accounts with plaintiff bank: a general, a payroll and a petty cash account. Thus, Penn Valley was a customer of the bank prior to the transactions at issue here.
Two separate loans between plaintiff and Penn Valley are the focus of plaintiff's claim that it was induced to loan money to Penn Valley by false and fraudulent representatives as to Drew's financial condition, a $50,000 loan in April, 1971, and a $25,000 loan in March, 1974. When the loans were applied for, Penn Valley informed Tri-County that the proceeds would be used for day to day working capital, and that was the use to which the proceeds were put. Both loans were issued on plaintiff's standard promissory note form, were due one day after issuance, and were endorsed by Drew. Payments of principal and interest on the loans were made by regular charges to Penn Valley's general account at the bank, a fixed weekly charge in the case of the larger loan, and a monthly charge for the smaller. The payments on the balance due were made from Penn Valley's own operating capital which had been deposited in its general account.
The April, 1971 loan of $50,000 was initially at an interest rate of 9 1/2 percent. The record shows that it was subsequently increased and renewed several times in varying amounts and at varying interest rates, and that the weekly payments were made regularly until April, 1975. For example, the bank's ledger sheets show that on October 19, 1973, the loan had an outstanding balance of $66,107.84 and was renewed in the amount of $100,000; on February 7, 1974, it had an outstanding balance of $73,727.98 and was renewed in the amount of $100,000; on July 2, 1974, the balance had been reduced to $62,044.90 and was renewed in the amount of $100,000; on December 31, 1974, the balance was $57,619.72 and was again renewed for $100,000; and by April, 1975, at the time of the last payment, the balance was $68,661.22.
The smaller loan was made at an initial interest rate of 12 percent. It was secured by certain of Penn Valley's inventory and all its equipment and machinery. It was also renewed several times, on each occasion in the amount of $25,000 after the outstanding balance had been substantially reduced by the regular monthly charges to Penn Valley's general account. After the last payment made by Penn Valley, in April, 1975, the outstanding balance was $16,749.
Besides the above facts concerning the transactions between Tri-County Bank and Penn Valley, plaintiff has also sought to introduce into the record facts concerning other loans made to Drew and its subsidiaries other than Penn Valley by banks other than plaintiff bank. In support of these facts, plaintiff has offered the affidavit of Mr. Carl A. Johnson, president of Tri-County Bank, which contains a list of ten banks, together with sums allegedly owed each bank by Drew and/or its subsidiaries; the list is taken from an exhibit, presumably a list of creditors, in Drew's petition in bankruptcy in the Southern District of New York. In addition to the list, Mr. Johnson's affidavit also contains some conclusory allegations regarding Drew's motivation in securing the various loans and the uses to which the proceeds of the loans were put. In essence these allegations are that the loans were part of a common scheme by Drew to raise capital in order to rejuvenate itself and its subsidiaries at a time of financial crisis in its affairs; that the lenders were unaware of the interrelatedness of the loans and of the purpose of the funds to finance Drew's revitalization; and that the entire scheme was "a common enterprise the success of which was totally dependent upon the ability of Drew National Corporation and its various subsidiaries to rejuvenate their business by and through the substantial amounts of money borrowed." Affidavit of Carl A. Johnson at 3.
It seems clear that plaintiff's purpose in advancing these allegations concerning other loans made to Drew and its subsidiaries is to establish that the transactions between it and Penn Valley, which standing alone appear to be ordinary commercial loans by a commercial lending institution to a business in need of working capital, were actually part of a large financing scheme on the part of defendants to rejuvenate Drew and its subsidiaries through a number of individual bank loans to raise capital in an attempt to continue operation in view of Drew's financial straits. Plaintiff's theory is that it and a number of other creditors of Drew, whom it purports to represent as a class, became unwitting joint participants in a common enterprise, the revitalization of Drew and its subsidiaries, and that the notes issued by Drew and its subsidiaries were the investment vehicle.
At first blush, however, the allegations concerning the purpose and uses of loans other than those made by Tri-County Bank are not credible, if only because the affiant on whose sworn statement the allegations are based, the president of Tri-County Bank, is not in a position to have any knowledge concerning loans made by banks other than his own institution. Plaintiffs have sought to remedy this defect by filing a discovery motion permitting them to contact the other lending institutions and have them file affidavits and/or briefs concerning the circumstances surrounding their loans to Drew and its subsidiaries in support of plaintiff's opposition to the motion to dismiss.
