FOX v. EHRMANTRAUT (1979)

Defendant Harry C. Ehrmantraut (hereafter appellant or Ehrmantraut) appeals from the trial court's decision awarding money judgment together with attorney's fees for plaintiff Theo L. Fox (hereafter respondent or Fox) and denying recovery on appellant's cross-complaint. The relevant facts leading to the present appeal may be summarized as follows:

Respondent was an investor and promoter of business. In July 1974, he purchased a corporation which dealt with placement of business executives. The corporation, which changed its name to Execudex, San Jose, Inc. (Execudex San Jose), was one of the several licensees of Executive Search Associates, Inc. (Executive Search), the parent company. In December 1974, respondent formed a new corporation named Execudex, Inc. (Execudex), which acquired the assets and selected liabilities of Executive Search, the parent. Thus, from December 1974 on, respondent was the sole owner and shareholder of not only Execudex San Jose, but also of Execudex, the new parent corporation.

In forming Execudex, respondent planned to establish a chain of executive placement offices throughout the United States and Canada. While Execudex received some royalties from its licensees, the primary inflow of cash resulted from fees charged for sale of licenses and the right to use the Execudex technique.

The company had an extensive training program for its licensees, teaching them how to use the Execudex marketing plan. The parent company provided its licensees with bulletins and information. In addition, it distributed to them a book entitled “Execudex” or “The Execudex System,” which, in fact, was a manual designed to furnish the licensees with a uniform system and procedure as to how to conduct the executive recruitment business.

As a part of the expansion program, Fox placed an advertisement in the Wall Street Journal, in which he, in essence, offered Execudex San Jose for sale. In reply to the advertisement, appellant came to California in order to discuss the details of the transaction. In the course of the negotiations, appellant received a copy of Execudex San Jose's statement of projected income, expenses and profit, covering the time span between September 1974 and August 1975. The statement proved to be a grossly inaccurate projection. Another statement given to appellant, which purported to reflect the financial condition of Execudex, the parent company, also turned out to be misleading. It showed as if the item of $58,000 had been a capital investment; although, in reality, said sum was a loan made by respondent to the parent company, which is a liability rather than an asset. In addition, the financial statement listed over $52,000 as accounts receivable. This amount represented fees due from the sale of licenses, and proved to be uncollectible.

After having attended several training sessions and financial seminars conducted by respondent's representatives, and after reviewing the financial statement, on or about February 12, 1975, appellant entered into a contract with respondent. According to the terms of the contract respondent agreed to sell and appellant agreed to buy 5,000 shares of Execudex San Jose for the price of $85,000, of which $25,000 was to be paid in cash and the balance by way of a promissory note payable in eight monthly installments.

On May 7, 1975, the Commissioner of Corporations issued a cease and desist order against the parent company, for the reason that Execudex was selling franchises in violation of the California Franchise Investment Law (Corp. Code, 1 s 31000, et seq.). Although the order resulted from an investigation of the parent company which had begun in October 1974, appellant was never told of the ongoing investigation of the parent company. The cease and desist order forced Execudex into voluntary bankruptcy. While appellant attempted to continue operating after the parent's downfall, in September 1975, he, too, had to walk out of business after having suffered a loss in excess of $36,000, in addition to the $25,000 downpayment.

Since appellant defaulted upon the promissory note, Fox brought an action against him for a money judgment and attorney's fees. In his answer, appellant admitted the allegations of the complaint and set forth the affirmative defenses of failure of consideration and fraud. In addition, appellant filed a cross-complaint seeking rescission and damages: 1) for illegality of the agreement involving a franchise; 2) breach of contract; 3) fraud and misrepresentation; and 4) failure of consideration. The trial court, sitting without a jury, found that Fox made no false representation of any material fact to Ehrmantraut, nor did he conceal any material fact from him any time here relevant. The court also found that the promissory note was properly executed and delivered, and there was no failure of consideration following the execution of the promissory note. Accordingly, the trial court entered judgment in favor of respondent in the sum of $60,000 plus interest, costs and attorney's fees.

Appellant raises numerous contentions on appeal. The most important of these is that the transaction in dispute was subject to rescission because (1) it was violative of the Franchise Investment Law and/or the Corporate Securities Law of 1968 (s 25000, et seq.); (2) there was a failure of consideration; and (3) respondent was chargeable with actionable misrepresentation or fraud. Appellant's additional claims are (4) that the trial court committed prejudicial error by failing to make a finding on the existence of a franchise, a material issue raised in the case; and (5) that the trial court's negative finding with respect to the failure of consideration and fraud is not supported by sufficient evidence. We believe the determinative issue on appeal is that the sale of stock in controversy violated the registration requirement of the corporate securities law, and consequently the transaction between the parties was illegal and void as a matter of law.

