Opinion ID: 1473033
Heading Depth: 1
Heading Rank: 7

Heading: The Sale of the Stock and the Alleged Fraudulent Representations in Connection Therewith.

Text: Of the 12,000 shares of stock of the new issue 1,000 shares were sold to Guy Huston Company in April, 1925, at 133, to net the bank 120 and accrued dividends. The government does not claim any false representations in regard to this sale, though criticism is offered of it in other respects. The remaining 11,000 shares were bought by Guy Huston Company at 140 net to the bank, according to the contention of the defendants. The government contends that there was no sale to the Guy Huston Company, but that the stock was sold to the public through Guy Huston Company as fiscal agent of the bank, and that Guy Huston Company appropriated part of the proceeds of the sale which should have gone to the bank. The government contends further that in connection with the sale of the stock to the public various false representations were made by the defendants. Inasmuch as the contention of the government that there was not a sale to Guy Huston Company has but an indirect bearing upon the main question involved in the case, we shall not discuss it at length, but simply state that in our opinion the evidence conclusively shows that the sale of the stock was made by the Southern Minnesota Bank direct to the Guy Huston Company, and by it in turn was sold through various syndicates to the public; that the profit made by Guy Huston Company was not inordinate, nor was the price paid for the stock by the public excessive, when due consideration is given to the facts, and to surrounding circumstances as they appeared at the time. The alleged false representations relied upon by the government in connection with the sale of the stock to the public are largely contained in a printed circular (Exhibit 100 substituted), copies of which were distributed in the latter part of May, 1925, through various brokers by mail and otherwise to investors interested in stocks. The alleged false representation most largely relied upon by the government is found in the following statement contained in the circular: Dividends: The initial dividend was declared as of July 1, 1922, at 8%. In January, 1923, the rate was increased to 9% and in May, 1925, the board of directors announced that the dividend rate of the capital stock had been increased from 9 to 10 per cent. The increase to be effective July 1, the first quarterly dividend of $2.50 per share will be paid October 1, 1925. It is the contention of the government that this statement is a representation not only as to the actual payment of past dividends, but also a representation that such dividends had been earned. This contention as to the meaning of the statement is conceded by the defendants. There is no claim that the dividends were not in fact paid as stated; but the question remains whether such dividends had been earned. The books of the bank were kept on what is known as the accrual basis, but the government contends that in determining whether dividends had been earned the books should be considered on the cash basis. However, the government witness McHale testified as follows: Q. The Farm Loan Board always has required these joint stock land banks to keep their books on an accrual basis so that these books, in choosing the accrual basis system, were being kept on the system that the Farm Loan Board directed all the time this bank was in operation? A. Yes, sir. Q. And the Farm Loan Board in figuring whether dividends have been earned or not, during all the period since organization of this bank, have based their figures on an accrual basis, rather than a cash basis, haven't they? A. The Farm Loan Board, in figuring dividends to be paid, yes, sir. Q. So in figuring on an accrual basis here, you are figuring on the basis that was authorized and directed and continuously used, and the only method that was ever used by the Farm Loan Board itself? A. Yes, sir. Mr. McHale, after an exhaustive examination of the books of the bank, testified that the showing from the books on the accrual basis was as follows: That sum of $426,494.99 is the total sum from organization to June 30, 1925, which was available from earnings for distribution as dividends. The total amount of dividends declared and paid in that same period was $483,125.00, leaving a net deficit of $56,630.01. In other words, they had paid $56,630.01 more in dividends than was available from the net earnings for the payment of dividends. In reaching this conclusion Mr. McHale did not use the premiums received by the bank on stock sold during the period in question in making his set-up of the legal reserve of the bank. He took instead the sum of $145,334.95 from earnings to fill the reserve. He testified, however, that if it was proper to use premiums on stock to fill up the reserve, thereby relieving the net earnings to that extent, then the books of the bank showed more than enough earnings to pay all the dividends. The question and answer were as follows: Q. Well, now, so there will be no question  if it be true that stock premiums can be used to fill up the legal reserve, and if it be true that the amount of net earnings which would then remain in the bank's account, could be under the law applied