Defendants have opposed the discovery motion on the grounds that by it plaintiff is seeking information concerning other members of the class it seeks to represent in the instant class action in order to establish its eligibility to sue in its own right, and that plaintiff must first establish its own right to sue before it may seek to represent other members of a class. See Kauffman v. Dreyfus Fund, Inc., 434 F.2d 727, 734 (3d Cir. 1970), cert. denied, 401 U.S. 974, 28 L. Ed. 2d 323, 91 S. Ct. 1190 (1971). Defendants, however, misperceive the relevance of the information concerning the character of other loans made to Drew and its subsidiaries. Plaintiff does not seek to establish by such information its fitness as a representative of a class, but merely to adduce evidence concerning the loans it made to Penn Valley in order to establish that those loans were part of a larger scheme by Drew and all its subsidiaries to raise capital to be used to rejuvenate the borrowers. Thus, there is no legal reason why plaintiff should be prevented from obtaining the discovery it seeks. Nevertheless, I do not find it necessary to permit plaintiff to obtain the desired discovery, because, even assuming that by it plaintiff could establish the propositions it has advanced, i.e., that its loans to Penn Valley occurred at a time when Drew and its subsidiaries were engaged in a scheme to raise capital for continued operation by individual loans from commercial lending institutions, under the prevailing law it will still have failed to establish that the promissory notes given by Penn Valley in exchange for the loans were securities within the meaning of the federal securities laws.
An analysis of that prevailing law must begin with the statutory framework. The Securities Act of 1933 and the Securities Exchange Act of 1934 differ slightly in their handling of the kind of notes that are at issue here. The 1933 act provides that "unless the context otherwise requires -- (1) the term 'security' means any note, stock, treasury stock, bond, debenture . . ." 15 U.S.C. § 77b(1) (emphasis supplied), but exempts from the registration and prospectus requirements "any note, draft, bill of exchange or banker's acceptance which arises out of a current transaction or the proceeds of which have been or are to be used for current transactions, and which has a maturity 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. § 77c (a)(3). However, Section 17 of the 1933 Act, the general anti-fraud provision which prohibits fraud in the "offer or sale" of any securities, 15 U.S.C. § 77q(a), provides that the exemptions in 15 U.S.C. § 77c shall be inapplicable to that section.
The 1934 act, on the other hand, defines the term "security" as follows:
"When used in this title, unless the context otherwise requires -- . . . the term 'security' means any note, stock, treasury stock, bond, debenture . . . or in general any instrument commonly known as a 'security'; 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, bill of exchange, or banker's acceptance which has a maturity 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. § 78c(a)(10).
In spite of the slight differences in the language of the two acts defining a security (in the context of notes, the main difference is the reference in the 1933 act, not present in the 1934 act, to "current transactions"), the Supreme Court has termed the definitions "virtually identical," Tcherepnin v. Knight, 389 U.S. 332, 336, 19 L. Ed. 2d 564, 88 S. Ct. 548 (1967), and for the purposes of this opinion, they will be regarded as the same. The two acts' handling of short-term commercial paper (essentially, notes with a maturity not exceeding nine months), however, is somewhat different. While the 1934 act exempts such paper altogether, the 1933 act only exempts it from its registration and prospectus requirements. It is still subject to the anti-fraud provisions of the 1933 act. Thus, if the acts were applied literally to the notes at issue here, which had a maturity at the time of issuance of one day, only the 1933 act would apply.
It is now well-settled, however, that the federal securities statutes are not to be construed literally in determining what is a security, but are to be applied flexibly in light of Congressional intent, with "form . . . disregarded for substance and the emphasis . . . on economic reality." Tcherepnin v. Knight, 389 U.S. 332, 336, 19 L. Ed. 2d 564, 88 S. Ct. 548 (1967). ". . . Congress intended the application of these statutes to turn on the economic realities underlying a transaction, and not on the name appended thereto." United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 849, 44 L. Ed. 2d 621, 95 S. Ct. 2051 (1975). Under this approach, the sale of shares in a co-operative housing development has been held not to be a security transaction, even though the shares in the development were called "stock," and the securities statutes' definition of a security includes the words "any . . . stock." Id.
In the case of notes, whether a note is within the acts or exempt turns not on its maturity, as it would under a strict interpretation of the statutes, but on whether the note was issued as commercial or investment paper. Lino v. City Investing Co., 487 F.2d 689 (3d Cir. 1973); Bellah v. First National Bank of Hereford, Texas, 495 F.2d 1109 (5th Cir. 1974); C.N.S. Enterprises, Inc. v. G. & G. Enterprises, Inc., 508 F.2d 1354 (7th Cir. 1975); Great Western Bank & Trust v. Kotz, 532 F.2d 1252 (9th Cir., 1976) reported in Federal Securities Law Reporter, Para. 95,494 at p. 99,496 (1976); Sanders v. John Nuveen & Co., Inc., 463 F.2d 1075 (7th Cir. 1972); and SEC v. Continental Commodities Corp., 497 F.2d 516 (5th Cir. 1974). As stated by the court in McClure v. First National Bank of Lubbock, Texas, 497 F.2d 490, 494-495 (5th Cir. 1974):
"On the one hand, the Act covers all investment notes, no matter how short their maturity, because they are not encompassed by the 'any note' language of the exemption. On the other hand, the Act does not cover any commercial notes, no matter how long their maturity, because they fall outside the 'any note' definition of a security. Thus, the investment or commercial nature of a note entirely controls the applicability of the Act . . .."