The opinion of the court was delivered by: GOETTEL
Plaintiffs bring this derivative action on behalf of Health-Chem Corp., alleging that Health-Chem's corporate parents, Health-Med Corp. and Medallion Group, Inc., looted Health-Chem and several of its subsidiaries through a series of fraudulent securities transactions. The complaint alleges that the acts constituted violations of Sections 10(b) and 14(a) of the Securities Exchange Act of 1934 (the 1934 Act), (15 U.S.C. §§ 78j(b), 78n(a)), and Rules 10b-5 and 14a-9 promulgated thereunder, (17 C.F.R. §§ 240.10b-5, 240.14a-9). Defendants move to dismiss the complaint for failure to state a claim upon which relief may be granted. For the reasons set forth below, defendants' motion is granted with leave to plaintiffs to replead.
Plaintiff Goldberger became a shareholder in Health-Chem in 1976; plaintiff Krauser has been one since 1973.
/ Health-Chem stock is traded on the American Stock Exchange (Amex). Health-Chem is controlled by Health-Med, which in turn is controlled by Medallion. The individual defendants are various officers and directors of Health-Chem and three of its subsidiaries, Perfection Paint & Color Co., Time Chemical, Inc. and Custom Spray Products, Inc.
The complaint sets forth six different sets of transactions, which Health-Chem was allegedly forced by its parents to enter into, as violations of the securities laws: First, that defendants forced Health-Chem to make at least $900,000 in loans to its parents from 1971 to 1976. This is said to be a violation of a representation made in a 1971 prospectus and registration statement. Second, that defendants caused the three subsidiaries of Health-Chem to enter into sale lease-back transactions involving substantially all of their assets, thereby damaging Health-Chem. Third, that defendants caused Health-Chem to buy and lease-back certain computer equipment from Funding Systems Leasing Corp. at a damaging cost to Health-Chem. These transactions were allegedly accompanied by misleading disclosure or nondisclosure in violation of Rule 10b-5. The complaint further alleges that certain proxy statements involving three more transactions, a stock option plan for executive compensation, the authorization of junior preferred stock and the election of directors, were misleading in violation of Rule 14a-9.
Of course, the plaintiffs' factual allegations must be considered true for purposes of the motion to dismiss for failure to state a claim. Conley v. Gibson, 355 U.S. 41, 2 L. Ed. 2d 80, 78 S. Ct. 99 (1957). The facts of each transaction will be considered in detail as they relate to plaintiffs' substantive claims.
I. Alleged Violations of Rule 10b-5
The complaint states that Health-Chem made a public offering in 1971 pursuant to the Securities Act of 1933. As part of the offering, a prospectus and registration statement were filed which stated that Health-Chem's parents would not cause Health-Chem to loan funds to any of its parents, and explained that such a representation was necessary as a condition of listing on the Amex. Nonetheless, the complaint alleges that from 1971 to 1976 Health-Chem was caused to make at least $900,000 in such loans in return for "notes and/or other securities." The plaintiffs allege that at the times such loans were made, the defendants "did not publicly disclose and did not disclose to shareholders of Health-Chem that said loans were in violation of the prospectus representation... and that Health-Chem received less than fair and adequate consideration for such loans." (Complaint [*] 12).
The complaint also states that in 1975 and 1976 defendants caused the three Health-Chem subsidiaries to sell substantially all of their fixed assets to a group consisting of the individually named defendant insiders, who then leased back the assets to the subsidiaries. The consideration received by the subsidiaries consisted of both short and long-term promissory notes. Plaintiffs allege that at the time these sale lease-backs were entered into, "the defendants did not publicly disclose or disclose to shareholders of Health-Chem that said transactions would substantially damage Health-Chem." (Complaint [*] [*] 20, 25). The extent and nature of the disclosures actually made are not set forth in the complaint.
Finally, plaintiffs state that in 1976, Health-Chem was forced by defendants to enter into an agreement with Funding Systems Leasing Corp. under which Health-Chem purchased over $14 million worth of equipment from Funding Systems and leased back the equipment at a "cost of up to $14,300,000 to Health-Chem." (Complaint [*] 36). Health-Chem allegedly issued a promissory note for part of the sale price, payable in 1985. Plaintiffs allege that defendants "did not disclose publicly or to the shareholders of Health-Chem... that (a) the sale lease-back resulted in Health-Chem committing more funds to the sale lease-back than the entire net worth of Health-Chem,... and (b) that the sale lease-back would decrease the earnings of Health-Chem and thereby depress the market price of the common stock of Health-Chem." (Complaint [*] 39). Again, the disclosures actually made are not set forth.
