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COURT OF APPEALS OF NEW YORK 1969.NY.41609 <>; 248 N.E.2d 910; 24 N.Y.2d 494 decided: May 15, 1969. HERMAN DIAMOND, RESPONDENT,v.WALTER R. OREAMUNO ET AL., APPELLANTS, ET AL., DEFENDANTS Diamond v. Oreamuno, 29 A.D.2d 285, affirmed. Counsel Norman Moloshok, Robert H. Kilroe and Evan L. Gordon for appellants. Sidney B. Silverman for respondent. Chief Judge Fuld. Judges Burke, Scileppi, Bergan, Keating, Breitel and Jasen concur. Author: Fuld

Diamond v. Oreamuno, Chief Judge Fuld. Judges Burke, Scileppi, Bergan, Keating, Breitel and Jasen concur.

Author: Fuld

 Upon this appeal from an order denying a motion to dismiss the complaint as insufficient on its face, the question presented -- one of first impression in this court -- is whether officers and directors may be held accountable to their corporation for gains realized by them from transactions in the company's stock as a result of their use of material inside information.

The complaint was filed by a shareholder of Management Assistance, Inc. (MAI) asserting a derivative action against a number of its officers and directors to compel an accounting for profits allegedly acquired as a result of a breach of fiduciary duty. It charges that two of the defendants -- Oreamuno, chairman of the board of directors, and Gonzalez, its president -- had used inside information, acquired by them solely by virtue of their positions, in order to reap large personal profits from the sale of MAI shares and that these profits rightfully belong to the corporation. Other officers and directors were joined as defendants on the ground that they acquiesced in or ratified the assertedly wrongful transactions.

MAI is in the business of financing computer installations through sale and lease back arrangements with various commercial and industrial users. Under its lease provisions, MAI was required to maintain and repair the computers but, at the time of this suit, it lacked the capacity to perform this function itself and was forced to engage the manufacturer of the computers, International Business Machines (IBM), to service the machines. As a result of a sharp increase by IBM of its charges for such service, MAI's expenses for August of 1966 rose considerably and its net earnings declined from $262,253 in July to $66,233 in August, a decrease of about 75%. This information, although earlier known to the defendants, was not made public until October of 1966. Prior to the release of the information, however, Oreamuno and Gonzalez sold off a total of 56,500 shares of their MAI stock at the then current market price of $28 a share.

After the information concerning the drop in earnings was made available to the public, the value of a share of MAI stock immediately fell from the $28 realized by the defendants to $11. Thus, the plaintiff alleges, by taking advantage of their privileged position and their access to confidential information, Oreamuno and Gonzalez were able to realize $800,000 more for their securities than they would have had this inside information not been available to them. Stating that the defendants were "forbidden to use [such] information * * * for their own personal profit or gain", the plaintiff brought this derivative action seeking to have the defendants account to the corporation for this difference. A motion by the defendants to dismiss the complaint -- pursuant to CPLR 3211 (subd. [a], par. 7) -- for failure to state a cause of action was granted by the court at Special Term. The Appellate Division, with one dissent, modified Special Term's order by reinstating the complaint as to the defendants Oreamuno and Gonzalez. The appeal is before us on a certified question.

In reaching a decision in this case, we are, of course, passing only upon the sufficiency of the complaint and we necessarily accept the charges contained in that pleading as true.

It is well established, as a general proposition, that a person who acquires special knowledge or information by virtue of a confidential or fiduciary relationship with another is not free to exploit that knowledge or information for his own personal benefit but must account to his principal for any profits derived therefrom. (See, e.g., Byrne v. Barrett, 268 N. Y. 199.) This, in turn, is merely a corollary of the broader principle, inherent in the nature of the fiduciary relationship, that prohibits a trustee or agent from extracting secret profits from his position of trust.

In support of their claim that the complaint fails to state a cause of action, the defendants take the position that, although it is admittedly wrong for an officer or director to use his position to obtain trading profits for himself in the stock of his corporation, the action ascribed to them did not injure or damage MAI in any way. Accordingly, the defendants continue, the corporation should not be permitted to recover the proceeds. They acknowledge that, by virtue of the exclusive access which officers and directors have to inside information, they possess an unfair advantage over other shareholders and, particularly, the persons who had purchased the stock from them but, they contend, the corporation itself was unaffected and, for that reason, a derivative action is an inappropriate remedy.