to dividends, then this bank had in its net earnings account, enough to pay all dividends that it ever paid, and $88,704.94 besides? A. I assume that would be correct. Furthermore, Mr. McHale in his tabulation did not allow stock premiums to be used in paying the cost of getting new business. The uncontradicted testimony showed that it was the custom of Joint Stock Land Banks to use stock premiums to build up their reserve and to pay for the cost of new business; that this question had been up before the Farm Loan Board and that the banks were told that the Board would not object to such use. Whether such use of the stock premiums was in accordance with law, we are not called upon to decide. The court below in the course of the trial took the view that it was not, but later charged the jury that such use was legal. What we do decide is that, in view of the facts and circumstances disclosed in the instant case, such use of stock premiums cannot be said to be unwarranted and without reasonable basis; that defendants believed that all dividends had been paid out of earnings; that when such use is recognized in calculating the amount of net earnings properly allocated to dividends, the uncontradicted evidence shows that all dividends paid up to June, 1925, had in fact been paid out of net earnings; and that there was no false representations in reference to such payments. It is further contended by the government that the statement in the circular (Exhibit 100 substituted), that beginning July 1, 1925, the dividends on the stock would be 10 per cent., was a false representation as to the earning power of the stock. We lay to one side the possible answer to this contention: That the statement was as to an expectation rather than as to a fact. We take up the question whether the defendants honestly believed that future dividends of 10 per cent. would be paid, and whether they had reasonable grounds for the belief. Glenn Gold, one of the defendants, testified: There was no question in our minds at all that, the minute that we got out those bonds and mortgages under that new stock issue, that we would be earning our full 10 per cent. very easily. Q. And what was the opinion and belief of yourself, and the other officers of the bank at that time, May 12th, and in June, 1925, as to whether or not that the Southern Minnesota Bank had actually earned, and was able to pay all the dividends that it had paid in the past? A. We knew that it had earned it. And again: Q. Now, there would be a period  I am assuming now that the farm depression had not dropped back again in 1925, in the fall, and 1926, in the spring  if things had turned the corner, and gone on normally, would there have been a period between the time that this stock was sold and the time that you got the full 15 times bonds behind it, where the earning of your bank would not be so great as it would be later, when the 15 times bonds got behind the stock? A. Yes, sir; they would have been. Q. And did you men, you officers of the bank, consider as to how  as to whether the bank was going to have enough earnings and assets on hand to take care of the 10 per cent. dividend during that period? A. We took that into consideration, and figured on that. He gave in detail the figures on which he based his belief. William H. Gold testified that the matter of a 10 per cent. dividend had been discussed as early as October, 1923. July 29, 1924, he wrote Guy Huston, stating that he believed conditions warranted an increase of dividend to 10 per cent. March 26, 1925, he wrote to Guy Huston: I have just been making some figures showing the estimated net earnings to July 1st, adding $21,000 premium on the premium on the present bond sale, and after deducting the April and July dividends, it will leave us about $340,000 net. If, at that time 5,000 shares of stock could be sold to net the bank $145 and three (3) million bonds to net the bank around $102, it would push the profit account up over $600,000, and I think half of the three million of new mortgages could be put out at 6% and the other half at 5½%. I would estimate the bank then could easily net 12%, and with its 20% and better set up, could pay 10% dividends, and set up around $50,000 a year in its surpluses. April 16, 1925, he wrote to the same party: Our earnings for April, May, and June will approximate $54,000, making a total of $444,000, and leaving a net of a little over $400,000 after the July 1 dividends have been paid. This would leave us over 20% on $1,900,000 capital with our tax matter still unsettled. Defendant William G. M. Smith, one of the directors, testified: As to the increase of the dividend to 10 per cent., beginning March 1st, the figures submitted to me showed there would be adequate earnings to take care of a 10 per cent. dividend. Defendant Guy Huston testified: It was my opinion that the bank would be able to pay and maintain a 10 per cent. dividend rate. The increased business, the capital stock paid in, would permit a large amount of increase of loanable funds through the sale of bonds, and the profit from that business would be very substantial. If I can refresh my memory, I can tell you exactly. Selling stock at $140 a share, under the plan then in general use, whereby you could use the premiums on stock to pay