CLARK, Circuit Judge:
This appeal raises substantial and complex questions involving the Securities Act of 1933. Defendants-Appellants, the Freemans and Browne, have appealed from a jury verdict awarding rescission
The evidence viewed in this light indicates that the Freemans and Browne had developed a franchise promotion scheme designed to funnel funds from the sale of stock in certain franchise sales centers to themselves as stockholders of American International Franchises, Inc. (American). The Freemans formed American in Springfield, Missouri, in July 1967 with Browne joining one month later as Executive Vice President. These three individuals comprised all of the officers and stockholders of American.
The franchising concept conceived by the Freemans involved the marketing of two restaurant franchises called Hickory Corral and Italian Den. The Chairman of the Board of Directors of Hickory Corral was Gurn Freeman, and the Chairman of the Board of Italian Den was Jack Freeman. The only restaurant of either type to be operated was one Hickory Corral which opened in Springfield, Missouri, and closed shortly thereafter. Under the plan commonly used, American would seek out local investors to incorporate a state-wide or regional franchise sales center. The payment of a franchise fee to American conferred upon this sales center the exclusive right to sell Hickory Corral and Italian Den franchises within the State or region. The local investors who formed the franchise sales center corporation would sell stock in the corporation to a small number of persons who would be most likely to furnish supplies and services to the restaurants; for instance, a real estate firm, an air conditioning company or a builder. American was also in the franchise consulting business and was to assist the local investors in organizing and developing the business of the sales center.
Several years prior to the transactions in question, these defendants formed another franchise operation named Nationwide Motorists Association (Nationwide). Nationwide was in the business of selling automobile club franchise distributorships throughout the United States. These statewide distributorships would in turn sell the franchise and the club membership package to independent insurance agencies. These agencies would market club memberships directly to the motoring public. In December 1967, the Securities Exchange Commission (S.E.C.) commenced an investigation of Nationwide and its officers and subpoenaed the Freemans to produce Nationwide's corporate records. The Freemans responded by denying they possessed any records. The ultimate outcome of the investigation is unclear, but no final disposition had been effectuated by the S.E.C. at the time of the transactions here in question.
During the first year of operation, the defendants formed the following franchise sales centers: Texas Franchise Systems, Inc.; Midwest Franchise Systems, Inc.; Georgia Franchise Systems, Inc.; Southeastern Franchise Systems, Inc.; Colorado Franchise Systems, Inc.; and Florida Franchise Systems, Inc. (Florida Franchise), the sales center involved in this case. During the period of the stock sales in Florida Franchise, the defendants' other sales centers were the object of investigations by various state securities commissions. Shortly
Florida Franchise was formed by dispatching Browne and William Osborne to Miami for the purpose of soliciting pre-incorporation subscriptions from Florida investors. An advertisement was placed in a local newspaper seeking a "Vice President of Marketing" for the proposed franchise sales center. When responses to the advertisement were received, the applicant was interviewed and asked to complete a financial statement indicating his net worth. If the applicant's net worth statement reflected an ability to invest in the proposed sales center, he was then told that to be hired by American, he would have to invest 5,000 dollars. The three applicants thus chosen to incorporate Florida Franchise were Shepherd, Quinn and McDaniel. The initial capitalization of 15,000 dollars invested by these three men was utilized to pay salaries and the expenses of Browne and Osborne in organizing the new sales center. Shepherd, Quinn and McDaniel were instructed by the defendants as to the solicitation of additional capitalization for Florida Franchise. This instruction included advice on what kind of investors to approach and the nature of the introductory language or "sales pitch" to be used. Between July 1968 and December 1968, Shepherd, Quinn and McDaniel, utilizing the instructions of Browne and Osborne, sold the remaining stock to plaintiffs. To induce them to purchase stock, the plaintiffs were shown promotional literature prepared by American, were told that Browne was an experienced capitalization consultant, and were given glowing reports on the operations of the other sales centers. Browne admitted at trial that the statement ascribed to him was false. The plaintiffs were never informed of the S.E.C. investigation of Nationwide nor of the State investigations of the other sales centers. Indeed, when Shepherd contacted the other sales centers, he received nothing but glowing reports from them.
American purchased 10,000 dollars worth of stock out of the 70,000 dollars worth of stock available in Florida Franchise. During the formative stages of Florida Franchise, American required that two of the five directors be representatives of American. American also required that Mickey Viles, an employee of American, become the secretary-treasurer of Florida Franchise, and in addition, Browne became the Chairman of the Board and chief executive officer. Browne later resigned, and Shepherd assumed these positions. American provided all stationery, promotional material, and sales and franchise literature. Florida Franchise was required to keep all of its corporate minute books and accounting books and records at American's office in Springfield, Missouri. All bank statements of Florida Franchise were sent directly from the bank to American in Missouri. American provided a set of recommended by-laws which were adopted by Florida Franchise. Finally, American prohibited Florida Franchise from marketing any franchises unless they were supplied by American.