In elaborating on this crucial issue, as a threshold matter, we emphasize that the question of securities violation was raised for the first time on appeal. While, as a general rule, a party to an action may not change the theory of recovery the first time on appeal, there are exceptions to the general doctrine. One of these exceptions is that an appellant may be permitted to change his theory when a question of law only is presented on undisputed facts appearing in the record (Ward v. Taggart (1959) 51 Cal.2d 736, 742, 336 P.2d 534; Barton v. Owen (1977) 71 Cal.App.3d 484, 491, 139 Cal.Rptr. 494; Roberts v. Roberts (1966) 241 Cal.App.2d 93, 98, 50 Cal.Rptr. 408; 6 Witkin, Cal. Procedure (2d ed. 1971), s 288, p. 4275). Corollary to this rule is that where, as in the case at bench, the evidence shows that the plaintiff in substance seeks to enforce an illegal contract or recover compensation for an illegal act, the court has both the power and duty to ascertain the true facts in order that it may not unwittingly lend assistance to the implementation of what statute or public policy forbids. In such an instance the party may raise a new issue, not only at any stage of the lower proceedings, but also on appeal (Lewis & Queen v. N. M. Ball Sons (1957) 48 Cal.2d 141, 147-148, 308 P.2d 713; Morey v. Paladini (1922) 187 Cal. 727, 733-734, 203 P.2d 760; LaFortune v. Ebie (1972) 26 Cal.App.3d 72, 75, 102 Cal.Rptr. 588).

Turning now to the substance of the dispute, we first refer to section 25130, which provides that “It is unlawful for any person to offer or sell any security in this state in any nonissuer transaction unless it is qualified for such sale under this chapter or under Section 25111 or 25113 of Chapter 2 (commencing with Section 25110) of this part (and no order under Section 25140 or subdivision (a) of Section 25143 is in effect with respect to such qualification) Or unless such security or transaction is exempted under Chapter 1 (commencing with Section 25100) of this part.” (Emphasis added.)

A brief analysis of the cited code section shows that in order to prove a statutory violation the following elements must be established: 1) there must be an offer or sale of securities; 2) the offer or sale must take place in a so-called “nonissuer transaction”; and 3) the transfer of securities must be either qualified or exempted. The uncontradicted facts appearing in the record leave no doubt that in the case at bench each element of the statutory violation has been met, and as a consequence the securities sale in question must be held Ipso jure unlawful under the securities law.

The first criterion that a sale of corporate shares took place is not even in dispute. Respondent admits the occurrence of the transaction both in his answer to appellant's cross-complaint and his trial brief. The illustrative portion of the trial memorandum reads as follows: “Plaintiff believes that the following facts will be stipulated to or are not seriously in dispute: (P) (i) That on or about February 12, 1975, plaintiff and defendant entered into an agreement for the sale and purchase of shares whereby plaintiff agreed to sell and defendant agreed to buy 5,000 shares of Execudex San Jose, Inc., a California corporation (which sale of shares amounted to the sale of the business).”

The next element of an unlawful sale of securities is also established. Section 25011 defines “ ‘Nonissuer transaction’ ” as any transaction not directly or indirectly for the benefit of the issuer. Respondent vigorously argued both at trial and on appeal that he owned all the outstanding shares of Execudex San Jose; that he was neither the Alter ego of Execudex nor was he acting on behalf of the parent in any fashion during the sale; and that he sold the shares of stock solely for his own account to appellant Ehrmantraut. This, of course, is an unmistakable indication that the sale of shares in question took place in a “nonissuer transaction” within the meaning of the law, since it was for Fox's account exclusively, and since no part of the benefit inured directly or indirectly to the issuer corporation.

Thirdly, the record is equally clear and undisputed that sale of stock here was not qualified within the meaning of the securities law.

This leads us to the last point, i. e., whether the sale at issue was exempted from the requirement of qualification. Respondent strenuously argues that the transaction at bench was exempted from the registration requirement under section 25104, subdivision (a), because the sale of the corporate shares was not effected through a broker-dealer in a public offering. Respondent's argument rests on an evident misinterpretation of the statute.

The pertinent part of section 25104 provides that “The following transactions are exempted from the provisions of Section 25130: (P) (a) Any offer or sale of a security by the bona fide owner thereof for his own account if the sale (1) is not accompanied by the publication of any advertisement and (2) is not effected by or through a broker-dealer in a public offering.”

