UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF NEW YORK
December 18, 1981
RUTH COHEN, Plaintiff, and HARRY LEWIS, Plaintiff-Intervenor, against EPHRIAM BLOCH, JOSEPH VITALE, ALVIN L. LEVINE, ALBERT BLOCH, HARRY FISHLOW, FRED A. LITTLE and PRF CORPORATION, Defendants.
The opinion of the court was delivered by: SWEET
The defendant officers and directors of the PRF Corporation ("PRF") ("the defendants") have moved under Fed.R.Civ.P. 12(b) for judgment dismissing the complaint in the stockholder derivative action now prosecuted by the intervening plaintiff Harry Lewis ("Lewis") on the ground that the action is now moot. An affidavit has been submitted in support of the motion setting forth certain facts which are set forth below and are not contester. For the reasons stated below the motion will be denied as to the first cause of action and granted as to the second cause of action.
This 1978 action has had a difficult and tortuous procedural past, a number of motions having been disposed of relating to the capacity of the plaintiff, discovery, and intervention without reaching the merits of the controversy. Familiarity with the prior decisions of the court dealing with this procedural history is assumed. What has remained before the court is an intervenor's complaint which, briefly stated, alleges violation of fiduciary duties by the defendants as well as Securities Act violations arising out of a termination of the purchase agreement entered into between Bloch and PRF, a subsequent plan of recapitalization and improprieties in the proxy solicitation relating to the termination and recapitalization. During this period, PRF terminated the stock purchase agreement which was the subject of the first cause of action and proceeded with its recapitalization plan which was the subject of the second cause of action.
As a result of a prior action brought against PRF by the Securities & Exchange Commission, and a consequent consent decree entered in the United States District Court for the District of Columbia, a special agent was appointed in connection with a proposed plan of reorganization. Proxy materials were sent the shareholders of PRF in December of 1978, describing the plan to be submitted to a meeting of the shareholders on January 26, 1979. Accompanying these materials was the report of the special agent based on an independent evaluation. The meeting was held, the plan approved, and the recapitalization took place. As a consequence, the Articles of Incorporation were amended to increase the authorized number of common shares, and Class A shares were eliminated altogether by substituting nineteen shares of common stock for each share of Class A stock. Prior to the recapitalization, Class A shares were equivalent to twenty common shares for voting and liquidation purposes, however participated equally with common shares for dividend purposes.
Thereafter on April 27, 1980 at a special meeting called for the purpose, the shareholders of PRF approved the sale of substantially all of the assets of PRF and the subsequent liquidation and dissolution of the company including the change of its name to the XYZ Liquidating Corporation. On December 31, 1980 a definitive agreement of sale was executed which was subsequently submitted to the shareholders at a meeting of April 27, 1981 where the agreement, the liquidation and the dissolution were approved. On May 14, 1981, the sale of assets closed, and the surrender of stock in liquidation commenced.
Pursuant to an agreement reached in late 1968, PRF acquired the right to purchase 80% of the class A shares held in the estate of Ephraim Bloch ("Bloch"), then chairman of PRF at a price to be fixed by the application of certain formulae (the "stock purchase agreement"). A stated purpose of the agreement was to prevent any disruption of PRF's management that might result from a sudden shift in ownership of a large block of stock caused by Bloch's death. However, the agreement in no way limited or prevented Bloch from selling any or all of his Class A holdings during his lifetime in which case the shares would not be subject to the agreement. In June of 1977 the PRF board terminated this agreement, a termination which is the subject of Lewis' first cause of action. On June 11, 1981 after the liquidation plan had been adopted as just described, Bloch sold his shares to his brother.
Lewis claims PRF's termination of the purchase agreement is null and void. Since such a declaration by the court would have no effect on the parties, their rights and obligations, that relief requested has been rendered moot by subsequent events. "[F]ederal courts are without power to decide questions that cannot affect the rights of litigants in the case before them." North Carolina v. Rice, 404 U.S. 244, 246 (1971). "Simply stated, a case is moot when the issues presented are no longer 'live' or the parties lack a legally cognizable interest in the outcome." Powell v. McCormack, 395 U.S. 486, 496 (1969). The requested declaration of invalidity of the termination would have the effect of determining the agreement to be binding and in effect. The agreement provided, however, that Bloch had the unfettered right to sell all or part of his holdings prior to his death in which case the shares would not be covered by the agreement. Since he has exercised this right, PRF would have no rights remaining under the agreement even if it were in effect, and therefore a declaration of invalidity of termination would not benefit Lewis as the representative of the corporation, and is therefore moot.