for legal reserves, and pay the cost of new business, on that basis, the capital account, legal reserve set up, and the earnings, 5½ per cent., is $79,200 annually, $18,000,000 of bonds could be issued, on which there was approximately a 1 per cent. differential annually, or $180,000, making a total gross possible income of $259,200, for this stock increase. Q. (by Mr. Sawyer): That is, on the new business alone? A. On the new business alone. A 10 per cent. dividend would be $120,000, leaving available for losses and expenses, an annual profit of $139,200. Now, that is taking no account for premiums on bonds. We are just assuming that the bonds would be sold at par. At the time this stock was sold to the public, I was sure the bank had actually earned and had available for dividends all the dividends it had paid in the past. He also gave in detail the figures on which he based his belief. W. A. Streater, one of the directors (not a defendant), testified: Q. And in your duties as a director, did you keep track in a general way with what the earnings of the bank were? A. I gave that some attention. I made some estimates at times. Q. So that in voting for that increase in dividend you were not simply blindly following the figures handed you by W. H. Gold at that meeting? A. I would not say that I was. Q. And was it your own independent judgment, from what you knew of the conditions and the earnings of that bank in the past, that that 10 per cent. dividend could probably be maintained? A. It was, providing that the bank could go ahead and sell some bonds and increase its amount of shares. Much correspondence was had in the fall and winter of 1924 between William H. Gold and Guy Huston relative to raising the dividend rate to 10 per cent. Misgivings and doubts were expressed at one time or another by each of them. In the spring of 1925 all of the circumstances seemed favorable to such a step, and it was taken. This correspondence to our mind shows integrity of purpose, instead of a scheme to defraud. Misgivings and doubts are indicative of honesty rather than of villainy. The foregoing evidence; the fact that dividends of 9 per cent. had been earned and paid; the testimony that it was the belief of the defendants, as well as of others well informed, that the agricultural depression was about over; the absence of any substantial evidence to the contrary  lead irresistibly to the conclusion that the defendants honestly believed and had reasonable grounds to believe that a dividend of 10 per cent. could and would be paid on the stock of the bank. Another contention of the government is that the circular (Exhibit 100 substituted) was false, in that it did not set up as a liability the sum of $135,000 still to be paid to Guy Huston under the contract of 1922, as provided in the cancellation contract of December, 1923. The statement in the circular was made up from the books of the bank. No such liability had ever been entered on the books of the bank. The evidence shows that the bank and Huston had proceeded on the theory that the installment payments should be made from time to time as the bank realized earnings from the loans made from the moneys derived from the bonds which Huston had sold under his contract. The payments were treated as in the nature of salary or expense items, rather than the whole sum as a liability. The payments were charged by the bank as an operating expense. The expert accountants were not agreed at the trial how the $135,000 should be handled from a bookkeeping standpoint. We do not think that a fraudulent intent can be inferred from such a state of facts. A further contention of the government is that a false representation is found in the circular (Exhibit 100 substituted) in the statement: Its loans outstanding as of May 12, 1925, were $28,362,800.96, on which amortization payments have been made to the amount of $833,616.24. These loans are secured by first mortgages on corn land farms in the southern section of Minnesota and in the extreme eastern section of South Dakota. These farms have been appraised for loan purposes at over $68,000,000. Included, either in whole or in part, in the total $28,362,800.96, was the mortgage of $500,000 given by the Farmers Fund, Incorporated, already described. The government contends that the whole plan of the Farmers Fund, Incorporated, was a subterfuge, and further that the $500,000 mortgage was not in any event a first mortgage. We have already considered and disposed of the former contention. As to the character of the $500,000 mortgage, the evidence shows without dispute that the lands conveyed by the bank to the Farmers Fund, Incorporated, were lands which had been duly appraised and on which first mortgage loans had been made by the bank. It further appears that these mortgages had been duly filed with the registrar. Some of these mortgages being in default had been withdrawn from the registrar, had been foreclosed, and the title to the lands had been taken in the name of the bank. These lands were conveyed to the Farmers Fund, Incorporated, and the $500,000 mortgage taken back covered the original amount of the loans on the lands, together with costs and other items chargeable against the lands. It is difficult to see why the $500,000 mortgage was not a first mortgage as to these lands. Of course, this $500,000 mortgage could have been separately stated in the circular and a history of the same given. In the case of Mandelbaum v. Goodyear Tire & Rubber Co., 6 F.