Petition — Heizer Corp. v. Wright
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Supreme Court, U. S, “< |
TT \
vee 7 1977
IN THE
MICHAEL RODAK, JR., CLERK
Supreme Court of the Guited States Y
OCTOBER TERM, 1977.
w 27-814
HEIZER CORPORATION,
Petitioner,
vs.
PETER WRIGHT, BENEFICIAL STANDARD
CORPORATION anp IDC SERVICES, INC.,
Respondents.
PETITION FOR A WRIT OF CERTIORARI TO THE
UNITED STATES COURT OF APPEALS
FOR THE SEVENTH CIRCUIT
WILLIAM A. MONTGOMERY
ALLAN HORWICH
JOHN ADAMS
7200 Sears Tower
233 South Wacker Drive
Chicago, Illinois 60606
BERNARD HARROLD
JERALD P. EsrIck
One IBM Plaza
\ Chicago, Illinois 6061 1
Attorneys for Petitioner
\ Scnirr HARDIN & WAITE
WILDMAN, HARROLD,
ALLEN & DIXON
Oj Counsel
Gunthorp-Wearren Printing Company, Chicago e¢ Financial 6-6565
WE Ole WET O ee om te
~ <r os
TABLE OF CONTENTS
PAGE
CS TI. oo oc ceicasctcescedtsucededeues oes l
ee eas ce ce hes een cbueneaens U8 2
ND ee ie a dg he wa ween 2
ee oa, soe sb ouateeeseehens
CG Ee rn ee Pee ee
\.;: CE. neds saseahetkesdenswenwaues 3
2. The Investments by Heizer Corporation....... 5
e. Tie “Pisst Teemenetiee . wo. ccscccess 6
b. The “Second Transaction”........... 7
C. Thee “Tite TRORORCUOR... wc ccccves 7
d. The “Fourth Transaction”........... 9
©. Thee “Pith Temmenctiom” . . occ cccieess 12
Reasons for Granting the Writ..............eeee cues 13
I. The Imposition of Liability on Heizer Corporation
Was inconsistent with This Court’s Decisions in
Ernst & Ernst v. Hockfelder and Santa Fe Indus-
tries Vv. Green and Is in Conflict with Decisions
of Other Courts of Appeals..............4.. 15
A. Heizer Corporation Did Not Act with
Scienter in the Fourth Transaction....... 15
B. Any Holding That Heizer Corporation Was
Vicariously Liable Under Rule 10b-5 Is in
Conflict with Decisions of Other Courts of
Agen ..cccsccccceed TETEERT TTT TT 20
C. The Court of Appeals’ Findings of Scienter,
Material Non-Disclosure and Causation in
the Fifth Transaction Were Improperly Based
on Considerations of a Supposed Fiduciary
FF 8 SS rere 22
SB errr cre s 22
BS TD cccccascensscoccnes 23
a. merry errrrrrr rrr 25
ii
II. The Relief Ordered by the Court of Appeals
Exceeded That Court’s Authority Under the
Securities Exchange Act, Is in Conflict with Deci-
sions of This Court and Would Establish a
Dangerous Precedent with No Limits on a Court’s
PD Subudcunneudeececs6eastceedees 26
Se: Pk 26
Pe PE: DES Sh. cbcccdccdtcscuccws 30
RES Cbd ceSu des duiv nd ddne ed eWasdereeseecens 31
Appendix
I. Statute and Rule
Securities Exchange Act of 1934,
Section 10(b), 15 U. S. C. § 78j(b).......... Al
Section 20(a), 15 U. S. C. § 78t(a).......... Al
Section 29(b), 15 U. S. C. § 78cc(b)......... Al
Rule 10b-5, 17 C. F. R. § 240.10b-5.............. A2
II. Opinions and Orders
Opinion of the Court of Appeals for the Seventh Cir-
cult (September 9, 1977)... 0c ccccccscccccces A3
Order of the Court of Appeals (September 9, 1977) .. A39
Order of the Court of Appeals on Petition for Rehear-
img (September 9, 1977)... 0.2 ccccccccccecces A4l1
Memoxandum Opinion of the United States District
Court for the Northern District of Illinois, Eastern
Division (December 3, 1975)..............05. A42
Decree of the District Court (December 3, 1975)... . A67
Memoraudum Opinion of the United States District
Court for the Northern District of Illinois, Eastern
Division (May 28, 1976) as Amended by Minute
Ne ee a A7l
Injunction Pending Appeal of the United States Dis-
trict Court for the Northern District of Illinois,
Eastern Division (June 18, 1976).............. A78
ee —
iii
TABLE OF AUTHORITIES
Cases
Affiliated Ute Citizens v. United States, 406 U. S. 128
CRED 6 dik dduyedéy des Caedeceteeudseeereegees 26
Bailey v. Meister Brau, Inc., 535 F. 2d 982 (7th Cir.
DD a nuceuus tbs cOanwendeedeuss 600s ceeeeds 23, 24
Blue Chip Stamps v. Manor Drug Stores, 421 U. S. 723
GED sc vecedcddwencceccesesesscese 13, 20, 26, 27, 29
Cole v. Schenley Industries, Inc., CCH Fed. Sec. L. Rep.
¢ 96,166 (2d Cir. 1977) [Current Binder]........-. 23
Coleco Industries, Inc. v. Berman, 423 F. Supp. 275
CH. Ba. Be. 1DTS). cc cccccvccccvccccceseveceese 17
Cort v. Ash, 422 U. S. 66 (1975)... 0... cece ee eeees 24
Deckert v. Independence Shares Corp., 311 U. S. 282
(. Fewer err rrer rrr rrr rt rrr rere 28
deHaas v. Empire Petroleum Co., 435 F. 2d 1223 (10th
Ce: GIS 0 660.6006 ccbee PMR icecectcecdeceseve 28
Eason v. General Motors Acceptance Corp., 490 F. 2d *
654 (7th Cir. 1973) cert. denied, 416 U. S. 960 (1974) 13
Ernst & Ernst v. Hochfelder, 425 U. S. 185 (1976).....
éudatewswkeds cueness 2, 5, 13, 14, 15, 19, 20, 21, 23, 28
Fey v. Walston & Co., Inc., 493 F. 2d 1036 (7th Cir.
DE nu vind dae 660 045 <aetindd awn tere cusesens 21
First Virginia Bankshares v. Benson, 559 F. 2d 1307 (Sth
Cie, GRU wis oo 0d hte ck dee ccenes cneneeeccoeecs 19
Globus v. Law Research Service, Inc., 418 F. 2d 1276 (2d
Cir. 1969), cert. denied, 397 U. S. 913 (1970)...... 28
Goldberg v. Meridor, CCH Fed. Sec. L. Rep. { 96,162
(2d Cir. 1977) [Current Binder]................4.. 25
iv
Great Western Bank & Trust v. Kotz, 532 F. 2d 1252
(Bib Ge. SOUG) « cccntesvecdvsedensnnsee 22
Hirsch v. du Pont, 553 F. 2d 750 (2d Cir. 1977)...... 17,19
Holladay v. Kennard, 79 U. S. 254 (1870)............ 21
Holloway v. Howerdd, 536 F. 2d 690 (6th Cir. 1975)... 21
Johns Hopkins University v. Hutton, 422 F. 2d 1124 (4th
Cir. 1970), cert. denied, 416 U. S. 916 (1974)...... 21
Kaplan v. Centex Corporation, 284 A. 2d 119 (Del. Ch.
CR. ODFED. oc ccccsccesesedsbannenennee 25
Lanza v. Drexel & Co., 479 F. 2d 1277 (2d Cir. 1973).. 21
McClure v. First National Bank of Lubbock, Texas, 497
F. 2d 490 (Sth Cir. 1974), cert. denied, 420 U. S. 930
CEDESD ccccnceccesepeceeeseusenee 22
Miller v. Schweickart, 413 F. Supp. 1062 (S. D. N. Y.
BOTED oc csccss0000000008005 5s eee 19
Mills v. Electric Auto-Lite Co., 396 U. S. 375 (1970)... 27
Myzel v. Fields, 386 F. 2d 718 (8th Cir. 1967), cert.
denied, 390 U. S. 951 (1968)...............000.- 21
Nelson v. Hench, 428 F. Supp. 411 (D. Minn. 1977).... 19
Peltz v. Northern Ohio Bank, 430 F. Supp. 382 (N. D.
CRED BDVED. oc ccccsccccvcscbetenssee 19
Piper v. Chris-Craft Industries, Inc., 430 U. S. 1 (1977)
cc ccccccccccneseendeseeee ewes enn 23, 24
Rochez Bros, Inc. v. Rhoades, 527 F. 2d 880 (3d Cir.
BOTS) wccccnccccosesevedeceseeen stl 21
Rondeau v. Mosinee Paper Co., 422 U. S. 49 (1975)
cevccccveccescosbeetenesuaeuewee 3, 13, 30
Sanders v. John Nuveen & Co., Inc., 524 F. 2d 1064 (7th
Cir. 1975), vacated and remanded, 425 U. S. 929
Ci Pr 23
OOP er aren
eT Om Om Oe OEE 6 ty
Vv
Santa Fe Industries, Inc. v. Green, 430 U. S. 462 (1977)
ee eae aD se oes 6 3, 5, 13, 14, 23, 24, 25
Sparks v. United States, 153 F. Supp. 909 (D. Vt. 1957) 27
Sundstrand Corp. v. Sun Chemical Corp., 553 F. 2d. 1033
(7th Cir. 1977), cert. denied, 46 U. S. L. W. 3207
SEE DUROCSb bese eS Kee ee cecercicesacccocccces 15
Tarasi v. Pittsburgh National Bank, 555 F. 2d 1152 (3d
Cir. 1977). cert. denied, 46 U. S. L. W. 3355 (1977) 28
TSC Industries, Inc. v. Northway, Inc., 426 U. S. 438
EEE SEES POPPE LOT TET EET E ETT 13,14
Zweig v. Hearst Corp., 521 F. 2d 1129 (9th Cir. 1975),
cert. denied, 423 U. S. 1025 (1975)........-..5.. 21
Statutes and Rules
Federal Rules of Civil Procedure, Rule 52(a)......... 14
General Rules and Regulations under the Securities
Exchange Act of 1934, Rule 10b-5, 17 C. F. R.
DTT cco nbeeccccececsesevscccccccccece passim
Judicial Code, 28 U. S. C. § 1254(1).. 2.6.6... . eee eee 2
Rules of the Supreme Court of the United States, Rule 19 15
Securities Act of 1933, 15 U. S. C. § 77a et seq.
Section 12(2), 15 U. S. C. § 771(2).. «ee eee eee 27
Sestien 15, 19 U. B.C. § TIO... ..ccecccccvced. 20
Securities Exchange Act of 1934, 15 U. S. C. § 78a et seq.
Section 3(a)(10), 15 U. S. C. § 78c(a)(10)...... 22
Section 9, 15 U. S. C. § 781... 6... eee eee eens 27
Section 10(b), 15 U. S. C. § 78j(b)........--... 3,19
Section 18, 15 U. S. C. § 78r.........-.00e sede
Section 20(a), 15 U. S. C. § 78t(a).......... 3, 20, 21
Section 28(a), 15 U. S. C. § 78bb(a)............ 27
Section 29(b), 15 U. S. C. § 78cc(b)...... 3, 26, 27, 29
vi
United States Constitution, Article 1, Section 8, Clause 4.. 29
United States Constitution, Amendment V............ 29
Other
5A Moore’s Federal Practice 4 52.06[2] (2d ed. 1977).. 15
Hawes, PLI Eighth Annual Institute on Securities Regu-
Ee _, , SEDER Ered neuen if eae ae
Hawes & Sherrard, “Reliance on Advice of Counsel as a
Defense in Corporate and Securities Cases,” 62 Va. L.
Rev. 1 (1976)
oe ee ie
IN THE
Supreme Court of the Anited States
OCTOBER TERM, 1977.
HEIZER CORPORATION,
Petitioner,
vs.
PETER WRIGHT, BENEFICIAL STANDARD
CORPORATION anp IDC SERVICES, INC.,
Respondents.
PETITION FOR A WRIT OF CERTIORARI TO THE
UNITED STATES COURT OF APPEALS
FOR THE SEVENTH CIRCUIT
Petitioner Heizer Corporation respectfully prays that a writ of
certiorari issue to review the judgment of the United States Court
of Appeals for the Seventh Circuit entered in this action on
September 9, 1977 insofar as it imposes liability upon and man-
dates injunctive relief against Heizer Corporation.
OPINIONS BELOW
The opinion of the Court of Appeals is officially reported at
560 F. 2d 236 and is printed in the appendix to this petition,
together with the order of the Court of Appeals.*(A3-A40)
* In footnote 1 of the Court of Appeals’ opinion it is indicated
that the record references contained in the Slip Opinion will not be
reprinted in the permanent edition of Federal Reporter 2nd. The
complete Slip Opinion is reprinted herein.
2
The principal opinion of the United States District Court for the
Northern District of Illinois, Eastern Division, is officially
reported at 411 F. Supp. 23 and is reprinted in the appendix
hereto. (A42-A66) The decree which was entered by the District
Court in accordance with that opinion is reprinted in the
appendix hereto (A67-A70), together with an additional opinion
rendered by that Court on May 28, 1976, not officially reported*
(A71-A77), and an injunction pending appeal, which was
entered by the District Court on June 18, 1976. (A78-A79)
JURISDICTION
The judgment of the United States Court of Appeals for the
Seventh Circuit sought to be reviewed was entered on September
9, 1977. The Court of Appeals originally issued an opinion on
June 30, 1977. Heizer Corporation filed a timely petition for
rehearing. On September 9, 1977 a modified opinion was issued
and an order was entered denying the petition for rehearing
except to the extent that any relief requested in that petition was
granted in the modified opinion. (A41) This Court’s jurisdic-
tion is invoked under 28 U. S. C. § 1254(1). ;
QUESTIONS PRESENTED
1. Whether in an action for alleged violation of Rule 10b-5
the “scienter” requirement of Ernst & Ernst v. Hochfelder, 425
U. S. 185 (1976), is met where defendant (a) acted on a
reasonable belief that full disclosure of all material facts had
been made and in good faith reliance on independent counsel, or
(b) committed at most a breach of fiduciary duty actionable
under state law.