Declaratory relief, however, is not the only relief sought in the complaint which also prays for "such other and further relief as the court may deem proper." Courts are granted considerable leeway in fashioning a remedy, United States for use of Bergen Point Iron Works v. Maryland Cas. Co., 384 F.2d 303, 304 (2d Cir. 1967); J.I. Case Co. v. Borak, 377 U.S. 426, 433-34 (1964), Bell v. Hood, 327 U.S. 678, 684 (1946); Columbia Nastri & Carta Carbone v. Columbia Ribbon & Carbon Mfg. Co., 367 F.2d 308, (2d Cir. 1966), and monetary relief can clearly fall within the prayer for relief quoted above. Truth Seeker Co. v. Dunning, 147 F.2d 54, 57 (2d Cir. 1945). Lewis, therefore, appears to claim that the corporation should be awarded monetary damages for the termination of the purchase agreement in violation of Section 10(b) and Rule 10b-5.
A shareholder derivative action on behalf of the corporation can be brought as an implied private action under Rule 10b-5 for damages resulting to the corporation. Shell v. Hensley, 430 F.2d 819, 824 (5th Cir. 1970); Herpech v. Wallace, 430 F.2d 792, 803 (5th Cir. 1970); Schoenbaum v. Firstbrook, 405 F.2d 215, 219 (2d Cir. 1968) (en banc), cert.denied, 395 U.S. 906 (1969); Ruckle v. Roto American Corp., 339 F.2d 24, 28 (2d Cir. 1964). In dealing with a derivative suit on behalf of corporate purchasers and sellers the problem arises "in the degree to which the knowledge of officers and directors can be attributed to the corporation, thereby negating the element of deception." Goldberg v. Meridor, 567 F.2d 209, 215 (2d Cir. 1977), cert.denied, 434 U.S. 1069 (1978). As stated by Judge Friendly:
There is deception of the corporation (in effect, of its minority shareholders) when the corporation is influenced by its controlling shareholder to engage in a transaction adverse to the corporation's interests (in effect, the minority shareholders' interests), and there is non-disclosure or misleading disclosures as to the material facts of the transaction.
Goldberg. v. Meridor, 567 F.2d at 217. See also Schoenbaum v. Firstbrook, 405 F.2d at 217; Pappas v. Moss, 393 F.2d 865 (3d Cir. 1968).
The complaint alleges a failure to disclose substantial back orders that would have resulted in higher anticipated future earnings at the time the option agreement was terminated and one can construe the complaint to allege that had such knowledge been available to a disinterested director or the shareholders, the cancellation of the option agreement would not have taken place. Although these omissions might conceivably appear material as facts that might "'have assumed actual significance in the deliberations' of reasonable and disinterested directors or created 'a substantial likelihood' that such directors would have considered the 'total mix' of information available to have been 'significantly altered,'" Goldberg v. Meridor, 567 F.2d at 219, see also Shell v. Hensley, 430 F.2d at 827, cf., TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976), whether this omission now meets the burden of materiality may be questionable in view of the uncertain value of the option. However, for these reasons the first cause of action is not moot although the nature of the damages will be discussed shortly in connection with the state claim.
It is also well established that a private action for damages under Section 10(b) and Rule 10b-5 can only be brought by a purchaser or seller of the security. Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 731-49 (1975); Birnbaum v. Newport Steel Corp., 193 F.2d 461 (1952), cert.denied, 343 U.S. 956 (1952). Although perhaps a restrictive application of the implied private right, this rule limits recovery and hence enforcement of the statutory scheme to:
those persons whose active participation in the marketing transaction promises enforcement of the statute without undue risk of abuse of the litigation process and without distorting the securities market.
Blue Chip Stamps v. Manor Drug Stores, 421 U.S. at 739, quoting Manor Drug Stores v. Blue Chip Stamps, 492 F.2d 136, 147 (9th Cir. 1973) (Hufstedler, J., dissenting).
The purchase or sale requirement appears to be established by the termination of the purchase agreement itself. 15 U.S.C. § 78c(a)(13) & (14) provide that "[t]he terms 'buy' and 'purchase' each include any contract to buy, purchase, or otherwise acquire" and "[t]he terms 'sale' and 'sell' each include any contract to sell or otherwise dispose of." In discussing these definitional provisions the Supreme Court stated:
A contract to purchase or sell securities is expressly defined by § 3(a) of the 1934 Act, 15 U.S.C. § 78c(a), as a purchase or sale of securities for the purposes of that Act.... [T]he holders of puts, calls, options and other contractual rights or duties to purchase or sell securities have been recognized as "purchasers" or "sellers" of securities for purposes of Rule 10b-5, not because of a judicial conclusion that they were similarly situated to "purchasers" or "sellers" but because the definitional provisions of the 1934 Act themselves grant them such status.
