United States District Court, Northern District of Illinois, E.D
February 5, 1982
LA SALLE NATIONAL BANK, PLAINTIFF,
ARTHUR ANDERSEN & CO., ET AL., DEFENDANTS. BANK OF CALIFORNIA, PLAINTIFF, V. ARTHUR ANDERSEN & CO., ET AL., DEFENDANTS. THE FIRST PACIFIC BANK OF CHICAGO, PLAINTIFF, V. ARTHUR ANDERSEN & CO., ET AL., DEFENDANTS.
The opinion of the court was delivered by: Bua, District Judge.
Before the court are defendants' motions to dismiss. The
plaintiffs, two national banking associations and one Illinois
banking corporation, have charged each of the three defendant
accounting firms, Arthur Andersen & Co., Coopers & Lybrand, and
Alexander Grant & Co., with violating sections 10(b) and 18 of
the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) and
78r, and sections 12(2) and 17(a) of the Securities Act of
1933, 15 U.S.C. § 77l(2) and 77q(a).*fn1 Subject
matter jurisdiction over Counts I-IV of the complaints is based
on section 27 of the Securities Exchange Act of 1934, 15 U.S.C. § 78aa,
22(a) of the Securities Act of 1933, 15 U.S.C. § 77v(a).
The court limited the initial briefing on the motions to
dismiss to the question of subject matter jurisdiction. Each of
the three defendants contends that no "security" as defined by
the federal securities laws*fn2 was involved in the
transaction giving rise to plaintiffs' claims.*fn3
Each of the claims based on federal law arises from alleged
misrepresentations made by the defendants in connection with
the issuance of three promissory notes by American Reserve
Corporation (ARC) to plaintiffs in the aggregate amount of
According to the complaint ARC "is a holding company that,
through various subsidiaries, was engaged in . . . the business
of writing property, liability, and life insurance." Complaint
"Beginning in late 1976, ARC sought to secure financing
through an offer to sell to a limited number of institutional
investors certain Promissory Notes in the aggregate principal
amount of $7,500,000. . . . The net proceeds from this proposed
sale were purportedly to be used to retire certain borrowings
with a certain bank and [an ARC subsidiary] and to supplement
ARC's working capital. Plaintiff was among those to whom the
offering was made." Complaint ¶ 17.
Each of three banks approached by ARC were given ARC's annual
report and Form 10-K's for the fiscal years ending December 31,
1974, 1975, and 1976. Defendants Andersen and Coopers acted as
ARC's independent auditors for these years and allegedly were
responsible for certain misrepresentations and omissions
violative of the securities laws. Defendant Grant was ARC's
auditor for fiscal 1977.
On September 8, 1977, in a face-to-face meeting with
plaintiffs' representatives at ARC's offices in Chicago,
representatives of the three defendants allegedly made further
misrepresentations and omitted to state certain important facts
concerning ARC's financial condition, reinsurance arrangements,
and reserves. Allegedly in reliance on these statements, the
plaintiffs purchased ARC's promissory notes on September 15,
1977. Complaint ¶¶ 22-23.
The promissory notes were not appended to the complaints.
However, the plaintiffs did attach a copy of the notes and note
agreements dated September 15, 1977 to their memoranda in
opposition to the motions to dismiss.
The relevant allegations contained in the complaint are as
1. The Promissory Note purchased by Plaintiff for
investment, as described more fully below,
constitutes a security for purposes of federal
securities laws. [Complaint ¶ 3].
2. This action arises from the offer and sale by
ARC of certain Promissory Notes in the
aggregate principal amount of $7,500,000.00 to
a limited number of institutional investors
including Plaintiff. [Complaint ¶ 9].
3. Beginning in late 1976, ARC sought to secure
financing through an offer to sell to a
limited number of institutional investors
certain Promissory Notes in the aggregate
principal amount of $7,500,000.00 (hereinafter
the "Offering"). The net proceeds from this
proposed sale were purportedly to be used to
retire certain borrowings with a certain bank
and GRC [an ARC subsidiary] and to supplement
ARC's working capital. Plaintiff was among
those to whom the Offering was made.