2. Whether vicarious liability for another’s violation of Rule
10b-5 may be predicated only on the express provisions of the
federal securities laws governing liability of controlling persons.
* As printed herein, that opinion reflects corrections entered by
the District Court in its order of July 2, 1976.
Nee OR TET
yy Lae
- ° RPO BPE Bers ERT et”
3
3, Whether the deception necessary to sustain a claim under
Rule 10b-5, as held by Santa Fe Industries, Inc. Vv. Green,
430 U. S. 462 (1977), can be determined solely from a breach
of fiduciary duty actionable under state law.
4. Whether compensatory relief for a violation of Rule 10b-5
is limited to damages or rescission, or may extend to the
restructuring of a securities transaction. ©
5. Whether prospective injunctive relief for a violation of
Rule 10b-5 may be imposed in the absence of findings of
irreparable harm and an inadequate remedy at law, as required
by Rondeau v. Mosinee Paper Co., 422 U. S. 49 (1975).
6. Whether it is proper for a Court of Appeals to make
findings of fact based on a de novo review of the trial record
when the District Court failed to make relevant findings and the
governing legal principles were substantially changed by this
Court after the District Court rendered its decision.
STATUTE AND RULE INVOLVED
Sections 10(b), 20(a) and 29(b) of the Securities Exchange
Act of 1934, 15 U. S. C. §§ 78j(b), 78t(a) and 78cc(b), and
Rule 10b-5, 17 C. F. R. § 240.10b-5, are set forth in the
appendix hereto. (Al-A2)
STATEMENT OF THE CASE
1. Introduction
This derivative suit was initiated by minority stockholders of
IDC Services, Inc. (“IDC”), a Delaware corporation (formerly
International Digisonics Corporation), under Section 10(b) of
the Securities Exchange Act of 1934 (“1934 Act”), 15 U. S.C.
§ 78j(b), and Rule 10b-5 promulgated thereunder by the Securi-
ties and Exchange Commission, 17 C. F.R. § 240.10b-5.* Plain-
* Petitioner is not a party to the sole non-derivative claim main-
tained by one of the plaintiffs.
4
tiffs below (respondents here) are Peter Wright, a holder of a
small percentage of IDC common stock, and Beneficial Standard
Corporation (“Beneficial”), the second largest common stock-
holder of IDC.
Petitioner Heizer Corporation (a defendant below) is a ven-
ture capital corporation which specializes in high-risk invest-
ments in newly-formed companies. Though never a holder of
IDC common stock, Heizer Corporation is and has been the
principal investor in IDC, contributing more than 80% of IDC’s
capital.
Jordan Ross (“Ross”)—a lawyer, accountant and the larvest
common stockholder of IDC—organized Talent & Residuals
(“T&R”) in 1962 and IDC in 1968. Until June of 1972,
Ross served as chief executive officer of IDC. T&R is an estab-
lished and successful company which provides the account-
ing and payroll services necessary for the payment of proper
“residuals” (payments for each rerun after the initial showing)
to actors performing in television commercials. IDC (a defend-
ant below) was organized to develop a system for the electronic
monitoring of television commercials as a method of accurately
recording the extent to which such commercials are broadcast.
The monitoring business was an entirely new and highly specu-
lative venture, but it had the potential to provide a unique and
invaiuabie service to the advertising industry.
The first substantial investment in IDC was by respondent
Beneficial, which purchased an IDC convertible debenture for
$425,000 in January of 1969, on the condition that T&R be
made a wholly-owned subsidiary of IDC. In July of that same
year, Beneficial converted that note into common stock in
anticipation of a public offering by IDC which, however, was
never consummated. The remainder of the common stock of
IDC is held by Ross and by a number of his friends and
associates, including plaintiff Peter Wright, who acquired stock
at Ross’ instance. The common stockholders had contributed, on
average, one dollar per share for the approximately 835,000
TO NPO OY CEE to) rn rR oe eo
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be el iene te, Set te
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5
shares outstanding, while petitioner Heizer Corporation made
a series of investments totaling approximately $9,000,000—
$3 million in preferred stock purchases and $6 million in loans.
Plaintiffs charged that all the principal investments of Heizer
Corporation in IDC were made in violation of Rule 10b-5.
The District Court, in an opinion written before this Court
rendered its decisions in Ernst & Ernst v. Hochfelder, 425 U. S.
185 (1976), and Santa Fe Industries, Inc. v. Green, 430 U. S.
462 (1977), found that the initial Heizer Corporation invest-
ments were untainted but that Heizer Corporation violated Rule
10b-5 in connection with two later transactions, the “fourth”
and “fifth” ones, because it acted unfairly and committed
breaches of fiduciary duty owed to IDC. (A63-A64)
The Court of Appeals, in an opinion written after Hochfelder
and Green, held that the District Court’s rationale for finding
liability was erroneous but nonetheless affirmed the liability of
Heizer Corporation on other grounds. (A15-A27) Injunctive
relief was ordered, cancelling and radically altering selected parts
of Heizer Corporation’s rights under the fourth and fifth trans-
actions, and restricting the manner in which future securities
transactions between Heizer Corporation and IDC may be
accomplished. (A27, A30-A33)
2. The Investments by Heizer Corporation
For the sake of clarity, the principal transfers of money from
Heizer Corporation to IDC have been divided into five distinct
transactions. There is a recurring pattern to the financings,
confirmed by undisputed évidence. Ross, as chief executive
officer of IDC, would seek the necessary financing for the devel-
opment of the continuously troubled monitoring business; his
efforts would prove unsuccessful; Ross would turn to Heizer
Corporation for interim financing, which Heizer Corporation
would provide; and Ross would again begin to look for more
money. Each time Heizer Corporation was the reluctant investor
of last resort, and gradually, through that pattern of events,
6
Heizer Corporation was brought steadily closer t@control of
IDC.
a. The “First Transaction”
The first transaction was consummated in November of 1969.
Ross, for IDC, was seeking a $1,000,000 capital contribution
from a private investor as a preliminary step necessary for fund-
ing the development of the monitoring operation, and in antici-
pation of a $5,000,000 public offering of securities. After nego-
tiation, IDC and Heizer Corporation agreed to a standard venture
capital investment—$1,000,000 for non-voting preferred stock
accompanied by warrants to purchase common stock, at the price
of $8.50 per share. Because of the wide disagreement between
the parties over the real value of IDC common stock, the agree-
ment included an “antidilution clause”, which is described below,
and a promise by IDC not to pledge the T&R stock or change
the nature of its business. Heizer Corporation also agreed to
loan IDC $500,000 for one year. Thus, in exchange for a
substantial investment in a new and uncertain business, Heizer
Corporation received a preferred stock position, a chance to
participate as a common stockholder if the company proved
successful, and a form of protection against the dilution of that
Opportunity. This transaction was approved by unanimous votes
of the IDC board of diretf6rs and stockholders, and was held to
be untainted. (A5-A6, A44-A45, A62-A63)
The “antidilution clause” was developed as a compromise to
bridge the gulf between Ross and Heizer Corporation as to the
proper exercise price for the warrants to purchase IDC common
stock. Under this clause, it was provided that if IDC should later
sell common stock or rights to acquire common stock at a price
below $8.50 per share, the initial price set in the Heizer Corpo-
ration warrants would automatically be reduced to that level and
the number of shares purchasable would be proportionately
increased. (A6 n. 2) Such provisions are commonly used in
investment agreements when there is no available market price
for the stock. (Trial Tr. 982, 2252)
OS UUM AI
b. The “Second Transaction”
The public offering contemplated at the time of the first
transaction did not take place. By September of 1970, IDC
was again strapped for cash and Ross turned to Heizer Corpora-
tion. For $2,000,000 from Heizer Corporation, IDC converted
Heizer Corporation’s 100,000 shares of preferred stock from the
first transaction into 100,000 shares of new voting preferred
stock and issued an additional 200,000 shares of the new
preferred stock with a stated value of $10 per share. Heizer
Corporation also received additional warrants to purchase
400,000 shares of IDC common stock at an initial exercise price
of $6 per share accompanied by an antidilution provision iden-
tical to that used in the first transaction.* Again, the transaction
was unanimously approved by IDC’s board of directors and
stockholders and was found free of wrongdoing. (A6-A7, A45-
A46, A62-A63)
c. The “Third Transaction”
From the beginning, the monitoring operation was faced with
a number of technical and regulatory problems. Its continuing
development costs more than offset T&R’s profits, and Ross was
constantly in search of large amounts of capital for IDC. Despite
a number of leads, the alternative sources of financing never
materialized.
In May of 1971, Ross once more approached Heizer Cor-
poration as the investor of last resort. By unanimous votes,
IDC’s board of directors and stockholders again approved a
transaction in which, this time, Heizer Corporation invested
$1,700,000 ($500,000 of which was used to repay a Heizer
Corporation loan due May 25, 1971) in return for a twenty-
year senior note for that amount and warrants to purchase an
additional 472,222 shares of common stock at $3.60 per share.
Under the prior antidilution clauses, the exercise price of
* By agreement, however, the antidilution provision of the first
transaction was not triggered by this transaction.
WO 0 QQ Sooo,
8
warrants issued in the first two transactions was reduced and the
quantity was adjusted upward so that Heizer Corporation's
warrants could then be exercised at $3.60 per share to purchase
1,304,000 common shares (or a total of 61% of the equity).
In order to provide for the possible exercise of the warrants
and to give Heizer Corporation voting power equivalent to its
pro forma equity position, IDC’s Certificate of Incorporation
was amended to increase the number of authorized common
shares to 3 million and to provide that the preferred stock
would receive 4.4 votes per share, thereby giving Heizer Cor-
poration maiority voting control (except where a class vote is
required}. This transaction, too, was found to be untainted. (A7-
A8, A46-A48, A62-A63)
Up to this point, Heizer Corporation had neither sought nor
accepted representation on IDC’s board. As Edgar F. Heizer,
Jr., president of Heizer Corporation, explained at trial, venture
capitalists normally are not interested in having control over or
participating in the management of their “investee” companies.
While Heizer Corporation must occasionally provide advice and
assistance to the management of such companies, it is only in the
business cf investing, and not of acquiring companies or operat-
ing them. (Triat Tr. 996) At the close of the third transaction,
however, two Heizer Corporation nominees were elected to the
seven-man board of directors of IDC. (A8)
The documentation for each of the early transactions, and
the fourth transaction was worked on by Bernard Kury, Esq.
of the New York law firm of Dewey, Ballantine, Bushby, Palmer
and Wood (Heizer Corporation’s counsel), by Michael Sigal,
Esq. of the Chicago law firm of Sidley & Austin (IDC’s counse!)
and by IDC’s in-house counsel. Edgar Heizer testified that he
relied entirely upon the lawyers to handle the details for all
transactions and to make certain that Heizer Corporation was
in full compliance with the law. (Trial Tr. 552-53) In that
regard, Ross specifically stated at trial that counsel for Heizer
Corporation never suggested that any information be withheld
from the common stockholders. (Trial Tr. 283-84, 31 1-12)
ie
d. The “Fourth Transaction”
During the summer of 1971, Ross again sought outside
funds, and Heizer Corporation tried to assist Ross whenever
possible. (Trial Tr. 1920-21, 1956) The monitoring operation
was still plagued with regulatory and technical problems, how-
ever, and IDC’s financial situation was becoming desperate.
In the fall of 1971 McCormick and Company, an investment
banking firm, decided that if IDC had a profitable first quarter in
1972. McCormick could conduct a successful speculative under-
writing for IDC in April of 1972.* Interim financing was
essential, however, and McCormick suggested that either Bene-
ficial or Heizer Corporation provide additional funds. Beneficial
refused and Heizer Corporation initially declined because its
investment in IDC was already substantial. (Trial Tr. 1653-54)
McCormick, on behalf of IDC, then began looking for $1.5
million in interim financing but was unable to locate any
outside money, in part because Ross had “soured” many po-
tential investors in IDC with his unfulfilled projections, (Trial
Tr. 1656) McCormick remained optimistic, however, and
Heizer Corporation agreed to cooperate fully with McCormick
in raising the interim funds through a private placement
(including waiving the triggering of its antidilution rights).