Blue Chip Stamps v. Manor Drug Stores, 421 U.S. at 750-51.See also Davis v. Davis, 526 F.2d 1286, 1289 (5th Cir. 1976); cf. First Nat. Bank of Las Vegas, New Mexico v. Estate of Russel, 657 F.2d 668, 674-76 (5th Cir. 1981) (noting the possibility of applying the economic reality test and the commercial investment dichotomy to the purchase or sale requirement.) Moreover, the term contract as used in the provision defining purchase or sale should be given a broad, liberal interpretion, Mt. Clemens Industries, Inc. v. Bell, 464 F.2d 339, 346 & n.12 (9th Cir. 1972), and is not limited to technical common law purchases and sales. Spector v. LQ Motor Inns, Inc., 517 F.2d 278, 286 (5th Cir. 1975), cert.denied, 423 U.S. 1055 (1976). Dasho v. Susquehanna Corp., 380 F.2d 262, 266 (7th Cir.), cert.denied, 389 U.S. 977 (1967).
Although the purchase contract was contingent upon several uncertain events the allegations set forth the purchaser or seller requirement sufficiently, at this stage of the litigation, to withstand a motion to dismiss. Thus the purchaser or seller requirement appears to be satisfied by PRF's involvement in the purchase agreement and its termination.
Rule 10b-5 also requires that the deceptive practice, material misstatement or omission or other such action to defraud be "in connection with the purchase or sale of a security." This requirement has been construed quite flexibly to require only that the deceptive practice "touch" the sale of the security. The Supreme Court required that the plaintiff have "suffered an injury as a result of deceptive practices touching its sale of securities as an investor." Superintendent of Ins. v. Bankers Life & Casualty Co., 404 U.S. 6, 12 (1971). See also United States v. Newman, Docket No. 81-1225 at 5215 (2d Cir. October 31, 1981). Lewis alleges that the directors' termination of the purchase agreement and omissions to state material facts concerning it were the deceptive practices which were "all in connection with the purchase and sale of securities, to wit: shares of PRF stock in violation of Section 10(b) and Rule 10(b) 5 promulgated thereunder." Since the material misstatements, omissions and fraudulent practices are claimed to be related to the termination of the purchase agreement which constitutes the purchase of sale and its termination the "in connection with" requirement is adequately stated. Based on the foregoing discussion the Rule 10b-5 cause of action is sufficiently pleaded.
In the first cause of action Lewis also contends that the termination of the purchase agreement was "made without consideration and was a gift to Ephriam Bloch and a waste of corporate assets of PRF." In supporting papers plaintiff contends that this gift and waste of corporate assets in the first cause of action states a cause of action under state law. Under Delaware law
directors and officers of a corporation owe a fiduciary duty to the corporation to manage it honestly, impartially and on behalf of the corporation, Zahn v. Transamerica Corp., 162 F.2d 36 (3d Cir. 1947); Petty v. Penntech Papers, Inc., 347 A.2d 140 (Del.Ch. 1975); Levien v. Sinclair Oil Corp., 261 A. 2d 911, 914 (De.Ch. 1969), aff'd, in part, rev'd. in part, 280 A.2d 717 (DelSup. 1971), and cannot use the position to further their personal interests. Gottlieb v. McKee, 34 De.Ch. 537, 107 A.2d 240, 243 (1954); Guth v. Loft, 23 Del.Ch. 255, 5 A.2d 503 (1939). Lewis has therefore established a colorable claim for relief under state law provided this court is capable of awarding such relief.
The proper form of recovery for such a breach of duty and appropriation for personal use is a constructive trust over the asset for the benefit of the corporation.
If an officer or director of a corporation, in violation of his duty as such, acquires gain or advantage for himself, the law charges the interest so acquired with a trust for the benefit of the corporation, at its election, which it denies to the betrayer all benefit and profit.
Guth v. Roth, 5 A.2d at 510; see also Gottlieb v. McKee, 107 A.2d at 243. If, however, a constructive trust were placed over the right to purchase the shares at Bloch's death if he owned the stock at death, that right would since have been rendered valueless by Bloch selling the stock so that this remedy would also clearly be moot.
