Opinion ID: 196244
Heading Depth: 2
Heading Rank: 2

Heading: Fraud Upon a Corporation by its Directors.

Text: 45 To prevail under Rule 10b-5, 'a plaintiff must prove, in connection with the purchase or sale of a security, that the defendant, with scienter, falsely represented or omitted to disclose a material fact upon which the plaintiff justifiably relied.'  Willco Kuwait (Trading) S.A.K. v. deSavary, 843 F.2d 618, 623 (1st Cir.1988) (quoting Kennedy v. Josephthal & Co., Inc., 814 F.2d 798, 804 (1st Cir.1987)) (emphasis supplied). The Act protects corporations as well as individuals who are sellers of a security. Bankers Life, 404 U.S. at 10, 92 S.Ct. at 167-68. We hold that the district court erred in ruling that the verified complaint did not state a claim for CMT under Sec. 10(b) and Rule 10b-5. 46 Briefly recounted, the scheme described in the complaint was allegedly hatched by CMT's president and by its secretary, both of whom were also its directors. The scheme was to cause CMT to issue and sell 200,000 shares of earlier authorized common voting stock 9 to UCMSJB--a medical school of which CMT's president was a trustee, and of which CMT's secretary was the owner--for the price of $10 a share. The issuance and sale of stock was allegedly accomplished without the knowledge or approval of the plaintiff directors, of the board of directors, and of the corporate entity itself. UCMSJB paid CMT for the stock largely in notes secured by an assignment of a contract between the Department of Health of Puerto Rico and UCMSJB. Two of CMT's other directors were at the time closely affiliated with UCMSJB, while the two plaintiff directors--who between them controlled a bare majority of CMT's stock--were unhappy with CMT's developing relationship with UCMSJB. As a result of the deliberately concealed sale, the proportion of CMT stock controlled by the plaintiff directors fell below 50%, leaving UCMSJB and those associated with it in practical control of CMT. The complaint alleged that an objective of selling the 200,000 shares of CMT stock to UCMSJB was to enable the latter to obtain a substantial block of CMT shares at a wholly inadequate price and to finance the stock purchase with fictitious collateral. According to the complaint, the appraised market value of CMT's stock when sold to UCMSJB in 1993 was $18, not $10, a share; and the government contract constituting collateral for the notes was non-assignable, rendering the collateral fictitious. The complaint further alleged that, although the stock was issued to UCMSJB on September 16, 1993, no mention was made of the fact at the two board of director meetings held in September--one held before and one after the 16th. By the time of the October shareholders' meeting, defendants--now firmly in control--revealed the stock transaction for the first time to the plaintiff directors and former majority shareholders. Plaintiffs were then ousted as directors. 47 It is by now well established that a corporation has a claim under Sec. 10(b) if the corporation was defrauded in respect to the sale of its own securities by some or even all of its directors. See, e.g., Goldberg, 567 F.2d at 215. In Ruckle v. Roto Am. Corp., 339 F.2d 24 (2d Cir.1964), a case factually close to the present, a director who represented more than half the stock entitled to vote at the 1964 annual meeting of the defendant corporation successfully brought a derivative action against his six fellow directors, who also constituted the corporation's officers. The complaint alleged that the officers had sought to perpetuate their control by, among other ways, having the board approve the issuance of some 75,000 treasury shares that were to be resold to the president or voted as he directed. The plaintiff alleged that the defendants had withheld the latest financial statements from the board, had arbitrarily ascribed a $3 value to the shares, and had approved several transactions involving the stock without disclosing pertinent facts to the entire board. Id. at 26. Reversing a dismissal, the Second Circuit held that it was possible under Rule 10b-5 for a corporation to be defrauded by a majority of its directors or even the entire board. Id. at 29. The court went on to say, 48 If, in this case, the board defrauded the corporation into issuing shares either to its members or others, we can think of no reason to say that redress under Rule 10B-5 [sic] is precluded, though it would have been available had anyone else committed the fraud. There can be no more effective way to emasculate the policies of the federal securities law than to deny relief solely because a fraud was committed by a director rather than an outsider. Denial of relief on this basis would surely undercut the congressional determination to prevent the public distribution of worthless securities. 