On October 4, 1968, American and Florida Franchise entered into a franchise agreement, utilizing a form agreement drafted by American. The price to Florida Franchise for this exclusive right to sell was 25,000 dollars. Subsequent to the payment of the 25,000 dollars, on October 22, American insisted that Florida Franchise enter into a new agreement which provided for an additional franchise fee of 1,000 dollars per month.
Plaintiffs, alleging that these activities amounted to a pyramiding scheme to funnel money to American, brought this suit for rescission of the stock sales and the return of their investments. The jury awarded rescission and a return of the stock purchase monies paid by all but two of the plaintiffs and in addition, assessed punitive damages of
Plaintiffs based their right of recovery on Section 12(1) and Section 12(2) of the 1933 Securities Act. The following issues are raised in this appeal: 1. Did the defendants violate either Section 12 (1) or Section 12(2)? 2. If the defendants are liable to the plaintiffs, may punitive damages be assessed against them? 3. Should a motion for a mistrial have been granted because of the alleged misconduct of plaintiffs' counsel?
SECTION 12(1) RECOVERY FOR SECTION 5 VIOLATION
Section 12(1) of the 1933 Securities Act, 15 U.S.C.A. § 77l(1), states:
Section 5(a) and (c) of the Securities Act of 1933, 15 U.S.C.A. § 77e, provides:
Thus it is evident that Section 5 establishes and defines proscribed conduct and that Section 12(1) provides a remedy for a Section 5 violation. The basic question then is whether or not Section 5 was violated by the defendants.
In order to establish a prima facie case for a Section 5 violation, a plaintiff must prove three elements. First, it must be shown that no registration statement was in effect as to the securities. Second, it must be established that the defendant sold or offered to sell these securities, and finally, the use of interstate transportation or communication or of the mails in connection with the sale or offer of sale must be proved. See Lennerth v. Mendenhall, 234 F.Supp. 59 (N.D.Ohio 1964); III Loss, Securities Regulation 1693 (2d ed. 1961).
It is conceded that no registration statement had been filed with the S.E.C. in connection with this offering of securities. The defendants contend, however, that the transactions come within the exemptions to registration found in 15 U.S.C.A. § 77d (2) [commonly known as Section 4(2)]. Specifically, they contend that the offering of securities was not a public offering.
The S.E.C. has stated that the question of public offering is one of fact and must depend upon the circumstances of each case [see 1 CCH Fed.Sec.L.Rep. ¶¶ 2740 (1935), 2770 (1962)]. We agree with this approach. It is of course apparent that presenting an issue of fact to S.E.C. analysts is totally different from presenting a question of fact to a jury unsophisticated and untrained in the niceties of securities law. Although courts accord a marked deference to the expertise of such an agency which is charged with broad regulation of a specific field when reviewing their regulatory action, we do not intimate that their procedures are binding precedent. However, to be consistent — which is the constant aim if not the invariable result of the law — and, most vitally, because we find S.E.C. criteria both legally accurate and meaningfully sufficient for testing the issue, we hold that a jury should consider the factors enumerated below which the S.E.C. considers, together with the policies embodied in the Act.
The following specific factors are relevant:
1. The number of offerees and their relationship to each other and to the issuer.
Here again there is no fixed magic number. Of course, the smaller the number of units offered, the greater the likelihood the offering will be considered private.
3. The size of the offering.
The smaller the size of the offering, the more probability it is private.
4. The manner of offering.
A private offering is more likely to arise when the offer is made directly to the offerees rather than through the facilities of public distribution such as investment bankers or the securities exchanges. In addition, public advertising is incompatible with the claim of private offering.
Even an objective testing of these factors without determining whether a more comprehensive and generalized prerequisite has been met, is insufficient. "The natural way to interpret the private offering exemption is in light of the statutory purpose." S.E.C. v. Ralston Purina Co., supra at 984. "The design of the statute is to protect investors by promoting full disclosure of information thought necessary to informed investment decisions." Id. Thus the ultimate test is whether "`the particular class of persons affected need the protection of the Act.'" Id.
It is evident that the jury instructions in this case did not expressly state every one of the specific criteria we have recited. However, we do not find the deficit constitutes reversible error. Most importantly, the Court correctly stated the ultimate test. Its instructions also made it clear that the number of offerees was not controlling and explicitly advised that every offeree had to have information equivalent to that which a registration statement would disclose. The only omitted specifics — the number of units offered, the overall size of the offering and the manner in which the offering was made — could not have changed the resolution of the issue for this case, as will be shown below.
