Petition — U. S. Steel Credit Corp. v. American Fletcher Mortgage Co.

» Court, US,

i i oo

80-1484

No. «FEB. 27 198

— . STEVAS,

CLERK

In the

Supreme Court of the Anited States

Octoser Term, 1980

U.S. STEEL CREDIT CORPORATION,

Petitioner,

vs.

AMERICAN FLETCHER MORTGAGE COMPANY,

INC., AMERiCAN FLETCHER NATIONAL BANK

AND TRUST COMPANY, and AMERICAN FLETCHER

CORPORATION,

Respondents.

PETITION FOR WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE SEVENTH CIRCUIT

(Seventh Circuit Nos. 80-1485, 80-1719)

Wriuiam A. Wick

1000 Merchants Bank Bldg.

11 South Meridian Street

Indianapolis, Indiana 46204

(317) 632-1348

Attorney for Petitroner

Of Counsel for Petitioner:

NicHo.as C. NizaMoFr

Waite, Ravs, Rets, Wick & RimGNer

1000 Merchants Bank Building

11 South Meridian Street

Indianapolis, Indiana 46204

Reiciasienerieie AS AE: OT NY CY RINE AP SRM

The Scheffer Press, Inc.—(312) 263-6850

.

1

QUESTIONS PRESENTED

1. Did the Court of Appeals err in affirming the Dis-

trict Court’s judgment dismissing the securities fraud

counts of Petitioner’s counterclaim on the ground that

Petitioner’s participation shares in mortgage loan notes

held by the Respondent Mortgage Company were not

“securities” under the federal securities acts?

2. Did the Court of Appeals err in concluding that a

participation share in a mortgage loan note held by a

commercial lender is not an “investment” within the

meaning of the Supreme Court’s Howey and Forman

decisions?

3. Did the Court of Appeals err in concluding that

Petitioner’s anticipated share of any interest paid on

the loans was not an “expectation of profits” under the

Howey and Forman decisions, because, said the Court of

Appeals, “the rate of return was [not] in any way de-

pendent on the actual profits, if any, of the project’?

4. Did the Court of Appeals err in concluding that

under the Howey and Forman decisions the expected re-

turn on a mortgage loan participation is not “derived

from the entrepreneurial or managerial efforts of others”,

if the investment decision is based in part on the par-

ticipant’s own business judgment and if the participa-

tion agreement prohibited modification of the loan or re-

lease of the collateral without participant’s consent and

authorized the participant to compel foreclosure in the

event of a default?

li

TABLE OF CONTENTS

PAGE

Report of Opimiew ...niciicnnnnsasmnnceesens ae vi

Suariadictional GOWNS oocscsescsscsssoxcssoscaccemeesaene vi

Applicable stytate oncsssscssisssscasscesinne vi

Statement of the case .......cccccsocccssssesesssssssssssssessessscosscesoess 1

BIC oa scecierssvrscinisineniaseanaiadalada ee 10

A. Seven reasons for granting petition coc. 10

B. Whether or not the notes were ‘‘investments”’

by Respondent Mortgage Company, Petitioner’s

participations therein were ‘‘investments’’ ...... 14

C. Petitioner’s expected return on its participa-

tions was an expectation of ‘‘profits’? under

Towey-F OP MG ssscvsscsssiieessssrarigteman ee 16

D. As a participant, Petitioner necessarily looked

to the ‘‘entrepreneurial or managerial efforts’’

of the Respondent Mortgage Company for any

profits on the Cromwell participations. ............ 18

TABLE OF AUTHORITIES

Cases

PAGE

Aaron v. SEC, weeeue Ue weelee , 100 S.Ct. 1945

(FOB) scciciseasecssiansinieiiens ieee ntssheadeddineleanealiaaa’ 11,14

CNS Enterprises, Inc. v. G@ & G Enterprises, Inc.,

908 F.2d 1354 (7th Cir. 1975) ciccccccccssssssssssssscessssceees 21

Canadian Imperial Bank of Commerce Trust Co. v.

Fingland, 615 F.2d 465 (7th Cir. RGF - sncsssinmisecensee 16

Commercial Discount Corp. v. Lincoln First Commer-

cial Corp., 445 F.Supp. 1263 (S.D.N.Y. 1978) 102. 13, 22

Eason v. General Motors Acceptance Corporation, 490

Fad GBA (7th Clr. 1978) .ncccsrssssevoressnssne ee 11

PAGE

Emisco Industries, Inc. v. Pro’s Inc., 543 F.2d 38 (7th

ns CUE ssaieuschtkchicaiisclsesstiabcedantvincinesieabisteenenisotaniienbimsetaniense 13

Exchange National Bank v. Touche Ross & Co., 544

ee ee CN Se BCG) eciciscn sycnseissrscsnrgcbivncducoveanis 12

FBS Financial v. CleveTrust Realty Investors, Fed.

Sec. L. Rep. (CCH) 96,341 (N.D.Ohio 1977) ........ 14

Goodman v, Epsteim, 582 F.2d 388 (7th Cir. 1978) .... 138

Great Western Bank & Trust v. Kotz, 532 F.2d 1252

I TIES IPUDE, - sincusnsspehatecanniibasaiindiicansbepa-eubnesnnalinedounlaboanialspines 24

In re Yale Express System, Inc., 245 F.Supp. 790

SOE Re, | IIE | clictaclaescelcasislovins tin bd slecnssadilasapamanianoseasnnaniee 18

International Brotherhood of Teamsters v. Daniel,

Ge Ui. Sk, BO AE, TH CLI TO) vvvcrssccssesscncsrmsnsonsssens 16

Lehigh Valley Trust Co. v. Central National Bank of

Jacksonville, 409 F.2d 989 (5th Cir. 1969) wu... 13, 22

Lincoln National Bank vy. Herber, 604 F.2d 1032

NN Eisenia rice ci cae datacehig as akanenanmaaseeneieennaavenNe Nein 15

NBI Mortgage Investment Corp. v. Chemical Bank

[1976-1977] Fed. See. L. Rep. (CCH) {95,632

(SDNY 1978) [1977-1978] Fed. See. L. Rep. 196,066

NE I iin asd tlc dadacsipa ne omlecanesadadentrnnpbeearomeieies 13

Provident Nat. Bank v. Frankford Trust Co., 468

PR, GED CRB EE, TEER) cacscsseicscscncicessnnsesecccsssecseens 14

Rubin v. United States, 41 CCH S.Ct. Bull. p. B824

ERIIITED: <jncihsdusesdensdacecoesbeedladpndisonicalacscasncniiesasninnsaashusbeiaieannivntes 15

SEC v. Capital Gains Research Bureau, Inc., 375 U.S.

