The opinion of the court was delivered by: MANSFIELD
MANSFIELD, District Judge:
This is a consolidated derivative stockholders' suit brought on behalf of Defiance Industries, Inc. ("Defiance" herein), an Ohio corporation formerly named The Serrick Corporation, against certain of its directors for damages for breach of fiduciary duty (first two causes of action) and for violation of § 10(b) and § 14 of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78j(b) and 78n, and S.E.C. Rule 10b-5 thereunder (third cause of action).
Diversity jurisdiction is invoked as to the first two causes of action (breach of fiduciary duty) and federal question jurisdiction as to the Securities Exchange Act claim (third cause of action).
Although five directors of the corporation are named in the action, the only ones served and before this Court are R. L. Huffines, Jr. and Victor Muscat. Edward Krock has been served in a similar action pending in the United States District Court for the District of Massachusetts.
Plaintiff attacks two transactions which were authorized and participated in by the individual defendants, allegedly at Defiance's expense:
(1) The 1962 issuance by Defiance of 487,502 shares of its Class B Voting Stock in exchange for all of the outstanding stock of Insurance and Industrial Enterprises ("IIE" herein), 77% owned by defendants Muscat, Huffines and Krock, pursuant to the said defendants' recommendation valuing the IIE stock at $70.51 per share, which resulted in their acquiring 62% of Defiance's outstanding stock and realizing a profit of approximately $2,304,610
on their own IIE shares; and
(2) The September 6, 1961 acquisition of 10,507 shares of IIE stock (representing approximately 10% of its issued stock) by the triumvirate of Huffines, Muscat and Krock at a price of $20.94 per share, which they then caused Defiance to acquire as part of the aforementioned 1962 exchange at a value of $70.51 per share, realizing a profit of approximately $520,832.
The 1962 exchange is attacked as a self-dealing transaction that was grossly unfair to Defiance and its stockholders for the reason that it resulted in Defiance's issuance of stock worth $7,050,759 in exchange for IIE stock worth $4,057,759, suffering a loss of $2,993,000 and thereby enabling the triumvirate not only to acquire control of Defiance but to reap a personal profit of approximately $2,304,610. It is further attacked (the third cause of action) on the ground that approval of Defiance's stockholders for the exchange was secured through false and misleading proxy material in violation of §§ 10(b) and 14 of the Securities Exchange Act of 1934 and S.E.C. Rule 10b-5 issued thereunder.
The September 6, 1961 transaction is attacked on the ground that by acquiring the 10,507 IIE shares at $20.94 per share for themselves at a time when they were about to authorize the acquisition of all of IIE's outstanding stock at a value of $70.51 per share, and by later transferring their IIE stock to Defiance pursuant to the exchange offer at the $70.51 price, defendants deprived Defiance of a corporate opportunity to purchase the IIE shares at the lower price and reaped a profit at Defiance's expense.
Following non-jury trial of the action in February 1968, the Court, after reviewing and appraising the evidence, including testimony of witnesses presented by both sides, finds the essential facts to be as follows:
Plaintiff is a co-partnership consisting of Joseph C. Galdi and Rita D. Galdi. Norte & Co. is a stockholder of Defiance Industries, Inc. and has continuously been a stockholder thereof since 1960. Each of the partners of Norte is a citizen and resident of the State of New York.
Each of the individual defendants is a citizen and resident of a state other than New York, as follows: See Table in Original
Defiance is an Ohio corporation engaged, among other things, in the manufacture of parts for automotive, appliance, oil well and other industries. At all times involved in this suit its Board consisted of five directors, of whom Muscat, Huffines, Serrick, and O'Gara were members,
Muscat holding the office of President and Huffines that of Chairman of the Board. At all times involved Krock was employed by Defiance as a salaried financial consultant. On June 20, 1962, he was added as a sixth director of Defiance. On January 6, 1963, Krock resigned as a director, and on April 29, 1965, he was re-elected a director.