The plaintiffs countered the defense of private offering by pressing two contentions. First, they argue that we must observe the entire nationwide
It is well-settled law that the defendants have the burden of proving their affirmative defense of private offering. S.E.C. v. Ralston Purina Co., supra, 73 S.Ct. at 985. The defendants, however, adduced no evidence on this issue, relying instead on the evidence introduced by the plaintiffs to prove these sales were exempt from registration. The evidence indicates that this offering was limited to sophisticated businessmen and attorneys who planned to do business with the new firm. The thirteen actual purchasers paid 5,000 dollars each for their stock. In order to be exempt from the Florida Blue Sky Law, the total number of purchasers in the first year of stock sales was deliberately kept below fifteen and the number of original subscribers below five, pursuant to advice these plaintiff-purchasers obtained from independent legal counsel who they retained to render advice on the Blue Sky and S.E.C. laws. Finally, the defendants assert that the plaintiffs had access to all the information they desired. We take this to mean that the plaintiffs had access to all information concerning Florida Franchise. We also interpret it to mean that the plaintiffs could have obtained any information they desired concerning American and the background of the individual defendants if they had just asked.
The defendants rely most strongly on the fact that the offering was made only to sophisticated businessmen and lawyers and not the average man in the street. Although this evidence is certainly favorable to the defendants, the level of sophistication will not carry the point. In this context, the relationship between the promoters and the purchasers and the "access to the kind of information which registration would disclose" become highly relevant factors. Relying specifically upon the words just quoted from Ralston Purina, the S.E.C. has rejected the position which the defendants posit here, stating: "`The Supreme Court's language does not support the view that the availability of an exemption depends on the sophistication of the offerees or buyers, rather than their possession of, or access to, information regarding the issuer * * *'." I Loss, Securities Regulation 657 n. 53 (2d ed. 1961). Obviously if the plaintiffs did not possess the information requisite for a registration statement, they could not bring their sophisticated knowledge of business affairs to bear in deciding whether or not to invest in this franchise sales center.
While defendants allude to other evidence in this case, the paucity of evidence pertaining to the relevant considerations remains stark. The record contains no evidence as to the number of offerees. The fact that there were only thirteen actual purchasers is of course irrelevant.
This Court reviews cases, it neither tries nor retries fact issues. Thus we must not be understood as even intimating that we can engage in the fact-finding process at the appellate level. What we decide in no wise impinges on these principles. Faced with the state of evidentiary development when the parties rested, the court below could properly reach the same conclusion as the court in Repass v. Rees, 174 F.Supp. 898, 904 (D.Colo.1959):
See also Nicewarner v. Bleavins, 244 F.Supp. 261 (D.Colo.1965). What we decide here is that the trial court cannot be faulted for failing to submit to a jury specific phases of an issue on which the proof would fail to meet the test enunciated in Boeing Co. v. Shipman, 411 F.2d 365
We must now determine if the plaintiffs have proved the remaining elements of a Section 5 violation, i. e., use of any means or instruments of transportation or communication in interstate commerce or of the mails and the sale or offer of sale of a security.
We need not tarry on the first of the above elements because the record is replete with evidence indicating the use of the mails between Missouri and Florida, the use of the telephone between these two states, and numerous trips by the defendants to Florida. The last element — sale or offer of sale of a security — however, gives us pause.
The law is settled that a purchaser may only recover from his immediate seller.
Applying this test to the problem at hand, it is at once apparent that the defendants fall within its letter and spirit. The defendants were the motivating force behind this whole project. They sought out the original incorporators of Florida Franchise and then trained them to solicit additional capital for the corporation. They provided the sales brochures designed to secure this additional capital. They rendered advice on every aspect of the corporate formation and subsequent development. In fact, the defendants did everything but effectuate the actual sale. We can deduce with certainty that the plaintiffs would not have purchased this stock had the defendants not traveled to Florida carrying their bag of promotional ideas. "The hunter who seduces the prey and leads it to the trap he has set is no less guilty than the hunter whose hand springs the snare." Lennerth v. Mendenhall, supra, 234 F.Supp. at 65. Thus we find the defendants to be persons who sold or offered to sell within the meaning of Section 12(1) and, therefore, hold them liable under that section.
We need not rest here, however, because we further find that the defendants are controlling persons within the meaning of 15 U.S.C.A. § 77o (1971) (Section 15), which reads:
Thus if Shepherd, Quinn and McDaniel have violated Section 5 and the defendants "controlled" them, then the defendants are liable under Section 12(1).
