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Sutter v. Groen

decided: August 20, 1982.


Appeal from the United States District Court for the Central District of Illinois, Peoria Division. No. 81 C 1158 -- Robert D. Morgan, Judge.

Bauer and Posner, Circuit Judges, and Larson, Senior District Judge.*fn*

Author: Posner

POSNER, Circuit Judge.

The complaint in this federal securities case alleges that the plaintiff, Sutter, owns 70 percent of the common stock of Happy Radio, Inc., a corporation whose only significant asset (apart from the capital contributed by its shareholders) is an agreement with the defendants, Mr. and Mrs. Groen, the sole shareholders of Bret Broadcasting Corporation, to purchase all of the Groens' stock in Bret Broadcasting over a 12-year period, during which Happy Radio has the right to manage Bret. The complaint alleges that the Groens overstated Bret Broadcasting's earnings in order to induce Happy Radio to pay an inflated price for Bret Broadcasting's stock and investors to buy stock in Happy Radio, and that Sutter was induced by these misrepresentations to buy stock in Happy Radio which is now worthless.

Count I of the complaint alleges that the defendants' conduct violated Rule 10b-5 of the Securities and Exchange Commission, 17 C.F.R. § 240.10b-5. Rule 10b-5, promulgated in 1942 pursuant to section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), which authorizes the Commission to promulgate rules against deceptive practices "in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered," forbids misrepresentations and related practices "in connection with the purchase or sale of any security." The federal courts have jurisdiction under 15 U.S.C. § 78aa and 28 U.S.C. § 1331 to adjudicate alleged violations of the rule.

Count II of the complaint alleges that the defendants' conduct violated state tort law. It bases federal jurisdiction on the doctrine of pendent jurisdiction and on 28 U.S.C. § 1332 (diversity of citizenship).

The defendants moved to dismiss Count I for failure to state a claim, relying on Frederiksen v. Poloway, 637 F.2d 1147 (7th Cir. 1981), and Count II for want of federal jurisdiction, pointing out that a pendent claim is invariably dismissed when the federal claim to which it is pendent is dismissed before trial, United Mine Workers v. Gibbs, 383 U.S. 715, 726, 16 L. Ed. 2d 218, 86 S. Ct. 1130 (1966), and attaching an affidavit to prove that Sutter and the Groens are citizens of Illinois, so that jurisdiction cannot be based on diversity either. The district court treated the motion as one for summary judgment, granted it, and dismissed the complaint. Sutter appeals.

Although the judgment entered by the district court purports to dismiss the entire action, not just Count I, the district court's opinion contains no reference to Count II, or indeed to any claim other than the Rule 10b-5 claim; and the district court's docket sheet indicates that pretrial discovery is continuing. Concerned that we might not have jurisdiction over this appeal, we issued an order on June 8, 1982, asking the district judge to tell us whether he had meant to dismiss the complaint in its entirety, and if not whether he wanted to certify his dismissal of Count I for immediate appeal under Rule 54(b) of the Federal Rules of Civil Procedure. He has responded by advising us that he had not intended to dismiss any diversity claim and by certifying his dismissal of Count I for an immediate appeal. His Rule 54(b) certification is valid even though made after the filing of the notice of appeal in this court. Local P-171, Amalgamated Meat Cutters & Butcher Workmen of North America v. Thompson Farms Co., 642 F.2d 1065, 1068 (7th Cir. 1981).

The issue on the merits is whether Sutter has succeeded in alleging "the purchase . . . of any security"; if he has not, he cannot invoke Rule 10b-5. The complaint mentions two purchases: Happy Radio's purchase of 100 percent of the stock of Bret Broadcasting from its owners, the Groens; and Sutter's purchase of stock in Happy Radio. The first is squarely within the scope of the sale of business doctrine adopted by this circuit in Frederiksen v. Poloway, supra. Under that doctrine, which has been adopted by two other circuits as well, see Chandler v. Kew, [1979] CCH Fed. Sec. L. Rep. P 96,996 (10th Cir. 1977); King v. Winkler, 673 F.2d 342 (11th Cir. 1982), the sale of an entire business to a single purchaser is not considered a "security" transaction for purposes of federal securities law even if it is accomplished by a sale of stock or other securities. We could thus reject the claim that Happy Radio's purchase of 100 percent of the common stock of Bret Broadcasting provides a basis for invoking Rule 10b-5 with a citation to Frederiksen, or to Canfield v. Rapp & Son, Inc., 654 F.2d 459, 464-65 (7th Cir. 1981), which reaffirmed Frederiksen. But instead we have decided to consider the doctrine yet again, this time in light of the Second Circuit's emphatic rejection of it (though by only a 2 to 1 vote) in Golden v. Garafalo, 678 F.2d 1139 (2d Cir. 1982), and the Supreme Court's recent decision in Marine Bank v. Weaver, 455 U.S. 551, 102 S. Ct. 1220, 71 L. Ed. 2d 409 (1982). Both decisions postdate Canfield.