A, Re ee Fe ID rice reetccindeniscessesceresersincsssnenesies 14

SEC v. Glenn W. Turner Enterprises, Inc., 474 F.2d

ee. Cle SED entetecinecinotamenicsemmnndin 20

SEC v. W. J. Howey, 328 U.S. 293, 66 S.Ct. 1100

IIE E:: as neeassuitigusibiniialasepekapvanselesnncdwebinieiaaeniatineans 11, 15-16, 20-21

iv

os PO a PAGE

Tcherepnin v. Knight, 389 U.S. 332, 88 S.Ct. 548

EGDUED) . shaaheiulasasdedessunsasstnadeekheesiibaiadieienidecsdenniisinesutiiades 11, 16,17

United American Bank of Nashville v. Gunter, 620

Be SO CI TID aaicsnceccsnsocssostcavensssssinancsenionnes 13

Umited California Bank v. THC Financial Corp., 557

ee CU Ra RED asacieecticsisntccnsenscaciatacerestsancs 22

United Housing Foundation v. Forman, 421 U.S. 837,

95: S.Ct. 2051 (1975) ...cccccccoces. 11, 12, 15, 17, 18, 20, 21, 25

United States v. Naftalin, 441 U.S. 768, 99 S.Ct. 2077

LACE Aa AAPOR LOR ENDO D et ert PA ON LEP Oa PCT 10

Williamson v. Tucker, 632 F.2d 579 (1980) occ 17

Statutes

Securities Act of 1933-15 U.S.C. §77(b)(1) veces vi

Securities Exchange Act of 1934-15 U.S.C. §78¢

NITE cesccdbed caicaeel botsadelscatitbidecstaiasccvcicie:sncetniaoesesaetesanmtemea oak: Vi, Vii

I aaa a he vi

Oe MR I Siac celal deat ais da cepeedadiines chun 3

Oe UII SEN siciscts ccna ectcencteebidecinmiinconesasinmmaciamsnlearns 3

Oe ieee ee vi

Rules

Ie BN = wrstiaraicsoceantcicesinasivecdncechcaasd 19

SOP: CPUS TG TG oasisceccoccnnecncecevsstarsssvesesocsaiecsoncs vi

Other Authorities

Bank Loan Participations: The Afirmative Duty to

Disclose Under SEC Rule 10b-5, 27 Syracuse L.Rev.,

ey GER CRE, TTB) aveesescccscecccscsscsassocsessesecnssasoncsess 23

*

v

PAGE

Jamk, The Colocotronis Dispute: When is a Loan

Participation Share a Security, 13 J. Int'l. Law

i seoidesshinsitliinowtbion 18

Loan Participations as Securities, 8 Cal. W. Int’l. L.

RE. 23

S. Rep. No. 47, 73d Cong., 1st Sess., to accompany

SN ee 14

Webster’s New International Dictionary Unabridged

en cacceemnniencnscmtsnoeincnnenebenase 15

vi

REPORT OF OPINION

The opinion of the United States Court of Appeals

for the Seventh Circuit in this case has not yet been

reported.

JURISDICTIONAL GROUNDS

The judgment and opinion of the United States Court

of Appeals for the Seventh Circuit were rendered on

November 3, 1980, and Petitioner’s timely petition for

re-hearing was denied on December 3, 1980.

Jurisdiction to review the Court of Appeals decision

by writ of certiorari resides in the Supreme Court under

28 U.S.C. $1254 and is timely invoked pursuant to 28

U.S.C. §2101(¢), as interpreted by Supreme Court Rule

20.4.

APPLICABLE STATUTES

At issue in this case are the substantially identical

definitions of a “security” under the Securities Act of

1933 [15 U.S.C. §77b(1)], and the Securities Exchange

Act of 1934 [15 U.S.C. §$78e(a)(10)]:

“When used in this title unless the context other-

wise requires—

“(1) The term ‘security’ means, any note, stock,

treasury stock, bond, debenture, evidence of indebt.

edness, certificate of interest or participation in any

profit-sharing agreement, collateral-trust certificate,

preorganization certificate or subscription, transfer-

able share, investment contract, voting-trust certif-

icate, certificate of deposit for a security, fractional

undivided interest in oil, gas, or other mineral rights,

or, in general, any interest or instrument commonly

known as a ‘security,’ or any certificate of interest

Vii

or participation in, temporary or interim certificate

for, receipt for, guarantee of, or warrant or right to

subscribe to or purchase, any of the foregoing. [15

U.S.C. §77b(1)]

“When used in this title unless the context otherwise

requires—

“(10) The term ‘security’ means any note, stock,

treasury stock, bond, debenture, certificate of interest

or participation in any profit-sharing agreement or

in any oil, gas, or other mineral royalty or lease,

any collateral-trust certificate, preorganization cer-

tificate or subscription, transferable share, invest-

ment contract, voting-trust certificate, certificate of

deposit, for a security, or in general, any instrument

commonly known as a ‘security’; or any certificate of

interest or participation in, temporary or interim

certificate for, receipt for, or warrant or right to

subscribe to or purchase, any of the foregoing; but

shall not include currency or any note, draft, bili of

exchange, or banker’s acceptance, which has a matur-

ity at the time of issuance of not exceeding nine

months, exclusive of days of grace, or any renewal

thereof the maturity of which is likewise limited.”

(15 U.S.C. §78e(a) (10) )

In THE

SUPREME COURT OF THE UNITED STATES

OctToBeR TERM, 1980

No.

U.S. STEEL CREDIT CORPORATION,

: Petitioner,

VS.

AMERICAN FLETCHER MORTGAGE COMPANY,

INC., AMERICAN FLETCHER NATIONAL BANK

AND TRUST COMPANY, and AMERICAN FLETCHER

CORPORATION,

Respondents.