Contrary to respondent's assertion, the clear meaning of the aforecited statute is that in order to be exempt from the qualification provisions of section 25130, the owner of a security must comply with two distinct conditions. One, he must show that the offer or sale of a security was not accompanied by the publication of any advertisement. Two, there must be an additional showing that the offer or sale of a security was not effected by or through a broker-dealer in a public offering. Plainly, unless the owner of a security substantiates that he met both of the abovestated criteria, he is not entitled to exemption under section 25104, subdivision (a).

Here the uncontroverted record demonstrates that the sale of corporate shares was offered and accompanied by an advertisement placed in the Wall Street Journal, and also that appellant became aware of the offer and came to California to perfect the deal as a result of that newspaper advertisement. The crucial fact that the corporate shares at issue were sold by use of a newspaper advertisement is supported not only by the evidence adduced at trial, but also by respondent's admission in his trial brief, as follows: “On December 11, 1974, plaintiff placed an advertisement in the classified section of the Wall Street Journal in an attempt to sell a business involving executive placement and related services. The business, known as Execudex San Jose Inc., had been acquired by plaintiff from M. A. Baker on or about July 22, 1974 . . ..” In sum, since the corporate shares in dispute were offered for sale by way of an advertisement (s 25002), respondent failed to comply with one of the two conditions set out in the statute and as a consequence he cannot avail himself of the exemption provided by section 25104, subdivision (a).

Respondent's further argument that the corporate securities law is inapplicable in the present instance because the sale of shares constituted a franchise within the meaning of section 31005, and that he was exempted from the registration requirement under section 31102,² is partially self-defeating, partially pointless.

It is, of course, true that under section 25019, “ ‘Security’ does not include . . . (4) any franchise subject to registration under the Franchise Investment Law, or Exempted from such registration By Section 31100 or 31101 of that law.” (Emphasis added.) This provision, however, obviously falls short of promoting respondent's cause. On the one hand, if the transaction in question qualifies as a sale of a franchise (which, by the way, has been vehemently denied by respondent throughout the entire proceeding including the present appeal), the conceded failure of respondent to register the deal renders it unlawful under section 31110³ as a violation of the franchise investment act. On the other hand, if respondent places his reliance on the exemption provision (4) of section 25019, he clearly fails to prevail because that subdivision takes out from the definition of “security” only those transactions that are predicated on either section 31100 or 31101, but most definitely not the one which is based on section 31102.

Respondent's contention that he was ignorant of the necessity of qualification and that at any rate the Commissioner of Corporations gave his consent and approval to the transfer of shares which obviated the qualification requirement under section 25130, requires but a short answer. The corporate securities law makes it plain that where, as here, the corporate shares are sold in a “nonissuer transaction,” both the qualification and the consent of the commissioner is needed to render the deal lawful. It is likewise indisputable that section 25503 imposes absolute, unqualified liability on any person who offers or sells a security in violation of section 25130, and that the party's good faith or ignorance of the law constitute no defense to the liability imposed by section 25503.⁴

Respondent's reliance on the case of Bula v. Mansfield (CCH 1979 Fed.Sec.L.Rep. (D.Col.1977) P 96964, at p. 96051) is misplaced. That case does not reflect the State of California law and is merely an interpretation of federal law.

In summary, we conclude the uncontradicted record demonstrates that the transfer of the Execudex San Jose shares to appellant took place without the statutorily required qualification or exemption. As a consequence, the transaction between the parties must be held illegal as a matter of law as violative of section 25130 of the corporate securities law.

Our next task is to decide to what remedy or remedies appellant is entitled as a result of the unlawfulness of the transaction.

1 An examination of the legal rules and the facts of the instant case convinces us that, first of all, appellant is empowered to rescind the contract. Civil Code, section 1689, subdivision (b), provides in part that “A party to a contract may rescind the contract in the following cases: . . . (5) If the contract is unlawful for causes which do not appear in its terms or conditions and the parties are not equally at fault.”

1 We believe the case at bench falls squarely within the aforestated statute. The failure to qualify or exempt the transaction at issue does not appear in the terms of the agreement. At the same time, the record as a whole indicates that even if respondent did not commit acts amounting to fraud or deceit, his dealing with appellant was not without fault or reproach. As pointed out earlier, there is evidence showing that respondent misrepresented, or at least failed to fully disclose, the financial condition of the parent with respect to both its adequate capitalization and the collectibility of the accounts receivable. It is needless to emphasize that accurate financial data are critical in commercial negotiations and in the purchase and sale of corporate assets, including securities and franchises. Moreover, the record is revealing that respondent was less than candid in informing appellant that Execudex, the parent corporation, had been under investigation by the commissioner since October 1974, for the suspicion that it was selling franchises in violation of the franchise investment law. While these data were well known, or at least easily accessible to respondent, appellant had no way of knowing about these important aspects of the deal, which is to say that in all these matters appellant was not at equal fault or In pari delicto with respondent.

