Opinion ID: 437628
Heading Depth: 2
Heading Rank: 4

Heading: Compensating Balances

Text: 27 Appellants contend that William Sullivan improperly used corporate funds to maintain compensating balances at banks that had loaned him money to finance his purchase of voting shares in Patriots. The district court found that this was an improper use of funds for Sullivan's benefit. It concluded, however, that plaintiffs had failed to demonstrate the materiality of the compensating balances because they had not shown to what extent this practice affected income. The court found that the Patriots' operating expenses required the corporation to maintain large cash reserves. It observed that plaintiffs had failed to show that the compensating balance requirement increased the amount of cash held in these reserves. Appellants advance two challenges to this finding. First, they argue that Mr. Sullivan's financing arrangement should have been disclosed because it constituted a breach of fiduciary duty. Second, they contend that the Securities and Exchange Commission has established that agreements to maintain compensating balances of this size are per se material. 28 Although the district court erred in holding that nondisclosure of a breach of fiduciary duty or waste of corporate assets is never material for purposes of Sec. 14(a), appellants have not demonstrated that Sullivan's improper activity was material in the context of this transaction. A breach of fiduciary duty involving self-dealing by a corporate officer would plainly be material to a proxy statement soliciting votes for the re-election of that officer. See Gaines v. Haughton, 645 F.2d 761 (9th Cir.1981). In this case, however, the question before the shareholders was whether or not to accept $15.00 per share for their Patriots stock; appellants have not shown how the improper conduct of the corporation's director was material to this question. 4 29 Appellants point out that a regulation promulgated by the Securities and Exchange Commission, 17 C.F.R. Sec. 240.14a-101, Item 15(a), requires that a proxy statement issued in connection with a merger contain financial statements prepared and certified in accordance with Regulation S-X, and that Regulation S-X, 17 C.F.R. Sec. 210.5-02-1, requires the disclosure of compensating balance arrangements. This requirement is qualified by the Rule of General Application set forth in 17 C.F.R. Sec. 210.4-02, which provides, If the amount which would otherwise be required to be shown with respect to any item is not material, it need not be separately set forth. The district court found that the compensating balance arrangements maintained by Mr. Sullivan were not material because they had no demonstrable effect on the Patriots' interest income. 30 Appellants argue, however, that the Securities and Exchange Commission's Accounting Series Release No. 148, which explains the Commission's policy regarding the disclosure of compensating balances, sets a different standard. The release begins by noting: 31 Compensating balances are to be segregated on the balance sheet only if they are legally restricted under the terms of the arrangement while any other determinable amounts of funds which are held as compensating balances are to be disclosed in the notes to the financial statements. Segregation recognizes that certain cash balances at the balance sheet date are not readily available for discretionary use by management. Footnote disclosure emphasizes information about financial management decisions which effectively restrict the availability of cash funds over time for alternative income yielding opportunities even though no legal restrictions exist which preclude such use. 38 Fed.Reg. 32440 (1973). 32 The release makes clear that compensating balances are not to be offset by the amount of the cash reserve that the corporation would maintain in the absence of a compensating balance requirement: 33 It has been argued that, in those cases where part of the compensating balance reflects funds that would be held anyway as a minimum operating balance, such funds should be subtracted from compensating balances since the maintenance of such a compensating balance has no incremental cost to the borrower. For purposes of these disclosure requirements, such a subtraction is not appropriate. The concept of subtraction implies that the compensating balance is of secondary importance and this is by no means apparent. It would be equally reasonable to contend that operating funds are free of cost because compensating balances must be maintained. In any event, the utilization of such amounts for compensating balances precludes the sound cash management alternative of investing available cash in highly liquid interest bearing securities. 38 Fed.Reg. 32441. 34 Finally, the release explains the standard of materiality to be applied to compensating balance arrangements: 35 In determining whether compensating balance arrangements are sufficiently material to require segregation or disclosure, various factors should be considered. Among these may be the relationship of the amount of the balances to total cash, total liquid assets and net working capital, and the impact of the balances on the effective cost of financing. In the usual case, reportable compensating balances which in the aggregate amount to more than 15 percent of liquid assets (current cash balances, restricted and unrestricted, plus marketable securities) would be considered to be material. Lesser amounts may be material if they have a significant impact on the cost of financing. 