PETITION FOR WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE SEVENTH CIRCUIT

(Seventh Circuit Nos. 80-1485, 80-1719)

STATEMENT OF THE CASE

This Petition for Certiorari seeks reviews by the Su-

preme Court of a decision of the United States Court of

Appeals for the Seventh Circuit affirming a judgment of

the United States District Court for the Southern District

of Indiana Indianapolis Division.. The sole ground of

1 Although there were several interlocutory orders of

the District Court also involved in the appeal to the

Seventh Circuit, the instant Petition seeks review of the

Seventh Circuit’s decision only insofar as it affirmed the

District Court’s judgment dismissing federal securities

fraud counts of Petitioner’s counterclaim against the Re-

spondents and its Order denying Petitioner’s motion for

partial summary judgment on such securities counts,

a

the judgment and order in question was that certain par-

ticipation shares acquired by Petitioner in mortgage loan

notes held by Respondent, American Fletcher Mortgage

Company, Ine. (the “Mortgage Company”) did not qualify

as “securities” under the applicable securities acts.

The instant litigation originated as two separate law-

suits filed on the same date, one filed by Petitioner against

the Respondents in United States District Court for the

Western District of Pennsylvania and the other by the

Respondent Mortgage Company against Petitioner, U. S.

Steel Credit Corporation (“USSC”), in the Indianapolis

Division of the United States District Court for the

Southern District of Indiana. Petitioner’s Pittsburgh suit

was for federal securities fraud in connection with the

acquisition by Petitioner from the Mortgage Company

of 40% participation shares in mortgage loans made by

the Mortgage Company for the development and con-

struction of a condominium project at Cromwell, Con-

necticut. Respondents, American Fletcher National Bank

and Trust Company (the “Bank”) and the parent cor-

poration, American Fletcher Corporation (“AFC”), were

charged with securities fraud liability, as “controlling

persons” and “aiders and abettors” of the Mortgage Com-

pany.”

The Mortgage Company’s Indianapolis suit was for

alleged breach by Petitioner, USSC, of its commitment

*The Pittsburgh suit also included counts for common

law fraud and breach of the participation agreements,

but those counts are not relevant to the instant Petition.

ee

under the participation agreements to fund in full its

share of the loan and certain related expenses.*

The District Court’s jurisdiction of the Pittsburgh suit

was based on federal question jurisdiction under 28

U.S.C. §1331, and jurisdiction of both suits was also

based on diversity of citizenship under 28 U.S.C. $1332

(a).

The Pittsburgh suit was subsequently transferred to

the District Court in Indianapolis, where it was consol-

idated with the Indianapolis suit. Since the issues in both

suits were substantially the same, the action originally

filed in Pittsburgh was thereafter dismissed and the counts

of the Pittsburgh complaint were embodied in an amended

counterclaim in the Indianapolis suit (App. pp. 28a-4la).

The events which led up to the instant litigation, as

set forth in Petitioner’s amended counterclaim‘ and in

deposition testimony referred to in affidavits submitted

with Petitioner’s motion for partial summary judgment

(App. pp. 77a-78a), were as follows.

In October, 1973, Petitioner received from the Mort-

gage Company 40% participation offerings in a $2,530,000

Land Acquisition and Development Loan (the “L&D

*By subsequent amendment of the Indianapolis com-

plaint, the Bank was added as a co-plaintiff, asserting

rights as an alleged third-party beneficiary of the partic-

ipation agreements and claims for interference with con-

tractual relations, none of which rights or claims are

at issue in this Petition.

*Sinee the District Court granted the Mortgage Com-

pany’s motion to dismiss the “securities” counts (App.

pp. 16a-22a), the facts set forth in the counterclaim must

be taken as true, as well as the uncontroverted facts re-

ferred to in affidavits submitted by Petitioner,

— -

Loan”) and a $3,290,000 Construction Loan, which in

March, 1973, the Mortgage Company had committed it-

self to make to a New York developer, Justin Develop-

ment Corp. for the purchase, development and construc-

tion of a condominium complex in the Town of Crom-

well, Connecticut. These loans ~ are designed to cover

the entire cost of land acquisition, development and first

phase construction of the project.

In processing a loan, the Mortgage Company’s practice

was to obtain all pertinent information on the project,

including appraisals, site survey, engineering and archi-

tectural plans and specifications, and market analysis; fi-

nancial and other pertinent information on the borrower

and its principal officers; similar information on the con-

tractor, includiag the contractor’s bonding capability; and

full cost information, including estimated construction

costs and cost breakdowns. (Trepinski dep., App. pp.

86a-88a). The Mortgage Company would then negotiate

the terms of the loan with the borrower to {it the esti-

mated costs, prepare the necessary documentation and is-

sue loan commitments. (App. pp. 86a-88a )

In the case of the Cromwell L&D Loan, the Mortgage

Company, prior to submitting its participation offering to

Petitioner, entered into a written loan agreement with

Justin Development Corp. and advanced to Justin major

sums of its own money. The Mortgage Company then as-

sembled the information it had gathered and submitted

the same to Petitioner along with the participation of-

ferings.

The participation offerings represented the Cromwell

project as ultimately involving a total of 450 condominium

units, of which 150 units were to be constructed in the

~~

first phase of the project. The three-year mortgage loans

were to be at ‘‘floating’’ rates of 5% over prime in the

case of the L&D Loan, and 4% over prime in the case

of the Construetion Loan. The offerings also indicated

that a 50% participation share had been offered to Ameri-

can Fletcher Mortgage Investors (the ‘“Trust’’), a Mas-

sachusetts real estate investors trust, and a 10% share

to the Mortgage Company’s affiliate, American Fletcher

National Bank (App. pp. 41a-45a).

Unlike the Mortgage Company, Petitioner, USSC, was

not staffed to originate or manage major real estate devel-

opment loans (Thomas dep., App. pp. 8la-82a). Instead,

USSC was engaged in the business of raising money,

largely through the sale of commercial paper, and in-

vesting in loan participations like the Cromwell project

(Mack dep., App. p. 80a). Generally, USSC’s prae-

tice was to acquire minority participations in loans in

which the lead bank had retained a major share (‘Thomas

dep., App. p. 82a).