It is well established that the remedy of rescission may be sought also by way of defense or cross-complaint (Civ.Code, s 1692; Modoc Mineral & Oil Co. v. Cal-Vada Drilling etc. Co. (1965) 236 Cal.App.2d 868, 873, 46 Cal.Rptr. 508; 1 Witkin, Summary of Cal. Law (8th ed. 1973), s 690, p. 582), and that the successful party is entitled to restitution, that is, the recovery of the consideration which he gave (Utemark v. Samuel (1953) 118 Cal.App.2d 313, 257 P.2d 656; Lobdell v. Miller (1952) 114 Cal.App.2d 328, 250 P.2d 357). The application of this rule to the instant case means that upon the tender of the shares appellant is entitled to recover the $25,000 consideration already paid, and deny any payment under the promissory note also given as a consideration for the purchase of shares.

As a second and additional remedy, appellant is entitled to consequential damages incurred as a result of the illegal contract. Civil Code, section 1692, provides in pertinent part that “A claim for damages is not inconsistent with a claim for relief based upon rescission. The aggrieved party shall be awarded complete relief, including restitution of benefits, if any, conferred by him as a result of the transaction and Any consequential damages to which he is entitled ; but such relief shall not include duplicate or inconsistent items of recovery.” (Emphasis added.) While the cases interpreting section 1692 of the Civil Code point out that in case the contract is rescinded merely upon the illegality of the contract, restitutionary damages do not lie, where, as here, the nonrescinding party is at fault, consequential damages may be awarded in order to do complete equity between the parties and to make the innocent party whole (Runyan v. Pacific Air Industries, Inc. (1970) 2 Cal.3d 304, 85 Cal.Rptr. 138, 466 P.2d 682; Crofoot Lumber, Inc. v. Thompson (1958) 163 Cal.App.2d 324, 331, 329 P.2d 302).

Respondent's contention, that the voluntary bankruptcy proceeding initiated by Ehrmantraut and the court order by which he was discharged from all debts (including the money judgment here) prevent this court from pursuing and determining the issues raised by the parties on appeal, is clearly mistaken and calls for only a short discussion. The discharge order which is issued by the bankruptcy court upon the face of a money judgment without testing and determining the merit of that judgment clearly fails to constitute Res judicata under the applicable law (Martin v. Martin (1970) 2 Cal.3d 752, 763-764, 87 Cal.Rptr. 526, 470 P.2d 662; Bernhard v. Bank of America (1942) 19 Cal.2d 807, 813, 122 P.2d 892). Moreover, it is equally evident that the effect of the discharge order extends no further than to provide relief to the bankrupt debtor against the claims of the creditors and cannot be availed of by a creditor in order to thwart a just and rightful claim of the bankrupt.

In light of our conclusion, the other issues raised in the briefs and the pleadings need not be discussed.

Judgments on the complaint and cross-complaint are reversed. The trial court is directed on the cross-complaint to enter judgment rescinding the contract for its illegality, and upon tender of the shares by Ehrmantraut he is to recover from Fox $25,000 together with interest; the trial court is further ordered to determine the amount of consequential damages suffered by Ehrmantraut as the proximate cause of the illegal transaction, and to award him attorney's fees and costs incurred in the proceedings.

FOOTNOTES

FOOTNOTE.  

FN1. Unless otherwise indicated, all references will be made to the Corporations Code of California..  FN1. Unless otherwise indicated, all references will be made to the Corporations Code of California.

2.  Section 31102 provides that “The offer or sale of a franchise by a franchisee for his own account or the offer or sale of the entire area franchise owned by a subfranchisor for his own account, is exempted from the provisions of Section 31110 if the sale is not effected by or through a franchisor. A sale is not effected by or through a franchisor merely because a franchisor has a right to approve or disapprove a different franchisee.”

3.  Section 31110 prescribes that “On and after April 15, 1971, it shall be unlawful for any person to offer or sell any franchise in this state unless the offer of the franchise has been registered under this part or exempted under Chapter 1 (commencing with Section 31100) of this part.”

4.  Section 25503 provides in relevant part that “Any person who violates Section 25110, 25130 or 25133, or a condition of qualification under Chapter 2 (commencing with Section 25110) of this part, imposed pursuant to Section 25141, or an order suspending trading issued pursuant to Section 25219, Shall be liable to any person acquiring from him the security sold in violation of such section . . . ” (emphasis added).

CALHOUN, Associate Justice.* FN* Assigned by the Chairperson of the Judicial Council.

TAYLOR, P. J., and MILLER, J., concur.