Obviously Shepherd, Quinn and McDaniel sold securities without a registration statement being in effect. The private offering exemption has been eliminated by our previous discussion. The closest question relates to their use of the mails or instruments of transportation or communication in interstate commerce and justifies a factual explication. Although the evidence in the record is scanty on this point, it does show that McDaniel made at least one interstate phone call to one of the plaintiffs in connection with this sale of stock. In addition, he traveled to Atlanta from Miami to discuss the sale. We do not know what mode of transportation McDaniel utilized, but that is irrelevant since this Circuit has held that interstate travel even by private automobile comes within the purview of the Act. Moses v. Michael, 292 F.2d 614 (5th Cir. 1961). The fact of travel from one State to another is what controls. The mails were used on a number of occasions, but the proof only indicates mailings within the state of Florida. However, purely intrastate utilization of the United States postal service has been held to be sufficient to generate the proscriptions of Section 5. Shaw v. United States, 131 F.2d 476 (9th Cir. 1942).
There is also ample evidence to support the jury finding that the defendants were controlling persons. The defendants rely mainly on the fact that they were not majority stockholders and did not possess majority control of the Board of Directors of Florida Franchise. This formalism alone is not determinative of the question since the statute refers to control by stock ownership, agency or otherwise.
The defendants fall neatly within this definition. The evidence as previously outlined in this opinion demonstrates that the defendants at least possessed and at times exercised the power to direct the management and policies of Florida Franchise.
Although we find no prior precedent on the subject, we hold that the plaintiffs had the burden of establishing control. The following points amply attest that the plaintiffs have discharged this burden. The whole project originated with the defendants, and all of the basic ideas for its effectuation came from them. In fact, the record indicates that Shepherd, Quinn and McDaniel were mere instruments in executing the plans of the defendants. The defendants told these men how to organize the corporation, how to solicit additional capital, and supplied them tangible paraphernalia for executing the scheme. But the most telling evidence against the defendants is their use of the franchise agreement as a Damocles sword in compelling compliance with their wishes. Shepherd, Quinn and McDaniel each knew that if they did not follow the defendants dutifully, the agreement would be cancelled, resulting in a lost business opportunity and the loss of a 5,000 dollar investment. For analogous cases in this area, see Stadia Oil & Uranium Co. v. Wheelis, 251 F.2d 269 (10th Cir. 1957) and Zachman v. Erwin, 186 F.Supp. 681 (S.D.Tex.1959).
Lastly, the defendants argue that they are exempted from liability by the controlling person's special defense embodied in the last clause — "unless the controlling person had no knowledge of or reasonable ground to believe in the existence of the facts by reason of which the liability of the controlled person is alleged to exist." The jury's verdict necessarily included a determination adverse to this defense
SECTION 12(2) RECOVERY
In addition to holding the defendants liable under Section 12(1), we also find them liable under Section 12(2). Section 12(2) reads as follows:
Thus the plaintiffs were required to prove that the defendants sold or offered to sell these securities by the use of the mails or instruments of transportation or communication in interstate commerce, and that the defendants misrepresented or omitted material facts. In addition the plaintiffs had to show that they had no knowledge of any untruth or omission. See Hayes, Tort Liability for Misstatements or Omissions in Sales of Securities, 12 Clev-Mar L.Rev. 100, 103-04 (1963). The plaintiffs need not prove scienter on the part of the defendants. Phillips v. Alabama Credit Corp., 403 F.2d 693 (5th Cir. 1968).
Some preliminary observations are appropriate. The exemptions found in Sections 3 and 4 (with one exception not pertinent here) are not applicable to the securities and transactions involved in a Section 12(2) cause of action. Woodward v. Wright, 266 F.2d 108, 116 (10th Cir. 1959); Moore v. Gorman, 75 F.Supp. 453 (S.D.N.Y.1948); III Loss, Securities Regulation 1699 (2d ed. 1961). Thus, contrary to a Section 12(1) violation, liability under Section 12(2) would not be affected by a finding that the offering was private. Our discussion as to the use of the mails and instruments of transportation or communication in interstate commerce in Section 12 (1) is equally applicable here. For the most part, the same is true of the reasoning relative to the status of the defendants as "sellers". While, as we previously pointed out, an even broader construction has sometimes been accorded the term "any person who sells or offers to sell" under Section 12(2) than under Section 12(1), we find no authority which has utilized a narrower standard. Therefore, applying the test we previously announced, we hold the defendants were sellers within the meaning of Section 12(2).