On the question of reliance upon the lead bank, Peti-

tioner’s representatives pointed out that a major faetor

was the reputation of the lead bank and the fact that the

lead had substanti~! sums of its own money at stake (Lang

dep., App. p. 8la; Thomas dep., App. p. 82a; Maek

dep., App. pp. 80a-83a). There was further testimony on

the management functions which were expected of a lead

bank in the course of administration of a loan, e.g., pe-

riodie inspections of the progress of the work, obtaining

certifications from inspecting architects or engineers, mon-

itoring of disbursements to insure proper application of

loan funds, periodie comparison of unconsumed loan bal-

ances with estimated cost to complete, negotiations with

borrower to resolve any problems that might arise and

_

notification to participants of any problems (Mack dep.,

App. pp. 84a-85a). Of course, Petitioner also relied on the

lead bank to see to it that the loans were properly closed

and loan documents properly exeeuted (Mack dep., App.

p. 85a).

After studying the participation offerings and the data

supplied by the Mortgage Company and visiting the Crom-

well site, but with reliance upon the truth, accuracy and

completeness of the Mortgage Company’s material repre-

sentations aid disclosures (Counterdaim 996-11, App. pp.

29a-35a) Petitioner prepared, executed and sent the par-

ticipation agreements to the Mortgage Company for sig-

nature. These were subsequently executed by the Mort-

gage Company under date of December 31, 1973 (see Par-

ticipation Agreement, App. pp. 45a-52a).

In effect, the participation agreements involved the ac-

quisition by Petitioner of 40% shares of whatever amounts

the Mortgage Company might recover on the Cromwell

loans, whether by payments on the notes, by foreclosure

against the security. or otherwise.

These agreements required the Mortgage Company to

hold in trust, for the benefit of Petitioner, the notes, the

security, all instruments related to the loan obligation and

all proceeds and avails thereof, while prohibiting the

Mortgage Company from modifving the terms of the loan

obligation or releasing any of the security without writ-

ten consent of Petitioner.

The participation agreements established a procedure

for advance notification to Petitioner of amounts due from

Petitioner as its share of proposed disbursements on the

loan and provided that such notification would be deemed

a representation by the Mortgage Company that there

atic

was no material breach of the loan agreement of which

the Mortgage Company was aware.

The Mortgage Company was required to ‘‘administer”’

the loan obligation in accordance with the terms of the

Loan Agreements, but the Mortgage Company’s liability

for loan mismanagement was limited to willful misconduct,

bad faith or gross negligence.

Provision was also made for prompt notice to Peti-

tioner by the Mortgage Company of any material default

in the terms of the loan obligation or any other matter

which, in the Mortgage Company’s judgment, adversely

affected Petitioner’s interest.

The agreements went on to provide that in the event

of any material default, the Mortgage Company shall

exercise all of its rights to enforce collection of the loan

obligation either upon its own initiative or upon request

of Petitioner.

The participation agreements prohibited any sale or

other dispostion by the Mortgage Company or by Peti-

tioner of the note or the participation, but authorized the

Mortgage Company to redeem Petitioner’s participation

by payment to Petitioner of all amounts due upon the

same.

Neither party to the Participation Agreements con-

strued the same as vesting in Petitioner any interest in

the unpaid loan or any rights against Justin Development

Corp., the borrower. (Mack Supp. Aff., App. p. 91a).

The counterclaim with detailed particularity, charges

the Mortgage Company with more than fifteen deliberate

or reckless misrepresentations or non-disclosures of mate-

rial fact (Counterclaim {/6-9, App. pp. 29a-34a), notably:

a

1, That over a sixteen months period from the date

of closing of the Construction Loan in February, 1974,

until mid-June, 1975, the Mortgage Company collected

more than $2,000,000 from USSC without disclosing to

USSC that disbursements on the loan were not legally

obligatory because the borrower had failed to comply with

the express conditions of the loan agreement that it sub-

mit a proper construction contract and performance bond.

(Counterclaim 7, App. p. 30a);

2. That the Mortgage Company failed to disclose to

USSC that it had thrown the Construction Loan out of

-balance by advancing to the borrower the amount of in-

terest payments on the Construction Loan, despite the

fact that there were no funds budgeted for the payment

of interest under the Construction Loan. (Counterclaim

19(a), App. p. 31a);

3. That the Mortgage Company failed to disclose to

USSC that prior to the closing of the Construction Loan,

the Mortgage Company’s legal counsel in charge of closing

and administering the loan had warned that the loan

would be inadequate to complete development and con-

struction of the first phase of the Cromwell project.

(Counterclaim §9(i), App. p. 33a).

On January 7, 1980, the Mortgage Company filed a

Motion to Dismiss or for Judgment on the Pleadings as

to Securities Law Claims (App. pp. 75a-76a).

USSC responded on February 22, 1980, with a Cross-

Motion for a partial summary judgment declaring its par-

ticipations to be ‘‘securities’’ under federal and state se-

curities acts (App. pp. 77a-78a).

ee

On March 21, 1980, the District Court issued an Order

granting the Mortgage Company’s Motion to Dismiss or

for Judgment on the Pleadings on the securities counts

of USSC’s counterclaim, and at the same time denied

USSC’s Cross-Motion (App. pp. 16a-22a). This Order, as

amended to include a Rule 54(b), F.R.Civ.P., certification

and direction for entry of final judgment (App. pp. 23a-

25a), was affirmed by the Court of Appeals, precipitating

the instant Petition.

— en

ARGUMENT

A. Seven Reasons for Granting Petition.

1. As inflation accelerates and the number of multi-

million dollar development and construction loans multi-

plies, more and more lenders are raising capital and

spreading risks by selling loan participations. These are

often sold to distant participants, who have little inde-

pendent knowledge of the borrowers or of the projects

for which they seek to borrow, and who must, therefore,

rely upon the lead bank to investigate, evaluate and nego-

tiate loans sufficient for the borrowers’ financial needs; to

supply prospective participants with complete and accu- ,

rate information sufficient for intelligent investment deci-

sions; to manage the loans once consummated; to super-

vise the application of loan funds, and to monitor the

progress of the work for which the funds are loaned.

It thus becomes a matter of increasing national im-

portance for the Supreme Court to resolve the question,

whether and to what extent participation shareholders

are entitled to the protection of the federal securities acts.

