Appeal from an order of the United States District Court for the Southern District of New York, Gerard L. Goettel, Judge, granting defendants-appellees' motion for summary judgment in a stockholder's derivative action. Reversed and remanded.
Before Van Graafeiland, Newman and Kearse, Circuit Judges.
This is an appeal from an order of the District Court for the Southern District of New York, Gerard L. Goettel, Judge, granting defendants' motion for summary judgment in a stockholder's derivative suit on behalf of TRW, Inc. ("TRW"), an Ohio corporation, raising claims under § 14(a) of the Securities and Exchange Act of 1934, 15 U.S.C. § 78n(a) (1976) ("1934 Act"), and under state law. The gravamen of the complaint is that defendant directors of TRW exceeded their authority under certain employee stock option plans by causing the granting of options in 1974 conditioned on the surrender of other options previously granted at higher exercise prices; that the proxy statements issued to secure approval of the stock option plans violated § 14(a) in that they failed to disclose the possibility of such conditional grants; and that subsequent proxy statements seeking the election of directors violated § 14(a) by failing to disclose that certain directors had personally benefited from the conditional grants.
A majority of TRW's board of directors, consisting of those directors who did not receive options, has determined that maintenance of this action would be contrary to the best interests of the corporation. The district court ruled that this determination was conclusive under the "business judgment" rule, and required dismissal of the action. We hold that appellant's claims under § 14(a) were not subject to dismissal under the business judgment rule, and that the dismissal of the state law claims under that rule must be reconsidered with reference to Ohio law. Accordingly, we reverse and remand for further proceedings.
In 1967 the stockholders of TRW approved an employee stock option plan which authorized the issuance and sale of 700,000 shares*fn1 of TRW stock. The options granted under the plan were intended to serve as a form of incentive compensation to officers and "key employees" of the company. The plan is administered by a Stock Option Committee (the "Committee"), which at all relevant times has consisted of four outside directors of TRW. Under the plan, the Committee may authorize the granting of options "upon such terms and conditions as it may determine,"*fn2 at exercise prices not lower than the fair market price of the stock at the time of the grant. Except in circumstances not present here, the plan does not provide that the exercise price of outstanding options may be reduced. The plan does not give the board of directors or the Committee authority to amend or modify any of its provisions.
By 1973, options had been granted covering all but 64,877 of the 700,000 shares authorized under the 1967 plan. In 1973 the stockholders approved a second stock option plan, authorizing the issuance and sale of 800,000 shares, which, in all material respects other than the number of shares, was identical to the 1967 plan.
Between 1971 and 1974 the market price of TRW stock declined substantially. The stock traded during 1971 and 1972 at varying levels between $30 and $40, but by December 31, 1973 the price had fallen to less than $18. Options that had been granted at earlier market prices consequently went "underwater" i. e., the exercise price was well above the current market price of the stock and these options were thus of little or no value to the employees who had received them. The directors apparently perceived this as a serious threat to employee morale because during the period of market price decline, the company's general earnings trend, in part due to the efforts of the optionees, had been positive. Thus, the purpose for which the options had been granted to provide incentive compensation was defeated.
In 1974 the Stock Option Committee therefore decided to replace the "underwater" options with new options carrying lower exercise prices. On May 1, 1974, employees holding options granted prior to December 31, 1972 were given new options, which by their terms would expire in 60 days unless options granted prior to 1973 covering an equivalent number of shares were surrendered for cancellation. The new options carried new "earn-out" provisions and did not give credit for employment prior to May 1, 1974 or for previous earn-out periods accumulated by an optionee in connection with the surrendered options.*fn3 As a result of these grants, old options covering 564,928 shares with exercise prices of $28.75-$37.625 were surrendered and were replaced by new options covering the same number of shares and exercisable at $18. The new grants covered 551,928 shares that were available under the 1973 plan and 13,000 shares that were available under the 1967 plan.
After May 1, the market price of TRW stock continued to decline. On October 1, 1974, the Committee issued new options covering 306,430 shares which were conditioned on the surrender of options that had been granted during 1973. The October grants covered shares then available under the 1967 plan, all, or nearly all, of which had become available as a result of the surrender of options pursuant to the May grants. The October options had an exercise price of $13.56, and replaced options that had been exercisable at prices ranging from $24.875 to $27.625.
As a result of the May and October 1974 grants, six officer-directors received new options covering 174,300 shares, or 20% of the total granted, exercisable at an aggregate price of $2,862,120, in exchange for the surrender of options to purchase the same number of shares at an aggregate price of $5,027,188.*fn4 In plaintiff's view the principal reason for the 1974 grants was to permit these six recipient-directors to profit unfairly from a temporary decline in the market price of TRW stock.