49 Id. 50 While Ruckle predated the Supreme Court's decision in Santa Fe, nothing in Santa Fe and its progeny invalidate Ruckle's relevant holding. See, e.g., Frankel, 984 F.2d at 1334 (citing Ruckle with approval); see also O'Neill v. Maytag, 339 F.2d 764 (2d Cir.1964); Schoenbaum v. Firstbrook, 405 F.2d 215 (2d Cir.1968) (en banc), cert. denied sub nom. Manley v. Schoenbaum, 395 U.S. 906, 89 S.Ct. 1747, 23 L.Ed.2d 219 (1969); Santa Fe, 430 U.S. at 462, 97 S.Ct. at 1295; Goldberg, 567 F.2d at 209; see also 7 Louis Loss & Joel Seligman, Securities Regulation 3530-41 (3rd ed. 1991) (discussing this line of cases). 51 As in Bankers Life, it is here alleged that the corporation on behalf of which suit has been brought was injured as an investor through a deceptive device which deprived it of [adequate] compensation for the sale of its valuable block of securities. 404 U.S. at 10, 92 S.Ct. at 168. The deceptive device was that interested directors of CMT and other parties deliberately omitted to inform CMT's disinterested directors and shareholders, at a time when they might still have acted to protect CMT, of an impending, allegedly deleterious, sale of stock to UCMSJB. CMT relied upon this omission to its detriment, in that its managers issued and sold its stock at an allegedly inadequate price and without adequate security, CMT having been fraudulently deprived of the judgment of its full board of directors on the matter and, in particular, of the judgment of those directors and stockholders who were disinterested and not personally connected with UCMSJB. Such facts plainly make out a claim of defendants' knowing deception of and injury to CMT in connection with the sale of its stock. 52 The district court recognized that, in the case before us, taking the facts as alleged by plaintiffs, the corporation was deceived when some members of the board of directors conducted a sale of corporate stock without informing the full board and the remaining shareholders. Estate of Soler, 847 F.Supp. at 242. The court even acknowledged that a Sec. 10(b) violation would have occurred had the directors been told of the proposed sale of stock but deceived as to related material facts. The court believed, however, that no violation occurred here, because the sale itself was concealed, resulting, it said, in no decision-making process at all. We do not see the distinction. The calculated concealment of the sale itself, thus depriving CMT's disinterested directors of the opportunity to take steps to prevent it before it occurred, was an omission to provide essential material information to the company regarding the stock sale. Indeed, accepting the allegations of the complaint as true, it is a reasonable inference that concealment of the proposed sale from CMT's board of directors was essential to the success of the fraud, since the plaintiff directors controlled a majority of CMT's outstanding shares and would doubtless have acted to block the sale had they known. 53 We see no merit in the district court's analogy between this case and Santa Fe. In Santa Fe, acting without fraud or concealment, a controlling company utilized Delaware's short form merger statute to force minority stockholders in a subsidiary to sell back their shares. The latter sued under Sec. 10(b) asserting a breach of fiduciary duty. Noting the absence of a manipulative or deceptive device, the Supreme Court held that Sec. 10(b) is not meant to remedy corporate mismanagement, but rather to promote full disclosure to those who buy or sell securities. The Court in Santa Fe nowhere suggested that a deliberate stock fraud, involving the calculated omission by personally interested directors to tell other directors that the company was selling its treasury stock at a below market price and without adequate security, was beyond the reach of Sec. 10(b). 54 The allegations here are precisely of a lack of full disclosure to CMT, the seller of the securities. They go beyond mismanagement to the calculated and deliberate concealment, by interested directors, of information that a substantial block of the company's stock was being sold at an improperly low price to another company with whom the interested directors were linked. The sale of CMT's securities, and the price and terms of the sale, were deliberately withheld to prevent the disinterested members of CMT's board of directors, who were also its controlling shareholders, from taking action prior to the completed sale. Hence those sharing in the legal responsibility to manage CMT's affairs were kept in the dark until the time had passed when they might still have acted to safeguard CMT's interests. As there was no full and fair disclosure to those legally empowered to act for the corporation, there was no full and fair disclosure to CMT itself. Unlike the situation in Santa Fe, the facts alleged go well beyond mere corporate mismanagement in which the essence of the complaint is that shareholders were treated unfairly by a fiduciary. 