2. It is submitted that decisions like the Seventh Cir-

cuit’s decision, below, spring from the tacit belief that

major corporate investors do not need the protection of

the securities acts. This theory has led to distortions of

the Supreme Court’s guidelines for testing securities sta-

tus and to frustration of the Congressional intent reflec-

ted in the Securities Acts. None of these guidelines or

enactments suggests any purpose to limit the Acts to small

or unsophisticated investors. To the contrary, see United

States v. Naftalin, 441 U.S. 768, 99 S.Ct. 2077 (1979),

—

While unsophisticated investors are, perhaps, more

easily duped, it does not follow that major investors need

no securities act protection. First, the absence of such

protection tends to dry up this important source of capi-

tal. Secondly, practical necessities require that loan par-

ticipants, with millions entrusted to their lead banks, must

have faith and confidence in their leads and avoid the

disruptive effect of policing their leads for potential mis-

conduct or mismanagement. Finally, one must remember

that losses suffered by corporate investors for want of .

securities act protection will ultimately devolve upon their

shareholders, often small investors of modest means. See

Eason vy. General Motors Acceptance ( ‘orporation, 490 F.2d

654, 657 (7th Cir. 1973)

3. Contrary to the Supreme Court’s repeated admoni-

tions that the Securities Acts should be construed broadly

and flexibly to achieve their remedial purposes | Tcherep-

nin v. Knight, 389 U.S. 332, 336, 88 S.Ct. 548, 553 (1967) ;

Aaron v. SEC, 100 S.Ct. 1945, 1960 (1980) ], the instant

decision of the Seventh Cireuit narrowly construes the

Supreme Court’s guidelines for determining securities

status by ruling that interest is not a form of ‘profits’?

and by restrictively applying the Mowey-Forman profits-

derivation test.’

4. Contrary to the Supreme Court’s admonition in

Forman, 421 U.S. 837, 848, 95 S.Ct. 2051. 2058 (1975) that

in construing the term, ‘‘security,’’ ‘‘form should be dis-

regarded for substance and the emphasis should be upon

economic reality,’’ the Court of Appeals held that. in-

terest was not ‘‘profits’’ because the rate of return on

*See SHC v. W. J. Howey, 328 U.S. 293, 301, 66 S.Ct.

1100, 1104 (1946); United Housing Foundation vy. l’orman,

421 U.S. 837, 852, 95 S.Ct. 2051, 2060 (1975).

— a

the notes was wholly independent of any profits (App.

p. 18a), ignoring the ‘‘economic reality’? that without

profits there would be no return on these notes.

5. In holding that where a prospective loan partici-

pant’s expectation of profits derives in part from the par-

ticipant’s own evaluation of the investment opportunity,

there is no ‘‘expectation of profits to be derived from the

entrepreneurial or managerial efforts of others’’ within

the meaning of Forman, supra, 421 U.S. p. 853 (App. p.

14a), the Court of Appeals misconceived the profits-

derivation test in two respects: first, in regarding the ‘‘ef-

forts of others’’. requirement as looking to the source of

the expectation of profits rather than merely to the source

of the profits, and, secondly, by construing [’orman as

requiring that the profits expectation must derive solely

from the ‘‘efforts of others.’’

The Supreme Court’s Howey-Forman formulation is in

need of clarification on this point.

6. Likewise, the Court of Appeals’ holding (App. p.

14a) that Petitioner’s reservation under the participation

agreements of rights to prohibit changes in loan terms or

release of the security and to demand foreclosure in case

of default precluded any inference of reliance upon the

3 managerial efforts of others, would disqualify, for exam-

ple, a corporate mortgage bond as a **security,’’ since

all of the above rights are possessed by bondholders.

7. While the Second Cireuit has not ruled on the pre-

cise question, whether a loan participation is a ‘*security,’’

its liberal approach to the ‘‘securities’’ Acts definitions,

as formulated in Exchange National Bank v. Touche Ross

& Co., 544 F.2d 1126 (2nd Cir. 1976), stands in marked

contrast to the restrictive interpretation of the Seventh

and some other Circuits.

— a

Touche Ross reflects a disposition to give broad scope

to the Securities Acts—as, indeed, the Supreme Court

has urged—by presuming instruments, expressly defined

as ‘‘securities,’’ to be what Congress says they are, un-

less the opposing party sustains the burden of proving

that ‘‘the context® otherwise requires.’’ Following this

approach, two District Court decisions in the Second Cir-

cuit have held loan participations to be ‘‘securities.”’

Commercial Discount Corp. v. Lincoln First Commercial

Corp., 445 F.Supp. 1263 (SDNY 1978) and NBI Mort-

gage Investment Corp. v. Chemical Bank, [1976-1977] Fed.

See. L. Rep. (CCH) 995,632 (SDNY 1978) and [1977-

1978] Fed. Sec. L. Rep. 96,066 (SDNY 1977).

Unlike Lehigh Valley Trust Co. v. Central National

Bank of Jacksonville, 409 F.2d 989 (5th Cir. 1969)", the

°**Context”’ looks to ‘‘surrounding factual circum-

stances’? [H’misco Industries, Inc. y. Pro’s Inc., 543 F.2d

38, 39 (7th Cir. 1976)] including ‘‘the actua! facts and

circumstances of the investment arrangement’’, Goodman

v. Epstein, 582 F.2d 388, 406 (7th Cir. 1978).

"Lehigh Valley held that a loan participation was a

““security’’ because so defined in the Acts. Though its

literal approach has been repudiated, it reached the cor-

rect result on the facts described in the opinion. Recently,

in United American Bank of Nashville v. Gunter, 620 F.2d

1108 (5th Cir. 1980), the Fifth Circuit affirmed a District

Court holding that loan participations were not within

the Securities Acts. Gunter, however, presented peculiar

facts in that the participant and the lead bank were af-

filiates, and, as a matter of routine, the participant took

whatever participations the lead offered from time to time

without question or expectation that the lead would keep

it informed of material facts. Thus, there was no reliance

by the participant on representations or disclosures of

the lead which could support a securities fraud claim. In

affirming, per curiam, the District Court in Nashville, the

Fifth Cireuit, significantly, disavowed approval (fn. 2,

a * en

Second Circuit’s approach gives full consideration to the

‘*context,’’ but resolves doubts in favor of inclusion. The

Seventh Circuit, by contrast, resolves doubt, in favor of

exclusion.

B. Whether or not the Notes Were “Investments” by

Respondent Mortgage Company, Petitioner’s Partic-

ipations therein were “Investments.”

