The opinion of the court was delivered by: PALMIERI
This is a stockholder's action to recover for the benefit of United States Lines Company (U.S. Lines) from directors and officers of U.S. Lines for alleged loss by and damages to that company. Plaintiff alleges that U.S. Lines was damaged because of (1) unlawful compensation paid to the personal defendants and others by U.S. Lines under a stock option plan involving shares of stock in the company, (2) a transaction with the Commissioner of Internal Revenue which was prejudicial to the company and concerned certain tax aspects of the stock option plan, and (3) improper grants of free and reduced rate ship passages.
The nominal corporate defendant, U.S. Lines, is a New Jersey corporation engaged in marine transportation of passengers and freight. The individual defendants are nine of the directors of U.S. Lines who served during the period 1943-1948 and the estates of three other such directors. There was no service of the summons and complaint upon Messrs. Bechtel, Bruce and McCarthy and the executors of Mr. Dawson nor has there been any appearance by them.
Involved in the instant case is the operation of a stock option plan that U.S. Lines adopted in 1943. The plan authorized the board of directors of U.S. Lines to grant to key employees options to purchase a total of 125,000 shares of the company's common stock at a price not less than the average of the closing prices on the New York Stock Exchange for the thirty consecutive trading days preceding the date of the board's resolution granting the options. The term of the options was not to exceed five years and unexercised options were to expire upon termination of an optionee's employment. The plan was adopted by overwhelming majorities at special meetings of stockholders.
It is not disputed that the stock option plan had a declared and valid corporate purpose -- namely, to provide an inducement to key employees to remain in the company's employ or, in the case of employees temporarily absent on war service, to return to the company at the end of such service, and to encourage diligent service by such employees. The plan was adopted during the height of the war effort when the problem of retaining and reacquiring qualified personnel was acute. But plaintiff contends that the profits that defendants and others have realized as a result of the stock option plan were unlawful because they were received in violation of section 805(c) of the Merchant Marine Act of 1936, 49 Stat. 2013 (1936), as amended, 52 Stat. 963 (1938), which provided civil and criminal penalties for corporations and others who wilfully caused a subsidized company to pay more than $ 25,000 to any of its officers, directors, or employees.
The plaintiff argues that since, at the time the options were exercised, the market value of the shares acquired by the optionees exceeded the option price paid for them, the defendants and the other option holders received 'compensation' within the meaning of former section 805(c). To the extent that this 'compensation' resulted in giving the optionees a total annual 'compensation' that was in excess of $ 25,000 it was illegal, says the plaintiff, and should be returned to the company, U.S. Lines.
In my opinion there was no violation of section 805(c) of the Merchant Marine Act of 1936. In 1945 U.S. Lines sought and obtained an opinion from the General Counsel of the United States Maritime Commission in which the General Counsel said:
'I am therefore of the opinion that if and when your employees exercise their option, the amount, if any, by which the market price of the shares of common stock of your company exceeds the option price, is not to be considered compensation for services received by such employees within the meaning of Section 805(c).'
I agree with the conclusion of the General Counsel that the profits realized as a result of the exercise of these stock options by defendants and others were not 'compensation' within the meaning of section 805(c). Furthermore, I agree with and adopt the reasoning by which the General Counsel arrived at this conclusion. He said:
'The primary purpose of Section 805(c) is to prevent the diversion in any form of the assets of subsidized operators or any affiliated or associated company by way of payment of compensation to the management in excess of $ 25,000 per year with respect to any one director, officer, or employee. The word 'compensation' is to be construed very broadly in order to correct the evils against which the statutory provision is aimed. Accordingly, if a subsidized operator disposes of any of its assets to its employees at less than what could fairly be obtained for it from third parties, there would be a very strong presumption, perhaps an irrebuttable one, that the difference between the value of the assets received and the consideration paid would be compensation for personal services within the meaning of Section 805(c). I believe this principle would be applied by the Commission to a subsidized operator's treasury stock (that is to say, stock previously issued and reacquired) and to any stock which it holds in subsidiary corporations. I believe, however, that it is beyond the intent and purpose of the statute to apply such principle to authorized unissued stock. Such stock is not, in any real sense, part of the property of the corporation. It is, at most, a provision for the interest of the stockholders as a whole in the assets of the corporation. The sale of unissued treasury stock does not, in any way, deplete the assets of the corporation. On the other hand, it increases the resources available for subsidized operations by the amount of consideration paid by its purchasers.
