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December 14, 1978

S. Hayward WILLS et al., Defendants

The opinion of the court was delivered by: GESELL


By this civil action the Securities and Exchange Commission ("SEC"), alleging violations of the federal security laws, seeks both injunctive relief and disgorgement against two former officers of a now-bankrupt land development corporate complex. The SEC has alleged that the defendants did not make disclosures as mandated by Sections 13(a) and 14(a) & (e) of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. §§ 78m(a) & 78n(a) & (e) (1976), and by Rules 13a-1, 13a-11, 13a-13, and 14a-9, 17 C.F.R. §§ 240.13a-1, 240.13a-11, 240.13a-13 & 240.14a-9. The SEC also contends that, in connection with such nondisclosures, the defendants violated the anti-fraud provisions of Section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b) (1976), Section 17(a) of the Securities Act of 1933 (the "Securities Act"), 15 U.S.C. § 77q(a) (1976), and Rule 10b-5, 17 C.F.R. § 240.10b-5 (1977), as well as the interstate prospectus rule of section 5(b)(1) of the Securities Act, 15 U.S.C. § 77e(b)(1) (1976).

 Following a substantial bench trial, the submission of detailed proposed findings of fact and briefs, and oral arguments, the Court now enters its findings of fact and conclusions of law.

 I. The Facts

 A. The Business and Capitalization of Properties and Credit, and Credit's Public Filings.

 The proof concerns the operations of GAC Corporation ("GAC"), a holding company; GAC Properties, Inc. ("Properties"), a wholly-owned subsidiary engaged in land sales; and GAC Properties Credit, Inc. ("Credit"), a wholly-owned subsidiary of Properties and financier of Properties' land sale operations. Defendants Wills and Stuken were major officers of each of the three companies. *fn1"

 Credit was created in 1970 to meet most of these financing needs. Credit was given the task of raising the cash needed to finance Properties' operations through public debt offerings, bank lines of credit, and collections on the installment land contract receivables which Properties' land sale operations generated.

 Credit sold two issues of debentures. In November 1970, it issued $ 50 million of 12 percent Senior debentures due November 15, 1975 (the "1975 debentures"). In September 1971, it issued an additional $ 50 million Senior debentures, these with an interest rate of 11 percent and due September 1, 1977 (the "1977 debentures"). Both issues were registered under the Securities Act and under Section 12(b) of the Exchange Act. Each was also accompanied by the appropriate prospectus and indenture. The SEC does not now challenge either the accuracy or the completeness of the disclosures made in those initial documents.

 The SEC's contentions center instead on the period between April 1974 and September 1975. During that time, Credit was obligated by law to file with the SEC one annual Form 10-K covering the calendar year 1974 and several quarterly 10-Q's. In addition, Credit in September 1975 sent an Exchange Offer to its 1975 debenture holders *fn2" and requested its 1977 debenture holders to consent to several indenture amendments. *fn3" Accordingly, Credit had to prepare and file an Exchange Offer Prospectus and a Solicitation Statement. The SEC maintains that all of these documents contained material misrepresentations and omitted to state material facts.

 B. The Relationship Between Credit and Properties.

 Comprehension of the SEC's allegations requires some familiarity with the framework within which Credit operated by agreement with its debenture holders. This framework was created by an Operating Agreement into which Credit and Properties entered on November 15, 1970 (the "Operating Agreement"), by the indentures which underlay the company's two debenture issues (respectively the "1970 indenture" and the "1971 indenture"), and the two prospectuses which accompanied those issues (respectively the "1970 prospectus" and the "1971 prospectus").

 The Operating Agreement provided that Credit was to enjoy first rights to Properties' Eligible Receivables *fn4" (Section 2), prices to be negotiated from time to time (Section 3). Correspondingly, Credit was obliged to purchase all such Receivables as Properties tendered to it (Section 2), so long as Credit was able to finance the purchases on a "reasonable basis" (Section 6).

 With respect to all Eligible Receivables which Properties sold to Credit, Properties promised to perform or have performed "all acts and things for which Properties or any Real Estate Affiliate is committed under the terms of, or in connection with, any item of Receivables . . . ." (Section 12(a); See also Section 9). In addition, Credit "at all times" was to maintain "reserves" against the Receivables it purchased (Section 4), these reserves to be based, among other things, on percentages of Properties' own reserves, Properties' development costs, and the Receivables' gross principal amount. These "reserves" were not cash, but simply the partial nonpayment by Credit of what it owed Properties for the Eligible Receivables it undertook to purchase. *fn5"

 The 1970 and 1971 indentures required that Credit and Properties "duly and punctually perform all of the terms, agreements and conditions of the Operating Agreement." (Section 1008). Neither corporation could "terminate, cancel, assign, or materially amend, modify or supplement the Operating Agreement" (Id.), except with the permission of those holding at least two-thirds of the outstanding debentures. (Section 1013; Section 1012). Violation of this covenant would amount to an "event of default" (Section 501(6)).

