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SPATZ v. BORENSTEIN

February 23, 1981

DAVID SPATZ AND CHARLES JANDA, PLAINTIFFS,
v.
JOSEPH BORENSTEIN AND STANLEY MELNICK, DEFENDANTS.



The opinion of the court was delivered by: Moran, District Judge.

      MEMORANDUM AND ORDER

Plaintiffs David Spatz ("Spatz") and Charles A. Janda ("Janda") have moved for summary judgment on Counts III through VI in this action alleging violations of § 12(2) and § 17(a) of the Securities Act of 1933, 15 U.S.C. § 77a-77aa (the "Securities Act"), § 10(b) of the Securities and Exchange Act of 1934, 15 U.S.C. § 78a-78hh (the "Exchange Act"), Rule 10b-5 of the Securities and Exchange Commission, 17 C.F.R. § 240.10b-5, and § 12 of the Illinois Securities Law of 1953, Ill.Rev.Stat. ch. 121 1/2, § 137.1 et seq., by defendants Joseph Borenstein ("Borenstein") and Stanley Melnick ("Melnick"). Plaintiffs also seek summary disposition against Borenstein for alleged breach of fiduciary duty.*fn1 The court has examined the pleadings, discovery and affidavits submitted in conjunction with the joint motion. This review indicates that although genuine issues of fact remain with respect to certain discrete issues in the action, a great majority of questions are amenable to resolution as a matter of law. And on the basis of these matters plaintiffs have established violations of the securities laws. Accordingly, summary judgment is granted in favor of plaintiffs against Borenstein and denied against Melnick.

FACTUAL BACKGROUND

The instant dispute concerns the sale of limited partnership interests by defendant Borenstein to Spatz and Janda. The sale of the partnership interests was part of a more complicated three-tiered transaction, the underlying purpose of which was to acquire an interest in an apartment complex known as Laurel Glen Apartments (the "Apartments" or the "Property"), located in State College, Pennsylvania.

The apartment complex was constructed in 1973 and upon its completion was managed by its owner, Laurel Glen, Inc. ("L.G., Inc."). The property was originally financed by securing first and second mortgages, the latter with the National Union Fire Insurance Company ("National Union"). During late 1974, L.G., Inc. defaulted on the first mortgage. In order to protect its interests, National Union cured these defaults and took possession of the property under the terms of the second deed of trust.

In April, 1975, defendant Melnick assumed management of the apartments from, and at the request of, National Union.*fn2 In accordance with Melnick's stated desire to acquire an equity interest in the property, National Union contacted defendant Borenstein with a view toward putting together a syndicate of investors to acquire the apartment complex.*fn3 As a result of discussions between Borenstein, Melnick and National Union, an arrangement for acquiring the property was conceived in the fall of 1975.

In basic part, the contemplated transaction was structured as follows: Borenstein would organize and become the sole General Partner of an Illinois limited partnership to be called Laurel Glen, Ltd. ("Limited"). The 595 units in Limited would then be offered for sale to investors at a price of one thousand dollars per unit. When and if the offering of units was fully subscribed, Limited and Melnick would each purchase fifty per cent interests in, and become sole General Partners of, a general partnership to be known as Laurel Properties ("Laurel Properties").

At the same time, Melnick, through U.S. Management, would acquire all of the stock of L.G., Inc., which still held legal title to the property. Laurel Properties would purchase the property from L.G., Inc. pursuant to a document entitled Articles of Agreement for Warranty Deed (the "Agreement"). Finally, Laurel Properties would lease the apartment complex to L.G., Inc. and Melnick personally, for a period of three years. As security for performance of its obligations as lessee, L.G., Inc. agreed to pledge all of its stock to Laurel Properties.

To implement the deal, Borenstein sent plaintiffs copies of a document entitled "Laurel Glen, Ltd. Private Placement Memorandum," dated October 15, 1975 (the "Prospectus"). On the basis of this document, Spatz and Janda purchased 102 and 100 units in Limited. When the offering of Limited's units was fully subscribed, the remainder of the transaction described above was effected.

DISCUSSION

As is often the case in deals that end in litigation, the expectations of Limited's investors were not satisfactorily fulfilled. The results, in this instance, are Spatz' and Janda's claims of securities fraud based on what they allege to be certain material misrepresentations in the Prospectus and other material omissions which induced them to invest in the deal. In opposition to the joint motion for summary judgment, Borenstein and Melnick resist the conclusion that any misrepresentations or omissions existed, or, if they did, defendants deny that they were material.

1. Preliminary Legal Issues.

Initially, defendant Borenstein has raised two "blanket" defenses. First, he claims that no private right of action exists under § 17(a) of the Securities Act. However, at least in this circuit, this issue already has been decided adversely to him. Lincoln National Bank v. Herber, 604 F.2d 1038, 1040 n. 2 (7th Cir. 1979); Daniel v. International Brotherhood of Teamsters, etc., 561 F.2d 1223, 1244-1246 (7th Cir. 1977), reversed on other grounds sub nom. International Brotherhood of Teamsters v. Daniel, 439 U.S. 551, 99 S.Ct. 790, 58 L.Ed.2d 808 (1979); Schaefer v. First National Bank of Lincolnwood, 509 F.2d 1287 (7th Cir. 1975).*fn4

Defendant's second preliminary defense is no more viable than his first. Borenstein claims that a genuine issue of fact exists as to whether the sale of the limited partnership interests in Laurel Glen, Ltd. qualified for the private placement exemption of § 77d(2). If so, Borenstein argues, then the anti-fraud provisions of the 1933 and 1934 Acts, § 12(2), § 17(a) and 10(b) respectively, are inapplicable to the transaction at issue.

Several courts have addressed this issue head-on, holding that the private placement exemption does not diminish the force or reach of the anti-fraud provisions of the securities laws. Ballard & Cordell Corp. v. Zoller & Danneberg Exploration, Ltd., 544 F.2d 1059, 1064 (10th Cir. 1976); Nor-Tex Agencies, Inc. v. Jones, 482 F.2d 1093 (5th Cir. 1973); Sohns v. Dahl, 392 F. Supp. 1208 (W.D.Va. 1975). And although the Seventh Circuit has not considered the issue in the specific context of the exemption in § 4(2), in the Daniel case, supra, the court did hold that employee pension funds, exempted from the registration requirements of § 5 of the 1933 Act, 15 U.S.C. § 77e, by § 3(a)(2)(A) of the same statute, 15 U.S.C. § 77c(a)(2)(A), were still subject to the constraints imposed by sections 17(a), 10(b) and Rule 10b-5.

The presence of a different exemption here does not suggest a result different from that reached in Daniel. The language of the anti-fraud provisions specifically encompass registered and unregistered securities.*fn5 Moreover, the conclusion reached herein is consistent with the Supreme Court's well-worn admonition that the securities laws should be enforced "flexibly to effectuate . . . their remedial purposes." SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 195, 84 S.Ct. 275, 284, 11 L.Ed.2d 237 (1963).*fn6

As a final "preliminary" matter, since the contours of securities law have changed rather dramatically in the recent past, it is helpful briefly to sketch the elements of plaintiffs' case on summary judgment. Spatz and Janda rely on several provisions of the federal securities laws here, and the elements of each claim vary significantly. Count III alleges a violation of § 12(2)*fn7 of the Securities Act. The elements of such a violation were set out in Sanders v. John Nuveen & Co., Inc., 619 F.2d 1222 (7th Cir. 1980), where the Seventh Circuit reasoned that liability attaches to one who offers or sells a security*fn8 by means of a prospectus which includes "an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements . . . not misleading . . .", without proof of reliance or scienter.

In contrast to § 12(2), it is well-established that to establish a violation of § 10(b) of the Exchange Act, proof of scienter and reliance, as well as material misrepresentations or omissions, is required. See, Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976); TSC Industries, Inc. v. Northway, 426 U.S. 438, 96 S.Ct. 2126, 48 L.Ed.2d 757 (1977); Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033 (7th Cir. 1977).

