Appeal from the District Court of the United States for the Southern District of New York.
Before MANTON, SWAN, and CHASE, Circuit Judges.
The appellee is the owner of 200 shares of common and 400 shares of common B stock, and seeks a decree declaring article XII of the by-laws of the American Tobacco Company invalid and ordering that all compensation paid thereunder to appellants be repaid to the corporation and future payments be perpetually enjoined. It is sought to have the court fix the amount of compensation to which the appellants, officers of the corporation, are justly entitled during their respective periods of service and that in the future the officers receive no additional contingent compensation. On motion by the appellee to strike out each of the five separate defenses interposed by the appellants, the court held that they were insufficient.
On March 13, 1912, the stockholders of the American Tobacco Company, appellant, adopted as a by-law article XII, which provided:
"As soon as practicable after the end of the year 1912 and of each year of the company's operation"s thereafter, the Treasurer of the Company shall ascertain the net profits, as hereinafter defined, earned by the Company during such year, and if such net profits exceed the sum of $8,222,245.82, which is the estimated amount of such net profits earned during the year 1910 by the business that now belong to the Company, the Treasurer shall pay an amount equal in the aggregate to ten percent. of such excess to the President and five Vice-Presidents of the Company in the following proportions, to wit: One-fourth therefore, or 2 1/2 per cent. of such amount, to the President; one-fifth of the remainder thereof, or 1 1/2 per cent. of such amount, to each of the five Vice-Presidents as salary for the year, in addition to the fixed salary of each of said officers."
By section 5 of this by-law, it was provided that the by-law may be modified or repealed only by action of the stockholders of the company and not by the directors. The by-law was adopted by a large majority in interest of the company's shares, 35 preferred shares voting against its adoption. Appellee became a stockholder in 1916. Appellant Hill became a director in 1921, and president on April 7, 1926; appellant Mower, a director on April 6, 1921, and has since become a vice president; appellant Penn, a director on April 6, 1921, and since a vice president; appellant Neiley, a director on April 6, 1921, and a vice president May 1, 1929; appellant Riggio, a director on April 4, 1928, and a vice president May 1, 1929.
Until the present suit was instituted, the legality of this by-law was never questioned.The charges of illegality are: (a) That by the charter of the company, the directors are empowered to apply surplus or net profits only to the acquisition of property or the payment of dividends, and they are not authorized to divert any portion of the profits to officers of the corporation by way of additional compensation; (b) that profit participation by the officers and employees of a New Jersey corporation was not legal prior to the passage of chapter 175, p. 354, of the Laws of 1920, subsection (b), § 1 (Comp. St. Supp. § 47-183); (c) that the power to make and alter by-laws was conferred upon the directors, and the stockholders had no power to adopt the by-laws; (d) that the notice of the meeting at which the by-laws was adopted did not specify the officers to whom the profit participation was to be paid, that it did not specify that the profit participation was to be paid to the officers as salaries in addition to their fixed salaries, and did not state that the participation was to be continued beyond the year when adopted.
Among the defenses which were held below to be insufficient were:
(1) That the stockholders of the company, including the appellee, ratified the payments made to the appellants in accordance with and under the authority of article XII.
(2) That the present suit is an attempt to interfere with the internal management of a corporation during a nationwide business, the affairs of which are dependent upon the statutes of New Jersey, and that by-law XII was legally adopted and is valid.
(3) That the amount of compensation paid to the individual appellants was and is far and reasonable for their services, that the board of directors had the right to fix the compensation of its agents, and that the payments were made in accordance therewith, as well as under the authority of by-law XII.
When the appellee purchased his stock he was presumed to know the provisions of the corporation's by-laws, and he made his investment with that knowledge. Giesen v. London & Northwest American Mortgage Co., 102 F. 584 (C.C.A. 8); Kavanaugh v. Commonwealth Trust Co., 223 N.Y. 103, 119 N.E. 237; State v. Shaw, 103 Ohio St. 660, 134 N.E. 643; Chicago, Springfield & St. L. Ry. Co. v. Martin, 249 Ill. App. 109. The character of the corporation (article II) provides, among other things, that the directors shall have the power "to direct and determine the use and disposition of any surplus or net profits or earnings over and above the capital stock paid in." Directors have power to hire employees. Nothing in the by-laws of this corporation forbade employing them upon a contingent basis. There is no rule of law of which we are aware that forbids directors from providing contingent or fixed compensation for the employees of a corporation, providing the agreements are fair and free from fraud. But the claim is advanced by the appellee that the directors were empowered to employ surplus, net profits or earnings only in the acquisition of property or in payment of dividends, and that the additional salary allotments here are in direct conflict with the charter provisions. Compensation to officers of a corporation is an operating expense of the company, whether a fixed salary or based upon a percentage of the profits, and until such expenditures are met there are no net profits of the corporation. It is the sum beyond this which constitutes the surplus net profits, or earnings referred to in this corporation's charter. Profit participation creates an item of expense in the operation of the business, and this has been recognized by judicial decisions in New Jersey, the state of the corporation's creation. Bennett v. Mllville Improvements Co., 67 N.J. Law, 320, 51 A. 706; Booth v. Beattie, 95 N.J. Eq. 776, 118 A. 257, 123 A. 925; Berendt v. Bethlehem Steel Co., 108 N.J. Eq. 148, 154 A. 321.
Under the General Corporation Law of New Jersey (Chapter 175, p. 354, Laws 1920 [Comp. St. Supp. N.J. § 47-183 et seq.]), stockholders have adequate power to pay officers an additional and contingent salary out of net profits. Section 1, paragraph 5 (2 Comp. St. N.J. 1910, p. 1598, § 1, par. 5), provides that every corporation shall have power to appoint such officers and agents as the business of the corporation shall require and to allow them suitable compensation. By-law XII is in strict conformity with the express powers delegated to the corporation by the General Corporation Act of New Jersey. Bennett v. Millville Improvement Co., supra. The right to pay compensation by way of a percentage of the net profits is recognized in New Jersey. Smith v. Bedell, 84 N.J. Eq. 268, 96 A. 898, affirmed 84 N.J. Eq. 509, 96 A. 898; Booth v. Beattie, supra.Corporate management may pay a participation of the net profits to officers as additional salary either as a bonus or in the ...