At all times since 1960 the Board of Directors and management of Defiance has been controlled by the triumvirate of Muscat, Huffines and Krock, who prior to 1960 had been associated together in various business ventures, including their acquisition of substantial stock ownership in Defiance itself. By June 1960 they controlled approximately 33 1/3% of its outstanding stock, which was the largest single block, following their acquisition of 20,000 shares from O'Gara, who resigned as Chairman of the Board, receiving a five-year contract as a $15,000 per year consultant. Prior to June 20, 1962, Krock received $1,000 per month from Defiance for financial advisory services, and beginning in November 1962 this payment was increased to $25,000 per year for his rendition of such services. Mr. Serrick is a salaried officer of Defiance, serving at will and without any contract of employment. For many years Mr. Joslin has been a friend of Huffines, at whose instance he was nominated as a director of Defiance.
In the summer of 1961 the triumvirate of Muscat, Huffines and Krock, together with their associates, owned over 77% of the outstanding stock of IIE, a Delaware corporation formed in January 1960, the principal asset of which was 77% of the outstanding stock of National Bankers Life Insurance Co. ("Nablico" herein), a Texas insurance company. Huffines, Muscat and Krock constituted three out of IIE's five directors, Huffines being Chairman of the Board and Muscat its President. Huffines and Muscat also held the identical positions in Nablico, of which they and Krock were directors.
To summarize, in the summer of 1961 the triumvirate (Huffines, Muscat and Krock) had working control of Defiance (by virtue of their ownership of 33 1/3%), IIE (of which they owned 77%) and Nablico (which was 77% owned by IIE). At that time the trio embarked on a scheme to cause Defiance to acquire all of the outstanding stock of IIE (amounting to 99,998 shares) in exchange for shares of Defiance. The effect of such exchange, depending upon the rate of exchange that would be adopted, would be to solidify the triumvirate's control of Defiance by giving them more than 50% of Defiance's issued and outstanding stock. The plan would also result in giving the stockholders of IIE, which was not publicly traded on any exchange, shares of Defiance which were publicly traded on the American Stock Exchange; and it would also serve to give additional security to certain unsecured IIE notes in the sum of approximately $350,000, which were held by the individual defendants and their associates, as well as to a debt in the sum of $96,750.50 owed by IIE to United Metals Corp., wholly owned by Muscat.
Since the triumvirate controlled the corporations involved in the proposed exchange, it could not be an arm's length transaction. As a basis for the exchange Muscat retained the firm of Hayden Stone & Co. to appraise the relative values of Defiance and IIE and to recommend a rate of exchange. On June 30, 1961, Hayden Stone rendered its written report, recommending an exchange ratio based on its evaluation of the underlying assets of both companies. Its appraisal of IIE turned principally on the value to be attributed to IIE's 77% owned subsidiary, Nablico, which was IIE's principal asset. Hayden Stone based its appraisal of this asset largely on unaudited earnings of Nablico for the period from 1956 to 1960 (the most important years being 1958 to 1960), which was supplied to it by Nablico's Comptroller, John P. Redwood, who testified that he arrived at the earnings figures through use of his own admittedly arbitrary adjustments of certain key items (S.M. 417). Substantially the same unaudited Nablico earnings figures were later submitted to Defiance stockholders in the proxy material which solicited approval of the proposed Defiance-IIE exchange, but were not adopted by Peat Marwick Mitchell & Co., a nationally known accounting firm, when it later audited Nablico's books for the years in question in accordance with generally accepted accounting principles, and arrived at very substantially lower earnings for the same years.
Accepting with only minor changes the unaudited earnings figures thus furnished to it by Redwood of Nablico, Hayden Stone capitalized the average of these earnings for the years 1958 to 1960, using both a 14-times and 15-times earnings ratio for the years 1958 to 1960, and adding 25% as a premium for IIE's control of Nablico, which resulted in its placing a value on Nablico's outstanding stock of between $8,392,613 or $72.90 per Nablico share, and $8,991,266 or $78.10 per Nablico share. In addition, although the actual book value of Nablico's assets was $1,490,000, Redwood adjusted the book value upward to $10,950,000 (including 25% additional value for controlling interest), or more than seven times the figure shown on its books, to arrive at a book value of $76.55 per Nablico share which was furnished to Hayden Stone and used by it in evaluating IIE's shares of Nablico stock.
