Appeal from the United States District Court for the Southern District of Indiana, Indianapolis Division. No. IP 78-C-34 -- William E. Steckler, Judge.
Before PELL, Circuit Judge, FAIRCHILD, Senior Circuit Judge, and BROWN, Senior District Judge.*fn*
FAIRCHILD, Senior Circuit Judge. This is an appeal from a judgment permanently enjoining defendant Holschuh, a former corporation president, from committing future violations of the registration and antifraud provisions of the federal securities laws. The action arose out of a plan to raise funds for the corporation by having a third-party broker form and sell interests in limited partnerships which would invest in the corporation's coal mining venture on the expectation of receiving highly profitable returns out of reciprocal lease arrangements between the corporation and the partnership. We hold: (1) that the exemption from registration liability afforded by subsection 4(1) of the Securities Act is inapplicable to this case because the transaction in question involved a distribution of new securities by an "issuer"; (2) that since the defendant was a "necessary participant" and "substantial factor" in the sale of the unregistered partnership interests, he was properly held primarily liable for those violations, notwithstanding the fact that he had no actual contact with the offerees; (3) that in ascertaining the existence of a scheme to defraud investors, the district court did not err in taking cognizance of defendant's post-sale misrepresentations which related back to his earlier deceptive statements; and (4) that the defendant acted with the degree of scienter necessary to find him liable for the antifraud violations. We affirm the award of a permanent injunction because a reasonable likelihood of future violations by the defendant has been shown.
After trial, the district court made detailed findings of fact. Their substance is reflected in the following narrative.
In October 1976, Pocahontas Coal Reserves (PCR), a West Virginia corporation, was formed by Edward E. Holschuh, Dominick E. Bartone, and Harold Fanklin for the purpose of securing and developing coal leases in that state. Mr. Holschuh had previously worked in the insurance business and had been part of several securities related enterprises.*fn1 In the summer of 1976, he was introduced by Mr. Franklin, whom he had known since 1974, to Mr. Bartone, who controlled a company called Coal Reserves for which Mr. Franklin then worked. Immediately prior to the introduction, Mr. Franklin told Mr. Holschuh that Mr. Bartone had served time in jail for either tax law violations or gunrunning. At the initial meeting, Mr. Holschuh was informed that Mr. Bartone had coal leases on property in West Virginia that he was interested in developing, and for that purpose the three decided to organize PCR. It was made clear to Mr. Holschuh that Mr. Bartone did not want his name associated with the new corporation, nor did he wish to be an officer or directly to own any of the stock. Mr. Holschuh learned, either then or in the fall of that year, that Mr. Bartone's reticence was due, at least in part, to his connection with the failure of an Ohio bank, which led in October, 1976 to his indictment for fraud.
In September or October 1976, Mr. Holschuh traveled to West Virginia to retain a law firm to prepare and file the necessary papers for creating PCR. Following incorporation on October 12, 1976, Mr. Holschuh, Mr. Bartone, and Mr. Franklin met to discuss the designation of officers and distribution of shares. It was decided that Mr. Holschuh would be PCR's president,*fn2 Mr. Franklin its vice-president, and Ms. Shirley Dixon, its secretary-treasurer.*fn3 Mr. Bartone was not made an officer, but was to have the status of a general manager, overseeing any mining operations. Mr. Holschuh was to receive 20% of the PCR stock and the remaining 80% was to be issued to Joseph Russo, a front-man for Mr. Bartone. Mr. Holschuh, Mr. Franklin, Ms. Dixon, Mr. Russo, and three former acquaintenances or business associates of Mr. Holschuh served on the PCR board of directors.
Among the possibilities considered by Mr. Holschuh, Mr. Bartone, and Mr. Franklin for securing the funds necessary to develop the coal properties was the formation of a limited partnership in which interests would be sold to outside investors. Mr. Holschuh had experience in this type of financing,*fn4 but he determined that there was insufficient time for CPR to mount such an effort on its own before the effective date of the Tax Reform Act of 1976, because PCR had neither a sales force nor a ready pool of customers. On January 1, 1977, the new Act would substantially reduce the tax advantages of such investments, and thus Mr. Holschuh decided that it was necessary to secure the services of an established broker-dealer, experienced in promoting tax shelters. This need was met when Mr. Holschuh was introduced to Buddy C. Stanley.
B. Formation Of The Limited Partnerships
Mr. Stanley was an officer and controlling person of Asset Management, an Indiana corporation which he had formed in 1973 to provide investment services to his customers. Asset Management had two wholly owned subsidiary corporations, Asset Development, which was set up by Mr. Stanley to serve as a general partner and management company for limited partnership ventures, and Asset Securities, a broker-dealer registered with the SEC and the state of Indiana.