(2d) 818 (C. C. A. 8), the question was involved whether in a prospectus for the sale of stock of a corporation the omission to discuss and analyze certain items amounted to fraud. The prospectus failed to disclose that the company had built a clubhouse for the use of its employés at a cost of $1,500,000. This omission was urged as constituting fraud. The court said (page 822): We do not think that the failure to discuss this item in its prospectus could be regarded as a concealment of the company's condition amounting to fraud. As well might it be contended that it was the duty of the Goodyear Company to disclose in its prospectus its entire previous course of business, in order that it might be judged whether its management had been judicious and free from criticism. A prospectus such as was involved in the Mandelbaum Case and in the case at bar is not intended to be a complete and detailed history of the financial transactions of the corporation. There were also mortgages which had become in default, and title to the lands covered thereby had been taken by the bank without foreclosure in the name of a trustee or a nominee. These mortgages were still with the registrar. The lands covered by these mortgages were also conveyed to the Farmers Fund, Incorporated. Disbursements made by the bank in connection with acquiring the title to these lands, and other expense, were reimbursed to the bank by the Farmers Fund, Incorporated, either by the $75,000 which was paid by it to the bank or by being included in the $500,000 mortgage. To the extent that such disbursements were included in the mortgage it was a second mortgage. The exact figures are not disclosed by the record. If, therefore, the whole of the $500,000 mortgage was included in the total $28,362,800.96, stated in the circular to be the amount of the first mortgages, it would follow that there was a misstatement of fact to the extent indicated. It is also true that certain other assets were conveyed by the bank to the Farmers Fund, Incorporated, in return for the $75,000 cash and the $500,000 mortgage. If any of these other assets were represented by the mortgage, and if the whole of the mortgage was included in the total of loans stated in the circular, then there was a misstatement of fact to that extent. The amount of these other assets is not shown with exactness; but the evidence does show that the amount must have been small. The statement in the circular was in our opinion, however, substantially correct, and we think the discrepancies noted, when considered in connection with all the facts and circumstances, do not support the charge of false representation. We have now discussed at some length the more important details of the alleged fraudulent scheme set out in the indictment; the other details alleged have been examined and considered, but will not be discussed. We have also discussed a number of the alleged false representations which are claimed to have been made in connection with the alleged fraudulent scheme. The remaining alleged false representations have also been examined and considered, but will not be discussed. In considering a case of the character of the one at bar, several well-established rules must be borne in mind: (1) Where the alleged scheme involves the sale of stock of a corporation, an inquiry of considerable importance is whether the corporation has for a substantial length of time been organized and conducting a legitimate business. Mandelbaum v. Goodyear Tire & Rubber Co., supra; Corliss v. United States, 7 F.(2d) 455 (C. C. A. 8). (2) Business adversity, especially in times of abnormal business conditions, does not necessarily spell fraud. Corliss v. United States, supra. (3) Good faith of a defendant in a prosecution for making use of the United States mail in carrying out an alleged scheme to defraud is ordinarily a complete defense. Durland v. United States, 161 U. S. 306, 16 S. Ct. 508, 40 L. Ed. 709; Rudd v. United States, 173 F. 912 (C. C. A. 8); Sandals v. United States (C. C. A.) 213 F. 569. (4) Where all of the substantial evidence is as consistent with innocence as with guilt, a conviction cannot be sustained. Turinetti v. United States, 2 F.(2d) 15 (C. C. A. 8); Grantello v. United States, 3 F.(2d) 117 (C. C. A. 8); Edwards v. United States, 7 F.(2d) 357 (C. C. A. 8); Bishop v. United States, 16 F.(2d) 410 (C. C. A. 8); Dickerson v. United States, 18 F.(2d) 887 (C. C. A. 8); Van Gorder v. United States, 21 F.(2d) 939 (C. C. A. 8); Salinger v. United States, 23 F.(2d) 48 (C. C. A. 8); Gerson v. United States, 25 F.(2d) 49 (C. C. A. 8); Philyaw v. United States, 29 F.(2d) 225 (C. C. A. 8). Applying these rules to the evidence in the case at bar, we are of the opinion that the alleged fraudulent scheme and the alleged false representations are without substantial support in the record, and that the items of evidence pointed out by the government as supporting the indictment are as consistent with the innocence of the defendants as with guilt on their part, and that a verdict of not guilty should have been directed by the trial court.