The opinion of the court was delivered by: SWEET
The defendant PRF Corporation ("PRF") and the individual director-defendants Ephraim Bloch, Chairman of the Board and Chief Executive Officer ("Bloch") and five other persons comprising the complete PRF board ("the directors"), have moved to dismiss the amended and supplemental complaint in this shareholder derivative suit for failure of the plaintiff Ruth Cohen (the "shareholder" or "derivative plaintiff") to fulfill the requirements of Rule 23.1 of the Fed.R.Civ.P. The motions presumably were made under Fed.R.Civ.P. 12(c); material in addition to the pleadings has been offered by both parties and considered.
The directors have also moved for protective relief from discovery under Fed.R.Civ.P. 26, and the shareholder has cross- moved to compel discovery under Fed.R.Civ.P. 37. For the reasons stated, the motions to dismiss the complaint are granted, thereby mooting the motions relating to discovery.
The history of this and related litigation is relevant to the disposition of the instant motions. This controversy had its genesis with the approval of a recapitalization proposal by the PRF Board of Directors (the "Board") in 1975. Under the proposal presented to shareholders in advance of the June 26, 1975 annual meeting, the number of authorized common shares would be increased and PRF's two-class stock structure revised by the elimination of all Class A shares and the issuance for each such share of 20 shares of Class B common. Under the existing structure each Class A share was entitled to twenty votes compared to one vote per Class B share. The distribution ratio was also 20 to 1, while the two classes participated on a one-to-one basis with respect to dividends.
After the shareholders approved the recapitalization proposal, the Securities and Exchange Commission (the "S.E.C.") began investigating possible violations by PRF of the Securities Exchange Act of 1934 and the Proxy Rules promulgated thereunder in the dissemination of the 1975 proxy material. With the S.E.C. determined to commence an action based on its conclusion that the proxy material was false, misleading, and contained material nondisclosures, PRF entered into a consent decree (the "decree") on May 29, 1976. The decree invalidated Board-approved proposals concerning recapitalization and the amendment of a previous stock purchase agreement between Bloch and PRF set forth in the 1975 proxy material and ratified at the annual meeting, and prohibited PRF from disseminating any non-complying proxy materials in the future. Additionally, the decree provided that prior to any submission by the Board to the shareholders of any new recapitalization proposal affecting the rights of the Class B shareholders, or the submission of any plan to buy shares of stock from Bloch, PRF first had to notify this court of its intent and appoint a special agent satisfactory to the S.E.C., who would investigate the fairness to each class of PRF stockholders of any such proposals. Following investigation the special agent was to report to the court and to the S.E.C., and PRF was to include that report in any relevant proxy statement. PRF also was enjoined from converting any Class A stock into common stock or other securities unless the matter was submitted to the shareholders for approval and a majority of the votes cast by the holders of common stock who owned no Class A stock voted in favor thereof.
During the S.E.C. investigation in connection with the 1975 proxy material, a derivative action was commenced in this court against PRF and all of its officers and directors by Arline Bronzaft, the wife of the attorney for the present derivative plaintiff, alleging facts and causes of action essentially similar to those contained in the S.E.C. complaint. The Bronzaft action was dismissed as moot in light of the entry of the consent decree, on November 18, 1976. By agreement, counsel in the present action ("Bronzaft"), who also represented plaintiff therein, received a $ 37,000 fee in connection with the dismissal.
Desiring to pursue recapitalization, PRF held discussions with the S.E.C. in 1977 covering financial reporting requirements. By January, 1978, the Board had worked out for the shareholders a proposed exchange of 19 shares of common stock for each Class A share. Further discussions between PRF and the S.E.C. were held, and pursuant to the 1976 decree, a special agent was approved by the S.E.C. and retained to report on the overall fairness of the proposed recapitalization and related proxy materials. The special agent's report issued, and a summary thereof was contained in the PRF proxy materials sent out in connection with the upcoming annual meeting on January 26, 1979.