(Trial Tr. 1660-62, 1702) In the midst of McCormick’s efforts,
IDC ran out of money and began withholding payments to its
trade creditors. Telephone companies began disconnecting the
lines to IDC’s monitors; and, according to expert testimony at
trial, at this point IDC was “bankrupt,” with no value at all
unless someone put more money into it. (Trial Tr. 864, 2239,
2267-68 )
Heizer Corporation advanced $60,000 to IDC and pre-
pared a proposal to save IDC from bankruptcy proceedings,
so that McCormick could continue its efforts to find outside
financing for IDC. Heizer Corporation’s proposal, which became
* McCormick had been told by an officer of IDC that the technical
— were over and that IDC projected that its operations would
reak even in early 1972. (Trial Tr. 1649)
10
the fourth transaction, was consummated on ‘November 19,
1971, and involved the issuance by IDC of up to $600,000 in
promissory notes.due on March 31, 1972. The agreement pro-
vided that if the full amount had been lent and not repaid by
that date, the loan would become convertible into common
stock at $1 per share. At that point the antidilution clauses
from the first three transactions would be triggered and Heizer
Corporation would become entitled to purchase 4,694,000 shares
of IDC common stock at $1 per share, or 85% of the company’s
equity. (A8-A9, A48-A49)
The resignation of two directors from the IDC board and the
absence of Loew, the Beneficial representative,* left only four
participating directors, two of whom were the Heizer Corpora-
tion nominees. By this point Heizer Corporation had already
invested $4.7 million (or approximately five times the total
investment of all the common stockholders). At the board meet-
ing on November 19, 1971 at which the transaction was ap-
proved, the Heizer Corporation nominees insisted that the other
two directors vote first, after telling them that Heizer Corpo-
ration would not make the investment unless both of them
approved. Ross and LaBow, an outside director, voted in
favor of the transaction; and the Heizer Corporation nominees
then made it unanimous. (A9, A49)
As an incident to this transaction, the attorneys for IDC and
Heizer Corporation prepared an amendment to the Certificate of
Incorporation to increase the number of authorized shares
of common stock from 3 million to 7 million. Stockholder
approval was required for this amendment. Both counsel for IDC
and Heizer Corporation decided that, because of IDC’s urgent
financial needs, there was not enough time to hold a stockholders’
meeting and that the quickest available procedure was to obtain
written consents from holders of a majority of the outstanding
stock, as is permitted under Delaware law. Consent forms were
* Loew had been apprised of the terms of the fourth transaction
but was out of the country on November 19, 1971.
EE
RQ LATIN PL ELITIST NT EN SEB Fo
ore a
11
prepared by counsel for Heizer Corporation (Kury) and by
counsel for IDC (Sigal); and, at the request of Sigal and
IDC’s in-house counsel, Ross, chief executive officer, principal
steckholder and founder of IDC, undertook to get the consents.
(Trial Tr. 225-26)
The District Court held that Heizer Corporation violated
Rule 10b-5 in connection with this transaction because the trans-
action was unfair and involved self-dealing by Heizer Corpora-
tion. (A63-A64) The Court of Appeals, after rejecting the
District Court’s theory in lighi of intervening decisions of this
Court (A14), made its own findings that Heizer Corporation
was guilty of non-disclosure and scienter, and, on the basis of
those findings, ruled that Heizer Corporation violated Rule
10b-5 in connection with this transaction. (A15-A19, A22,
A25-A26)
By March 13, 1972, IDC had borrowed the entire $600,000,
and a second loan under the terms of the fourth transaction had
been made for $250,000. McCormick’s efforts to find financing
had been halted earlier when still greater technical problems
with IDC’s monitoring operations were revealed. (Trial Tr.
1655) None of these loans was repaid by March 31, 1972
and Heizer Corporation then was in a position to acquire
87% of IDC’s common stock at $1 per share. (Al10, A50)
Since IDC still remained essentially bankrupt, none of these
warrants was ever exercised by Heizer Corporation.
12
e. The “Fifth Transaction”
Between March of 1972 and April of 1973, Heizer Corpora-
tion extended $2,015,000 in nonconvertible demand loans to
IDC to keep the monitoring business afloat while solutions to its
problems were being pursued. In April, 1973, Heizer Cerpora-
tion agreed to defer repayment of all demand loans and to
commit additional funds in exchange for a pledge of the T&R
stock. Following the pledge IDC borrowed an additional $1.4
million from Heizer Corporation on the same terms. None of
these loans was convertible into stock and no warrants were
issued with them. (A11-A12, A51)
With respect to the fifth transaction, the District Court found
that Heizer Corporation had engaged in self-dealing while oc-
cupying a fiduciary relationship to IDC and therefore declared
the pledge of T&R stock void. (A64) The Court of Appeals
aga‘n rejected the trial court’s theory of decision but held that
Heizer Corporation nevertheless violated Rule 10b-5 because
the IDC common stockholders were not given the opportunity
to vote on the transaction. (A19-A21)
TO IT ee ey ONO Ree
EO RN Its ee re
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13
REASONS FOR GRANTING THE WRIT
The Court of Appeals’ decision in this action is in direct
conflict with principles established in recent decisions of this
Court and is in conflict with established, reasoned lines of
precedent in other circuits. A number of the recent decisions of
this Court interpreting the federal securities laws have been
reversals of the Court of Appeals for the Seventh Circuit. TSC
Industries, Inc. Vv. Northway, Inc.; 426 U. S. 438 (1976),
rev'g 512 F. 2d 324 (7th Cir. 1975); Ernst & Ernst V.
Hochfelder, 425 U. S. 185 (1976), rev’g 503 F. 2d 1100 (7th
Cir. 1974); Rondeau v. Mosinee Paper Co., 422 U. S. 49
(1975), rev’g 500 F. 2d 1011 (7th Cir. 1974). See also Blue
Chip Stamps v. Manor Drug Stores, 421 U. S. 723, 732, 748
(1975), disapproving Eason v. General Motors Acceptance
Corp., 490 F. 2d 654 (7th Cir. 1973), cert. denied, 416 U. S.
960 (1974).
In each of the cited cases, the Seventh Circuit had imposed
an improperly light burden of proof on the plaintiff. The same
is true of the instant case. Review of the decision below is
particularly important because the Court of Appeals seriously
misinterpreted this Court’s most recent decisions under Rule
10b-5.
After the District Court rendered its principal decision herein
on December 3, 1975, this Court decided several cases under
Rule 10b-5 which control issues presented by the instant case.
Ernst & Ernst v. Hochfelder, 425 U. S. 185 (1976), held that
in order to sustain a private cause of action for damages under
Rule 10b-5 there must be a showing of scienter, i.e., an “intent
to deceive, manipulate, or defraud.” 425 U. S. at 193. After oral
argument of the instant case before the Court of Appeals,
this Court rendered its decision in Santa Fe Industries,
Inc. v. Green, 430 U. S. 462 (1977), which held that in
order to sustain a private cause of action under Rule 10b-5 there
must be a showing of manipulation or deception, and that evi-
14
dence of a breach of fiduciary duty not involving deception or
manipulation is insufficient. 430 U. S. at 473-480.* In the instant
case, however, the District Court had found liability under Rule
10b-5 on a theory not involving deception or manipulation
and without finding scienter on the part of petitioner Heizer
Corporation. (A63-A64) Thus, the District Court functioned
under a serious misapprehension of correct legal principles in
numerous respects.
In its decision the Court of Appeals ostensibly relied heavily
on the intervening rulings in Hochfelder, Green and Northway.
(Al4, Al7, A21, A25) After noting the absence of relevant
findings by the Disisict Court on the issues of scienter and
deception (A15 n. 9, A25) and the errors of that court’s legal
reasoning (A114), the Court of Appeals proceeded to conduct
a de novo review of the trial record, The Court of Appeais then
made its own findings of fact andfcame to its own conclusions
as to the liability of Heizer Corpofation.
Wholly apart from the decisional conflicts and errors of
law discussed below, it is important to emphasize the mani-
fest unfairness of this approach to petitioner. The finder of fact
in a non-jury trial is the District Court, not the Court of Ap-
peals. Fed. R. Civ. P. 52(a). In these circumstances, where there
are disputed issues of fact which the trial court did not resolve
and the whole framework of the litigation has been altered by
several intervening decisions of a higher court, the proper course
for an appellate tribunal is to remand the case for a thorough
review by the finder of fact in the first iastance, not to usurp
that function by making findings of its own, especially when
the District Court has decided the case on theories no longer
*In a third apposite decision rendered by this Court after the
D'strict Court ruling, TSC Industries, Inc. v. Northway, Inc., 426
U. S. 438 (1976), this Court held, in effect, that the test of whether
a fact is “material” for purposes of a private cause of action under
Rule 10b-5 is whether there is a “substantial likelihood” that dis-
closure of the fact in question “would have assumed actual signifi-
a the deliberations of the reasonable shareholder.” 426 U. S.
at .
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15
viable under Rule 10b-5.* See generally 5A Moore’s Federal
Practice 4 52.06[2] (2d ed. 1977). The appellate usurpation of
that function in this case requires the exercise of this Court’s
supervisory powers under Supreme Court Rule 19.**
I. \
THE IMPOSITION OF LIABILITY ON HEIZER CORPORA-
TION WAS INCONSISTENT WITH THIS COURT'S DECI-
SIONS IN ERNST & ERNST v. HOCHFELDER AND SANTA
FE INDUSTRIES v. GREEN AND IS IN CONFLICT WITH
DECISIONS OF OTHER COURTS OF APPEALS
A. Heizer Corporation Did Not Act with Scienter in the
Fourth Transaction
The Court of Appeals not only arrogated to itself the right
to make the finding of scienter required by Ernst & Ernst v.
Hochfelder, 425 U. S. 185, 193 (1976), but in so doing ap-
plied an erroneous legal standard.
The Court of Appeals held that Heizer Corporation acted with
scienter because—at a time when it was clearly not in control
of the board of directors or the management of IDC—it should
not have delegated certain responsibility, or permitted certain
delegation of responsibility, in connection with obtaining the
common stockholders’ approval of IDC corporate action re-
lated to the fourth transaction.*** That is, in deferring to a
* This is not the only recent instance of appellate fact-finding
by that court. In Sundstrand Corp. v. Sun Chemical Corp., 553 F. 2d
1033, 1050 n. 35 (7th Cir. 1977), cert. denied, 46 U. S. L. W. 3207
(1977), the Court of Appeals expressly sanctioned appellate fact-
finding in reliance on material outside the trial record.
** Rule 19.1(b) provides for the grant of certiorari where the
lower court “has so far departed from the accepted and usual course
of judicial proceedings . . . as to call for an exercise of this court’s
power of supervision.”
*** The precise basis for the court’s holding is not clear. It may
have been based on vicarious liability for the supposed scienter of
those to whom responsibility was delegated. That theory, as well,
would be erroneous. See Part 1.B, infra.
16
partner of the eminent law firm of Dewey, Ballantine, Bushby,
Palmer and Wood (as well as to IDC’s outside and inside coun-
sel) to assure that all legal requirements were met and in
permitting IDC’s chief executive officer, Ross, to obtain common
stockholder consents to an IDC charter amendment which was
not essential to the financing, Heizer Corporation was held to
have acted with intent to defraud.*
There is simply no basis for concluding that petitioner acted
with scienter in relying upon Bernard Kury of Dewey Ballan-
tine. There is no evidence which even suggests that Heizer
Corporation suspected that Kury would fail in his responsibility
in any respect.** Indeed, as the Court of Appeals noted, in the
past Kury had required IDC to retrace some of its steps when
Kury was not Satisfied that legal requirements had been observed.
(A18)
Petitioner does not suggest that reliance upon counsel
in and of itself precludes a finding of scienter. Rather, where
counsel has been relied upon in a matter requiring legal exper-
tise, there cau be no finding of scienter absent affirmative evi-
dence of some knowledge on the part of the defendant that the
attorney would probably act improperly. Hawes & Sherrard,
“Reliance on Advice of Counsel as a Defense in Corporate and
Securities Cases,” 62 Va. L. Rev. 1, 127 et seq. (1976) (analyz-
* The single act of stockholders in the fourth transaction was
to consent to an amendment to the IDC Certificate of Incorpora-
tion increasing the number of common shares authorized from 3
million to 7 million. But this amendment was surplusage to the
financing itself. As a matter of corporate law, the fourth transaction
could have been consummated without the increase in the number
of authorized common shares. The increase was undertaken merely
because the number of common shares into which warrants and con-
v -rtible securities held by Heizer Corporation might be converted at
some future date would in the aggregate exceed the number of un-
issued authorized common shares. Indeed, if the amendment had not
been presented or approved, Heizer Corporation could have con-
verted enough shares at a later date to obtain a majority of the
common stock and then voted for an amendment authorizing suffi-
cient additional shares to fulfill IDC’s contractual obligation to it.
** Petitioner does not concede and, in fact, denies that Kury acted
improperly in any respect.
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17
ing the defense in actions under Rule i0b-5 primarily in the
context of liability for negligent conduct); Hawes, “Reliance on
Advice of Counsel as a Defense,” PL/ Eighth Annual Institute
on Securities Regulation 39, 41-43 (1977). Cf. Coleco Indus-
tries, Inc. v. Berman, 423 F. Supp. 275, 296 (E. D. Pa. 1976)
(scienter consists of “conscious deception” or conduct so reckless
as to be “virtually indistinguishable in its culpability from delib-
erate fraud”); Hirsch V. du Pont, 553 F. 2d 750, 759 (2d Cir.
1977) (to aid and abet another's actionable non-disclosure, the
defendant must have “knowledge of the fraud, and not merely
[of] the undisclosed material facts”).
The Court of Appeals also held that Heizer Corporation acted
with scienter in permitting IDC (whose board Heizer Corpora-
tion did not control at that time) to delegate to Ross the respon-
sibility to obtain the consents, even though Heizer Corporation
had no obligation to supervise that corporate act and IDC was
represented by its own responsible outside and inside counsel.
Here the Court of Appeals constructed its own chain of infer-
ences upon inferences in order to find scienter where the
District Court had made no finding at all. Ross had told
IDC’s outside counsel and Kury that because the stockholders
were his friends, he (Ross) “would be able to get their
signatures in the short period of time available.” (A26)
From that the Court of Appeals “implie[d] that consents would
be solicited on the basis of friendship” rather than full disclosure.
(A26) Moreover, the stockholders’ tendency to trust the
judgment of Ross “would be further enhanced by the fact that
Ross, who was the single largest shareholder, would seem to be
the most vitally concerned with the corporation’s welfare.”
(A26) (Emphasis added.) The emphasized phrases indicate
the extent to which the Court of Appeals was dealing in the
speculative where the District Court did not make any findings at
all on the ultimate issue of scienter. The fact that in other con-
texts Heizer Corporation believed that Ross had a tendency to be
“unrealistic about IDC and its prospects” (A26) hardly supports
18
a finding that in this particular instance Heizer Corporation was
guilty of scienter in standing silent while IDC’s chief
executive officer and largest stockholder, Ross, undertook to
obtain the stockholder consents.