The Supreme Court has repeatedly emphasized that

federal securities legislation should be construed, ‘‘not

technically and restrictively, but flexibly to effectuate its

remedial purposes,’? SEC v. Capital Gains Research Bu-

reau, Inc., 375 U.S. 180, 195, 84 S.Ct. 275, 285 (1963);

Aaron v. SEC, ........ <B Sieeeere , 100 S.Ct. 1945, 1960 (1980).

The purpose of the Securities Acts was summarized in the

Senate Report on the Bill for the 1933 Act, as follows:

The purpose of this Bill is to protect the investing

public and honest business. The basic policy is that

of informing the investor of the facts concerning se-

curities to be offered for sale in interstate and foreign

commerce and providing protection against fraud and

misrepresentation, S. Rep. No. 47, 73d Cong., 1st

Sess., to accompany S. 875, April 27, 1933.

The Supreme Court’s fourfold guidelines for testing

‘‘security’’ status, as initially laid down in SEC v. W. J.

* (Continued)

620 F.2d p. 1110) of two other District Court decisions

on which the District Court in Nashville had based its

holding that participations were not ‘‘securities.’’ The

District Court decisions in question were FBS Financial

v. CleveTrust Realty Investors, Fed. Sec. L. Rep. (CCH)

196,341 (N.D.Ohio 1977), and Provident Nat. Bank v.

Frankford Trust Co., 468 F.Supp. 448 (E.D.Pa. 1979),

both relied upon by the District Court, below, in the case

at bar.

—15 —

Howey, 328 U.S. 293, 301, 66 S.Ct. 1100, 1104 (1946), was

further refined in United Housing Foundation v. Forman:

The touchstone is the presence of [1] an investment

in [2] a common venture premised on [3] a reason-

able expectation of profits to be derived from [4] the

entrepreneurial or managerial efforts of others.

421 U.S. at 852, 95 S.Ct. at 2060

Accordingly, the initial question is whether Petitioner’s

Cromwell participations were ‘‘investments.’’ Like the

District Court, the Seventh Cireuit concluded that the

Cromwell participations met none but the ‘‘ecommon ven-

ture’ test of Howey-Forman (App. p. 12a). No ex-

planation was offered for denying that the participations

were “‘investments.’’ In common usage, an ‘‘investment”’

is ‘‘an expenditure of money for income or profit’’, Web-

ster’s New International Dictionary Unabridged (3rd Ed.,

1965). Assuming that Howey-Forman used the term in

that broad sense, one may ‘‘invest’’ in a non-security,

and there may be ‘‘security”’ transactions, e.g. gifts, which

involve no ‘‘investinent’’.*

It is submitted that I/owey-l’orman intended to charac-

terize as an ‘‘investment’’ any profit-motivated ex pendi-

ture, even one not involving the acquisition of a ‘‘secu-

rity’’ by reason of other aspects of the Hlowey-Forman

test. That profit-motivation is the key to an investment

is consistent with the holdings of United Ilousing Foun-

dation v. Forman, 421 U.S. 837, 95 S.Ct. 2051 (1975) that

‘Illustrative of a ‘‘securities’’ transaction not in-

volving an ‘‘investment’’, was Lincoln National Bank v.

Herber, 604 F.2d 1038 (1979), where the Seventh Circuit

held that a pledge of stock to secure a loan was not with-

in the Securities Acts. Herber has been ,epudiated, how-

ever, by the Supreme Court’s recent decision in Rubin v.

United States, ........ Pa secenne , 41 CCH S.Ct. Bull. p. B824

(1981).

—

housing co-op ‘‘stock certificates’? did not qualify, where

purchasers were motivated by a desire for housing, rather

than profits, and by International Brotherhood of Team-

sters v. Daniel, 439 U.S. 551, 99 S.Ct. 790 (1979), holding

that union pension funds were not securities, where the

inducement was employment, rather than pension profits.

In Tcherepnin v. Knight, 389 U.S. 332, 88 S.Ct. 548

(1967), on the other hand, savings and loan certificates

were held to be covered, when acquired for profit.

C. Petitioner’s Expected Return on its Participations

was an Expectation of “Profits” under Howey-

Forman,

The Seventh Circuit’s holding to the contrary was based

upon the following rationale:

“Steel [Petitioner] was not to participate in any of

the profits from the Justin project, and neither the

repayment of the loan nor the rate of return was in

any way dependent on the actual profits, if any, of

the project’’. (App. p. 13a)

This reasoning is faulty in several respects. First, the

statement that the ‘‘rate of return’’ was not dependent

upon profits is true of any interest-bearing instrument.

To regard this fact as disqualifying is, in effect, to read

out of the Securities Acts interest-bearing instruments,

such as notes, participations and certificates of deposit,

which Congress expressly included in its broad definitions

of ‘‘securities.”’’

*See Canadian Imperial Bank of Commerce Trust Co.

v. Fingland, 615 F.2d 465 (7th Cir. 1980), holding that

certificates of deposit were not ‘‘securities’’, largely on

the theory that interest was not ‘‘profits’’,

a, pee

Secondly, to say that the rate of return was not de-

pendent on profits, is true only in a legal sense. As di-

rected in Forman, however, in construing the Securities

Acts, ‘‘form should be disregarded for substance and the

emphasis should be upon economic reality’’. 421 U.S. at

848. The “economic reality” of 100% loans like the

Cromwell loans is that in the absence of profits, there. will

be no return of either principal or interest on the notes.

Though apparently lost on the Seventh Circuit, this point

was recognized by the Fifth Cireuit in Williamson v.

Tucker, 632 F.2d 579, 604 (5th Cir. 1980):

But a note holder may nevertheless be dependent on

the profitability of the enterprise for the payment of

interest or the return of principal. Unless the note

holder’s reliance on the success of the enterprise is

insignificant, the holder can be said, in effect, to share

in the profits of the enterprise in the sense contem-

plated by the Supreme Court in Forman (Emphasis

the Court’s).

Third, consistent with its policy of construing the

Securities Acts broadly, the Supreme Court in Tcherepnin

v. Kmght, 389 U.S. 332, 3388, 88 S.Ct. 548, 554 (1967)

expressly described as “profit” the interest return upon

the loans of a savings and loan association. Holding that

withdrawable certificates in a savings and loan associa-

tion were ‘‘securities’’, the Court stated in T'cherepnin:

Petitioners are participants in a common enterprise

—a money lending operation dependent for its suc-

cess upon the skill and efforts of the management

of City Savings in making sound loans... [T]he

petitioners can expect a return on their investment

only if City Savings shows a profit. (Emphasis—

added.) 389 U.S. at 339, 88 S.Ct. at 55

— oa

Whether or not commercial loan notes in the hands of a

commecial lender qualify as “securities” under the profits-

derivation test of Howey-Forman, there is no justification

for disqualifying them by narrowly defining “profits” to

exclude interest.