The Hayden Stone report, dated June 30, 1961, used the above-mentioned figures submitted by Redwood to appraise the total IIE assets as ranging from $6,751,685, or $67.52 per IIE share, to $7,350,338 or $73.50 per share, an average of $70.51 per share, which was recommended as the basis for exchange with Defiance's stock at $14.49 per share. This appraisal resulted in an exchange ratio of 4 7/8 shares of Defiance Class B Common Voting stock for each share of IIE stock, or 487,502 shares of Defiance stock for 99,998 shares of IIE stock, which was adopted by Defiance's Board of Directors on September 12, 1961, as the basis for an exchange that would be submitted to Defiance's stockholders for approval. Present and voting in favor of the recommendation at the September 12, 1961 Defiance Board meeting were Huffines, Muscat, Serrick and O'Gara. The exchange offer was promptly accepted by every stockholder of IIE, each agreeing to tender his IIE shares at the proposed ratio. However, due to difficulties and delays in obtaining SEC review of the proxy material to be sent out to Defiance's stockholders, the cut-off date in the agreements between Defiance and IIE expired and the agreements lapsed.
In the meantime on September 6, 1961, although the proposed exchange ratio placed a value of $70.51 on the IIE stock to be acquired by Defiance, the triumvirate (Muscat, Huffines and Krock) purchased 10,507 IIE shares from Andrew D. Griffith, then a director of IIE, for $20.94 per share in an arm's length transaction which was negotiated in hard bargaining fashion over a period of some weeks. These 10,507 shares represented more than 10% of IIE's 99,998 outstanding stock. The transaction was consummated more than two months after submission of the Hayden Stone report of June 30, 1961, and one week prior to the adoption by Defiance's Board of the resolution recommending its acquisition of all of IIE's stock (including the 10,507 shares) at a value of $70.51 per share. Since the triumvirate controlled Defiance's five-man Board, the inference is irresistible that at the time of the purchase of the 10,507 shares from Griffith, i.e., on September 6, 1961, the triumvirate were well aware that the proposed exchange would be approved by the Board for submission shortly to Defiance's stockholders.
Although the negotiations for purchase of the 10,507 IIE shares from Griffith were handled principally by Krock and took the form of a transfer of the shares from Griffith to Krock who in turn transferred 3,502 IIE shares to Huffines, 1,751 shares to Muscat, and 1,751 shares to Muscat's mother, and retained 3,503 shares for himself, the evidence is clear that Krock was acting on behalf of the triumvirate in making the purchase. The three had been associated together in various ventures over a period of several years. In the spring of 1960, for instance, acting as a group they had acquired their one-third interest in Defiance. They had likewise acted together in the formation of National Bankers Investment Co. ("NBIC" herein), the predecessor of IIE, which they formed to acquire control of Nablico. Huffines, who had known Krock since 1945 in various business dealings (some involving Muscat), brought in Krock as a partner in the IIE venture. From this close joint association in numerous prior similar ventures, it must be inferred that the triumvirate were acting together in the immediate transaction and a sufficient foundation was thus established to permit introduction of Krock's own testimony to the effect that in negotiating with Griffith for the purchase of the 10,507 IIE shares, Krock was acting for the group consisting of Huffines, Muscat and himself, and that he confirmed the deal with Griffith only after telephoning Huffines and Muscat and obtaining their approval. Krock's agency for the group is further confirmed by his letter to Griffith dated August 16, 1961 to the effect that if he purchased the IIE stock he would offer his shares to his "partners," referring, of course, to Muscat and Huffines, and by the further fact that within a few days after acquiring the 10,507 shares from Griffith for $20.94 per share he transferred a one-third interest each to Huffines and Muscat, respectively, at his own cost price of $20.94 per share.
Even if defendants' contention that Defiance lacked cash to take advantage of the corporate opportunity offered by Griffith had legal validity, which is doubtful, Irving Trust Co. v. Deutsch, 73 F.2d 121 (2d Cir. 1934); Meinhard v. Salmon, 249 N.Y. 458, 164 N.E. 545, 62 A.L.R. 1 (1928), there is insufficient proof to support it. There is no showing, for instance, that the opportunity was ever offered to Defiance, much less rejected by it for lack of cash. Defiance's balance sheet reveals that it had current assets of more than $3.2 million shortly prior to the transaction, including almost $1 million in cash and $1 million in net current receivables against total current liability of approximately $2 million. In May and June 1961 Defiance apparently had had no difficulty paying a total of ...