In fact, rather than suspecting that Ross would not make ade-
quate disclosure, Heizer Corporation knew that holders of a
majority of the stock were fully informed. Not counting Bene-
ficial (which opposed the fourth transaction), more than 50%
of the common stock was held by persons who were fully ad-
vised of the terms of the proposed transaction, had expressed no
Opposition to it, and who therefore did not need any additional
disclosure.* However, in getting the signatures necessary to
make a majority from others than himself, Ross did not contact
only those who were fully informed. Rather—without any
knowledge or participation of Heizer Corporation—he bypassed
some who knew all about the transaction and gathered a few
consents from smaller stockholders who had not participated in
the negotiations.** Heizer Corporation reasonably believed
that any required disclosure had been made, a fact con-
firmed in the legal opinion issued by IDC’s own law firm.***
* Ross controlled 42% ; DeKraker and Johnston, both IDC board
members, owned 7% in the aggregate; LaBow owned 2%; Sigal’s
law firm owned 1%. (Plaintiff's Exhibit 66) DeKraker and Johnston
attended the November 12, 1971 board meeting at which the fourth
transaction was negotiated. (Trial Tr. 1967)
** Ross, LaBow and Sigal’s law firm (the only consent Ross did
not secure personally) all had full disclosure and signed consents.
They represented 45% of the common stock. The other eight com-
mon stockholders who signed consents (holding 7% ) were friends or
business associates of Ross.
*** The opinion of IDC’s outside counsel stated, in part, as
follows:
The execution, delivery and performance of the Agreement
by IDC, and the amendment of its Certificate of Incorporation
as set forth in the aforesaid Certificate of Amendment, have
been duly authorized by all requisite action of IDC’s Board of
Directors and stockholders. ( Plaintiffs’ Exhibit 76)
ee
1 PONS Qed 2
19
In nevertheless finding Heizer Corporation liable, the Court
of Appeals’ decision conflicts with Hirsch v. du Pont, 553 F. 2d
750, 759 (2d Cir. 1977) (no scienter where defendant reason-
ably believes ali the facts have been disclosed); see also Nelson
v. Hench, 428 F. Supp. 411, 416 (D. Minn. 1977) (failure to
make disclosure when defendant did not know that such failure
aided another’s unlawful scheme is not scienter).
These facts, and the Court of Appeals’ heavy reliance upon
what “would” seem to be the case and upon what might be
“implied” from the record, demonstrate that that court in
fact merely held that Heizer Corporation “should have known”
that Ross and Kury would not faithfully discharge their re-
spective responsibilities. Courts have ruled uniformly, after
Hochfelder, that an allegation or finding that a defendant “should
have known” of certain facts does not constitute the necessary
allegation or finding of scienter. E.g. First Virginia Bankshares
v. Benson, 559 F. 2d 1307, 1318-19 (Sth Cir. 1977); Miller
v. Schweickart, 413 F. Supp. 1062, 1065 n. 8 (S. D. N. Y.
1976); Peltz v. Northern Ohio Bank, 430 F. Supp. 382, 384
(N. D. Ohio 1976). In effectively holding to the contrary,
the Court of Appeals for the Seventh Circuit has placed itself
in conflict with every other court which has considered this
question.
Hochfelder had left open the question whether reckless con-
duct, when equivalent to intentional conduct, constitutes scienter
as required by Section 10(b). 425 U. S. at 193 n. 12. Even if
recklessness which is equated with intentional conduct consti-
tutes scienter for purposes of Rule 10b-5, no such conduct was
present here. The holding below that petitioner acted reck-
lessly in violation of Rule 10b-5 (A25) so dilutes the nature
of recklessness as to render it indistinguishable from gross negli-
gence or ordinary negligence, thereby obliterating the very dis-
tinction which this Court sought to establish in Hochfelder, 425
U. S. at 210, 214.
In sum, in the fourth transaction the petitioner, a venture
capital firm, sought to provide further financial aid to a failing
ed
20
entity with a handful of stockholders, principally friends of the
founder. In the course of that transaction, petitioner voluntarily
participated to a limited degree, through counsel, in submitting
a single issue for the consent of stockholders—consent which was
not essential to the financing. The attorney on whom petitioner
principally relied had acted with demonstrated care in the past.
The predominant proportion of the necessary stockholder con-
sents came directly from the principal stockholder and founder
of IDC, who obtained the other consents as well. (A17) Peti-
tioner manifestly did not act with “intent to deceive, manipulate.
or defraud.” If it did, then Hochfelder, a reversal of another
decision of the Court of Appeals below, has brought no change
in the law.
B. Any Holding That Heizer Corporation Was Vicariously
Liable Under Rule 10b-5 Is in Conflict with Decisions of
Other Courts of Appeals
If, in finding Heizer Corporation liable under Rule 10b-5 in
connection with the fourth transaction, the Court of Appeals
was not holding Heizer Corporation primarily liable but rather
only secondarily liable for the failures of others—i.e., Dewey
Ballantine or Ross—then the Court of Appeals erred in failing
to apply the standards of Section 20(a) of the Securities
Exchange Act of 1934, 15 U. S.C. § 78t(a).
Whenever vicarious liability is to be imposed for a violation
of the federal securities laws, such liability must be founded,
if at all, on the secondary liability provisions of the securities
laws, Section 15 of the 1933 Act, 15 U. S. C. § 770, and Section
20(a) of the 1934 Act, the so-called “controlling person”
sections. That is the clear import of this Court's recent decisions
holding that implied rights of action under the federal securities
laws are circumscribed by the parameters of express causes of
action under those laws, including statutory defenses. Blue
Chip Stamps v. Manor.Drug Stores, 421 U.S. 723, 736 (1975);
21
Ernst & Ernst v. Hochfelder, 425 U. S. 185, 208-210 (1976).
If the Court of Appeals’ opinion should be read as imposing
vicarious liability on Heizer Corporation, the decision con-
travenes the foregoing requirement.
As distinguished from the common law doctrine of respondeat
superior, where the principal's liability is absolute (Holaday v.
Kennard, 79 U. S. 254 (1870) ), liability of controlling persons
under the securities laws is expressly subject to a specific
affirmative defense. The affirmative defense under Section 20(a)
of the 1934 Act is that the defendant “acted in good faith and
did not directly or indirectly induce the act or acts constituting
the violation or cause of action.” (The facts demonstrating that
Heizer Corporation could have sustained that defense as to the
fourth transaction, had the courts below considered it, are dis-
cussed above at pages 10-11, 16-18.)
The following Courts of Appeals have held that the con-
trolling person sections are the exclusive means of establishing
vicarious liability in actions under Rule 10b-5 and various other
provisions of the federal securities laws: Zweig v. Hearst Corp.,
521 F. 2d 1129, 1132-33 (9th Cir. 1975), cert. denied, 423
U.S. 1025 (1975); Lanza v. Drexel & Co., 479 F. 2d 1277, 1299
(2d Cir. 1973); Rochez Bros., Inc. v. Rhoades, 527 F. 2d 880,
884-86 (3d Cir. 1975); Myzel v. Fields, 386 F. 2d 718, 738
(Sth Cir. 1967), cert. denied, 390 U. S. 951 (1968). The fol-
lowing Court of Appeals have held that vicarious liability may
be predicated upon common law concepts even if the liability of
the primary wrongdoer was founded solely under the federal
securities laws: Holloway v. Howerdd, 536 F. 2d 690, 695
(6th Cir. 1975); Johns Hopkins University v. Hutton, 422 F.
2d 1124, 1130 (4th Cir. 1970), cert. denied, 416 U. S. 916
(1974); Fey v. Walston & Co., Inc., 493 F. 2d 1036, 1052 (7th
Cir. 1974). This conflict between the circuits should be resolved
so that the applicable principles of vicarious and secondary
liability under the federal securites laws may be settled.
22
C. The Court of Appeals’ Findings of Scienter, Material Non-
Disclosure and Causation in the Fifth Transaction Were
Improperly Based on Considerations of a Supposed Fidu-
ciary Duty and Fairness.
In an action under Rule 10b-5 a plaintiff must prove not only
scienter but also deception and causation. In finding liability
under Rule 10b-5 in connection with the fifth transaction,* the
Ceurt of Appeals effectively ignored recent decisions by this
Court concerning each of these elements. **
1. Scienter
In the fifth transaction IDC pledged to Heizer Corporation
the stock of T&R, IDC’s wholly-owned subsidiary, to secure
additional short-term loans and to obtain a delay in payment
of outstanding demand loans. In finding scienter there, the Court
of Appeals held merely that Heizer Corporation participated in
a decision not to submit the transaction to the stockholders of
IDC for approval, approval which was not required by the
Delaware General Corporation Law. (A19) The Court of
Appeals held that in so doing Heizer Corporation was “blinded
by a conflict of interest” and “wantonly ignored evidence of the
* Althouch the issue was not presented below, it should be noted
that since the only purchase or sale even arguably involved in the
fifth transaction was that of several short-term notes with no equity
feature, no purchase or sale of a “security” was involved at all.
Section 3(a)(10) of the 1934 Act, 15 U. S. C. § 78c(a) (10); Great
Western Bank & Trust v. Kotz, 532 F. 2d 1252 (9th Cir. 1976);
McClure v. First National Bank of Lubbock, Texas, 497 F. 2d 490,
492-95 (Sth Cir. 1974), cert. denied, 420 U. S. 930 (1975). A
pledge of securities in these circumstances is not a “sale.” McClure.
supra, 497 F. 2d at 495.
** Although the Court of Appeals’ ruling discussed herein was
ostensibly an alternative basis for the relief granted to the plaintiffs
(A27-A28), that fact should not preclude review by this Court where
an important question of federal law is presented, especially since
petitioner seeks review of the fourth transaction, the illegality of which
was the predicate for the alternative basis for relief as to the fifth
transaction. (A27-A28)
23
unfairness of the securities transaction,” citing the Seventh
Circuit’s own decision in Bailey v. Meister Brau, Inc., 535 F. 2d
982, 993 (7th Cir. 1976).* (A27) The quoted test is not one
of intent to deceive, but rather bespeaks a breach of fiduciary
duty, which is not scienter. Cole v. Schenley Industries, Inc.,
CCH Fed. Sec. L. Rep. € 96,166, at p. 92,288 (2d Cir. 1977)
[Current Binder].
2. Deception
Santa Fe Industries, Inc. v. Green, 430 U. S. 462 (1977),
made clear that it is not the purpose of the federal securities laws,
and in particular, Rule 10b-5, to vindicate every common law
breach of fiduciary duty which may touch a securities trans-
action. 430 U. S. at 471-80. See also Piper v. Chris-Craft
Industries, Inc., 430 U. S. 1, 40-41 (1977). Nevertheless, in
holding the fifth transaction unlawful the Court of Appeals relied
on nothing more than an arguable breach of fiduciary duty as
the basis for finding the elements of deception and causation to
be present.
The Court of Appeals acknowledged that the Delaware
General Corporation Law did not require stockholder approval
of the pledge of the T&R stock. (A19) There was full disclosure
to the IDC board of directors, and, the court reasoned, disclo-
sure of relevant facts to the IDC board was sufficient under
Rule 10b-5 unless Heizer Corporation controlled the board “to
such an extent that only the independent shareholders were able
to safeguard the corporation’s interests.” (A19) The court con-
cluded that since a majority of the directors of IDC was con-
* Bailey cannot stand as a_ well-considered post-Hochfelder
analysis of Rule 10b-5. Bailey was briefed and argucd more than a
year before Hochfelder was decided by this Court. Bailey was
decided just a few weeks after Hochfelder. The sole reference in
Bailey to Hochfelder is a mere statement that nothing in Bailey is
contrary to Hochfelder (535 F. 2d at 994 n. 14), yet at 535 F. 2d
at 993 Bailey expressly relied on Sanders v. John Nuveen & Co.,
Inc., 524 F. 2d 1064, 1069 (7th Cir. 1975), which had been
vacated by this Court for reconsideration in light of Hochfelder
prior to the Bailey decision. 425 U. S. 929 (1976).
24
trolled by Heizer Corporation and Heizer Corporation had an
alleged “conflict of interest, it had the obligation to disclose to the
other stockholders information in its possession which reflected on
the fairness of the transaction.” (A20, quoting Bailey v.
Meister Brau, Inc., 535 F. 2d 982, 993 (7th Cir. 1976), dis-
cussed supra, p. 23 n.*) Accordingly, Heizer Corporation
was held obligated under Rule 10b-5 to disclose the material
facts regarding the pledge to the other stockholders.
In so holding, the Court of Appeals was evidently paying lip
service to Green, which held that manipulation* or deception
is necessary to sustain a cause of action under Rule 10b-5, and
that unfairness or breach of fiduciary duty alone is not enough.
430 U. S. at 473-78. Yet the Court of Appeals conceded that
there was reasonably prompt disclosure of the transaction to
the stockholders after it was approved. (A20-A21) Advance
disclosure to stockholders was not necessary to permit the
stockholders to vindicate their rights under state law, since no
irrevocable steps had been taken prior to disclosure of the
transaction to the stockholders. To paraphrase Green (430 U. S.
at 474 n. 14) (where there also was disclosure after the fact,
430 U. S. at 474), plaintiffs cannot point to any state law remedy
such that “they might have acted differently’—and with greater
effect—“had they had prior notice of” the pledge.
The real gravamen, then, was nct non-disclosure but the
domination of the IDC board of directors by Heizer Corpo-
ration and the alleged conflict of interest. “[T]he essence
of the complaint is that shareholders were treated unfairly by
a fiduciary.” Green, 430 U. S. at 477. Such issues are “tradi-
tionally relegated to state law.” Green, 430 U. S. at 478,
quoting P.per v. Chris-Craft Industries, Inc., 430 U. S. 1, 40
(1977), in turn quoting Cort v. Ash, 422 U. S. 66, 78 (1975).
