.2d 297 (1974); Spencer Cos. v. Armonk Indus., Inc., 489 F.2d
704, 707 (1st Cir.1973) (denying preliminary injunction but assuming stock
was a security); Alberto-Culver Co. v. Scherk, 484 F.2d 611, 615 (7th
Cir.1973) rev'd on other grounds sub nom. Scherk v. Alberto-Culver Co., 417
U.S. 506, 94 S.Ct. 2449, 41 L.Ed.2d 270 (1974); Walling v. Beverly Enters.,
476 F.2d 393, 395 (9th Cir.1973) (exchange of all common stock)
The parties appear to have assumed that the sale of 100 percent of the stock of a
firm constitutes the sale of a "security" in Superintendent of Ins. v. Bankers
Life & Cas. Co., 404 U.S. 6, 92 S.Ct. 165, 30 L.Ed.2d 128 (1971). There the
Supreme Court doubted whether a non-purchaser/non-seller (Manhattan
Casualty Co.) had standing to invoke the Acts, see id. at 13-14 n. 10, a question
later settled in Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 95 S.Ct.
1917, 44 L.Ed.2d 539 (1975). No party at any stage of the litigation, however,
appears to have questioned that the stock constituted a "security."
21
22
23
The subtle distinctions in short-term note coverage under the Acts is examined
in Note, Commercial Paper, supra note 15, 39 U.Chi.L.Rev. at 380-401; and in
Exchange National Bank, supra, 544 F.2d at 1131-32. See note 15 supra
24
consistent with the public interest and the protection of investors, either
unconditionally or upon specified terms and conditions or for stated periods,
exempt from the operation of any one or more provisions of this chapter which
by their terms do not apply to an "exempted security" or to "exempted
securities".
15 U.S.C. Sec. 78c(a)(12) (1982).
25
Cf. Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 733-34, 95 S.Ct.
1917, 1924, 44 L.Ed.2d 539 (1975) (noting distinction between "purchase or
sale " in Sec. 10(b) of 1934 Act and "offer or sale" in Sec. 17(a) of 1933 Act,
and stating, "When Congress wished to provide a remedy to those who neither
purchase nor sell securities, it had little trouble in doing so expressly."); see also
Touche Ross & Co. v. Redington, 442 U.S. 560, 572, 99 S.Ct. 2479, 2487, 61
L.Ed.2d 82 (1979); Southeastern Community College v. Davis, 442 U.S. 397,
411, 99 S.Ct. 2361, 2369, 60 L.Ed.2d 980 (1979)
26
See also Daily v. Morgan, 701 F.2d 496, 502 (5th Cir.1983); Golden v.
Garafalo, 678 F.2d 1139, 1146-47 (2d Cir.1982)
27
28
The Seventh Circuit has espoused this "factual context" position. See Emisco
Inds., Inc. v. Pro's Inc., 543 F.2d 38, 39 (7th Cir.1976); C.N.S. Enters., Inc. v. G
& G Enters., Inc., 508 F.2d 1354, 1357-62 (7th Cir.), cert. denied, 423 U.S.
825, 96 S.Ct. 38, 46 L.Ed.2d 40 (1975)
29
See, e.g., Marine Bank v. Weaver, 455 U.S. 551, 102 S.Ct. 1220, 71 L.Ed.2d
409 (1982), holding that a certificate of deposit was not a security under the
federal securities Acts because it enjoyed sufficient protection under the
banking laws. Id. at 558-59, 102 S.Ct. at 1224-25. Although the Court relied in
part on the context clause, its holding was independently supported by the
legislative history and structure of the banking laws and securities Acts
30
See Daily v. Morgan, 701 F.2d at 503; Golden v. Garafalo, 678 F.2d at 114546; Note, Sale-of-Business Doctrine, supra note 2, 83 Colum.L.Rev. at 1741-44
31
See also Exchange National Bank, 544 F.2d at 1137 ("While banks are in a
favored position to obtain disclosure, the target of [the Acts] is fraud, which a
bank's ability to obtain disclosure cannot always prevent."); Occidental Life
Ins. Co. v. Pat Ryan & Assocs, Inc., 496 F.2d 1255, 1263 (4th Cir.) ("In one
sense the large investor has a more pressing need for protection to the extent
that he has expended a greater amount of his resources."), cert. denied, 419 U.S.
1023, 95 S.Ct. 499, 42 L.Ed.2d 297 (1974); Mifflin Energy Sources, Inc. v.
Brooks, 501 F.Supp. 334, 336 (W.D.Pa.1980); Titsch Printing, Inc. v. Hastings,
456 F.Supp. 445, 449 (D.Colo.1978)
32
33
34
See Daily v. Morgan, 701 F.2d at 503; Golden v. Garafalo, 678 F.2d at 1146
("in truth, purchasers of a business rightly regard themselves as investors as
well as managers"); Note, Sale-of-Business Doctrine, supra note 2, 83
Colum.L.Rev. at 1738-39
The Seventh Circuit acknowledges that purchasers may be both investors and
entrepeneurs but assumes that investment must constitute the "purchaser's main
purpose." Sutter, 687 F.2d at 203 (emphasis added). We see no evident source
in the Acts for the requirement that investment must be a "main purpose" rather
than a "subsidiary" purpose. Moreover, this interpretation opens a new avenue
of inquiry into gradations of the purchaser's intent; we doubt that lengthy
pretrial discovery and hearings on such subtleties as whether the purchaser's
See, e.g., Goodwin v. Elkins & Co., 730 F.2d 99, 103 (3d Cir.1984); id. at 112
(Seitz, C.J., concurring); id. at 114 (Becker, J., concurring) (partnership
agreement did not constitute an investment contract under the terms of the
agreement)
36
McGrath v. Zenith Radio Corp., 651 F.2d 458, 467-68 n. 5 (7th Cir.), cert.
denied, 454 U.S. 835, 102 S.Ct. 136, 70 L.Ed.2d 114 (1981); see Seldin, supra
note 2, 37 Bus.Law. at 679-81
37
The final sale itself arguably would not constitute the sale of a security because
it transferred control to the buyer. Similarly, all prior sales may not constitute
sales of securities if they were effectively part of a single step transaction. On
the other hand, it is plausible that each of the sales would constitute the sale of
securities because each comprised less than 50 percent of the business. We
hesitate to speculate on the proper application of the doctrine in these
circumstances
38
39
40
See generally 1 L. Loss, supra note 28, at 22; 3 id. at 1430-34; Note, Sale-ofBusiness Doctrine, supra note 2, 83 Colum.L.Rev. at 1739 n. 12, 1742; Note,
Commercial Paper, supra note 15, 39 U.Chi.L.Rev. at 401 & n. 264
41
See Herman & MacLean v. Huddleston, 459 U.S. 375, 103 S.Ct. 683, 689-90,
74 L.Ed.2d 548 (1983) (availability of express remedy under Sec. 11 of 1933
Act does not preclude action under Sec. 10b of 1934 Act); Affiliated Ute
Citizens of Utah v. United States, 406 U.S. 128, 151, 92 S.Ct. 1456, 1471, 31
L.Ed.2d 741 (1972); Tcherepnin v. Knight, 389 U.S. 332, 336, 88 S.Ct. 548,
553, 19 L.Ed.2d 564 (1967); see Lino v. City Investing Co., 487 F.2d 689, 692
(3d Cir.1973)