Plaintiff filed suit against all fifteen of TRW's directors on May 16, 1976, challenging the 1974 grants and various proxy statements issued before and after. Jurisdiction was predicated on § 27 of the 1934 Act*fn5 and on diversity of citizenship.*fn6 The complaint asserted principally that the grants were invalid because they were, in effect, unauthorized reductions in the exercise prices of existing options, and because the share limitation in the 1967 plan had been exceeded. It charged that the recipient-directors and the members of the Stock Option Committee had breached their fiduciary duties to the corporation, and that the other directors were responsible for having acquiesced in the invalid grants.
In addition, plaintiff charged that five proxy statements violated § 14(a) of the 1934 Act*fn7 and Rule 14a-9 promulgated thereunder*fn8 because of alleged nondisclosure of facts relating to the 1974 grants.*fn9 The 1967 and 1973 proxy statements urging stockholder approval of the 1967 and 1973 plans were attacked as false and misleading, principally on the ground that they did not disclose the possibility of conditional grants, such as those made in 1974, that could be used to reduce the exercise prices of outstanding options. The 1974 proxy statement for the annual meeting at which certain directors were elected was challenged on the ground that the board of directors had determined to implement the May conditional grants but failed to disclose that determination, with the result that certain directors were to receive more remuneration than was disclosed in the proxy statement.*fn10 Finally, the proxy statements for the 1975 and 1976 annual meetings at which directors were elected, although they listed the number of options and the average per-share option price for each director, were attacked for not disclosing that these options had replaced older, higher-priced options as a result of the 1974 grants.
In redress of his state law claims, plaintiff sought rescission of the 1974 grants and demanded that the defendant directors account for any losses to the corporation resulting from those grants. On his § 14(a) claims plaintiff demanded that the 1967 and 1973 plans be declared void, and that the elections of directors in 1974, 1975 and 1976, be set aside.
The Directors' Resolution Concerning Plaintiff's Suit
The directors of TRW received reports on plaintiff's lawsuit at their July 1976 and October 1976 meetings. They received a written memorandum of the background of the 1974 conditional grants and regrants from TRW's general counsel, who was a recipient of the 1974 grants. They instructed TRW's outside counsel to investigate the merits of the claim that the conditional grants and regrants were invalid, and obtained a reconfirmation of that firm's original opinion that the grants and regrants were valid.
On December 15, 1976, the board met with two additional independent law firms to discuss the action. Each of those firms gave its opinion that the 1974 grants were valid and that the TRW board could authorize counsel to seek dismissal of this suit. Following some discussion, the six directors who had received options under the 1974 grants were excused from the meeting. According to the defendants' affidavits, which were credited by the district court, the remaining nine directors concluded that the best interests of the company required dismissal of the action; they believed the 1974 option grants were valid, that the pursuit of the lawsuit would have a detrimental effect on the morale of key employees by creating uncertainty as to the validity of their options, and that if plaintiff succeeded in his quest to have the 1974 options cancelled, TRW would be injured by the demoralization of the key employees. Consequently, the nine directors voted to authorize counsel to seek dismissal of the action as contrary to the best interests of the corporation.
The Motions and Decision Below
Following this resolution by the nine TRW directors, but prior to its implementation, plaintiff sought discovery on the merits of his claims. On March 25, 1977, TRW and its directors moved for summary judgment under Fed.R.Civ.P. 56 dismissing the entire action, on the ground that the independent directors of the company had determined that it would not be in the company's best interests to pursue any of the claims asserted in the complaint, and moved for dismissal of the 1934 Act claims under Fed.R.Civ.P. 12(b)(6) for failure to state a claim upon which relief may be granted. They followed with a motion, which was granted, to limit discovery to issues of the good faith of the nine directors in their exercise of business judgment to seek dismissal.*fn11 There ensued ten months of discovery including depositions of eight of the nine directors,*fn12 and the TRW general counsel.
Following this discovery, the defendants renewed their motion for summary judgment and dismissal. In addition to complaining of a lack of discovery on the merits, plaintiff took the position that, for various reasons, none of the nine directors was independent: three had approved the 1974 grants as members of the Stock Option Committee; and plaintiff charged six directors with causing to be issued the 1967 and 1973 proxy statements, eight with causing to be issued the 1974 and 1975 proxy statements, and all nine with causing to be issued the 1976 proxy statement. All of the directors voting had been elected pursuant to the ...