* On any theory there was no “manipulation” here, since that
‘efers generally to practices . . . that are intended to mislead
investors by artificially affecting market activity.” Green, 430 U. S.
at 476.
25
See Section 144 of the Delaware General Corporation Law;
Kaplan v. Centex Corporation, 284 A. 2d 119 (Del. Ch. Ct.
1971). Rule 10b-5 is not a charter for federal courts to frame
federal standards of corporate conduct or fiduciary duty. Green,
430 U. S. at 479-80. If the reasoning of the Court of Appeals
herein were followed, however, every act of a board of directors
involving a breach of fiduciary duty and incidentally involving
a securities transaction would, ipso facto, entail a deceptive
non-disclosure to stockholders and thus become a matter of
federal concern—in direct contravention of the spirit if not the
letter of Green. See Goldberg v. Meridor, CCH Fed. Sec. L.
Rep. § 96,162, at p. 92,271 (2d Cir. 1977) [Current Binder]
(Meskill, J., concurring in part and dissenting in part).
3. Causation
The Court of Appeals’ holding that plaintiffs had also estab-
lished causation (A22-A24) was similarly predicated on the
erroneous conclusion that the failure to make disclosure in
advance deprived ‘.e stockholders of a viable common law right
to assert that the fifth transaction was unfair. But the stock-
holders had ample opportunity after the transaction was dis-
closed to assert their common law rights.
In using a conflict of interest analysis to manufacture the
necessary finding of deception and using an analysis of the
fairness of the transaction to establish causation, the Court of
Appeals inextricably intertwined the concepts of fiduciary duty
and state corporate common law with the federal securities laws
in a manner which directly contravenes this Court’s admonition
to leave state law concerns to the proper forum. The expansion
of Rule 10b-5 here to “corporate conduct traditionally left to
state regulation” (430 U. S. at 478) is especially egregious in
light of the fact that IDC is a closely held corporation whose
stock was never sold to the public, while the Securities Exchange
Act of 1934 is “chiefly concerned with the regulation of post-
distribution trading on the Nation’s stock exchanges and securi-
a
~
26
ties trading markets.” Blue Chip Stamps v. Manor Drug Stores,
421 U. S. 723, 752 (1975). This petition should be granted so
that the separation between the proper concerns of federal law
and of state law can be clarified and preserved.
II.
THE RELIEF ORDERED BY THE COURT OF APPEALS
EXCEEDED THAT COURT’S AUTHORITY UNDER THE
SECURITIES EXCHANGE ACT, IS IN CONFLICT WITH
DECISIONS OF THIS COURT AND WOULD ESTABLISH
A DANGEROUS PRECEDENT WITH NO LIMITS ON A
COURT'S DISCRETION
A. The Primary Relief
The relief which the Court of Appeals ordered in connection
with the fourth transaction changed the convertible notes to
nonconvertible notes. That court also ordered that demand loans
made after the third transaction should be changed to provide a
set maturity date “commensurate with IDC’s ability to pay”, to
be determined at a further hearing by the District Court, and
nullified the pledge of T&R stock. (A27-A31) In going beyond
compensatory damages and rescission, that relief, misleadingly
characterized as “unraveling past transactions” (A27), is totally
unwarranted under the 1934 Act.*
It is settled that an award of damages is an appropriate
remedy for violation of Rule 10b-5. Affiliated Ute Citizens v.
United States, 406 U. S. 128, 155 (1972). Rescission is another
available remedy, subject to traditional equitable defenses. In
particular, Section 29(b) of the 1934 Act, 15 U. S. C.
$ 78cc(b), provides in pertinent part as follows:
* The Court of Appeals’ statements that Heizer Corporation
“agrees” to the appropriateness of certain relief (A27) are in error.
Petitioner never stated any such concession at any stage of these
proceedings. Moreover, certain of the relief challenged in this petition
was first imposed by the Court of Appeals.
™
Every contract made in violation of any provision of
this title or of any rule or regulation thereunder . . . shall
be void (1) as regards the rights of any person who, in
violation of any such provision, rule, or regulation, shall
have made or engaged in the performance of any such
contract....
As interpreted by this Court in Mills v. Electric Auto-Lite Co.,
396 U. S. 375, 387 (1970), Section 29(b) means that an
innocent party to a transaction induced by a violation of, e.g.,
Rule 10b-5, has a right to void the transaction. To the same
effect, see Blue Chip Stamps v. Manor Drug Stores, 421 U. S.
723, 735 (1975). Void, of course, means to nullify in its
entirety, not to undo or revise selected portions of the transac-
tion. E.g., Sparks v. United States, 153 F. Supp. 909 (D.
Vt. 1957).
Other provisions of the federal securities laws which expressly
establish private rights of action specify remedies of damages
or rescission, but none permits dissection of a transaction so as
to saddle the defendant with only part of what he had bargained
for or leave him with an entirely different investment. Section
12(2) of the Securities Act of 1933 (“1933 Act”), 15 U. S.C.
§ 771(2), which provides a buyer with an express cause of
action for misrepresentation in certain circumstances, provides
the remedies of damages or rescission. Sections 9 and 18 of
the 1934 Act, 15 U. S. C. § 78i and § 78r, which provide
express causes of action for purchasers and sellers in certain
circumstances, provide a damage remedy. Section 28(a) of
the 1934 Act, 15 U. S. C. § 78bb(a), limits recovery to “actual
damages.” Blue Chip Stamps v. Manor Drug Stores, 421 U. S.
723, 734 (1975). As noted, Section 29(b) explicitly provides
for rescission.
This Court held in Blue Chip Stamps v. Manor Drug Stores,
421 U. S. 723, 736 (1975):
It would indeed be anomalous to impute to Congress an
intention to expand the plaintiff class for a judicially im-
28
plied cause of action beyond the bounds it delineated for
comparable express causes of action. (Footnote omitted.)
See also Ernst & Ernst v. Hochfelder, 425 U. S. 185, 208-211
(1976). Similarly, when the express civil liability provisions have
such narrowly circumscribed, but nevertheless sufficient, remedies
it would be at least anomalous, if not patently outside the in-
tent of the federal securities laws, to permit such a drastic remedy
as wholesale restructuring of transactions under an implied right
of action.*
Nevertheless, in the instant case the Court of Appeals, as
well as the District Court, did not void or even “unravel” the
transactions but modified them in such a way as to make their
terms not at all what had been bargained for, to the great preju-
dice of petitioner Heizer Corporation. Thus, after petitioner
parted with its cash, it was left with all of the risks—indeed
more of the risks—but none of the potential benefits of the
transactions at issue.**
The relief imposed on Heizer Corporation was clearly puni-
tive, yet punitive damages are not recoverable under the federal
securities laws. deHaas v. Empire Petroleum Co., 435 F. 2d
1223, 1229-32 (10th Cir. 1970); Globus v. Law Research Serv-
ice, Inc., 418 F. 2d 1276 (2d Cir. 1969), cert. denied, 397
* The issue presented by this petition does not pertain to equitable
relief pendente lite (Deckert v. Independence Shares Corp., 311
U. S. 282 (1940)) or ancillary relief necessary to implement an
award of damages or rescission (e.g., an accounting).
** There are several anomalies arising from this extreme remedy.
First, the primary beneficiary of any reduction in Heizer Corpora-
tion’s equity or right to equity in IDC is Ross, the principal common
stockholder. Yet it was Ross’ failure to disclose certain material
facts which gave rise to Heizer Corporation’s liability under the
Court of Appeals’ theory. (A16-A17, A26) Second, IDC, the reai
party in interest, was a fully active and voluntary participant—Hcizer
Corporation did not control the board of IDC at the time of the
fourth transaction. (A18) The equitable doctrine of in pari delicto
should bar IDC and Ross from obtaining any relicf. directly or
indirectly, as a result of their own wrongs. Tarasi v. Pittsburgh
National Bank, 555 F. 2d 1152 (3d Cir. 1977), cert. denied, 46
U. S. L. W. 3355 (1977), and cases cited at 555 F. 2d at 1159-60.
29
U. S. 913 (1970). In light of the absence of statutory authority
for the confiscatory action of the Court of Appeals, petitioner
has been deprived of its property without due process. U. S.
Const. Amendment V.
The precedent established by the Court of Appeals here is
a pernicious one. For example, it would sanction a ruling that
an unlawfully induced loan be converted into equity or that an
investment in common stock be converted into debt, quite
possibly on terms very unfavorable to the investor. A federal
court has similar broad discretion to restructure property rights
in proceedings under the bankruptcy laws, but such laws are
authorized by a specific independent Constitutional power. U. S.
Const. Art. 1, § 8, cl. 4. Here there is not even a statutory basis
for the far-reaching relief which has been ordered.
Venture capital firms such as petitioner supply the life-
blood for risky enterprises with apparent potential, such as IDC.
Sufficient financing in the early stages of development may
not be available elsewhere, as was the case with IDC. To expose
venture capital firms (or any investor or lender) to the risk of the
unfettered discretion of a court operating years after the fact will
only deter such investment, which is vital to the growth of our
economy and the enterprise of the citizenry. In Blue Chip
Stamps v. Manor Drug Stores, 421 U. S. 723, 759-60 (1975),
this Court stated in a similar context:
If such a far-reaching change is to be made, with unpre-
dictable consequences for the process of raising capital so
necessary to our economic well-being, it is a matter for the
Congress, not the courts.
Petitioner does not contest the proposition that remedies
should be imposed upon those who violate the federal securities
laws, but it strongly opposes the holding below to the effect
that a court has carte blanche in fashioning any remedy it may
choose beyond awarding actual damages or voiding the transac-
tion, as provided in Section 29(b) of the 1934 Act. There is
no authority for a court completely to rewrite the terms of a
transaction involving the purchase or sale of securities.
30
B. Prospective Relief
The Court of Appeals’ imposition of prospective relief was
also in contravention of principles established by this Court. In
Rondeau v. Mosinee Paper Co., 422 U. S. 49 (1975), this
Court held that in order to impose prospective injunctive relief
on one who has violated the federal securities laws, the plaintiff
must establish the traditional requisites of such equitable relief,
including a showing of irreparable harm and the inadequacy
of a remedy at law. 422 U. S. at 60-65. Neither necessary find-
ing was made by the District Court or the Court of Appeals
in this case. Accordingly, all of the prospective relief imposed
by the Court of Appeals, as well as that originally imposed by
the District Court, should be vacated.
Moreover, in light of the pervasive retrospective relief granted
by the Court of Appeals (which, however, Heizer Corporation
challenges), there could be no showing of irreparable harm or
inadequacy of a remedy at law requiring the prospective relief
imposed here. Indeed, if the fourth and fifth transactions were
voided (rather than restructured in contravention of applicable
principles of the 1934 Act (supra, pp. 26-29)), there could be
no basis at all under Rondeau for the prospective relief which
was ordered by the Court of Appeals.
31
CONCLUSION
For the reasons given, petitioner Heizer Corporation prays
that a writ of certiorari issu* to review the judgment and
opinion below.
Respectfully submitted,
WILLIAM A. MONTGOMERY
ALLAN HORWICH
JOHN ADAMS
7200 Sears Tower
233 South Wacker Drive
Chicago, Illinois 60606
BERNARD HARROLD
JERALD P. EsRICK
One IBM Plaza
Chicago, Illinois 60611
Attorneys for Petitioner
SCHIFF HARDIN & WAITE
WILDMAN, HARROLD,
ALLEN & DIXON
Of Counsel
December 7, 1977.
Al
APPENDIX
Section 10(b) of the Securities Exchange Act of 1934,
15 U.S. C. § 78j(b)
It shall be unlawful for any person, directly or indirectly, by
the use of any means or instrumentality of interstate commerce
or of the mails, or of any facility of any national securities
exchange—
* * * * *
(b) To use or employ, in connection with the purchase
or sale of any security registered on a national securities
exchange or any security not so registered, any manipula-
tive or deceptive device or contrivance in contravention of
such rules and regulations as the Commission may prescribe
as necessary or appropriate in the public interest or for the
protection of investors.
Section 20(a) of the Securities Exchange Act of 1934,
15 U.S. C. § 78t(a)
(a) Every person who, directly or indirectly, controls any
person liable under any provision of this chapter or of any rule or
regulation thereunder shall also be liable jointly and severally with
and to the same extent as such controlled person to any person
to whom such controlled person is liable, unless the controlling
person acted in good faith and did not directly or indirectly
induce the act or acts constituting the violation or cause of
action.
me * * e s
Section 29(b) of the Securities Exchange Act of 1934,
15 U.S. C. § 78cc(b)
(b) Every contract made in violation of any provision of this
title or of any rule or regulation thereunder, and every contract
(including any contract for listing a security on an exchange)
heretofore or hereafter made the performance of which involves
the violation of, or the continuance of any relationship or practice
in violation of, any provision of this title or any rule or regulation
A2
thereunder, shall be void (1) as regards the rights of any person
who, in violation of any such provision, rule, or regulation, shall
have made or engaged in the performance of any such contract,
and (2) as regards the rights of any person who, not being a
party to such contract, shall have acquired any right thereunder
with actual knowledge of the facts by reason of which the making
or performance of such contract was in vioiation of any such
provision, rule, or regulation: Provided, (A) that no contract
shall be void by reason of this subsection because of any viola-
tion of any rule or regulation prescribed pursuant to paragraph
(2) or (3) of subsection (c) of section 15 of this title, and (B)
that no contract shall be deemed to be void by reason of this
subsection in any action maintained in reliance upon this sub-
section, by any person to or for whom any broker or dealer sells,
or from or for whom any broker or dealer purchases, a security
in violation of any rule or regulation prescribed pursuant to para-
graph (1) of subsection (c) of section 15 of this title, unless such
action is brought within one year after the discovery that such
sale or purchase involves such violation and within three years
after such violation.