However, Lewis argues that money damages should be awarded to compensate the corporation for the loss of the contingent right to purchase Bloch's shares relying on the clause seeking "such other and further relief as the court may deem proper." Courts are granted considerable leeway in fashioning a remedy, Bell v. Hood, 327 U.S. at 684, and monetary relief could clearly fall within the clause quoted above. Truth Seeker v. Durning, 147 F.2d at 57. Thus, it is claimed that the directors gave away a right which at the time of the "gift" was quite valuable and the corporation should be compensated for that right. The value of the right to purchase the block of stock from Bloch's estate would be quite speculative as it would involve consideration of Bloch's life expectancy, the possibility of the purchase price being advantageous at the time Bloch died as well as the likelihood that Bloch would have sold his block before his death if its value were greater than the option price. Speculation, however, bars damages only when the fact of resultant damages is uncertain, not when the uncertainty concerns the amount of damages. Story Parchment Co. v. Patterson Parchment Paper Co., 282 U.S. 555, 562 (1931); Perma Research & Dev. v. Singer Co., 542 F.2d 111, 116 (2d Cir.), cert.denied, 429 U.S. 987 (1976); Compania Pelineon De Navegacion, S.A. v. Texas Petroleum Co., 540 F.2d 53, 55-56 (2d Cir. 1976), cert.denied, 429 U.S. 1041 (1977). Although these factors significantly reduce the value of the right, they must be considered in determining the value of the right. Lewis contends that a valuable asset was given away for which the corporation was not compensated. The loss is allegedly established, and the uncertainty concerns only the amount, minimal though it may appear to be.
The fact that this complaint sufficiently alleges a state law breach of fiduciary duty does not preclude its consideration under Section 10(b) and Rule 10b-5. Although a claim of breach of fiduciary duty is alone insufficient to establish a federal securities law claim, the alleged wrongs are cognizable provided the claim satisfies the requirements of the implied right of action under Rule 10b-5 in alleging deception, misrepresentation, or non-disclosure. Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1977). As these requirements have at this point been sufficiently established, the 10b-5 action is properly stated. Since the burden of demonstrating mootness is a heavy burden, County of Los Angeles v. Davis, 440 U.S. 625, 631 (1979); United States v. W.T. Grant Co., 345 U.S. 629, 632-33 (1953), the first cause of action has not been proven to be moot.
Lewis' second cause of action claims that the defendants made material misrepresentations and omissions in connection with the issuance of a proxy statement in violation of Section 14(a) of the Securities Exchange Act of 1934, 15 U.S.C. § 78n(a), and Rule 14a-9 promulgated thereunder, 17 C.F.R. § 240.14a-9. The proxy statement was solicited for approval of a recapitalization of PRF Corporation, the effect of which was to convert the Class A shares into common shares at a ratio of 1:19. Therefore Lewis claims the common shareholders were not treated fairly in the exchange. The defendants contend that this claim is not derivative in nature, and therefore no recovery can be stated on behalf of the corporation. They further claim that since prior to the recapitalization the effective exchange ratio was 1:20 for the purposes of liquidation, the minority shareholders were not harmed because the corporation was subsequently dissolved. Thus they claim that the minority shareholders benefited from the recapitalization.
Lewis' request for declaratory relief is moot. In determining whether setting aside the recapitalization is an appropriate form of relief, the court must consider whether such action would be in the best interests of the shareholders of the corporation. It should be "set aside only if a court of equity concludes, from all the circumstances, that it would be equitable to do so." Mills v. Electric Auto-Lite Co., 396 U.S. 375, 388 (1970). In this instance the requested declaration would have the effect of shifting the exchange ratio for Class A shareholders from 1/19 back to 1/20. Since such a declaration would harm the common shareholders, the remedy is clearly inappropriate. Browning Debenture Holders' Committee v. DASA Corp., 524 F.2d 811, 816 (2d Cir. 1975). Nor would it in any way further the congressional purpose of enforcing the securities laws. Id.
Damage actions, however, can be brought even where declaratory relief may be moot or inappropriate. Mills v. Electric Auto-Lite Co., 396 U.S. at 388; J.I. Case Co. v. Borak, 377 U.S. at 433-34. Such a request for monetary relief can be implied in the clause seeking "such other and further relief as the court may deem proper." Lewis, however, has failed to assert or even hypothesize any damages that the corporation has suffered as a result of the alleged violation. Fed.R.Civ.P. 23.1; see Papilsky v. Berndt, 466 F.2d 251, 255 (2d Cir.), cert. denied, 409 U.S. 1077 (1972). To state a cause of action under Section 14(a) damages must be asserted. Browning Debenture Holders' Committee v. DASA Corp., 524 F.2d at 816; Schlick v. Penn-Dixie Corp., 507 F.2d 374, 382 (2d Cir. 1974), cert.denied, 421 U.S. 976 (1975). The only damages that Lewis asserts are those resulting directly to common shareholders who allegedly received less than they were entitled to in the alleged unfair recapitalization. These claims, however, are not derivative in nature, and Lewis in his pleadings, his argument and his supporting memorandum, has made no claim of a cognizable or compensable injury to the corporation which he claims to be asserting derivatively. Whatever a properly certified class action on behalf of the shareholders might produce under the particular facts presented here, such claims are not before this court in this derivative suit and this second derivative action is therefore moot.
For the foregoing reasons the motion will be denied as to the first cause of action and granted as to the second cause of action.
IT IS SO ORDERED.