Fourth, the lender’s expected return on its notes must

be differentiated from the participant’s expected return

on its participations. The lender has an absolute right

of repayment of principal and interest on the notes. The

participant, by contrast, has no rights against the bor-

rower. The participant’s sole right is to share in whatever

return, if any, the lead bank realizes on its note. See

In Re Yale Express System, Inc., 245 F.Supp. 790, 792

(SDNY 1965), so holding. As stated in Janik, The

Colocotronis Dispute: When is a Loan Participation

Share a Security, 13 J. Int’l. Law & Keon. 165, 179

(1978) :

Finally, it is critically important to always recall

that the participants, holding no notes, had no right

against the Colocotronis group [borrowers]. These

factors clearly indicate that even though their money

was used by a borrower, the participants were not

loaning their funds; they were investing their funds.

D. As a Participant, Petitioner Necessarily Looked to

the “Entrepreneurial or Managerial Efforts” of the

Respondent Mortgage Company for any Profits on

the Cromwell Participations.

The fourth element of the Howey-Forman test is some-

what ambiguous. This fourth element stipulates that the

reasonable expectation of profits is “to be derived from

the entrepreneurial or managerial efforts of others”,

United Housing Foundation v. Forman, 421 U.S. 837,

852, 95 S.Ct. 2051, 2060 (1975). Does this profits-deriva-

= =

tion test look only to the derivation of the future profits,

or to the derivation of the profits expectation, or to both?

It will be recognized that if “efforts of others” must

be the source, not only of the future profits, but also of

the investor’s expectation of profits that prompts his

investment, few investments will qualify as ‘‘seecurities.’’

This follows because every prudent investor relies in

part—and often in large part—on his own evaluation

of the prospective investment. Is it, then, the poliey of

the Securities Acts to protect only imprudent investors,

and penalize those who look before they leap? Apparently,

that is how the Seventh Cireuit construed the profits-

derivation test when it ruled that Petitioner was not *‘de-

pendent upon the Mortgage Company’s entrepreneurial

efforts’’, because **Steel’s decision to enter the participa-

tion agreement was based on its own business judgment’’

(App. p. I4a)."°

‘Tf this was a finding that Petitioner did not rely upon

the truth, accuracy and completeness of the material

representations and disclosures presented by the Mortgage

Company as inducements to Petitioner to purchase its

participations and to continue disbursements under them,

then it was a wholly improper finding on a disputed

issue of material fact. The judgment dismissing the

securities counts of Petitioner’s counterclaim was a judg-

ment on a Rule 12(b)(6) F.R.civ.P., motion to dismiss,

under which the factual averments of the pleadings

sought to be dismissed must be taken as true, except to

the extent controverted by any evidentiary matter von-

sidered by the Court. Petitioner’s counterclaim ineludes

an averment that Petitioner did rely to its detriment

upon the truth, accuracy and completeness of the Mortgage

Company’s representations and disclosures. The deposi-

tion testimony that Petitioner visited the job site and

studied the material submitted by the Mortgage Company

(see p. 6, supra) is entirely consistent with this aver-

ment, demonstrating no more than common investor’s

prudence.

=

It is submitted that the language used in Forman to

describe the profits-derivation test, particularly when read

back into the Howey decision, where it originated, shows

that efforts of others must be the source of the profits,

but not necessarily the souree—and certainly not the sole

source—of the profits expectation which induced tie in-

vestment. Thus, Forman speaks of an “expectation of

profits”, to be derived from the efforts of others. “To be

derived” is language of futurity, indicating that future

efforts of others will give rise to the profits. But since

the efforts giving rise to the expectation of profits have

already heen expended, the future tense, “to be derived”,

is inappropriate language for describing the efforts that

created the expectation of profits.

Compare the Howey formulation, where an “investment

contract” was simply defined as “an investment of money

in a common enterprise with profits to come solely from

the efforts of others,” SEC v. W. J. Howey Co., 328 U.S.

293, 301, 66 S.Ct. 1100, 1104 (1946). It is clear that under

the Howey formulation, only the profits need “come

solely from the efforts of others”, whatever may have

given rise to the expectation of profits that prompted

the investment. There is nothing in Forman to suggest

an intent to change the Howey rule, except the elimination

of the term ‘‘solely’’ as applied to the ‘‘efforts of others.’’

In striking the term ‘‘solely,’’ the court in Forman, 421

U.S. 837, 852, 95 S.Ct. 2051, 2060, fn. 16, took note of

the Ninth Circuit’s holding in SEC v. Glenn W. Turner

Enterprises, Inc., 474 F.2d 476 (9th Cir. 1973) that the’

language, ‘‘solely from the efforts of others,’”’ should not

be so rigidly applied as to preclude “securities” status

for an investment contract in which the investor’s own

efforts made some minor contribution to profits. In

at eae

Turner Enterprises the Ninth Cireuit concluded that the

Howey “efforts of others” test had been satisfied so long

as:

the efforts made by those other than the investor

are the undeniably significant ones, those essential

managerial efforts which affect the failure or success

of the enterprise. 474 F.2d at 482.

Although the Supreme Court in Forman declined to

pass Judgment on the holding in Turner Enterprises, its

consideration of that case in conjunction with deletion

of “solely” from its restatement of the “efforts of others”

requirement must reflect a deliberate decision to disre-

gard inconsequential activities of investors in relation

to profits. Certainly, such minor activities of an investor

as a visit to a job site would not be disqualifying.

The question next arises as to whether a lender, in

financing a construction project, for example, makes such

a significant contribution to the success and profitability

of the project that the anticipated profits from the loan

will not be deemed “to be derived from the entrepreneurial

or managerial efforts of others”. It is this problem, and

not the exercise in semantics that leads to characteriza-

tion of a bank loan as a non-investment “commercial

loan’’, C.N.S. Enterprises, Inc. v. G & G Enterprises,

Inc., 508 F.2d 1354 (7th Cir. 1975), cert. denied 423 U.S.