SEC Rule 10b-5, 17 C. F. R. § 240.10b-5
It shall be unlawful for any person, directly or indirectly,
by the use of any means or instrumentality of interstate com-
merce, or of the mails or of any facility of any national securi-
ties exchange,
(a) To employ any device, scheme, or artifice to
defraud,
(b) To make any untrue statement of a material fact
or to omit to state a material fact necessary in order to make
the statements made, in the light of the circumstances under
which they were made, not misleading, or
( c) To engage in any act, practice, or course of business
which operates or would operate as a fraud or deceit upon
any person,
in connection with the purchase or sale of any security.
A3
OPINION OF THE COURT OF APPEALS
SEPTEMBER 9, 1977
IN THE UNITED STATES COURT OF APPEALS
For the Seventh Circuit
Nos. 76-1140, 76-1700, 76-1701 and 76-1702
PETER WRIGHT and BENEFICIAL STANDARD CORPORATION,
Plaintiffs-A ppellants,* Cross-Appellees,
Vv.
THE HEIZER CORPORATION,
Defendant-A ppellee, Cross-Appellant,
and
INTERNATIONAL DIGISONICS CORPORATION,
Defendant-A ppellee.
Appeal from the United States District Court for the
Northern District of Dlinois, Eastern Division.
No. 72-C-2536—Prentice H. Marshall, Judge.
Argued December 10, 1976—Decided June 30, 1977
Opinion Modified September 9, 1977
* Plaintiffs in the derivative action (see the first paragraph of the
text) filed the first notice of appeal (No. 76-1139) but later dis-
missed that appeal voluntarily. Thus, Heizer Corporation, although
its role is essentially that of an appellant, is labelled the appellee and
cross-appeliant and plaintiffs are labelled the appellants and cross-
appellees in the appeals filed in that action, which are Nos. 76-1140,
76-1700, and 76-1702. In No. 76-1701, an appeal from a separate
action by Beneficial Standard Corporation against International
Digisonics Corporation (see the first paragraph of the text), Benefi-
cial is the appellant and IDC is the appellee.
A4
Before CASTLE, Senior Circuit Judge, and TONE and Woop,
Circuit Judges.
TONE, Circuit Judge. These consolidated appeals arising out
of a single case present issues under § 10(b) of The Securities
Exchange Act of 1934, 15 U. S. C. § 78j, and Rule 10b-5
thereunder. Both plaintiffs join in a shareholders’ derivative claim,
asserting that the dominant shareholder defrauded the corpora-
tion in a series of five securities transactions. In addition, one
of the plaintiffs asserts a claim against the corporation itself,
alleging that false representations by one of the corporation's
officers induced that plaintiff to convert a debenture into com-
mon stock.
I.
The Derivative Claim
A. Facts
International Digisonics Corporation (IDC) was formed in
1969 to develop electronic monitoring of television commercials
as a service for the advertising industry. IDC’s founder was
Jordon Ross, who since 1962 had been successfully operating a
company called Talent & Residuals Inc. (T&R), which pro-
vided advertising agencies with the complex accounting and pay-
roll services required by the “residuals” paid to actors performing
in television commercials.
The first investor in IDC, plaintiff Beneficial Standard Corpo-
ration, purchased a $425,000 convertible IDC debenture on the
condition that the well-established and profitable T&R be made
a subsidiary of IDC. In anticipation of a planned public offering
of its stock, IDC requested that Beneficial convert its debenture
to IDC common stock, at a $2.50 per share exchange ratio.
This conversion is the subject of the individual action, discussed
in Part II, infra. After the conversion, Ross and Beneficial owned
approximately two-thirds of the corporation’s stock; the remain-
ing third was held by Ross friends and business associates.
AS
As originally conceived, electronic monitoring involved en-
coding film or videotape commercials with electronic impulses
which, while invisible to the viewer, could be read by electronic
monitors. Placed in all major television markets, these monitors
would report to a central computer, which would then use the
data to generate a proof-of-performance report. This report
would replace the affidavits from television stations that the
advertising agencies were relying upon as proof that their com-
mercials had been properly broadcast at the agreed-upon time.’
In the fall of 1969 IDC was seeking a $1,000,000 capital
contribution from a private investor as a preliminary step to
taking the company public. One investor it approached was de-
fendant Heizer Corporation, which specializes in venture capital
investments in newly-formed companies considered too risky for
Heizer’s stockholders—banks, pension funds, and universities—
to invest in directly. Heizer was told that, provided FCC ap-
proval could be obtained, its $1,000,000 investment would
enable the monitoring business to reach the break-even point
necessary for a successful public offering. They were also told
that, given a $5,000,000 capital investment from that public
offering, a $5,500,000 profit could be anticipated from the
monitoring business by 1971. [Pl. Ex. 62, Heizer Pre-Investment
Summary & Analysis.] These “exceptional” prospects, coupled
with the protection afforded by T&R’s consistently good perform-
1. It was hoped that eventually the monitoring system could be
used to perform more sophisticated fuuctions such as market re-
search and could also serve as an automated data-gathering system
for a fully computerized T&R payroll system and a billing system
between advertising agencies and television stations. [Jordon Ross,
Tr. 207; Pl. Ex. 66, Heizer Corp. Business Appraisal Report, Aug.
1970. Occasional citations to the record and briefs of the parties are
included in brackets in this slip opinion for the convenience of
counsel and other representatives of the parties in their study of the
opinion. Since the materials cited will ordinarily not be available to
others, these bracketed citations will serve no further purpose when
the opinion is published in the Federal 2d reports, and they, as well
as this bracketed explanation, will therefore be deleted before the
opinion is submitted to the publisher.)
A6
ance, convinced Heizer that IDC was a desirable investment
opportunity. [/d.]
Heizer offered to purchase IDC preferred stock, accompanied
by warrants to purchase common stock, for $1,000,000; it also
agreed to loan IDC $500,000 for one year. Following unani-
mous approval of this first transaction by the board of directors
and stockholders of IDC on November 9, 1969, Heizer was
issued 100,000 shares of a newly-created class A common stock
(in reality a preferred stock) at $10 per share and warrants to
purchase 155,000 shares of common stock at $8.50 per share.
Although the preferred stock was not made expressly con-
vertible, it was redeemable at Heizer’s option and could be used
at par in lieu of cash in exercising the warrants. During nego-
tiations, the proper exercise price of the warrants was hotly
disputed, with Jordon Ross, who negotiated for IDC, insisting
on at least $10 per share and Heizer offering only $5 per share.
The dispute was settled by compromising on the price and adding
to the warrants an “antidilution clause’”—or, as a Heizer vice-
president called it, a price-adjustment clause—which would auto-
matically readjust the price downward and the number of shares
purchasable upward if IDC sold stock or rights to stock at a
price lower than $8.50 per share.” The agreement also contained
a number of other provisions designed to protect the Heizer
investment, including IDC’s agreement not to pledge its T&R
stock or to change the nature of its business without Heizer’s
consent.
The contemplated public offering did not take place, however.
Over the next eleven months IDC encountered a number of
technical problems with monitoring, as well as administrative
delay. At last, in April 1970, the FCC ruled favorably on the
company’s request for rulemaking, and in June 1970, IDC began
actively marketing its services. [DeKraker monthly memos to
2. The formula for determining the new number of shares
purchasable is: old exercise price x old number of warrants
new exercise price
A7
IDC board. Def. Ex. 1(b)-1(i).] Although a public offering was
still contemplated [Def. Ex. 24], IDC was by this time also
investigating other financing alternatives.* Needing additional
operating capital immediately, IDC turned once again to Heizer.
In September 1970 the second transaction, a $2,000,000 invest-
ment in two takedowns of $1,000,000 each, was arranged on the
same general basis as before and was unanimously approved by
IDC’s board and shareholders. Heizer was to receive 200,000
shares of a new preferred stock at $100 per share,* with warrants
to purchase 400,000 shares of common stock at an initial exer-
cise price of $6 per share. If IDC had not met certain conditions
not relevant here at the time of the second takedown, the price of
the warrants would drop to $4 per share.® These warrants had an
antidilution clause identical to that used in the first transaction;
however, Heizer waived the antidilution provision in its first set
of warrants so that their exercise price remained at $8.50 per
share. [C. Palmer, Tr. 1903.]
In the next six months IDC was faced with more technical
problems: film commercials often could not be monitored be-
cause of improper coding by film processors or improper align-
ment in broadcasting, and the apparent solution to these prob-
lems could not be implemented without a new ruling from the
FCC. However, in his reports to IDC’s board, the president of
3. There is disagreement over why none of these efforts ever
produced concrete results: Heizer officers testified that Jordon Ross
always insisted on unrealistic prices for the stock [E. Heizer, Tr.
994; C. Palmer, Tr. 1889], while an IDC director testified that
rapidly deteriorating market conditions, the restrictive provisions in
the first Heizer financing, and IDC’s own operational difficulties
made it impossible to acquire financing on a reasonable basis.
{R. LaBow dep. 61-62.]
4. The Class A common stock created in the first transaction was
also exchanged for the new preferred stock in this transaction.
5. In February 1971 Heizer, while proceeding with the second
takedown, notified IDC that it was in default and that the warrant
exercise price had therefore dropped to $4 per share. [Pl. Ex. 65.]
IDC responded, denying default. [Def. Ex. 35.] The matter was
never resolved.
A8
the company, Glenn DeKraker, stated that monitors had been
placed in all twenty-five top markets and that, while the system
was turning out to be more complex than originally thought, it
was being successfully debugged. (Def. Ex. 1(j)-1(n).]
In May of 1971, after several possible alternative sources of
financing had fallen through, IDC again found it necessary to
turn to Heizer for a third financing. IDC’s board and stock-
holders again unanimously approved a transaction in which
Heizer invested $1,700,000 ($500,000 of which was used to
repay the Heizer loan due May 25th) in return for a twenty-year
note in that amount and warrants to purchase an additional
472,222 shares of common stock at $3.60 per share. Fhe prior
antidilution clauses were partially triggered and, as a result,
Heizer became entitled to 1,304,000 shares at $3.60 per share,*
or a total of 61 per cent of the company’s equity. In order to
equate Heizer’s voting power with this pro forma equity position,
IDC’s charter was amended to provide that the preferred stock
would receive 4.4 votes per share. [E. Heizer, Tr. 660.] Two
Heizer officers, Edgar Heizer and Charles Palmer, also became
members of the IDC board at this time.
Over the next six months, IDC continued to experience tech-
nical difficulties with film encoding while pursuing a constant
search for financing from sources other than Heizer. [Def. Ex.
1(o)-1(u).] The most promising source in the summer and fall
of 1971 was the underwriting firm of McCormick & Co. Im-
pressed by IDC’s profit projections and by Heizer’s substantial
commitment to the company [Tr. 1687], McCormick issued a
letter of intent in October 1971 looking toward a public offering.
6. This figure is 200,000 shares less than Heizer might have
insisted upon receiving. At $3.60 per share Heizer was entitled to
365,972 shares under the warrants issued in the first transaction; a
Heizer vice-president testified that this figure was negotiated down
to 276,223 shares. [C. Palmer dep. 216.] The warrants from the
second transaction would have entitled Heizer to 666,666 shares if
the price had originally been pegged at $6 per share or 444,444 if
pegged at $4 per share. At this pouat the parties apparently split the
difference on price and triggered at $5 per share or 555,555 shares.
A9
[Def. Ex. 78.] Because it appeared that $1,500,000 would be
needed before such an offering could be made, McCormick also
agreed to attempt to locate private investors. By November,
these efforts had not proved successful and IDC’s financial situa-
tion was desperate. Again, IDC looked to Heizer for an interim
financing of up to $600,000 to be repaid from the private place-
ment, which was now expected to materialize in January. [Tr.
179-180, 995, 1620.] An agreement was reached whereby
Heizer would lend IDC up to $600,000, payable on demand
after March 31, 1972; if the full amount had been lent and not
repaid by that date, the loan would become convertible to com-
mon stock at $1 per share.’ At that point the antidilution clauses
in the warrants from the previous three transactions would be
triggered and Heizer would vecome entitled to 4,694,400 shares
of IDC common stock at $1 per share, or approximately 85 per
cent of the corporation’s equity.
The resignation of two directors from the IDC board®* and the
absence from the country of another, who was Beneficial’s rep-
resentative, left only four participating directors, two of whom
were Heizer nominees, when a board meeting was held on
November 19, 1971. Because of their conflict of interest, the
Heizer nominees allowed the two independent directors to vote
first, after telling them that there would be no transaction if
either of them disapproved. The vote was unanimous in favor of
the proposal.
Once the board had approved this fourth transaction, it was
necessary to obtain the common shareholders’ approval of a
7. Heizer vice-president, and IDC director, Charles Palmer testi-
fied that the purpose of the $1 conversion — was to provide IDC
with a strong incentive to obtain outside financing or, in the event
the financing fell through, to give Heizer what it considered to be a
fair percentage of the company’s equity. [C. Palmer dep. 137-138,
148-150.}
8. Edgar Heizer testified that he had refused to consummate the
transaction unless one of these two, Glenn DeKraker, was removed
from both the board and his position as president of the company.
{Tr. 1009.]
Ald
charter amendment increasing the number of authorized shares
of common stock from three to seven million. Counsel for Heizer
and for IDC testified that, because of the company’s pressing
need for immediate financing, they decided that the best pro-
cedure was to obtain written consents from a majority of the
stockholders, as permitted by the law of Delaware, the state in
which IDC was incorporated. [Tr. 1135, 1629-1630, 1784.]
Because Beneficial opposed the transaction, the consents had to
be secured from Jordon Ross and his friends and business
associates. Ross made the necessary contacts himself, obtaining
consents from shareholders (including plaintiff Peter Wright)
holding 52.4 per cent of the corporation’s outstanding common
stock.