36 Compensating balances maintained by the company for the benefit of affiliates, officers, directors, principal stockholders or other similar parties may be of particular significance to investors. Separate disclosure of such balances may be required under other Commission rules and regulations even if they are not of a magnitude such that they would meet the materiality guidelines set forth above. 38 Fed.Reg. 32441. 37 The district court's observation that it was unable to determine what amounts should have been invested [in interest-bearing accounts] given the corporation's obvious need for ready cash suggests that it used a cash reserve offset of the type disapproved in the Commission's release. We remand the compensating balance claim to the district court for reconsideration in light of the standard set forth in Accounting Series Release No. 148. These are some of the points the court may wish to consider on remand: (1) whether the compensating balances involved determinable amounts of corporate funds that would be subject to the disclosure guidelines in the release; (2) whether the compensating balances were restricted, so that they would be affected by the guidelines for segregated disclosure, or unrestricted, so that they would be affected by the guidelines for footnote disclosure; (3) whether the compensating balances amounted to more than 15% of Patriots' liquid assets and so would fall within the release's presumption of materiality. 38 We note that the failure to disclose the existence of compensating balances is more likely to have overstated than to have understated Patriots' profitability. Since the point of appellants' argument is that the proxy statement induced them to sell by understating material sources of income, the concealment of the compensating balances might not have been material to them--indeed, it might have tended to counteract the harm of which they complain. On the other hand, it might be argued that the Commission's guidelines create a per se rule that the nondisclosure of compensating balances in excess of 15% of liquid assets constitutes a material omission. We express no opinion on the question whether the district court must find that the proxy statement violated Sec. 14(a) if the statement failed to disclose compensating balances in excess of 15% of liquid assets, or whether it may find no violation if it determines that the compensating balances were not material to these shareholders. The court may, of course, accept briefs from the parties on this issue or invite the Securities and Exchange Commission to file an amicus brief if the court believes that additional information would be helpful. 39 If the court determines on remand that the Patriots proxy statement violated Sec. 14(a), it has broad power to fashion appropriate remedial relief. See J.I. Case Co. v. Borak, 377 U.S. 426, 433-35, 84 S.Ct. 1555, 1560-61, 12 L.Ed.2d 423 (1964). It may, for example, restore the plaintiffs to the position they would have occupied as dissenters to the merger and allow them to receive the fair value of their shares as determined in the appraisal proceeding now pending in Norfolk Superior Court; or it may grant other appropriate relief. See generally Securities and Exchange Commission v. MacDonald, 699 F.2d 47 (1st Cir.1983); Janigan v. Taylor, 344 F.2d 781 (1st Cir.1965) (discussing the purpose and nature of damage remedies under the securities laws). 40 The Sec. 14(a) claim was only one of nine claims that plaintiffs originally brought against the Patriots' management. They waived two claims before trial. The court's findings of fact and rulings of law specifically addressed only the Sec. 14(a) claim; it dismissed the remainder of the suit with the sentence, [Plaintiffs'] other claims for relief have either been waived or are without merit. Appellants argue that this conclusion of law, unsupported by specific findings of fact, violates Fed.R.Civ.P. 52(a), which provides that the court in a bench trial shall find the facts specially and state separately its conclusions of law thereon. 41 Although it is possible that the court correctly found the remaining claims to be without merit, we find it difficult to review the court's ruling without the separate findings of fact and conclusions of law called for in Rule 52(a). Because we are remanding the case in any event, we would like to give the court the opportunity to supplement its findings of fact and conclusions of law on those claims that the plaintiffs did not waive. 42 We hasten to add that we believe both parties had an ample opportunity to develop a full record at trial. Although the appellants complain that the court improperly excluded various exhibits, we find their arguments unconvincing, and we affirm the court's evidentiary rulings. On remand, the court may, of course, require the parties to submit or present any additional information that it considers appropriate; but our ruling should not be construed as requiring the court to hear additional argument or to admit additional evidence. 43 The judgment of the district court is affirmed in part, vacated in part, and remanded for further proceedings consistent with this opinion. No costs at this time.