825, which casts doubt upon the ‘‘securities’”’ status of

bank loan notes in the hands of the lending bank.

Adequate financing of a major construction project is not

merely important, but crucial. Accordingly, a bank’s

entrepreneurial activities in appraising the property,

evaluating market prospects, estimating construction

costs, analyzing the borrower’s financial resources, and

realistically calculating the borrower’s total financial

needs, are major essentials to profitability.

— =

But precisely because of the vital role which a bank

plays in creating and managing a loan, when that same

bank goes into the market place and invites investors

to purchase major participations in its loan in reliance

upon its expertise as a lender and loan manager, it

should be held to the same standards of full and fair

disclosure which would obtain if it were selling its cor-

porate shares. This distinction between the posture of

the lead bank as a commercial lender and the posture

of a participating shareholder, who takes no part in the

creation or management of the loan, has been recognized

by the better reasoned cases and articles.

Thus, in United California Bank vy. THC Financial

Corp., 557 F.2d 1351 (9th Cir. 1977), the Ninth Circuit,

while holding that non-negotiable short term notes (one

month) secured by receivables were not ‘‘securities,’’

distinguished the case of a loan participation. Though

criticizing as an overly ‘‘literal reading of the statute’’

the Fifth Cirenit’s decision in Lehigh Valley Trust Co.

v. Central National Bank, 409 F.2d 989 (5th Cir. 1969), in

which it held that a “wt participation was necessarily a

‘*security’’ because the statute so defined it, the United

California Bank court went on to say:

[T]his case [Lehigh Valley Trust] remains vital by

instructing that, while the underlying note may not

be a security, the participation interest may fall with-

in the definition of a security. Cf. Avenue State Banik:

v. Toutrelot, 379 F.Supp. 250, 254 (N.D.IIl. 1974). 557

F.2d at 1357, fn. 8.

This distinction was also recognized in Commercial Dis-

count Corporation v. Lincoln First Commercial Corpora-

tion, 445 F.Supp. 1263 (SDNY 1978), where the court

held that CDC’s purchase of a participation in Lincoln

First’s (the lead bank’s) secured short term loans to

Piccard was an investment in a ‘‘security’’:

= on

CDC’s [the participant’s] contractual relationship

under this agreement was with Lincoln First [the

lead bank], not with Piccard [the borrower]. CDC

did not lend money to Piceard, nor did it hold

evidence of indebtedness signed by Piccard. Further-

more, CDC had no direct interest in the collateral

(the accounts receivable in the inventory) pledged by

Piccard, though it did have a right to participate

in any ‘amounts received by [Lincoln First] through

realization upon the specifie collateral, in repayment

of the principal amount of the advances’ and even

though Lincoln First agreed to hold the collateral

‘as agent of and trustee for’ CDC. 445 F.Supp. at 1265.

Differentiating the position of a loan participant from

that of the lead bank, the author of a law review note

states:

Typically, the lead bank not only negotiates the

terms of the loan with the client, but also actually

makes the loan from its own reserves. Thus the lead

is the sole party holding any documentation, ecol-

lateral or rights against the borrower. After the

loan has been made, the lead will then line up syndi-

cate members, who in turn purchase a participation

share evidencing a share in the loan. * * *

Janik, The Colocotronis Dispute: When Is a Loan

Participation Share a Security, 18 J. Int’l. Law

& Econ. 165, 170 (1978)."

**See also notes, Loan Participations as Securities, 8

Cal. W. Int'l. L. J. 510, 520 (1978), and Bank Loan

Participations: The Affirmative Duty to Disclose Under

SEC Rule 10b-5, 27 Syracuse L. Rev. 807, 816 (Spring

1976): “The participation certificate merely symbolizes

the right of the participant to share pro rata in the profits

or losses derived from the venture. It gives the participant

the right to proceed against neither the lead nor the

borrower in the event of default.”

Dy

— 24 —

The principal reason for treating a participation share

as a “security”, even though the underlying note is not,

is that the participation shareholder stands at a remove

from the venture being financed and must rely chiefly

upon the lead bank, not only for information concerning

the project, but also for management of the loan when

consumated. As observed by Judge Wright in his special

concurring opinion in Great Western Bank & Trust v.

Kotz, 5382 F.2d 1252, 1261-1262 (9th Cir. 1976):

“While banks are subjected to risks of misinforma-

tion, their ability to verify representations and take

supervisory and corrective action places them in a

significantly different posture than the investors

sought to be protected through the securities acts.

“In an investment situation, the issuer has superior

access to and control of information material to the

investment decisions. . . . The commercial bank deals

‘face-to-face’ with the promissor [borrower].”

In like vein, see California Western Law Journal:

[E]ven if a participating bank were to employ out-

side consultants and advisors, it could never put

itself in the position of the informed lead lenders

who work closely with the borrower in developing

and supervising the loans. . . . Thus, the participants

had no choice but to rely on EAB, as lead lender,

for their credit evaluation and their ability to nego-

tiate loan covenants and restrictions. Subsequent to

the purchase of participations and the loan being

made, reliance on EAB necessarily continues for loan

surveillance and administration, 8 Cal. West. L. J.

O10, 532 (1978).

As regards the rights reserved to Petitioner under

the participation agreements to veto any change in the

loan terms for release of the collateral and to require

— 95 —

foreclosure in the event of a default, those are merely

the rights of any bondholder. If those minimal rights

for protection of the investment were disqualifying, it

would not be true as stated by this Court in United

Housing Foundation, Inc. v. Forman, 421 U.S. 837, 850,

95 S.Ct. 2051, 2059 (1975) with reference to a “note, a

bond, or a share of stock’’ that, ‘‘inost instruments bear-

ing those traditional titles are likely to be covered by

these statutes.’’

For all of the foregoing reasons, this Petition should

be granted.

Respectfully submitted,

Wituiam A. WIck

Wuite, Ravus, Reis, Wick & RieGNer

1000 Merchants Bank Building

11 South Meridian Street

Indianapolis, Indiana 46204

(317) 632-1348

Attorney for Petitioner

Of Counsel for Petitioner:

Nicuoias C. NIzaAMOFF

Wuite, Ravs, Reis, Wick & RieGNER

1000 Merchants Bank Building

11 South Meridian Street

Indianapolis, Indiana 46204

(317) 632-1348