It is true that the complaint before us does not contain any allegation of damages to the corporation but this has never been considered to be an essential requirement for a cause of action founded on a breach of fiduciary duty. (See, e.g., Matter of People [ Bond & Mtge. Guar. Co.], 303 N. Y. 423, 431; Wendt v. Fischer, 243 N. Y. 439, 443; Dutton v. Willner, 52 N. Y. 312, 319.) This is because the function of such an action, unlike an ordinary tort or contract case, is not merely to compensate the plaintiff for wrongs committed by the defendant but, as this court declared many years ago (Dutton v. Willner, 52 N. Y. 312, 319, supra), "to prevent them, by removing from agents and trustees all inducement to attempt dealing for their own benefit in matters which they have undertaken for others, or to which their agency or trust relates." (Emphasis supplied.)

Just as a trustee has no right to retain for himself the profits yielded by property placed in his possession but must account to his beneficiaries, a corporate fiduciary, who is entrusted with potentially valuable information, may not appropriate that asset for his own use even though, in so doing, he causes no injury to the corporation. The primary concern, in a case such as this, is not to determine whether the corporation has been damaged but to decide, as between the corporation and the defendants, who has a higher claim to the proceeds derived from the exploitation of the information. In our opinion, there can be no justification for permitting officers and directors, such as the defendants, to retain for themselves profits which, it is alleged, they derived solely from exploiting information gained by virtue of their inside position as corporate officials.

In addition, it is pertinent to observe that, despite the lack of any specific allegation of damage, it may well be inferred that the defendants' actions might have caused some harm to the enterprise. Although the corporation may have little concern with the day-to-day transactions in its shares, it has a great interest in maintaining a reputation of integrity, an image of probity, for its management and in insuring the continued public acceptance and marketability of its stock. When officers and directors abuse their position in order to gain personal profits, the effect may be to cast a cloud on the corporation's name, injure stockholder relations and undermine public regard for the corporation's securities. As Presiding Justice Botein aptly put it, in the course of his opinion for the Appellate Division, "[the] prestige and good will of a corporation, so vital to its prosperity, may be undermined by the revelation that its chief officers had been making personal profits out of corporate events which they had not disclosed to the community of stockholders." (29 A.D.2d, at p. 287.)

The defendants maintain that extending the prohibition against personal exploitation of a fiduciary relationship to officers and directors of a corporation will discourage such officials from maintaining a stake in the success of the corporate venture through share ownership, which, they urge, is an important incentive to proper performance of their duties. There is, however, a considerable difference between corporate officers who assume the same risks and obtain the same benefits as other shareholders and those who use their privileged position to gain special advantages not available to others. The sale of shares by the defendants for the reasons charged was not merely a wise investment decision which any prudent investor might have made. Rather, they were assertedly able in this case to profit solely because they had information which was not available to any one else -- including the other shareholders whose interests they, as corporate fiduciaries, were bound to protect. Although no appellate court in this State has had occasion to pass upon the precise question before us, the concept underlying the present cause of action is hardly a new one. (See, e.g., Securities Exchange Act of 1934 [48 U.S. Stat. 881], § 16[b]; U.S. Code, tit. 15, § 78p, subd. [b]; Brophy v. Cities Serv. Co., 31 Del. Ch. 241; Restatement, 2d, Agency, § 388, comment c ; Israels, A New Look at Corporate Directorship, 24 Business Lawyer 727, 732 et seq.; Note, 54 Cornell L. Rev. 306, 309-312.) Under Federal law (Securities Exchange Act of 1934, § 16[b]), for example, it is conclusively presumed that, when a director, officer or 10% shareholder buys and sells securities of his corporation within a six-month period, he is trading on inside information. The remedy which the Federal statute provides in that situation is precisely the same as that sought in the present case under State law, namely, an action brought by the corporation or on its behalf to recover all profits derived from the transactions.

In providing this remedy, Congress accomplished a dual purpose. It not only provided for an efficient and effective method of accomplishing its primary goal -- the protection of the investing public from unfair treatment at the hands of corporate insiders -- but extended to the corporation the right to secure for itself benefits derived by those insiders from their exploitation of their privileged position. The United States Court of Appeals for the Second Circuit has stated the policy behind section 16(b) in the following terms (Adler v. Klawans, 267 F. 2d 840, 844):

"The undoubted congressional intent in the enactment of § 16(b) was to discourage what was reasonably thought to be a widespread abuse of a fiduciary relationship -- specifically to discourage if not prevent three classes of persons from making private and gainful use of information ...

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