The term "security" as used in the Securities Exchange Act is defined in section 3(a) (10) of the Act, 15 U.S.C. § 78c(a) (10), as follows: "Unless the context otherwise requires . . ., the term 'security' means any note, stock, treasury stock, bond, debenture . . . or in general, any instrument commonly known as a 'security' . . . ." (The corresponding definition in the Securities Act of 1933, 15 U.S.C. § 77b(1), is nearly identical, but we shall confine our attention in this opinion to the 1934 Act.) Read literally, this definition embraces the common stock of Bret Broadcasting Corporation; the question is whether it should be read literally. There is considerable judicial authority against doing so. Though most of the early cases involved promissory notes (see Exchange Nat'l Bank of Chicago v. Touche Ross & Co., 544 F.2d 1126, 1133-36 (2d Cir. 1976), for a review of those cases), United Housing Foundation v. Forman, 421 U.S. 837, 44 L. Ed. 2d 621, 95 S. Ct. 2051 (1975), on which this court relied heavily in Frederiksen, involved stock, albeit stock in a nonprofit cooperative housing corporation. To obtain a cooperative apartment from the corporation the would-be tenant had to purchase a fixed number of shares for each room desired, at a fixed price per share; and he could sell his shares only to a new occupant of the same apartment or back to the corporation, and only at the price at which he had bought the shares plus a pro rata share of the amortization of the mortgage on the apartment complex. The stock thus lacked the most important characteristics of corporate stock and in particular had no investment value -- it could yield its owners neither dividends nor appreciation. It was really just a deposit recoverable from either the landlord or the succeeding tenant.

The Supreme Court held that it was not a "security." But the Second Circuit in Golden distinguished Forman from Frederiksen, pointing out that the question in Forman had been how to characterize an unconventional instrument -- something called "stock" but lacking the essential attributes of corporate stock -- while the sale in Frederiksen (as in the present case) was of garden-variety common stock although the purpose was to acquire an entire business rather than to invest passively. On this view, Forman merely used the catch-all definitional phrase in section 3(a) (10) -- "any instrument commonly known as a 'security'" -- to limit the range of meanings otherwise assignable to the specifically enumerated instruments, such as "stock."

This may take care of Forman, but Marine Bank v. Weaver, supra, provides, we think, solid support for Frederiksen. At issue in Weaver was a six-year seven-and-one-half percent certificate of deposit issued by a bank and insured by the Federal Deposit Insurance Corporation. Such a certificate of deposit is a type of promissory note -- and "note" of course is one of the instruments specifically listed in section 3(a) (10) -- and it is also what is "commonly known as a 'security.'" It is an unusually safe security, but no safer than a Treasury bill, which like other U.S. government obligations is also commonly known as a security. Yet the Supreme Court held that the bank's certificate of deposit was not a security under the Securities Exchange Act. The Court reasoned that "it is unnecessary to subject issuers of bank certificates of deposit to liability under the antifraud provisions of the federal securities laws since the holders of bank certificates of deposit are abundantly protected under the federal banking laws." 102 S. Ct. at 1225, 71 L. Ed. 2d at 416. The Court got around the seemingly uncompromising statutory language by treating the word "context" in the introductory clause of section 3(a) (10) as having reference to the economic as well as linguistic context. Forman had dealt with this problem more directly by remarking -- we paraphrase -- that in interpreting statutes as in interpreting Biblical commands, the letter killeth but the spirit giveth life. See 421 U.S. at 849.

The method that the Supreme Court used in Weaver to decide whether a securities transaction is within the Securities Exchange Act is not limited to certificates of deposit insured by the FDIC. The Court disregarded the literal meaning of section 3(a) (10) in order to avoid casting the net of Rule 10b-5 liability farther than the Congress that enacted the Securities Exchange Act can reasonably be thought to have wanted it cast; it would be inconsistent to subject every sale of common stock to Rule 10b-5 regardless of legislative purpose. Of course if Congress lays down a flat rule for the courts to follow they have no right to cut it down to fit their conception of legislative purpose. Western Transport Co. v. Wilson & Co., 682 F.2d 1227, slip op. 4-5 (7th Cir.1982). But there is no indication that Congress wanted to do this in the Securities Exchange Act. It defined "security" very broadly, but presumably to prevent the financial community from evading regulation by inventing new types of financial instruments rather than to prevent the courts from interpreting the Act in light of its purposes.

So we may and perhaps in light of Weaver must ask whether the sale of 100 percent of the common stock of Bret Broadcasting was the kind of transaction that Congress, if it had foreseen the promulgation of Rule 10b-5, would have wanted brought within its scope. We must ask in other words what class of people Congress wanted to protect by enacting the Securities Exchange Act, and in particular section 10(b). The answer is not in doubt: investors. In his message to Congress of February 9, 1934, President Roosevelt recommended "the enactment of legislation providing for the regulation by the Federal Government of the operations of exchanges dealing in securities and commodities for the protection of investors, for the safeguarding of values, and so far as it may be possible, for the elimination of unnecessary, unwise, and destructive speculation." S. Rep. No. 792, 73d Cong., 2d Sess. 2 (1934). These are investor interests. The Report of the Senate Committee on Banking and Currency describes the objective of the legislation as follows: "The three principal problems with which the bill deals are the excessive use of credit for speculation, the unfair practices employed in speculation, and the secrecy surrounding the financial condition of corporations which invite the public to purchase their securities." S. Rep. No. 792, supra, at 5. The victims of these (real or imagined) evils are investors. The Committee's report contains a chorus of references to "disastrous results to investors," "tremendous losses to the investing public," "losses incurred in speculative transactions," "severe financial losses . . . ...

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