The opinion of the court was delivered by: WEINFELD
This is a derivative action on behalf of Zapata Corporation ("Zapata" or the "Corporation") for alleged violations of various provisions of the Securities Exchange Act of 1934
(the "Exchange Act") and of the common law. Jurisdiction is asserted under the Exchange Act,
diversity of citizenship
and the principle of pendent jurisdiction. The defendants are the Corporation's directors from approximately 1970 to the present; Zapata is named as a defendant for whose benefit the action is brought.
The case is now before the Court on cross-motions by the parties. Plaintiff moves pursuant to Rule 56 of the Federal Rules of Civil Procedure for summary judgment on the ground there is no genuine issue of fact; the defendants move to dismiss: (a) the Exchange Act claims pursuant to Federal Rule of Civil Procedure 12(b)(6) for failure to state claims upon which relief can be granted, and (b) the remainder of the complaint on the ground that this Court lacks both subject matter jurisdiction, and, as to the individual defendants, in personam jurisdiction. Defendants accept as true all of plaintiff's allegations for purposes of their 12(b)(6) motion, but contend that if the complaint is held sufficient, factual issues exist which preclude granting plaintiff's motion. Plaintiff's common law claims are also the subject of a suit between the parties in the Delaware state court where extensive discovery has been conducted and which, defendants assert, is "approaching trial." For this reason, defendants urge that if any of plaintiff's claims survive this series of motions, proceedings herein should be stayed pending outcome of the Delaware suit.
Plaintiff's claims center about a stock option plan (the "plan") established in 1970 for key employees of Zapata and its subsidiaries, and certain modifications to that plan made by the Corporation's board of directors in July 1974 immediately prior to announcing a tender offer by the Corporation for its own shares. Under the original plan, which Zapata's shareholders approved on January 11, 1971, the price per share upon exercise of an option was $12.15, purchases could be made only for cash, and the options would be exercisable at five stages: 20%, ninety days after the date the options were granted -- July 14, 1970 -- and an additional 20% on each of the next four successive anniversaries of the date of grant. Thus the last option exercise date was July 14, 1974. The Corporation's board of directors was authorized to make any and all changes in the plan, except those which would: (a) increase the total number of shares offered; (b) change the class of employees covered; or (c) extend the program's ten-year life. These three categories of changes had to be submitted for shareholder approval.
Toward the end of June 1974, defendant Flynn, the chief executive officer of Zapata, had considered in consultation with its bankers a tender offer in the open market for Zapata stock. By July 1 the mechanics of the offer and financing were arranged; by then all the directors were aware of the prospect of the offer and had discussed it informally with Flynn. On July 2, 1974, following the opening of the New York Stock Exchange, trading in Zapata stock was suspended upon the request of Zapata management pending a future announcement of the tender offer. When trading was halted, the price per share was approximately $18.50.
Later that day, July 2, a meeting of Zapata's board was held attended by Flynn, who as chief executive officer was entitled to participate in the stock option plan, and defendants Israel, Mackin, Woolcott and Gueymard, non-officers and hence ineligible under the plan. The three remaining directors at the time, defendants Harrison, Shiels and Naess, each of whom was also an officer, were not present. At the meeting, with Flynn not voting, the board unanimously modified the plan to permit: (a) non-interest bearing loans to be made to key officers in sums required to purchase stocks under the option plan; and (b) loans, also non-interest bearing, to these same employees to meet the tax liability resulting from their acquisitions under the plan. Each of these loans was to be secured by the stock to be purchased. The board also voted to accelerate the exercise date of the final 20% of the options from July 14, to July 2, 1974. Finally, although none of these modifications fell within the three categories listed above requiring shareholder approval, the board nonetheless resolved to submit these modifications (the "July 2 modifications") to the shareholders at the next regular or special meeting and a provision was contained in each loan agreement stating that if the modifications were not approved, the stock so purchased would be returned, the loans cancelled and the options reinstated. Pursuant to these resolutions, each of the officer-directors (including those not present at the board meeting) and a number of additional officers exercised their options on July 2, 1974. This constituted a purchase and sale of securities within the meaning of Section 10(b) and Rule 10b-5.
Thus, the stockholders of Zapata, as the seller of the securities, may bring a derivative action for any damages to the Corporation claimed to have been suffered by reason of an alleged violation of the Section and Rule.
On the following day, July 3, the board formally approved the tender offer, which was announced on July 8, when trading of the stock was resumed on the Exchange. The closing price for the shares on that day was $24.50 per share. When as already noted, the officer-directors and other officers exercised their options on July 2, 1974, trading had been suspended and the market price then was $18.50 per share.