See also Gilbert v. Nixon, supra, 429 F. 2d at 356; Johns Hopkins University v. Hutton, supra, 422 F.2d at 1128-1129; Hayes, supra at 106-107. One note of caution should be sounded here. A causation test should not be read into this Section. A plaintiff does not have to prove that the sale would not have occurred absent the misrepresentation or omission. Gilbert v. Nixon, supra, 429 F.2d at 357; Johns Hopkins University v. Hutton, supra, 422 F.2d at 1129.
In similar fashion, we again reject the defense based upon the plaintiffs' sophistication. "Neither the monumental credulity of the victim nor the investor's sophistication or independent knowledge offer a refuge to the defendant." Hayes, supra at 107 (footnotes omitted). The defendants' argument concerning the availability of information to the plaintiffs is equally unavailing here. The plaintiffs do not have to prove that they could not have discovered the falsity upon reasonable investigation. Gilbert v. Nixon, supra, 429 F.2d at 356. To put it simply, the availability of information elsewhere does not excuse misleading or incomplete statements. Dale v. Rosenfeld, 229 F.2d 855, 858 (2d Cir. 1956). Finally, the record contains abundant evidence supporting the fact that the plaintiffs were indeed ignorant of the untruths and omissions.
In their final argument the defendants contend that they did not know, and in the exercise of reasonable care could not have known, of such untruth or omission. For example, the defendants argue that they could not have known of the investigations of the other sales centers because they were not named parties to those investigations. We need only comment that the defendants had the burden of proof of establishing a lack of scienter. Gilbert v. Nixon, supra, 429 F.2d at 357; Woodward v. Wright, supra, 266 F.2d at 116.
There is of course another ground upon which the defendants' liability might have attached under Section 12 (2). That ground is based upon the controlling persons concept of Section 15. This would of course require a showing that Shepherd, Quinn and McDaniel violated Section 12(2). Every reasonable inference from the evidence, however, supports the conclusion that these men were as ignorant as the plaintiffs concerning the defendants' misrepresentations and omissions. It is evident, therefore, that these men did not violate Section 12(2), and thus the plaintiffs could
Having determined that defendants are liable under both Section 12(1) and Section 12(2), we must now decide whether or not punitive damages are available on these grounds of liability. We hold that they are not available. We deem it significant and persuasive that only four authorities out of the vast array of cases, texts and law review articles cited and examined in our independent research contain any discussion concerning punitive damages in such a context as here presented. One such authority is the case of Nagel v. Prescott & Co., 36 F.R.D. 445 (N.D.Ohio 1964). The court in dictum stated that punitive damages could be awarded if the defendants were actuated by malice. On the other hand, three commentators have flatly stated that no authority for the award of such damages exists.
The parties have completely misconceived the nature of their arguments concerning punitive damages. They have centered their arguments around cases which pertain to the propriety of awarding punitive damages under Section 17 (the fraud section). That Section is not and has never been a part of this case. Needless to say, we intimate no views concerning the propriety of allowing punitive damages under Section 17. Indeed, this Circuit has not yet decided whether or not an implied right of action exists for violations of Section 17. John R. Lewis Inc. v. Newman, 446 F.2d 800 (5th Cir. 1971).
ALLEGED MISCONDUCT OF PLAINTIFFS' COUNSEL
In the contentious atmosphere engendered by this case, which took more than two weeks to try, lawyer talk has again created the most heat. But after dissipating that heat and shedding some light, we find that this issue boils down to a tempest in a teapot. The defendants bitterly complain of the repeated questions concerning the "troubles" of the "Freeman boys" with the S.E.C. and the various state securities commissions. Defendants assert that there is no evidence that they knew of these troubles. They further contend that on many occasions the trial judge sustained objections to questions regarding the "troubles", but that plaintiffs' counsel persisted in posing questions along this same line. Therefore, the trial judge, they contend, erred in not granting their motion for a mistrial.
The trial judge specifically allowed questioning about the various investigations. He obviously realized that such questions were highly relevant to Section 12(2) liability. On most occasions the line of questioning met with other occasions their objections were no objection from the defendants and on overruled. Whenever the objections were sustained, the grounds generally
The judgment ordering rescission of the stock sales and return of the purchase price was correct. The award of punitive damages was in error. The final judgment appealed from is vacated and the cause is remanded with directions to enter judgment in accordance with this opinion.
Affirmed in part, reversed in part, and remanded.
Certainly limiting the class of offerees does not invariably avail the person who claims the exemption as the following statement by the court in S.E.C. v. Sunbeam Gold Mines Co., 95 F.2d 699, 701 (9th Cir. 1938) reveals: