On Appeal from The United States District Court for The District of New Jersey.
Gibbons and Hunter, Circuit Judges, and Rambo, District Judge*fn*
This appeal requires that we determine whether stock transferred to effectuate the sale of all or part of a business is a "security" within the meaning of the 1933 and 1934 Securities Acts.*fn1 The district court, holding that the purchase or sale of 50 percent of the stock of a business is a security only if the transaction satisfies the "investment contract" or "economic reality" test of SEC v. W.J. Howey Co., 328 U.S. 293, 90 L. Ed. 1244, 66 S. Ct. 1100 (1946), entered summary judgment for the defendants. The plaintiff, and the Securities and Exchange Commission as amicus curiae, urge that the district court erred in applying the Howey test in these circumstances. The question whether the Howey test applies to the sale of stock having the traditional attributes of stock ownership is the subject of considerable academic commentary*fn2 and has produced a split of authority in the circuits.*fn3 Joining the Second, Fourth, Fifth and Eighth Circuits, we hold that the Howey test does not apply to the sale of all or part of a business effectuated by the transfer of stock bearing the traditional incidents of stock ownership. Thus we reverse.
I. Facts and Proceedings in the District Court
Continental Import & Export, Inc., is an importer of wines and spirits. Joachim Birkle is president of Continental and, until 1980, owned or controlled 100 percent of its stock. Ruefenacht, the plaintiff, alleges that early in 1980 he purchased 2500 shares of Continental's stock for $250,000 -- said to represent 50 percent of the company -- in reliance on financial documents and other oral representations made by Birkle, Christopher O'Halloran, a certified public accountant, and W. George Gould, Continental's corporate counsel.
In deposition testimony, Ruefenacht asserted that the consideration for the price for Continental's stock included a promise by him to devote certain efforts to the firm's business. In conformance with that promise, Ruefenacht engaged in various activities on behalf of the company. In the summer of 1980, for example, he solicited contracts to import beverages on behalf of the firm. On other occasions Ruefenacht participated in the hiring of company employees. He also applied for and received a state liquor license (or solicitor's permit), representing at that time that he would sell alcoholic beverages to wholesalers and receive in return a salary and compensation for expenses. On another occasion Ruefenacht signed a banking resolution denominating himself an officer of Continental. That resolution was signed at Birkle's request for the purpose of permitting Ruefenacht to sign corporate checks when Birkle was out of the country.
The record also reveals that Ruefenacht participated in the affairs of Continental in other minor ways. He attended luncheon meetings, occasionally translated documents, maintained telephone contact with Continental employees on a regular basis, and visited warehouses considered for use by Continental. While engaging in these activities, however, Ruefenachht remained a full-time employee of another corporation. Moreover, his actions on behalf of Continental were at all times subject to the veto of Birkle.
After Ruefenacht paid $120,000 of the total $250,000 purchase price for Continental stock, he began to doubt the accuracy of certain representations made to him by Birkle and others. Soon thereafter he filed this action, alleging violation of sections 12(2) and 17(a) of the Securities Act of 1933, 15 U.S.C. §§ 77(2), 77q (1982), section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) (1982), and Rule 10(b)(5), 17 C.F.R. § 240.10(b)(5) (1983). Ruefenacht charges that financial statements prepared by O'Halloran and signed by Birkle overvalued Continental's goodwill and licenses by $243,000; that these financial statements assigned a $400,000 value to import or contract rights with no substantial worth; that the firm reported a surplus when in actuality it maintained a deficit; and that the defendants represented that net profits on sales between 1980 and 1981 would be $848,000 under a nationwide distribution program, and $1.197 million in the New York area, when in fact Continental was not seriously negotiating contracts for nationwide distribution at all and could not reasonably project these net earnings. In reliance on these representations, Ruefenacht alleges, he had purchased 1000 shares of Continental's stock and had advanced $120,000 to Birkle. The complaint seeks recission and restoration of the amount paid. Ruefenacht also pleads pendent state claims for fraud and breach of fiduciary duties.*fn4
The district court granted summary judgment for defendants, concluding that the stock purchased by Ruefenacht was not a "security" within the meaning of the 1933 and 1934 Acts. The court so concluded not because the instrument purchased by Ruefenacht lacked any of the indicia of stock ownership; indeed, the court conceded that the "stock which Ruefenacht received contains all the attributes mentioned by the Forman*fn5 Court as indicating that the transaction did involve a security." App. at 220. Rather, the court held, the instrument was not a "security" because of the degree of Ruenfenacht's control over Continental's business. "Because Mr. Ruefenacht intended to jointly manage Continental with Mr. Birkle," the district court reaosned, "he did not purchase securities' as defined in the federal acts." App. at 309. Finding no federal jurisdiction over the securities claims, the district court dismissed the complaint in its entirety.
History of the Sale-of-Business Doctrine
The 1933 and 1934 Securities Acts include within the definition of "security" a series of specific terms -- e.g., "note," "stock," "bond," and "debenture" -- and thereafter employ a number of more general phrases -- e.g., "investment contract," "any interest or instrument commonly known as a security.'"*fn6 As early as 1943 the Supreme Court held that certain novel economic transactions were encompasseed within these latter, more generic terms, even though not embraced by their more specific provisions like "stock, "bond," or "note." See SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 348-55 (1943) (holding that leasehold interests in property adjacent to exploratory oil wells were "securities"). The Court's leading opinion on this point, SEC v. W.J. Howey Co., 328 U.S. 293 (1946), held that agreements for the sale of a citrus crop coupled with optional service contracts were "investment contracts." Howey propounded a definition of "investment contract" derived from descriptions widely employed in state "blue sky" laws: an investment or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party. . . ." Id. at 298-99. This definition came to be known as the " Howey test" and led many courts to classify a variety of novel economic schemes as "investment contract."*fn7
While the courts were giving the term "investment contract" a broad compass, the more specific term "note" was read narrowly, so as not to embrace every instrument comporting with the Acts' terms that is technically a "note" under state law. The first appellant holding that not every such "note" is a "security" under the federal Acts is this court's decision in Lino v. City Investing Co., 487 F.2d 689 (3d Cir. 1973).*fn8 In Lino, this court held that a personal promissory note tendered as partial consideration for rights under a franchise agreement was not a "note" under the federal Acts. Id. at 693-96. Significantly, we did not apply the Howey test to the notes in question, as Part I of the opinion pointedly made clear by applying the Howey test to the franchise agreements themselves. Id. at 691-93. Rather, we examined the entire context of the note transaction, declining at that time to expound "a test' . . . that would aid in determining whether there has been a purchase or sale of securities when a personal promissory note is involved." Id. at 696 n.15.
Following Lino's lead, several courts strove to define the circumstances under which a "note" should be considered a "security" under the Securities Acts. The Fifth Circuit sought to determine whether a note comprised an "investment."*fn9 The Ninth Circuit approached the problem on a slightly different tack, seeking to determine whether the lender supplies "risk capital" to the market.*fn10 In a leading opinion written by Judge Friendly, the Second Circuit rejected both of these approaches. See Exchange National Bank of Chicago v. Touche Ross & Co., 544 F.2d 1126 (2d Cir. 1976) (Friendly, J.). In part the Second Circuit feared that the "investment" and "risk capital" tests obliterated Congress' carefully drawn distinctions among those notes included within and excluded from the Acts. Congress took care to provide that any note arising out of a "current transaction" and having a maturity not exceeding nine months was excluded from the registration provisions, but included in the anti-fraud provisions, of the 1933 Act;*fn11 and that any note with a maturity not exceeding nine months was excluded from the 1934 Act.*fn12 As the Fifth Circuit candidly acknowledged, its "investment test" "virtually writes [these distinctions] out of the law." McClure v. First National Bank of Lubbock, 497 F.2d 490, 494 (5th Cir. 1974), cert. denied, 420 U.S. 930, 43 L. Ed. 2d 402, 95 S. Ct. 1132 (1975). In addition, the Second Circuit expressed concern over the uncertainty that would inevitably follow from a weighing of factors "without any instructions as to [their] relative weights." Exchange National Bank, 544 F.2d at 1137. In lieu of the "investment" and "risk capital" approaches, the Second Circuit enumerated a family of note transactions presumptively excluded from the Act -- all concerning consumer financing or business financing of current costs -- and held that other notes not bearing the family pedigree were presumptively securities under federal law.*fn13
There matters stood when late in 1976 the Seventh Circuit held that the Howey test for "investment contract" applies to determine whether a "note" is a security under the Acts. Emisco Industries, Inc. v. Pro's Inc., 543 F.2d 38, 39-40 (7th Cir. 1976). The extension of Howey into the note arena was problematical. This application of Howey further obliterated the special statutory distinctions drawn by Congress among notes included in and excluded from the Acts, and injected into the note area the same uncertainty that pervades litigation over the inherently vague term "investment contract." Moreover, the Seventh Circuit doctrine seemed to ignore some important statutory policies underlying the securities Acts. As the legislative history makes abundantly clear,*fn14 one such policy is the protection of "investors"; and to the extent that Howey maps the entire set of "investors" marked for protection -- not an obviously correct assumption -- then that policy may be satisfied. But a second policy of the Acts is, as we observe below, the protection of the marketability of certain instruments of commerce, whether or not purchased by "investors" under the Howey formula. Among the favored instruments, for example, is certain commercial paper.*fn15 Several commentators have perceiptively remarked that an application of the "investment" or " Howey " tests to these commerical instruments would undermine federal protection for many instruments most deserving of coverage.*fn16
Notwithstanding these concerns, in 1981 the Seventh Circuit extended the Howey or "economic reality" test to the purchase or sale of stock. Frederiksen v. Poloway, 637 F.2d 1147 (7th Cir.), cert. denied, 451 U.S. 1017, 69 L. Ed. 2d 389, 101 S. Ct. 3006 (1981). While the extension of the Howey test to the note area had been greeted with some concern, the further extension of that doctrine to the purchase or sale of stock sparked a considerable amount of alarm.*fn17 While the difficulties attending the simple extension of Howey to notes still applied, two other difficulties loomed even larger.