 The 1970 and 1971 indentures defined with particularity the contours of the "business" in which Credit could engage:

 (Section 1004(b)).

 Credit, therefore, enjoyed a flow of income which depended heavily on Properties' customers continuing to make payments on the Eligible Receivables Credit held. These customers were not legally bound to make such payments, although upon default they generally did forfeit all previously paid sums. Whether or not they would default largely depended on Properties meeting its development obligations under the installment land contracts, on overall economic conditions, and on the nature of the publicity which surrounded the installment land contract business as a whole. As to Properties' ability to continue to meet its development obligations, this rested on its success in obtaining new installment land contract receivables (to sell to Credit for cash), on not having to buy back cancelled Eligible Receivables from Credit, and, of course, on the soundness of its initial development cost predictions. Customer defaults did not proportionately reduce development costs which were largely geared to projects rather than individual lots.

 The inherent weaknesses in this structure were highlighted by both the 1970 and 1971 prospectuses. There, the debenture holders were informed that Credit's Eligible Receivables "may become uncollectible" if Properties defaults on its development obligations and these obligations are not assumed by Credit. *fn6" The debenture holders were further warned that:

Performance of the development obligations of Properties under instalment land contracts will require Properties to expend substantial sums of cash over the terms of such contracts . . . . Cash expenditures to date have exceeded the total cash generated by sales, and, therefore, Properties' operations have required, and it is anticipated that they will continue to require, substantial funds in addition to cash generated from sales . . . .

 In conjunction with this disclosure, the prospectuses made clear that Properties' customers were not legally bound to continue to make payments on Credit's Eligible Receivables and that "no significant resale market for instalment land contracts" existed. In short, Credit's financial posture was highly dependent on "the continued ability of Properties to operate as a going concern" and on "general economic conditions." Any adverse trend in the latter could "induce substantial numbers of contract purchasers to discontinue making installment payments . . . ."

 The debenture holders were further alerted to the conflicts of interest which might arise between Properties and Credit:

The directors and officers of the Company are also directors or officers of Properties, GAC Corporation or one of its subsidiaries and, accordingly, Properties and GAC Corporation can exert control on the Company and its affairs. As a consequence, dealings between the Company, Properties and GAC Corporation cannot be considered to be at arm's length and at times could present possible conflicts of interest.

 The prospectuses also discussed the means by which the two debenture issues would probably be repaid:

There will be no sinking fund for the Debentures and no provision for redemption in the event of a decline in levels of Eligible Receivables not in default. In the absence of future borrowing, the primary source of repayment for the Debentures will be cash generated by the collection of Eligible Receivables held by the Company.

 C. The Key Transactions.

 By early 1974, this fragile edifice had begun to crumble. For a variety of reasons, Properties' installment land sales started to decline drastically. Yet, many costly development obligations remained outstanding and, accordingly, Properties desperately needed to find a source of cash other than continued land sales. Otherwise, Properties could not complete the promised development work and Credit's Eligible Receivables would largely become uncollectible. This situation led to the series of events between April 1974 and September 1975 which form the basis of the SEC's suit.

 Almost from its inception, Credit had, for accounting purposes, pooled its cash in GAC with all other cash receipts of the GAC complex. *fn7" This accounting procedure meant that all expenditures and investments on Credit's behalf, as well as for the benefit of Properties and the other components of the GAC complex, were funded by a common cash pool. It also necessitated the maintenance of an inter-company account. This account was balanced on a monthly basis through September 1974; thereafter, it was balanced on a quarterly basis. On each occasion, the balancing took place after Credit's cash had been sent to the cash pool.

 Throughout the period from 1970 to September 1975, the inter-company account regularly reflected book balances that were favorable to Credit. Until April 1974, this was accomplished solely on the basis of the usual transfers to Credit of installment land contract receivables. Then in April 1974, for the first time, such transfers fell short of supporting the cash (less Credit's expenses met by the pool) which Credit had sent that month to the pool. Each subsequent accounting period until Credit's declaration of bankruptcy in December 1975 witnessed the same phenomenon.

 Thus, at the end of each internal accounting period from April 1974 to September 1975, GAC's management was faced with a choice: either to cause Properties to sell to Credit assets other than the installment land contract receivables Credit had customarily bought or to return some cash to Credit from the pool. It consistently chose to adopt the former course of action.

 Accordingly, a series of transactions occurred commencing in April 1974 that involved Credit's purchase of marketable securities, certificates of deposit, its own stock, fixed assets, and "other receivables." These transactions are all itemized, explained, and scheduled in Appendix A, which is incorporated herein.