On August 22, 1978, the shareholder, step-mother of Bronzaft's wife, filed the original complaint in this derivative action, challenging the Board's termination in 1977 of the 1968 agreement between Bloch and PRF by which PRF was to buy 80% of the Class A stock owned by Bloch at his death, for a price equal to the market value of 61/2 shares of the common stock for each Class A share, with a maximum payment of $ 1,500,000. The complaint alleged that the termination of that agreement was effectuated with recourse to material inside information, in violation of § 10(b) of the Securities Exchange Act of 1934, and that it was unfair to PRF, constituting a gift and a waste of corporate assets.
Upon receipt of final S.E.C. comments, in mid-December, 1978 the proxy materials were sent out to PRF shareholders, including the derivative plaintiff and Bronzaft himself. Later that month a meeting was arranged between Bronzaft and counsel for the directors, to discuss resolution of the existing cause of action. During the lunch meeting which transpired in New York City on January 11, 1979, Bronzaft apparently raised the matter of possible settlement of "a second cause of action" he intended to inject into the litigation respecting the new 1979 recapitalization proposal. Bronzaft declined to elaborate on the alleged omissions and misstatements in the recently disseminated proxy materials which would be the basis of the new claim, despite counsel's urging that he do so in order that corrective steps might be taken before the upcoming annual meeting. The recapitalization proposal was presented to and approved by the shareholders at that meeting on January 26, 1979, with 27% of the eligible Class B common shares opposed. At no time after receipt of the proxy materials did the shareholder or Bronzaft communicate anything further with respect to this matter, or make any claims or disclosures amounting to a "demand" pursuant to Fed.R.Civ.P. 23.1.
Subsequently, on May 17, 1979, this court granted the shareholder's motion of April 6 to file an amended and supplemental complaint containing an additional cause of action alleging material omissions and misstatements in the relevant 1979 proxy materials issued in December, 1978. The actionable wrongs alleged with respect to the proxy materials involve nondisclosure of the history of the Board's efforts to rescind the existing Bloch purchase agreement and amend it to Bloch's substantial financial advantage, the pendency of this and another derivative action challenging the alteration of the Bloch purchase agreement, and certain of the Board's activities and other facts relating to the proposed 19:1 recapitalization. As discovery progressed, on November 9, 1979, this court ruled that since the shareholder lacked adequate knowledge, her counsel Bronzaft could be deposed on matters relating to the commencement of the derivative action.
At his deposition Bronzaft testified that he and his law partner had promptly reviewed the proxy statement and additional materials received upon request from PRF, and determined that there were deficiencies sufficiently serious as to render void any shareholder vote which utilized such a proxy solicitation. He stated that he was very familiar with PRF and its activities being a shareholder himself, and having maintained a file on the company at least since the institution of the previous derivative action initiated by his wife. Bronzaft also conceded that he had not called any of these alleged violations to the attention of the defendants before the recapitalization was acted upon at the January 26, 1979 shareholders' meeting or indeed, at any time before filing the amended complaint stating specifically, in answer to a question as to whether he had disclosed the proxy infirmities then known to him at the January 11 lunch meeting: "No, I didn't. I certainly wasn't going to sit there and tell you how I could show you how it was wrong at the time."
It is alleged and defendants do not dispute that at all relevant times until January 26, 1979, Ephraim Bloch and his family and related trusts owned or controlled 21.5% of the outstanding PRF common stock and 86.5% of the Class A stock, and therefore possessed some 65.5% of the voting power. In fact, the shareholder alleges that the director-defendants, comprising PRF's entire Board, together with their relatives owned approximately 99% of the Class A stock.
Defendants move to dismiss the entire action pursuant to Rule 23.1 on the basis that the present plaintiff is not a "fair and adequate representative," or alternatively to dismiss the second cause of action on the ground that the shareholder has failed to comply with the Rule 23.1 demand on directors requirement.
The derivative action may not be maintained if it appears that the plaintiff does not fairly and adequately represent the interests of the shareholders or members similarly situated in enforcing the right of the corporation ....
Defendants urge dismissal of the action on this ground, relying primarily on the proposition that the shareholder, in pursuing the second cause of action, has breached a fiduciary duty she owes to PRF and all its shareholders by ...