'In a prior opinion of the General Counsel, it was ruled, upon somewhat similar reasoning, that payment of compensation to officers by a holding company, parent of the subsidized operator, was not within the prohibitions of the statute unless such parent was by reason of other relationships to be considered an affiliated or associated company. If it is true that a parent holding company is not subject to the Act, it is obvious that the individual stockholders of the subsidized operator are not included among the persons from whom compensation may not be received by the management except subject to the limitations of Section 805(c). Obviously, the stockholders could, without coming within the ambit of Section 805(c), each contribute a portion of their stock interest for the benefit of the employees. It seems to me that, in practical effect, this is all that is being done when the stockholders of a corporation authorize the directors to issue the common stock of the corporation upon advantageous terms to certain of the employees. Such action on the part of the stockholders has at most the effect of diluting their previous interest in the corporation. It does not deprive the corporation of a single asset and, as stated above, has the contrary effect of increasing the total assets of the company.' See plaintiff's exhibit No. 47.
Plaintiff's second cause of action also involves the stock option plan adopted in 1943. From the time the stock option plan was first considered the question of the tax consequences of the plan to the prospective optionees and U.S. Lines was given careful consideration. Defendants knew that if the stock option plan were held to be one which provided for 'compensation' to the optionees, the optionees would have to pay income taxes at the normal and surtax rates on the difference between the market price and the option price at the time the options were exercised, and U.S. Lines would be entitled to deduct that amount from its gross income. Defendants also knew that if the stock option plan were held non-compensatory in nature, the optionees would only have to pay income tax at the capital gains rate on the profits from any sale of the optioned stock and U.S. Lines would not be entitled to any deduction because of the options. To a great extent the stock option plan was attractive because of the favorable tax consequences to the optionees that might result from its operation.
Until May 31, 1946, when the Commissioner of Internal Revenue ruled on the tax consequences of the U.S. Lines stock option plan, those consequences could not be predicted with any degree of certainty. On the one hand there were cases like Albert R. Erskine, 1932, 26 B.T.A. 147, holding that stock option profits were 'compensation' to the optionees. On the other hand there were cases like Delbert B. Geeseman, 1938, 38 B.T.A. 258, and Herbert H. Springford, 1940, 41 B.T.A. 1001, holding that stock option profits were not compensation to the optionees. Nor did the Supreme Court's opinion in Commissioner of Internal Revenue v. Smith, 1945, 324 U.S. 177, 65 S. Ct. 591, 89 L. Ed. 830, clarify the law in this area. The Court assumed that the stock options involved in that case were given 'as compensation for * * * services.' See 324 U.S. at page 177, 65 S. Ct. at pages 591, 593.
After the Supreme Court's decision in the Smith case, the Treasury Department issued I.T. 3795, 1946-1 Cum.Bull. 15, advising the public how the Bureau of Internal Revenue would treat (1) stock option profits resulting from options granted after the Smith case was decided by the Supreme Court and (2) stock option profits resulting from options granted before the date of the Smith case decision. The I.T. said,
'* * * in view of the prior development of the regulations and interpretations relative to employee stock options * * * as respects an option granted to an employee prior to February 26, 1945 (the date of the Smith case decision), unless * * * the employee would otherwise clearly realize income by way of compensation through the exercise or transfer of the option, this office will hold that the exercise or transfer of such option, as the case may be, does not result in income to the employee by way of compensation * * *, provided, however, that on or before July 1, 1946, the employee to whom such option is granted and any transferee thereof, and the employer corporation or any other taxpayer who granted such option to the employee, file * * * with the Commissioner of Internal Revenue * * * written consents (1) agreeing that the basis to the employee, and to any transferee of the option, for the stock acquired or to be acquired pursuant to the option shall be the actual price paid therefor and that no deduction shall at any time be ...