First, at least in the note area there is, as we held in Lino, some necessity for fine-tuning the definition of "note" to avoid sweeping within the coverage of section 10(b) of the 1934 Act every consumer and business loan financing current operational costs. But there is no such necessity in the stock area. Stock is a well-defined term, is not issued by consumers, and is not ordinarily employed by business to finance current transactions. While the importation of the Howey test into the note arena might be justified as an expedient -- albeit an imperfect one -- for limiting the definition of "note," no such expedient seems necessary for the issue of stock.
Second, because the Howey test turns in part on whether the purchaser derives profits "from the entrepreneurial of managerial efforts of others," see United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 852, 95 S. Ct. 2051, 44 L. Ed. 2d 621 (1975), a central aspect of the test, when applied to stock, requires a determination whether the purchaser exercises a controlling share of the corporation.*fn18 A controlling share may be exercised with less than 100 percent stock ownership -- indeed, at times with far less than 50 percent ownership. See Sutter v. Groen, 687 F.2d 197, 203 (7th Cir. 1982). Thus an instrument might be transformed from a security into a non-security by virtue of a small increase in the number of shares traded. Instruments purchased by multiple investors might be securities as to some purchasers and non-securities as to others, or securities as to sellers but not as to purchasers.*fn19 Instruments might be securities if traded in a series of small transactions but non-securities if the same transaction is effectuated in a single sale. To many judges and lawyers with up to 50 years of experience with the securities laws, these seemed extraordinary consequences.*fn20
The case now before us illustrates just how far the extension of Howey from investment contract to note to stock may be taken. Ruefenacht is the purchaser of 50 percent of the stock of Continental. Had he purchased only 49 percent, Ruefenacht would presumably have lacked corporate control, rendering the instrument purchased (at least presumptively) a security. Had he purchased 51 percent, in contrast, the instrument would presumptively not have been a security. Both presumptions, of course -- at least under the Seventh Circuit approach, see Sutter, 687 F.2d at 203 -- would have been subject to rebuttal. Because Ruefenacht purchased exactly 50 percent, a more sophisticated analysis would presumably be required -- although just what that analysis should be is less than obvious.
III. The Securities Acts as Interpreted by the Supreme Court
If Congress or the Supreme Court has mandated these results, then, regardless of their deficiencies in logic, we would be bound to apply them. We turn, therefore, to the language, history, structure, and policies of the 1933 and 1934 Acts. Then we consider the impact of recent Supreme Court decisions.
Statutory Language, Structure, and History
1. The definition and exemption provisions
Section 2(1) of the 1933 Act as amended provides that the term "security" means any note, stock, treasury stock, bond, debenture, . . . investment contract, . . . or, in general, any interest or instrument commonly known as a security'. . . ." 15 U.S.C. § 77b(a) (1982). The legislative history to section 2(1) indicates that Congress cast the definition of security "in sufficiently broad and general terms so as to include within that definition the many types of instruments that in our commerical world fall within the ordinary concept of a security." H.R. Rep. No. 85, 73d Cong., 1st Sess. 11 (1933).
Although Congress intended that the term "security" embrace those instruments that "fall within the ordinary concept of a security," several important qualifications limit this definition. Preceding all of the definitions in the 1933 Act is the clause "unless the context otherwise requires." The significance of the so-called "context clause" is addressed in Part III A 3 infra.
In addition, section 3 of the 1933 Act defines a number of important "exempted securities." Among the defined exemptions in the 1933 Act is an exception for short-term notes. Section 3(a) provides that the Act shall not apply to:
"Any note, draft, bill of exchange, or banker's acceptance which arises out of a current transaction . . . and which has a maturity at the time of issuance of not exceeding nine months. . . ." 15 U.S.C. § 77c(a)(3) (1982). As one commentator has observed, Congress intended the short-term note exemption to free from the Act's registration requirements prime quality commercial paper sold to knowledgeable investors. The necessity for disclosure in a registration statement to these investors was less vital than for sales of other, more speculative paper to other, less knowledgeable ...