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

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## Record

- **Collection:** Supreme Court brief
- **Document type:** Petition
- **Published:** January 1, 1981
- **Citation:** 451 U.S. 911

## Text

» 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

---

Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385007_1424%3A1. Public record. Not legal advice.