In October or November 1976, Mr. Holschuh was introduced to Mr. Stanley by an old friend. Mr. Holschuh informed Mr. Stanley that PCR had coal leases in West Virginia that required further financing to develop. Mr. Stanley indicated that some of his customers might be interested in investing in such a venture, and the two discussed the possibility of forming at least one limited partnership.
Three or more additional meetings were held between Mr. Holschuh and Mr. Stanley before the end of December 1976, for the purpose of formalizing the details of the venture and discussing the coal properties which PCR purportedly had available. Also in attendance on these occasions were Mr. Franklin and Richard D. Hodgin, an attorney employed by Asset Development. During the course of the meetings, Mr. Holschuh and Mr. Franklin were introduced as the president and vice-president of PCR and at no time was Mr. Bartone's name or relationship to PCR mentioned.
At the meetings, Mr. Holschuh told Mr. Stanley that PCR had coal leases on two pieces of property in West Virginia, referred to as the Twohig and Patterson properties, for which it needed $200,000 to commence mining operations. He also said that PCR had two other West Virginia parcels available, known as the McGrew property and the Sun Mine, and that another parcel was going to be leased from the Georgia-Pacific Corporation. After discussions concerning these properties, it was decided that Mr. Stanley would form five limited partnerships, each of which would invest $100,000 in the venture.*fn5 Mr. Holschuh testified at trial that he told Mr. Stanley that the monies raised by the sale of the partnership interests would be used to develop the coal properties. He agreed with Mr. Stanley that PCR would lease to each partnership an interest in coal producing property and that PCR or an affiliate would be responsible for actually mining the coal. It was further determined that the investors could expect at least a $400,000 return on each $100,000 investment over a four-year period.
For the purpose of implementing the mining ventures, Mr. Holschuh formed Pocahontas Coal Processors (PCP), a wholly owned subsidiary corporation of PCR. Each partnership was to sublease to PCP the properties it had leased from PCR. PCP would secure the necessary mining permits, contract out work, oversee the actual coal mining, and make royalty payments to the partnerships on at least a specified tonnage of coal each year. The partnerships' profits would be determined by the extent to which the royalty payments from PCP exceeded their lease payments to PCR, figured at $1.00 per ton on at least 100,000 tons for each partnership for four years.
On December 21, 976, Mr. Stanley, a former associate of his named David Kimball, and Asset Securities began soliciting investors, primarily thorugh mail distribution of an offering circular prepared by Mr. Hodgin. Although Mr. Holschuh had no direct part in writing the circular and did not read it prior to distribution, the district court expressly found that much of the information contained therein was directly traceable to his conversations with Mr. Stanley.*fn6 Among other things, the circular informed potential investors that the purpose of the partnerships would be to lease from PCR the mining rights to certain West Virginia properties; that PCR represented that it had title to the properties and the right to mine the coal therefrom; that the subsidiary, PCP, was to be primarily responsible for the mining and sale of the coal; and that investors could anticipate at least a 400% return on their investments over a period of four years. Attached to the circulars were copies of the proposed lease agreement.
On December 28, 1978, while the solicitation of investors was still underway, Mr. Holshuh and Mr. Stanley met to finalize the details of the transaction. During that meeting the partnerships were actually formed. Mr. Holschuh signed the leases between PCR, PCP, and the five limited partnerships, which granted interests in the Georgia-Pacific property, the McGrew property, and the Sun Mine.*fn7 The terms of the lease agreements were essentially identical to those proposed in the attachments to the offering circulars and represented that PCR had title to the leaseholds assigned to the partnerships. The trial court found, however, that as of December 28, 1976, PCR had no leasable interest in any of the properties. Although it had an option to lease the Georgia-Pacific property, that right was not exercised until after January 1, 1977, and even then the property could not be subleased without first securing Georgia-Pacific's approval, which in fact was not obtained until March 1977. As to the McGrew property, PCR held an option to purchase, but no purchase was made until February 1977.And with respect to the Sun Mine, Mr. Holschuh testified at trial that PCR never had obtained any option or interest therein.
The solicitation of investors ended on December 30, 1976, by which time the five partnerships had been fully funded. Interests had been sold to 59 investors, only one of whom had any experience in coal related ventures. The interests were never registered with the SEC.
Of the money raised by the solicitation, PCR received $200,000 in the form of an advance from the partnerships on December 28, 1976. The following day, Mr. Bartone attended and dominated a meeting of the $200,000 would be spent. He would receive $100,000, Mr. Holschuh $25,000, Mr. Franklin $25,000, and Ms. Dixon $15,000. Thus, only one day after PCR had received the money, and at a time when solicitation was continuing and the participants were still uncertain whether the additional $300,000 ...