 With the exception of one monthly accounting period (December 1974), all of these non-customary transfers were recorded by hand-written entries on so-called "top sheets," kept "in the drawer" of one of GAC's accountants. Unlike Credit's usual journal entries, "top sheet" transactions were not entered into GAC's computer databank. December was the one accounting period when all asset transfers were entered into the GAC computer databank.

 While the manner in which these transactions were posted and Credit's occasional failure adequately to perfect their documentation or effectuate formal transfers other than by bookkeeping raise questions, it is clear from the preponderance of the evidence that these transactions were in fact intended to and did in fact occur. At trial, the SEC conceded that it could not prove that any of these transactions were fictitious.

 The indentures and Operating Agreement indisputably permitted Credit to purchase short-term marketable securities, certificates of deposit, and "other receivables." *fn8" (1970 and 1971 indentures, § 1004(b), § 101; O-A, § 13). In addition, the indentures permitted Credit within certain limitations, apparently not transgressed during these time periods to pay dividends and purchase its own stock. *fn9"

 The defendants admit that these transactions were entered into to support the continued flow of cash from Credit to Properties; that Properties desperately needed funds to complete its development obligations and that such funds could realistically have only come from Credit. As put by the defendants, management had by the end of 1974 at the latest, "embarked on a course to use whatever flexibility there was, including maximum use of the dividend or treasury stock formula, in the Operating Agreement and Indentures to continue to pay over Credit's cash collections to support the operations of Properties." (Defendants' Proposed Findings, P 221).

 II. The SEC's Major Contentions and Defendants' Response

 Against this background the Court now turns to the SEC's major contentions, as the Court has been able to glean them from the SEC's various statements of position at pretrial and in its post-trial briefs. The SEC urges that material events were inadequately revealed in Credit's 1974 10-K and in its 1975 Exchange Offer Prospectus and Solicitation Statement, and that these documents should at least have included the following disclosures:

 1. Credit transfers to Properties substantially all of its cash promptly upon receipt. Subsequently, "supporting transactions" are entered into with the view of keeping as much transferred cash as possible in Properties. This practice is likely to continue.

a. Credit's intention to let Properties keep as much of the cash as possible reflects a business judgment, made by GAC's management, that the needs of GAC and of Properties take precedence over Credit's need to pay at maturity its debenture obligations.
b. The described practice means that Credit is no longer engaged in the business depicted in the 1970 and 1971 indentures and prospectuses and in the Operating Agreement; thus, Credit's acts violate the strictures contained in those documents.
c. These practices make it less likely than would otherwise be the case that Credit will pay off the debentures when they mature.
d. The supporting transactions lack economic reality, I. e., are of no economic benefit to Credit.
e. These transactions conceal defaults under the Operating Agreement and indentures which are otherwise occurring.
f. The certificates of deposit and the marketable securities listed as assets on Credit's balance sheets are being purchased from Properties, and not from third parties.

 2. With respect to certain fixed asset purchases:

a. Their purchase at book value may not reflect actual market value, no independent appraisal having been performed;
b. Recovery of their value will occur long after the 1975 and 1977 maturity dates, for they are subject to long-term lease-backs.

 3. As a result of Management's practice of transferring all of Credit's cash to Properties, there exists no "substance" to Credit's "income" for purposes of the Indentures' dividend/stock redemption restriction.

 4. During 1974, Credit made contributions to the GAC complex for income taxes owed, but GAC, filing on a consolidated basis, incurred no federal income tax liability for 1974.

 5. Development guarantees were given by Credit to third parties in 1974.

 6. In the Exchange Offer Prospectus and in the Solicitation Statement, June 1975 balance sheet figures should have been included, not March 1975's figures.

 The SEC further contends that various of the intercompany transactions operated as a fraud upon the debenture holders in violation of Section 10(b) of the Exchange Act of 1934 and of Section 17(a)(3) of the Securities Act of 1933. In particular, the SEC points to the following allegedly fraudulent practices:

 1. The aforementioned insufficient disclosures.

 2. The treasury stock purchases in and of themselves operated as a fraud upon Credit's debenture holders, for

a. they were of no economic benefit to Credit or its debenture holders, had no business purpose, and were entered into to cover defaults;
b. they were not "consistent" with the impending due dates of the debentures or with Credit's covenant to pay the debentures at maturity.

 3. Credit did not give the debenture holders advance notice of its intention to effect the stock and fixed asset purchases.

 Defendants urge that adequate disclosures were in fact made with the advice of their lawyers and public accountants and that there were no material omissions. Many disclosures were, in fact, made relating to the course of dealings between Properties and Credit, to the decline of Properties' business, and to other matters on which the SEC's contentions focus. Without attempting to itemize all disclosures on which the defendants rely, Appendix B lists the significant statements taken from the 1974 10-K and the 1975 Exchange Offer Prospectus and Solicitation Statement as an aid to the discussion which follows. ...

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