[Complaint ¶ 17].
4. Plaintiff reviewed [ARC's financial statements
and 10K Forms] in detail and materially relied
upon them in making its decision in the summer
of 1977 to invest in ARC through the Offering.
[Complaint ¶ 18].
5. To allay Plaintiff's fears, and to induce and
secure Plaintiff's participation in the
Offering, representatives of ARC [and the
defendants] personally met with
representatives of Plaintiff and other
institutional investors . . . [ARC financial
statements audited by defendants were]
supplied to Plaintiff, reviewed by it and
specifically relied upon in its investment
decision. [Complaint ¶ 20].
6. [T]he Defendants . . . misrepresented various
facts material to plaintiff's investment
decision . . . to induce Plaintiff's
investment purchase of ARC's Promissory Notes.
[Complaint ¶ 22].
The plaintiffs' characterization of the transaction in terms
of an "offering," an "investment," and an "investment decision"
by "institutional investors" adds very little to this court's
ability to determine whether the promissory notes are properly
considered a "security." These allegations are conclusory and
do not provide the facts necessary to establish federal
jurisdiction. As was the case in Canadian Imperial Bank of
Commerce Trust Company v. Fingland, 615 F.2d 465 (7th Cir.
1980), the court is left with the bare words "promissory note"
and conclusory allegations regarding the investment purpose of
the plaintiff bank.
The defendants, and Arthur Andersen in particular, contend
that these allegations cannot suffice to turn what is no more
than a commercial bank loan into a securities transaction in
order to establish federal jurisdiction. This court agrees.
In United Housing Foundation, Inc. v. Forman,
421 U.S. 837, 95 S.Ct. 2051, 44 L.Ed.2d 621 (1975), plaintiff
alleged that certain shares representing a purchaser's
interest in a nonprofit cooperative were within the meaning of
the term "security" under the Securities Act and the Exchange
Act. Similar to the banks' reliance upon the allegation that a
"note" was purchased for investment, the plaintiff in
Forman alleged that the shares were "stock," included
in the definition of "security" in both Acts.
The Supreme Court, drawing on the reasoning of SEC v.
W.J. Howey Co., 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244
(1946), reversed the Court of Appeals and affirmed the district
court's dismissal for lack of subject matter jurisdiction. In
so doing, the Supreme Court stated:
"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." "[I]n searching for the meaning
and scope of the word `security' in the Act[s],
form should be disregarded for substance and the
emphasis should be on economic reality."
Id., 421 U.S. at 848, 95 S.Ct. at 2058.
"In considering these claims, we must again
examine the substance — the economic
realities of the transaction — rather than
the names that may have been employed by the
parties. . . . The touchstone is the presence of
an investment in a common venture premised on a
reasonable expectation of profits to be derived
from the entrepreneurial or managerial efforts of
Id. at 851-52, 95 S.Ct. at 2060-61.
In this circuit, Forman has been construed in a
number of cases in which a bank loan, evidenced by a promissory
note of the borrower, was invoked as the jurisdictional basis
for a claim under the federal securities laws. In C.N.S.
Enterprises, Inc. v. G. & G. Enterprises, Inc.,
508 F.2d 1354 (7th Cir. 1975), the Court of Appeals held that whether or
not a note is a security depends upon whether the note is a
"commercial" or "investment" note. In that case the Court
affirmed the dismissal of a complaint for lack of subject
matter jurisdiction because in the context of the business
transaction out of which the claim arose the complaint failed
to show that the notes were anything
other than the evidence of an "ordinary commercial loan." The
Court stated that:
[N]othing alleged in the complaint indicated that
these two notes represent anything beyond the
borrowing of money to make partial payment upon
the purchase of the assets of a business.
Nothing alleged in the complaint indicated in any
way that the bank was an investor in the business
or a co-partner in the enterprise. The impetus for
the transaction appears to have come from the
borrowers who needed cash to complete the
purchase. There is no allegation that the bank
solicited the plaintiffs to interest, them in an
investment. The business enterprise involved was
to be operated by the plaintiffs, not by the bank
or by the defendants as an investment for the
plaintiffs. The complaint was silent as to any of
the factors which conceivably might tend to
transform an ordinary commercial loan into an
508 F.2d at 1362-63.
In Emisco Industries, Inc. v. Pro's Inc.,
543 F.2d 38 (7th Cir. 1976), the Seventh Circuit affirmed the dismissal
of a complaint for lack of subject matter jurisdiction because
the complaint failed to allege facts necessary to conclude that
a note given as consideration for a loan to be used to purchase
assets of a business represented an "investment in a common
venture premised on a reasonable expectation of profits to be
derived from the entrepreneurial or managerial efforts of
others." Id. at 40.
The complaints in these cases make it clear that ARC, the
issuer of the notes, "sought" a loan from plaintiffs in order
to refinance outstanding indebtedness to another bank and one
of its subsidiaries, and to increase its working capital.
See Complaint ¶ 17.
In determining whether or not jurisdictional allegations
relating to the existence of a "security" are sufficient under
the commercial-investment dichotomy approach, this court has
been educated in the difficulties of applying this test. As
Judge Sprecher pointed out in C.N.S. Enterprises, Inc.,
supra at 1359:
In one sense every lender of money is an investor
since he places his money at risk in anticipation
of a profit in the form of interest. Also in a
broad sense every investor lends his money to a
borrower who uses it for a price and is expected
to return it one day. On the other hand, the
polarized extremes are conceptually identifiable:
buying shares of the common stock of a publicly
held corporation, where the impetus for the
transaction comes from the person with the money,
is an investment; borrowing money from a bank to
finance the purchase of an automobile, where the
impetus for the transaction comes from the person
who needs the money is a loan. In between is a
gray area which, in the absence of further
congressional indication of intent or Supreme
Court construction, has been and must be in the
future subjected to case-by-case treatment.
These cases fall in that gray area and in this court's
opinion support Judge Friendly's observation that "efforts to
provide meaningful criteria for decision under the
`commercial-investment' dichotomy do not seem . . . to carry
much promise of success." Exchange National Bank of Chicago
v. Touche Ross & Co., 544 F.2d 1126
, 1136 (2d Cir. 1976).
In approaching the motions to dismiss the court notes that
defendant Arthur Andersen emphasizes the deficiency in the
factual allegations supporting jurisdiction and the court notes
that the Seventh Circuit has applied a much stricter standard
of pleading in the context of a Rule 12(b)(1) motion to dismiss
for lack of subject matter jurisdiction than it has applied to
an attack on a complaint for failure to state a claim upon
which relief can be granted. Compare Fingland, supra
with Conley v. Gibson, 355 U.S. 41, 78 S.Ct. 99, 2
L.Ed.2d 80 (1957).
Thus, the burden of pleading specific facts showing that the
jurisdictional requirement of a "security" is involved in a
case falls on the plaintiff, and given the Seventh Circuit's
decisions in this area it
would seem that a great deal of information would be required
in order to allege jurisdiction whenever a claim was based on
an instrument that falls in the "gray area" between a clearly
commercial and clearly investment instrument.
In Canadian Imperial Bank of Commerce Trust Company v.
Fingland, 615 F.2d 465 (7th Cir. 1980), the Court of
Appeals affirmed the dismissal of a complaint for lack of
subject matter jurisdiction and held that the following
allegations were insufficient to conclude that a certificate of
deposit was a security within the meaning of the Exchange Act:
In fact, through the period indicated, contrary to
its representations as to the investments it would
make of trust funds, Mercantile Bank from time to
time invested trust funds in excess of $500,000.00
in its own certificates of deposit. On information
and belief, plaintiff states that none said [sic]
certificates of deposit were guaranteed by
International Bank inasmuch as the information
conveyed to the beneficiaries about said
investments by Mercantile Bank was deliberately
inaccurate. Plaintiff believes that there was in
excess of a million and a half dollars so
invested. Had the beneficiaries known of this they
could have appointed an investment committee or
removed Mercantile Bank as Trustee.
On or about December, 1976, advisors of the
beneficiaries of the Trusts were informed that the
Trusts had some three million five hundred
thousand dollars not committed to liabilities or
other investments. Mercantile Bank further
informed the advisors of the beneficiaries that it
intended to invest said funds in certificates of
deposit in a bank or banks in London, England.
Contrary to said representations said funds were
invested, without the knowledge of the
beneficiaries or any of their advisors, in
certificates of deposit of Mercantile Bank. At
that time Mercantile Bank knew it would not redeem
the certificates of deposit.
Id. at 467-468.
The Seventh Circuit noted that the use of "invested" and
"investment" in the complaint in that case was conclusory. In
conclusion the Court of Appeals stated:
[O]n this record with this complaint there is no
showing of a scheme involving an investment of
money in a common enterprise with profits to come
from the efforts of others. Nor is there adequate
pleading of an investment in a common venture
premised on a reasonable expectation of profits to
be derived from the entrepreneurial or managerial
efforts of others. The complaint simply describes
a victim whose currency was being held in a
commercial transaction and not a victim-investor
aspiring for profits.
The definitional provision begins with the words
"unless the context otherwise requires" and if a
victim can adequately plead non-conclusory
allegations showing the context, substance, and
reality surrounding the sale or purchase of a
particular investment, he may well succeed.
However, such a pleading would require the great
host of additional facts that we have indicated
were lacking in the present complaint.
Id. at 470.
This court agrees with the defendant Arthur Andersen that the
complaints do not properly allege the existence of a "security"
for purposes of showing federal jurisdiction and that they
should therefore be dismissed. The parties have, however,
brought to the court's attention, through the submission of
additional materials relating to the transaction, enough
additional facts for this court to determine that the defect
appearing on the face of the complaint goes beyond pleading
The primary thrust of Coopers & Lybrand's and Alexander Grant
& Company's jurisdictional attack is that the promissory note
is not, in fact, a "security." This approach is also proper
under Rule 12(b)(1), Fed.R.Civ.P.
Recent decisions of the Court of Appeals for the Seventh
Circuit illustrate the accuracy of the observation that:
[A] motion under Rule 12(b)(1) may be used to
attack two different types of defects. The first
is the pleader's failure to comply with Rule
8(a)(1), which means the allegations in the
complaint are insufficient to show that the
federal court has jurisdiction over the subject
matter of the complaint. If the complaint does not
properly invoke the court's jurisdiction, then the
complaint is defective and, unless the deficiency
is cured, the motion must be granted regardless of
the actual existence of subject matter
jurisdiction. The other defect that may be
challenged under Rule 12(b)(1) is the court's
actual lack of jurisdiction over the subject
matter, a defect that may exist despite the formal
sufficiency of the allegations in the complaint.
Wright & Miller, Federal Practice and Procedure: Civil §
1350, p. 549.
It appears from the opinions in C.N.S. Enterprises Inc.
v. G & G Enterprises, Inc., 508 F.2d 1354, 1362 (7th Cir.
1975), and Fingland, supra, that these cases turned on
the insufficiency of the jurisdictional facts alleged in the
complaint. On the other hand, the opinions in Emisco
Industries, Inc. v. Pro's Inc., 543 F.2d 38 (7th Cir.
1976) and Frederiksen v. Poloway, 637 F.2d 1147 (7th
Cir. 1981), cert. denied, 451 U.S. 1017, 101 S.Ct.
3006, 69 L.Ed.2d 389 (1981), make it clear that the motions to
dismiss were granted because facts in the record but outside of
the complaint showed that the notes at issue were not
"securities" for purposes of the federal securities laws.
The promissory notes at issue in this case are attached as
Exhibit A to plaintiffs' memoranda in opposition to the motions
to dismiss. They are dated September 15, 1977 and provide that
ARC will pay to the banks an aggregate amount of $7,500,000. in
30 quarterly installments of "one/thirtieth of the original
principal amount" plus
interest at the rate of one percent above the
Prime Rate, . . . during each of the Company's
fiscal years following any fiscal year at the end
of which the sum of the Company's Consolidated Net
Worth . . . plus its Consolidated Subordinated
Indebtedness is at least Twenty-five Million
Dollars . . .; three quarters of one percent above
the Prime Rate . . . during each of the Company's
fiscal years following any fiscal year at the end
of which the sum of the Company's Consolidated Net
Worth plus its Consolidated Subordinated
Indebtedness is at least Twenty-five Million
Dollars but less than Thirty Million Dollars; and
one half of one percent above the Prime Rate . . .
during each of the Company's fiscal years
following any fiscal year at the end of which the
sum of the Company's Consolidated Net Worth plus
its Consolidated Subordinated Indebtedness is
equal to or greater than Thirty Million
Dollars. . . .
"Prime Rate" as used in this Note shall mean
the rate of interest charged by the payee named
herein on 90-day unsecured loans made to its most
substantial and credit-worthy commercial
borrowers . . . (emphasis added)
See also sections 1.2(b) and 8.2(p) of Note
Agreements, Exhibit B to Plaintiff's Memoranda.
The above-quoted language from the notes is strong evidence
that the instruments present nothing more than normal
commercial loans with interest tied to the prevailing Prime
Rate. See Amfac Mortgage Corp. v. Arizona Mall of Tempe,
Inc., 583 F.2d 426, 434 (9th Cir. 1978); United
California Bank v. The Financial Corp., 557 F.2d 1351,
1359 (9th Cir. 1977) (both applying "risk capital" test of
security); Lincoln National Bank v. Lampe, Civ. No.
75-2806, slip op. at 10 (N.D.Ill. June 19, 1978) aff'd
and adopted sub. nom.; Lincoln National Bank v.
Herber, 604 F.2d 1038, 1042 (7th Cir. 1979).
The plaintiffs argue that the fact that the interest rate
fluctuates above the Prime Rate depending on the equity of the
Company is indicative of the investment character of the
transaction. On the contrary, the fact that the interest rate
decreases as assets available for payments on the notes
increase indicates the commercial character of the notes. As
the risk of default decreases, the interest rate decreases
This court sees in this provision and in section 5.6 of the
contemporaneously executed Note Agreements no indication that
plaintiffs "saw themselves as together engaged in a common
enterprise which had as its goal ARC's prosperity." Plaintiff's
Memorandum of Law in Opposition to Motion of Defendants to
Dismiss, p. 15. This provision merely reflects the reduced
risks associated with a loan to a more substantial commercial
borrower, rather than "an investment in a common venture
premised on a reasonable expectation of profits to be derived
from the entrepreneurial or managerial efforts of others."
Section 5.6 of the Note Agreements which the plaintiffs claim
evidences the investment character of the transaction contains
ARC's covenants that "the sum of its Consolidated Net Worth
plus its Consolidated Subordinated Indebtedness" will increase
in each of the years 1977 through 1982 by a specified amount.
The plaintiffs contend that a "variable interest rate tied in
with [a] requirement of corporate growth . . . [provides' an
ostensible `incentive' for ARC to meet explicit corporate
growth guidelines, [demonstrating] . . . that
plaintiff[s] . . . and ARC saw themselves as together
engaged in a common enterprise which had as its goal
ARC's prosperity." Id.
This court does not agree that these provisions evidence the
investment character of the transaction. The covenant contained
in section 5.6 of the note agreements is tied to another
provision in the note agreements making a breach of that
covenant an event of default when the breach "continues for
more than 30 days after written notice thereof shall have been
received by the company from the holder of the notes." Note
Agreement § 7.1(d) The notes provide that upon the
occurrence of "an Event of Default as defined" in the Note
Agreement, the maturity of the note may be accelerated. These
provisions along with many other defined "Events of Default,"
see Note Agreement § 5.1-5.16, seem clearly to be
of the kind and character that any bank making a large
commercial loan would insist on in order to insure payment of
the debt and minimize its risk as a commercial lender.
This court agrees with the argument of defendant Arthur
Anderson & Co. that the above-mentioned provisions of the note
and note agreements, providing for acceleration of the note
upon 30 days notice to ARC in the event that ARC's "equity"
fell below the stated amount in section 5.6 of the Note
Agreement indicates the commercial character of the
"The Bank's insistence upon a myriad of financial
`fail safe' systems [see sections
5.1-5.16 of Note Agreement] is the archetype of a
commercial loan transaction and the antithesis of
a `common venture premised on a reasonable
expectation of profits . . .'"
Reply Memorandum of Arthur Anderson & Co. in Support of its
Motion to Dismiss, p. 12.
The plaintiffs also argue that the use of the loan proceeds
is evidence of the sale of a security. This court again
disagrees. Section 5.1 of the Note Agreement limits the use of
loan proceeds to the immediate repayment of outstanding debt in
the amount of $5,200,000. to Illinois National Bank and Trust
Company of Chicago and Guaranty Reinsurance Company Limited, an
ARC subsidiary. The remainder of the $7,500,000. was to be
applied to the expenses of the loan transaction and was to be
used by ARC to supplement its working capital. This court
believes that all of these uses of the proceeds of the
transaction are consistent with commercial loans made by banks.
Cf. United California Bank v. The Financial Corp.,
557 F.2d 1351, 1359 (9th Cir. 1977) (loan for working capital);
Great Western Bank & Trust v. Kotz, 532 F.2d 1252,
1258 (9th Cir. 1976) (loan to maintain financial position).
The plaintiffs have also pointed to references in ARC's
financial statements and in a Form 10-K filed with the
Securities and Exchange Commission which they maintain shows
that ARC considered the notes securities. However, the
defendants have pointed to a number of places in the Note
Agreement, as supplemented and amended
where the parties to the transaction characterized the
transaction in terms of "lender" and "borrower." The court
believes that ARC's characterization of the notes in the
statements relied on by the banks is, at best, a highly
ambiguous indication that ARC considered the transaction a sale
The court has attempted to focus on the economic realities
surrounding the transaction and has been left unpersuaded by
the plaintiffs' attempts to characterize notes, seemingly
evidencing only a large commercial bank loan, as securities,
under the six factor test discussed in C.N.S. Enterprises,
Inv. v. G & G Enterprises, Inc., 508 F.2d 1354 (7th Cir.
1975). This court has been persuaded by the arguments of the
three defendants that the plaintiffs have failed to show that
the notes at issue are anything more than the evidence of a
commercial loan to a substantial borrower.
Moreover, the court has been persuaded by the arguments of
the defendants and the documentation submitted by the parties,
that the economic realities of the transaction indicate that
the transaction at issue was a commercial loan. It is clear
that the borrower ARC sought the financial assistance of three
banks to "roll-over" existing indebtedness and supplement its
working capital. The notes provided for a variable interest
rate tied to the Prime Rate, i.e., the rate charged the banks'
"most substantial and credit-worthy commercial borrowers." The
Note Agreements provided a variety of risk reducing provisions
and events of default calling for immediate acceleration of the
note at the Banks' option, thus minimizing the extent of the
Banks' reliance on the efforts of others. Only three notes were
involved in the transaction and the total dollar amount of the
transaction represented only a fraction of ARC's consolidated
liabilities and shareholder's equities. See Exhibit D
to Plaintiffs' Memoranda. These facts lead the court to agree
with defendants that the plaintiffs have failed to demonstrate
that these notes are securities under the commercial/investment
dichotomy test applied in this circuit and thus, have failed to
demonstrate the existence of subject matter jurisdiction over
the complaints filed in these cases.
Defendants' motions to dismiss for lack of subject matter
jurisdiction are therefore granted.