In December 1971 McCormick & Co. informed IDC that it
would not be able to arrange financing. One month later it
became apparent that film monitoring was not technically feas-
ible. After a period of re-evaluation, Heizer decided that the
monitoring effort should focus on the feasibility of videotape
monitoring, and, so limited, should be continued while a search
for new management was conducted. [Def. Ex. 95, 100-101,
103-108, 111-112.]
By March 13, 1972, IDC had borrowed the entire $600,000
authorized in the fourth transaction and was again in need of
funds. At that point, the IDC board, with the Beneficial nominee
dissenting, authorized an amendment to the November 19th
agreement whereby Heizer would lend the company up to
$250,000 more and the amount lent, plus unpaid management
fees and interest, would also become a loan convertible to com-
mon stock at $1 per share if not paid by March 31, 1972. On
March 31 IDC had not repaid any of these loans, and Heizer
therefore gained the right to purchase 5,513,968 shares of IDC
common stock, or 87 per cent of the company’s equity on a pro
forma basis, at $1 per share.
A new board of directors, consisting of three Heizer nominees,
a representative of Beneficial, and Jordon Ross, was elected in
All
May 1972. The Beneficial director, however, resigned less than
a month later. In June 1972, Paul Roth was elected president of
the company by the three Heizer directors voting in Jordon Ross’
absence and apparently over his objections. Roth was given six
months to study the viability of a videotape-only monitoring
system. [P. Roth, Tr. 301.] In the meantime, from April 14,
1972 to April 19, 1973, Heizer extended $2,015,000 in non-
convertible demand loans to IDC to make up the difference
between its operating losses and T&R’s profits.
In October 1972, Beneficial and Peter Wright, an individual
shareholder, filed this derivative action. In their complaint, twice
amended, they alleged that Heizer had effectively gained contro!
of IDC through the protective provisions of the first transaction
and had then violated Rule 10b-5 by failing to disclose to IDC’s
shareholders its controlling position and the unfair valuation
placed on IDC stock in the second, third, and fourth transac-
tions. Alternatively, they alleged that Heizer, if not in control of
IDC, had aided and abetted IDC’s management in its failure to
disclose material facts concerning the four transactions. They
also alleged that Heizer was liable as a controlling person for the
actions of its nominees on the IDC board in voting for the alleg-
edly unfair and improperly disclosed fourth transaction.
In June 1973, while this case was pending, the fifth transac-
tion now complained of was consummated. Paul Roth and Heizer
officers testified that they had found it impossible to arrange
outside financing without recapitalizing the corporation. Once
this suit was filed, recapitalization, which would have involved
exercise of the disputed warrants, also became impossible. Heizer
was thus left as IDC’s sole source of financing. Edgar Heizer
testified that because Heizer Corp. is not in the business of
making unsecured loans, it was at that point “totally justified” in
demanding security for its continued support of the business—
even though its investment was not in any immediate danger.
[Tr. 933, 936-937.] The security it received for all its loans after
April 14, 1972 was a pledge of all the stock of T&R. In return,
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Heizer agreed to postpone demand on the various short-term and
demand loans extended pursuant to, and after, the fourth transac-
tion until January 1974 and agreed to lend the company a
minimum of $460,000 and a maximum of $1,181,700 during
the remainder of 1973, also to be secured by the pledge and
payable in January 1974.
Paul Roth testified that he was told one purpose of the pledge
was to “smoke [plaintiffs] out of the woodwork,” [Tr. 1291]
apparently by threatening to foreclose on IDC’s most profitable
asset, T&R. In count II of their second amended complaint,
plaintiffs challenged this pledge transaction, alleging that Heizer
had demanded the pledge as protection against the outcome of
the litigation and that this use of its control over the corporation
constituted a manipulative and deceptive device operating as a
fraud on IDC in violation of Rule 10b-5.
B. The District Court Opinion
In Wright v. Heizer Corp., 411 F.Supp. 23 (N.D. Ill. 1975),
the District Court held that plaintiffs could maintain a derivative
action on behalf of IDC but ruled that, in light of the Supreme
Court’s re-affirmance of the Birnbaum purchaser-seller standing
requirement in Blue Chip Stamps v. Manor Drug Stores, 421
U.S. 723 (1975), they could not sue personally as shareholder-
investors in IDC. The court then ruled that the first three trans-
actions, which it found to be “open and at arm’s length,” could
not be attacked on the ground that they had not been fully
disclosed to the shareholders because under the Blue Chip
limitation “[t]his theory of fraud by concealment practiced on
the shareholders” was not available. 411 F.Supp. at 36. The
court went on to hold, however, that even if the theory were
available, plaintiffs had failed to provide proof of nondisclosure.
With respect to the fourth and fifth transactions, the court
held that because Heizer was a fiduciary engaged in self-dealing
in the sale of securities, it had the “heavy burden of proving
en
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[the] fairness” of those transactions. /d. Finding its proof in-
adequate, the court ordered the notes from the fourth transaction
declared nonconvertible, cancelled any warrants issued in con-
nection with that transaction, declared void the triggering of the
prior warrants, and cancelled the pledge of T&R stock. Heizer
was also enjoined from purchasing securities from or lending
money to IDC in the future under conditions that were
not “fair and equitable.”
On appeal, plaintiffs do not challenge the District Court's
ruling on the first three transactions. By means of the appeal
in No. 76-1700 from an order denying a petition for supple-
mental relief, they challenge the scope of the relief granted,
arguing that the court also should have forced Heizer to assume
a portion of IDC’s monitoring losses by requiring it to give up
its senior position. In No. 76-1140, Heizer challenges the court's
ruling on liability under 10b-5; it also argues that, even if that
ruling was correct, the court erred in granting overly broad
prospective relief. Finally, in No. 76-1702, Heizer appeals
from an order entered after the District Court’s decision, enjoin-
ing it pending appeal from proceeding with a proposed
recapitalization plan.
C. The Applicable Law
In voiding the unfair portions of the fourth and fifth trans-
actions, the District Court held that a “breach of trust by
corporate fiduciaries clearly falls within [the] ambit” of Rule
10b-5. 411 F.Supp. at 35. The court then found that the Heizer
nominees were directors whose votes were necessary to the
approval of the transactions and therefore imposed on the
defendant the burden of proving that its self-dealing had been
fair. Cf. Schlensky v. South Parkway Building Corp., 19 Ml. 2d
268, 166 N.E.2d 793 (1960). On appeal, plaintiffs did not
seek to support the District Court’s judgment with the fairness
analysis the Second Circuit adopted in Green v. Santa Fe In-
dustries, Inc., 533 F.2d 1283 (1976), decided by that court
Al4
after Judge Marshall's decision and reversed by the Supreme
Court after oral argument before us in the case at bar, Santa
Fe Industries, Inc. v. Green, 97 S.Ct. 1292 (1977). See also
Marshel v. AFW Fabric Corp., 533 F.2d 1277 (2d Cir.),
vacated and remanded for a determination of mootness, 97 S.
Ct. 228 (1976). Perhaps anticipating the Supreme Court's
reversal in Green, plaintiffs instead advanced an argument simi-
lar to the District Court’s rationale. They argued that self-
dealing by a corporate fiduciary that results in the sale of securi-
ties for a grossly inadequate consideration has been considered
fraud in connection with the sale of such securities since the
Second Circuit’s en banc decision in Schoenbaum v. Firstbrook,
405 F.2d 215 (1968), cert. denied, 395 U.S. 906 (1969), and
in this circuit since the decision in Jannes v. Microwave Com-
munications, Inc., 461 F.2d 525 (1972). See also Superin-
tendent of Insurance V. Bankers Life & Casualty Co., 404 U.S.
6 (1971). Thus, they argued, findings of a fiduciary duty and
gross unfairness in the price of securities sold to the-fiduciary
are sufficient to establish liability under Rule 10b-5, without
proof of deception or nondisclosure of material facts.
In light of the Supreme Court's decision in Green, the District
Court’s reasoning cannot stand, and the plaintiffs’ argument
must be rejected. In Green the Court pointed out that Schoen-
baum, and the cases following it, all “involved an element of
deception,” 97 S.Ct. at 1301 n.15, and thus “do not support
the proposition .. . that a breach of fiduciary duty by majority
stockholders, without any deception, misrepresentation, or non-
disclosure, violates the statute and the Rule.” Jd. at 1302. More-
over, in interpreting § 10b of the 1934 Act and Rule 10b-5
thereunder, the Court held that “once full and fair disclosure
has occurred, the fairness of the terms of the transaction is at
most a tangential concern of the statute.” The Court said that
“[A]bsent a clear indication of congressional intent,” it was
“reluctant to federalize the substantial portion of the law of
corporations that deals with transactions in securities” in order
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to create a parallel federal remedy for unfairness. Jd. at 1303-
1304.
While attempting to support the District Court’s reasoning
in the case at bar, plaintiffs have also argued that Heizer is
liable under Rule 10b-5 because it deceived the IDC stock-
holders, and thus IDC itself, by not informing them of the
terms of the fourth and fifth transactions. Heizer has replied
to this argument, both here and in the District Court. We are
of course free to affirm the District Court’s judgment on grounds
other than those relied upon by that court.® Dandridge v.
Williams, 397 U.S. 471, 475 n.6 (1970).
D. Violation of Rule 10b-5: Duty to Disclose and Materiality
1. The Fourth Transaction
In Birnbaum v. Newport Steel Corp., 193 F.2d 461 (2d
Cir.), cert. denied, 343 U.S. 956 (1952), Judge Augustus Hand
established the familiar principle, since adopted by the Supreme
Court, Blue Chip Stamps v. Manor Drug Stores, supra, 421
U.S. 723, that only a defrauded purchaser or seller has standing
to sue under Rule 10b-5. A corporation issuing securities, such
as the warrants here, is a “seller” of those securities for purposes
of the -Birnbaum rule, and its interest may be asserted in a
derivative action. E.g., Dasho v. Susquehanna Corp., 461 F.2d
11 (7th Cir.), cert. denied, 408 U.S. 925 (1972). When no
shareholder approval is required for the transaction, disclosure
9. We are not persuaded by plaintiffs’ argument that the District
Court made findings of fact on the issues of disclosure and control.
In denying defendant’s motion to dismiss at the close of plaintiffs’
case, Judge Marshall did say that he believed “the evidence at this
posture of the case would warrant findings in favor of the plaintiffs
with respect to nondisclosure, control by Heizer, unfairness with
respect to the fourth transaction and the pledge agreement.” But
he also stated that he had not “by any means started to make
up [his] mind on the total merits of the case” and had not weighed
the evidence. [Tr. 1518-1519.] Inasmuch as the judge did not men-
tion these issues in his published opinion, we cannot treat these
remarks as findings of fact subject to the “clearly erroneous” rule.
Al6
to the board of directors is disclosure to the corporation, at
least when, as here at the time of the fourth transaction, a
majority of the board is disinterested. Dasho v. Susquehanna
Corp., supra, 461 F.2d at 24-26. Compare Bailey v. Meister
Brau, Inc., 535 F.2d 982 (7th Cir. 1976). When shareholder
approval is required by state corporation law, however, it is
the shareholders who represent the corporation and it is they
who are entitled to disclosure of all material facts. See Dasho
Vv. Susquehanna Corp., supra, 461 F.2d at 24; Popkin v. Bishop,
464 F.2d 714, 720 (2d Cir. 1972); Sherrard, Fiduciaries and
Fairness Under Rule 10b-5, 29 Vanderbilt L. Rev. 1385, 1427
(1976). ” :
In the case at bar, one critical elemetit of the fourth trans-
action, the charter amendment increasing the number of author-
ized shares of common stock from three to seven million,
required shareholder approval.'® Under Delaware law, such an
amendment must be approved by a majority of the common
shareholders voting as a class. Del. Code Ann., Title 8, § 242
(c)(1) and (c)(2). Because Heizer held no common stock,
never having exercised any of its warrants, this requirement
meant that IDC’s independent shareholders had the power to
refuse the amendment and thereby block the entire transaction.
Before deciding whether to exercise this power, the shareholders
were entitled to full disclosure of all material facts concerning
the transaction.
The record indicates that full disclosure was not made. The
form of consent that plaintiff Peter Wright and other share-
holders signed and the notice to shareholders who had not
warrants for only 2.16 million, instead of 4,694,400, shares (three
million minus the approximately 840,000 shares held by independent
shareholders). Thus, Heizer could not have obtained a warrant
exercise price of less than $2.20 or a pro forma equity position
greater than 72 per cent. And, so long as the three million share
ceiling was maintained, additional convertible investments would
have merely increased the price per share rather than the number of
shares purchasable.
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signed were uninformative, stating only that the number of com-
mon shares would be increased from three to seven million by
action of the shareholders voting as classes. Jordon Ross, who
obtained all but one of the consents, testified that he told most
of the shareholders he spoke to that the amendment was neces-
sary for financing. The meetings were conducted hastily and the
only information he volunteered to anyone was the amount of
the financing involved. [Tr. 230-233.] Wright corroborated
Ross’ account, testifying that Ross did not tell him Heizer was
the source of the financing or that the deal involved anything
more than a simple purchase of steck. [Tr. 1405.]
In arguing a motion to dismiss at the close of plaintiffs’ case
in the District Court, Heizer contended that this disclosure was
sufficient. From the documents submitted to them, the share-
holders knew that there was a possibility that their equity position
could be seriously eroded. Heizer argued that this knowledge
should have prompted them to solicit more information from
Jordon Ross, who presumably had ready access to all the
material facts.
We find this argument unpersuasive. Although the share-
holders knew that dilution was a possibility, they did not know
what the terms of the transaction were, how Heizer had arrived
at the $1 per share valuation, or what alternative would be
available to IDC if the transaction could not be consummated.