The elements of a violation of § 17(a) of the Securities Act have never been delineated as clearly as those for § 10(b). This is hardly surprising in view of the fact that these two provisions are largely complementary, and because plaintiffs have often "boot-strapped" § 17(a) allegations to their 10b-5 claims. Until recently, the elements of proof for the two sections were regarded as identical. However, the Supreme Court in Aaron v. Securities Exchange Commission, 446 U.S. 680, 100 S.Ct. 1945, 64 L.Ed.2d 611 (1980), recently held that, although scienter is an element required by § 17(a)(1), the language of §§ 17(a)(2) and 17(a)(3) requires only negligence to complete the violation.*fn9

  2.  The Existence of Material Misrepresentations or
      Omissions.

Given the legal context set out above, the question addressed to the court is whether plaintiffs have established that no genuine issue of fact exists as to whether certain statements made by Borenstein were false and whether certain other facts were not disclosed, thus rendering the information available to plaintiffs misleading. In addition, the court must determine whether these statements or omissions were material as a matter of law under the standard articulated by the Supreme Court in Northway, supra. Since under the precedent Spatz' and Janda's reliance may be inferred from any omissions but not from any false statements (see, note 14, infra), the two types of statements are considered separately below.

a. The Alleged Misrepresentations.

Each of the statements characterized by plaintiffs as false or misleading is contained in the Prospectus, which Borenstein drafted to sell the limited partnership interests in Limited. Plaintiffs claim the following portions of the Prospectus were false or misleading: (1) "To date the occupancy rate [of the apartments] is approximately 96% on an annual basis"; (2) "As additional security for Lessee's performance of its lease obligations, Mr. Melnick has pledged to the General Partnership [Laurel Properties] . . . all of the issued and outstanding stock of Laurel Glen, Inc."; (3) "Effective December 1, 1975, the General Partnership entered into Articles of Agreement . . . with the Seller of the Property [Laurel Glen, Inc.] . . ."; and (4) that the Prospectus misrepresented the amount of money needed in the first calendar year of the deal for repair and maintenance of the property when in its "Operating and Expense Statement" it listed under an item captioned "Replacements" an amount of $15,000.

On this motion, plaintiffs have established beyond doubt that each of these statements was false. Defendant Melnick, in his deposition, admitted that the occupancy rate of the Laurel Glen apartments was not 96% "on an annual basis." Rather, Melnick stated that the apartments were approximately 96% occupied during September through May of each year, but, since College Park was a "university town", during the summer months the complex was only 50% rented. Thus, on an annual basis, the apartments were only 85% occupied.*fn10 (Melnick Dep. at 112-114.)

The falsity of the Prospectus' claim that Laurel Properties and L.G., Inc. entered into a binding agreement "effective December 1, 1975" is also established by the record. The clear implication of the Prospectus is that as of October 15, 1975 (the date the Prospectus was issued) a binding agreement between the parties had been accomplished, to be effective at a later date. In fact, the Agreement could not be and was not closed until after December 1, 1975 (making the statement false on its face). More to the point, until sometime in December, Melnick, the seller in this transaction, possessed only an option to acquire the stock of L.G., Inc. and had only orally agreed to cause L.G., Inc. to sell the property to Limited, an agreement of doubtful legal enforceability. He did not actually come into possession of the shares until after December 1. (Melnick Dep. at 40, 172-173; Borenstein Dep. at 52-53.)

Finally, Borenstein himself suggested that the $15,000 amount stated for repairs and maintenance was inaccurate. Borenstein testified in his deposition that the item labelled "Replacements" referred to repairs and maintenance and, as the following colloquy illustrates, that he was cognizant of the fact that these expenses were understated:

  Q:  Did you have reason to believe based on the
      discussions that you had with Mr. Melnick and
      Mr. Weisman in the Fall of 1975 that $15,000
      was an accurate reflection of the amount that
      would have to be expended?
A:  [Borenstein] No.

(Borenstein Dep. at 80.)

Even if we accept Borenstein's present contention that "Replacements" referred only to minor repairs, as distinguished from more major capital expenditures contemplated as necessary, nowhere is there a disclosure that such additional expenditures would be necessary.

b. The Alleged Omissions.

In addition to the affirmative misrepresentations, plaintiffs allege that the Prospectus failed to state certain material facts necessary in order to make the Prospectus' other statements not misleading. In particular, Spatz and Janda assert that Borenstein (through the Prospectus) failed to disclose that 25 of the 562 units in the Laurel Glen apartment complex were "below grade" and thus uninhabitable. The Prospectus also failed to disclose that, prior to the preparation and distribution of the offering, payments on the mortgages encumbering the property became delinquent. Finally, the plaintiffs allege that the failure to inform the ...


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