Based upon the changes in the option plan as authorized by the resolutions of July 2, 1974 and the exercise thereunder of their options by the officer-directors and others, plaintiff asserts three claims under the Exchange Act in addition to a basic common law claim for waste of corporate assets -- violations of Section 10(b) and Rule 10b-5,
of Section 14(a) and Rule 14a-9
and Section 7.
The claims will be dealt with seriatim.
Plaintiff claims that Zapata was the victim of a 10b-5 violation perpetrated by its board of directors, when with knowledge prior to July 2, 1974 that a tender offer at a price above the prevailing market price would be made, its members voted to modify the terms of the option plan so that in end result those who exercised their options derived a tax advantage at the expense of Zapata -- in essence, that the action of the board constituted a fraudulent or manipulative device or scheme to benefit the optionees to the detriment of the Corporation.
Plaintiff's position runs along these lines. Under tax law and regulations, employees exercising stock options such as those in question realize ordinary income equal to the difference between the option price and the market price at the time the option is exercised,
hereinafter referred to as the "bargain spread";
correspondingly, the corporation is entitled to deduct the same difference.
Since the options were exercised on July 2, 1974 when trading was suspended and the market price was $18.50, the difference between that market price and the option price of $12.15 per share, the bargain spread, was slightly over $6.00; the total bargain spread, which constituted ordinary taxable income to the purchasers and was tax deductible by Zapata, amounted to $1,007,000. Plaintiff's argument proceeds that by exercising their options on the accelerated date, July 2, the officers thereby avoided paying tax on an ordinary income basis on the difference between $18.50, the market price of Zapata stock on July 2, 1974, and $24.50, the market price of the stock on July 8, 1974, the date trading was resumed.
Thus they contend the defendants avoided paying taxes on an ordinary income basis on an aggregate of an additional $860,000 (the additional bargain spread had the option been exercised on July 8) and simultaneously prevented Zapata from realizing the benefit of a tax deduction in that amount. This difference of $860,000 -- or more specifically, assuming a 50% tax rate, a $430,000 net tax benefit of which it is alleged Zapata was deprived -- is plaintiff's claim of damages. The argument, of course, is postulated upon an assumption that absent the July 2 modification, the defendants nonetheless would have exercised their option on July 8.
To meet the "deception" or "manipulative conduct" requirement of the Supreme Court's decision in Santa Fe Industries v. Green,13 plaintiff relies upon the fact that Zapata's shareholders were never given the information concerning the circumstances surrounding the change in the option program as authorized by the July 2 resolution. Defendants do not suggest otherwise but contend that these allegations do not constitute manipulative or deceptive conduct proscribed by Section 10 or Rule 10b-5.
They argue that no disclosure was required to be made to the shareholders, for Zapata's board of directors -- which plaintiff admits was fully aware of the implications and consequences of the July 2 resolutions and the exercise of options -- was apprised of all the material facts and based thereon authorized the sale on the Corporation's behalf. Simply stated, defendants argue that there was no deception and hence there can be no 10b-5 claim.
However, the corporate interest (really that of the shareholders) is not so readily disposed of. The Exchange Act "protects corporations as well as individuals who are sellers of a security,"
and its right to protection under the Act is not foreclosed simply because the directors acted with knowledge and hence, as defendants necessarily urge, the Corporation cannot deceive itself. The courts have cut through this technical dilemma.
As our Court of Appeals has repeatedly stated: "In order to establish fraud it is surely not necessary to show that the directors deceived themselves. It must be enough to show that they deceived the shareholders, the real owners of the property with which the directors were dealing."
Thus disclosure to the directors, even the entire board, does not necessarily foreclose a Section 10(b) and Rule 10b-5 claim in favor of the Corporation. The inquiry turns to the "degree to which the knowledge of officers and directors must be attributed to the corporation, thereby negating the element of deception."
The scope of the inquiry is directed to those circumstances under which, notwithstanding the knowledge of the directors attributable to the Corporation, disclosure to the shareholders is nonetheless required. Directors' knowledge is insufficient when there is a duty to disclose directly to the shareholders because "it is practical as well as just to do so."
Such is the case where, for example, dealings between a corporation and its parent or controlling person are questionable,
or where the decision is one which under state law must be made by the shareholders directly
or where material facts were misrepresented or withheld from some members of the board of directors.
But none of these situations is applicable herein.
The only situation requiring disclosure directly to shareholders of even possible relevance here is the requirement that under certain circumstances disclosure be made to a corporation's shareholders when the directors have a financial interest in the transaction in question, for where the directors are so interested, it cannot be assumed that they will safeguard the corporation's interests.
This is not to say, however, that any transaction involving any board member must be disclosed to and approved by a corporation's shareholder under Rule 10b-5. As long as a disinterested majority of a board's directors which has authority to consummate the transaction
is fully informed of all relevant ...