430 U.S. at 477, 97 S.Ct. at 1303. 55 Appellees contend that the verified complaint alleges no more than violations of state law, such as breach of fiduciary duty, and that therefore this case falls into the exception to Sec. 10(b) liability created by Bankers Life. We do not agree. That state causes of action are also available to the plaintiff does not mean that a right of action will not lie under Sec. 10(b). Section 10(b) must be read flexibly, not technically and restrictively. Since there was a 'sale' of a security and since fraud was used 'in connection with' it, there is redress under Sec. 10(b), whatever might be available as a remedy under state law. Bankers Life, 404 U.S. at 12, 92 S.Ct. at 169. The statement in that case that [C]ongress by Sec. 10(b) did not seek to regulate transactions which constitute no more than internal corporate mismanagement, id. (emphasis added), means only that a breach of fiduciary duty, without any deception, misrepresentation, or nondisclosure, Santa Fe, 430 U.S. at 476, 97 S.Ct. at 1302, does not violate Sec. 10(b). Where corporate fiduciaries deceive other board members and stockholders by withholding key information pertinent to the corporation's sale of its own securities, the corporation may have redress through Sec. 10(b). 56 In dismissing the corporation's Sec. 10(b) claim, the district court also held that the defendants' alleged deception here was not sufficiently linked causally to a sale of securities. The court cited to cases where the misrepresentations or omissions did not relate to the inherent nature, characteristics or value of the security. See, e.g., Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930 (2d Cir.), cert. denied, 469 U.S. 884, 105 S.Ct. 253, 83 L.Ed.2d 190 (1984). From these, the court reasoned that simply omitting to tell CMT's directors and majority shareholders of the fact of the sale of CMT's authorized stock was different from feeding them false information about the specifics of the sale. In so reasoning, the court sought to distinguish cases such as Bankers Life, 404 U.S. at 6, 92 S.Ct. at 169, Goldberg, 567 F.2d at 209, 219-20, and Frankel v. Slotkin, 984 F.2d 1328 (2d Cir.1993). The short answer, we think, is that these cases cannot be distinguished. The district court asserts that the sale in this case did not take place because the corporation was uninformed about the nature of the stock. Estate of Soler, 847 F.Supp. at 240. Yet the complaint alleges that an appraisal of the stock indicated that it was worth $18, not $10, a share. Had the board of directors been so advised, and had it been told of other aspects of the sale (such as the alleged fictitious security), it might not have agreed to the sale, and, in any case, the minority directors (who were majority shareholders) might have been able to take action to block the sale. 57 Nor do we agree that this case is controlled by Ketchum v. Green, 557 F.2d 1022 (3d Cir.1977). In that case, the Third Circuit wrote: 58 Upon review of the stipulation of facts and the record of the proceedings before the district court, it becomes clear that the case at hand involved little more than allegations pertaining to an internal corporate conflict. Although the complaint seemingly stresses the importance of the relinquishment of plaintiffs' shares under the stock retirement plan, the factual stipulation and other segments of the record are largely silent on this point. For example, it is only in the concluding paragraphs of the stipulation that there is any mention of the forced sale of securities. It thus is manifest that the essence of the plaintiffs' claim concerns their dismissal as officers of Babb, Inc. 59 557 F.2d at 1027 (footnote omitted). 60 The alleged fraud in Ketchum was defendants' failure to reveal their intentions to oppose the reelection of the plaintiffs as officers. While termination of plaintiffs as corporate employees would trigger a by-law forcing them to sell their stock, the Third Circuit concluded that Sec. 10(b) did not apply as the essence of the relief sought was directed against termination of plaintiffs as officers, not to the sale of securities. In contrast with Ketchum, the stock sale to UCMSJB is central to the fraud detailed in the complaint here. We see no basis in Ketchum from which to hold that the present scheme was not in connection with the sale of a security, as Rule 10b-5 requires. 61 We have considered appellees' other arguments, including those related to the adequacy of the complaint under Fed.R.Civ.P. 9(b), and find them to be without merit. We hold that the complaint in this case, viewed in a light most favorable to the plaintiffs, states a cause of action under Sec. 10(b) and Rule 10b-5. Of course, nothing we say is meant to relieve appellants of their burden of proof as to the matters alleged in the complaint, nor to suggest that we accept those matters as necessarily being complete or true. 10 62