The analysis of these derivative claims begins with the proposition that only a defrauded purchaser or seller of securities has standing to sue under Rule 10b-5. Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 44 L. Ed. 2d 539, 95 S. Ct. 1917 (1975); Birnbaum v. Newport Steel Corp., 193 F.2d 461 (2d Cir.), cert. denied, 343 U.S. 956, 96 L. Ed. 1356, 72 S. Ct. 1051 (1952). It is also clear that the Rule "protects corporations as well as individuals" who are purchasers or sellers. Superintendent of Insurance v. Bankers Life & Casualty Co., 404 U.S. 6, 10, 30 L. Ed. 2d 128, 92 S. Ct. 165 (1971); see Hooper v. Mountain States Securities Corp., 282 F.2d 195 (5th Cir. 1960), cert. denied, 365 U.S. 814, 5 L. Ed. 2d 693, 81 S. Ct. 695 (1961). Therefore, a shareholder suing derivatively may assert the rights of a corporation that has been defrauded in connection with the purchase or sale of securities. See, e.g., Dasho v. Susquehanna Corp., 461 F.2d 11 (7th Cir.), cert. denied, 408 U.S. 925, 33 L. Ed. 2d 336, 92 S. Ct. 2496 (1972).
As the Second Circuit recently stated, the problem with the application of Rule 10b-5 to derivative actions involving internal corporate transactions "has lain in the degree to which the knowledge of officers and directors must be attributed to the corporation, thereby negating the element of deception." Goldberg v. Meridor, [Current] Fed. Sec. L. Rep. (CCH) [*] 96,162, at 92,263 (2d Cir. Sept. 8, 1977). As Judge Friendly explained in Meridor, the resolution of this problem has come in the theory that if the board or a majority of directors has a conflict of interest in the challenged transaction, even though complete disclosure is made to them, they could be held to have defrauded the corporation. Id.; Bailey v. Meister Brau, Inc., 535 F.2d 982 (7th Cir. 1976). See Jennings & Marsh, Securities Regulation 998-99 (1977). Of course, when no shareholder approval is required for a certain transaction, disclosure to a disinterested board is equivalent to disclosure to the corporation. Wright v. Heizer Corp., [Current] Fed. Sec. L. Rep. (CCH) [*] 96,101, at 91,963 (7th Cir. June 30, 1977).
The law having settled on the proposition that an interested board or controlling shareholder could be held to have deceived the minority interest by causing the corporation to enter into transactions without making adequate disclosure, and in so doing violate Rule 10b-5, the further question arose as to what constituted an actionable "deception." Compare Popkin v. Bishop, 464 F.2d 714 (2d Cir. 1972) with Schoenbaum v. Firstbrook, 405 F.2d 215 (2d Cir. 1968) (en banc), cert. denied, 395 U.S. 906, 89 S. Ct. 1747, 23 L. Ed. 2d 219 (1969). Because of the conflict of interest inherent in this type of case, some courts seemed to concentrate more on the improper conduct of the controlling shareholder rather than on the details of disclosure. See Popkin v. Bishop, 464 F.2d at 719.
Recently, in Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 97 S. Ct. 1292, 51 L. Ed. 2d 480 (1977), the Supreme Court definitively held that deception and not mere unfairness was a necessary element of a derivative action under Rule 10b-5. In that case, a minority "squeeze out" under the Delaware short-form merger law had been held by the Second Circuit to violate the Rule, the court stating that "neither misrepresentation nor nondisclosure was a necessary element of a Rule 10b-5 action." It was this holding that the Supreme Court reversed. See 97 S. Ct. at 1299 & n.8.
Now that it is clear that Rule 10b-5 does not reach breaches of fiduciary duties without some deception or misrepresentations by the controlling shareholder, the question remains as to what constitutes an actionable deception. In Meridor, supra, the Second Circuit construed Green in relation to the court's previous ...