Despite the reference to voting by classes, there is no evidence
that the shareholders knew that a majority of their votes were
necessary for passage of the amendment: knowing, as they ap-
parently did, that Heizer was a major power in the corporation,
they may have assumed that the 300,000 votes indicated for
Heizer at the bottom of the consent form were sufficient to
carry the proposal. All these facts would be “material” in the
sense that “there is a substantial likelihood that a reasonable
shareholder would consider [them] important in deciding how to
vote.” TSC Industries, Inc. v. Northway, Inc., 426 U. S. 438,
499 (1976). Indeed, without this information the shareholders
EE
Al8
could not possibly have made an intelligent decision on the
proposed charter amendment. To impose a duty of inquiry on
them under these circumstances would be to encourage con-
cealment rather than the full disclosure Rule 10b-5 requires.
Although Heizer did not control the IDC board at the time
of the fourth transaction, it assumed responsibility for the in-
adequacy of the disclosure when it undertook to control and
supervise IDC’s communications to its shareholders. Heizer’s
counsel, Bernard Kury, testified that he drafted the closing
documents for all four transactions, as well as whatever board
or shareholder resolutions he considered necessary for IDC’s
approval of the transactions. In the second and third trans-
actions, when he found notices of IDC shareholder meetings,
prepared by IDC counsel and mailed without his prior approval,
to have been inadequate, Kury himself drafted waiver of notice
forms and directed IDC counsel to have them signed by all the
shareholders. [Tr. 1092, 1105, 1109.]"' In the fourth transaction
he drafted the shareholder consents approving the increase in
the number of authorized shares, as well as the notice of share-
holder action that was mailed to those who did not sign the
consent form.
In the first three transactions Heizer was a lender to, and
shareholder of, a corporation it did not control and on whose
board it was not represented. We may assume that as such it
was entitled to act solely in its own interest in dealing with
IDC’s management, whose responsibility it was to advise the
shareholders. By the time of the fourth transaction, however,
Heizer had gained voting control of IDC and had placed two of
its officers on IDC’s board of directors. Thus it stood in a fiduciary
position and could no longer act for itself alone. When Heizer
chose to continue its participation in communications to the IDC
11. Letters from Kury to IDC’s counsel indicate that Kury
closely supervised the process of cbtaining these waivers, at one
point requiring IDC counsel to go back to some shareholders who
had replied by telegram to obtain their written signature. [PI.
Ex. 26-28.]
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shareholders, it owed them the duty of full disclosure. As we
have already noted, Heizer breached that duty by failing to
disclose any of the material facts concerning the transaction.
2. The Pledge Transaction
We turn now to the fifth, or pledge, transaction. Delaware
law specifically provides that no shareholder approval is neces-
sary to pledge a corporation’s assets. Del. Code Ann., title 8,
§ 272. Therefore, under Rule 10b-5 disclosure to IDC’s board
of directors would be sufficient, unless Heizer controlled the
board to such an extent that only the independent shareholders
were able to safeguard the corporation’s interests. Bailey v.
Meister Brau, Inc., supra, 535 F. 2d at 993. See also Dasho v.
Susquehanna Corp., supra, 461 F. 2d at 26.
Although the District Court made no findings to that effect, the
record indicates that Heizer controlled three of the four members
of IDC’s board for purposes of the pledge transaction. Two
directors were Heizer nominees. The third was Paul Roth, who
had recently been hired as president of IDC by the Heizer
directors, over the objection of the fourth director, Jordon Ross.
Heizer’s control over Roth is apparent from his trial testimony
that, although he was unsure why Heizer wanted the pledge
from a business standpoint.
“I was pretty much convinced that Heizer, you know,
would insist on the pledging of the stock, and that I didn’t
have a hell of a lot of alternative short of resigning if it
came to a matter of the pledge agreement.” [Tr. 1326.]
It is clear that Roth was not alone in his perception of the
situation: Edgar Heizer himself acknowledged that his company
had assumed control of IDC when Jordon Ross (in his opinion
irresponsibly) refused to hire Roth. [E. Heizer, Tr. 980.]
When an entire board of directors is controlled by a self-
dealing director or shareholder the corporation can only be
represented by the independent shareholders, to whom full dis-
closure must be made. See, e.g., Dasho v. Susquehanna Corp.,
A20
supra, 461 F. 2d at 26; Schoenbaum v. Firstbrook, supra, 405
F. 2d at 219-220; Pappas v. Moss, 393 F. 2d 865, 869 (3d Cir.
1968); Ruckle v. Roto American Corp., 339 F. 2d 24, 26, 29
(2d Cir. 1964). Conversely, where disinterested directors con-
Stitute a majority of the board of directors, disclosure to the
board is sufficient. Dash v. Susquehanna Corp., supra, 461 F. 2d
at 25. We are not aware of any prior case in which the court has
confronted the issue of who represents the corporation in the
middle situation presented here, where a majority, but not all,
of the directors are controlled.
In the first Dasho v. Susquehanna Corp., 380 F. 2d 262, 270
(7th Cir.), cert. denied, 389 U. S. 977 (1967), however,
Judge Fairchild, concurring in the court’s holding that the com-
plaint stated a cause of action, observed that it would not be
“sound to differentiate between situations where the directors
were unanimous in their wrongdoing and those where less than
all were involved.” And in Bailey v. Meister Brau, Inc., supra.
535 F. 2d at 993, the court, while dealing with a situation in
which the board was completely controlled, stated the general
principle of law as follows:
“Where the controlling stockholder causes the corporation
to engage in a securities transaction in which the stock-
holder has a conflict of interest, it has the obligation to
disclose to the other stockholders information in its pos-
session which reflects on the fairness of the transaction.”
Whether this rule, which is somewhat broader than the facts
required, is to be automatically applied in all the cases it appears
to describe, we need not decide. It should be applied here,
where the lone minority director did not represent the interests
of the second largest common shareholder and was completely
excluded from the negotiation of the transaction. Under these
circumstances, Heizer was obliged to disclose the material facts
concerning the transaction to the independent shareholders prior
to its consummation. This obligation was not fulfilled: the
shareholders were first informed of the general terms of the
pledge and the reasons therefore two months after the trans-
A21
action. Thus, we hold that Rule 10b-5 was also violated by
Heizer’s failure to disclose material facts to the corporation in
the fifth transaction.
E. The Private Cause of Action: Reliance and Scienter
In addition to proof of a technical violation of Rule 10b-5,
a plaintiff in a private action based on the rule must also prove
two elements traditionally associated with a common law action
for fraud: he must show, first, that the defendant caused the
alleged harm by inducing him to rely on material misstatements
or misrepresentations and, second, that, in doing so, the de-
fendant intended to deceive, manipulate, or defraud. Ernst
& Ernst v. Hochfelder, 425 U.S. 185 (1976).
1. Reliance
In the ordinary 10b-5 case involving a failure to disclose,
proof of materiality is sufficient to establish reliance. Affiliated
Ute Citizens v. United States, 406 U. S. 128, 153 (1972). In
other words, courts will not attempt to determine whether the
individual investor, once fully informed, would have refused to
consummate the proposed transaction. Instead, reliance is
presumed if the omitted information “would have been viewed
by the reasonable investor as having significantly altered the
‘total mix’ of information made available.” TSC Industries, Inc.
v. Northway, Inc., supra, 426 U. S. at 449.
In the transactions before us, in which the corporation itself
is the “reasonable investor,” we have held that the minority
shareholders represented the corporation for 10b-5 purposes. If
these shareholders would have been powerless to prevent the
proposed self-dealing by the controlling shareholder even if they
had possessed knowledge of all the facts, the failure to disclose
to them would presumably be immaterial and reliance could not
be shown. See Santa Fe Industries v. Green, supra, 97 S. Ct. at
1301 n.14. But that was not the case with either the fourth or
fifth transactions in the case at bar.
A22
In the fourth transaction, the shareholders had the power
under state law to veto the transaction entirely. Thus, under the
rationale of Affiliated Ute Citizens, proof of materiality is suf-
ficient to establish reliance. Cf. Mills v. Electric Auto-Lite Co.,
396 U. S. 375 (1970).” In the fifth transaction, the minority
shareholders would have had the right to bring a derivative
action in the state court on behalf of the corporation to enjoin
any breach of Heizer’s fiduciary duty to deal fairly with the
corporation. In such an action, there would be a heavy burden
upon the self-dealing fiduciary to demonstrate that the trans-
action was fair to the corporation. Cf. Shlensky v. South Park-
way Building Corp., supra, 19 Ill. 2d 268, 166 N. E. 2d 793.
Thus, again applying the principle underlying Affiliated Ute
Citizens, in a 10b-5 action brought derivatively on behalf of the
corporation by minority shareholders to whom the self-dealing
controlling shareholder failed to make disclosure, if the con-
trolling shareholder cannot demonstrate that the transaction is
fair to the corporation, the requisite materiality is shown and
reliance is to be presumed.** The minority shareholders are thus
afforded the same right they would have had if full disclosure had
been made, i.e., the right to obtain a judicial determination of
the fairness of a transaction forced upon the corporation by
a controlling shareholder with a conflict of interest. The exist-
ence of a causal link between Heizer’s technical violation of
Rule 10b-5 and the consummation of the pledge transaction
depends, therefore, on the fairness of the transaction.
Heizer argues that the pledge should be sustained because it
had no obligation to extend a loan to IDC and without the
12. In Mills, the Court held that proof of unfairness is not
required to show that plaintiffs relied on misrepresentations in proxy
materials. In footnote 7 of its opinion, 396 U.S. at 385, the Court
specifically reserved the question of what standard would be applied
in cases where the majority had sufficient voting strength to carry the
proposal but nevertheless sought proxies from the minority through
proxy statements containing material misstatements or omissions.
13. A fairness analysis has always been ied in 10b-5 deriva-
tive actions, see, e.g., Schoenbaum Vv. First , supra, 405 F.2d at
219; Bailey v. Meister Brau, Inc., supra, 535 F.2d at 993, although
without any articulation of the basis for doing so.
ee) eee
Sn em Dp
Oe ee ee eee
A23
pledge it never would have loaned the funds necessary to con-
tinue the monitoring business. It is at least doubtful, however,
that Heizer would have chosen to sacrifice the profit potential
of that business, in which it had already invested $5.5 million,
merely because it was denied a pledge which, by its own ad-
mission, was not necessary to secure repayment of its loans.
[Tr. 933, 936-937.] But more importantly, Heizer forgets that,
in view of its conflict of interest, once it chose to deal with
IDC, it had an obligation under state law to structure the
transaction in a manner consistent with its duty to “protect and
preserve the corporation. . . . maintain[ing) a high standard of
loyalty to [it].” State ex rel. Farber v. Seiberling Rubber Co.,
53 Del. 295, 168 A.2d 310 (1961). In light of this obligation,
its attempt to divorce its role as a creditor from its role as a
fiduciary, in 2 transaction that required its consent in both
capacities, cannot succeed. See Todd v. Temple Hospital Asso-
ciation, Inc., 273 P. 595, 597, 96 Cal.App. 42 (1928). Allow-
ing such a sleight of hand would render a fiduciary’s duty of fair
dealing meaningless whenever the corporation he served was in
financial straits, because he could defend his conduct, as Edgar
Heizer did on the witness stand in this case, by arguing that in
his role as a fiduciary he was powerless to resist the demands
he himself had made in his role as a creditor."
Given the obvious risks of unfairness created by Heizer
Corporation’s limited view of its fiduciary responsibility, the
presumption of unfairness applied by the District Court was par-
ticularly appropriate. As the court noted, Heizer’s explanations
for the pledge did not overcome that presumption. Heizer sought
to justify the pledge first as a device to discourage what it con-
sidered to be a nuisance suit, which, by calling into question
Heizer’s right to exercise its warrants to purchase common stock,
14. Heizer stated: “Well, it’s very hard, as you know, to separate
your hats, but the way I had to look at it from Heizer Corporation's
standpoint first, it was totally justified that we have security.
“Then, wearing my IDC hat as a director, I don’t have very much
choice. . . . I knew what Heizer Corporation would do if I didn't
agree to give the security to Heizer Corp.” (Tr. 933-934.]
A24
prevented IDC from effecting the recapitalization it needed in
order to attract outside financing. Assuming that IDC genuinely
needed such protection, nevertheless Heizer’s method of dis-
couraging the suit was inconsistent with its duty to deal fairly
with the minority. In threatening foreclosure on the pledge,
Heizer was threatening to use a power acquired through its
control of the corporation for the purpose of excluding the
independent shareholders from further participation in IDC’s
business. Such a “freeze out” of the minority would appear to
be a breach of fiduciary duty under Delaware law. See Condec
Corp. v. The Lunkenheimer Co., 43 Del. Ch. 353, 230 A.2d
769, 775 (1967).
The second explanation Heizer advances for the pledge does
not even purport to be connected with IDC’s welfare. Plaintiffs’
suit threatened the flexibility Heizer had gained through the
first four transactions, to maintain its senior position or to
convert its holdings into common stock: if plaintiffs were suc-
cessful and Heizer was prohibited from exercising its warrants
at what it considered to be a reasonable price, Heizer would be
effectively locked into a senior position. Edgar Heizer testified
that, under those circumstances, it would want to have the kind
of security a conservative lender, such as a bank, would require
to cushion its investment.
Under Delaware law, Heizer would have breached its fiduciary
duty by using its power over the corporate machinery to effect
a transaction intended solely to maintain or increase its control
over the corporation. See, e.g., Bennett v. Propp, 41 Del. Ch. 14,
187 A.2d 405 (1962). In this case Heizer’s conduct in using its
control of IDC to protect itself in the event that it was found to
have deceived the corporation was at least equally improper.
Thus, we agree with the District Court’s conclusion that the
pledge was unfair and find the element of reliance to have been
properly established in the fifth, as well as the fourth, trans-
action.
A25
2. Scienter
The final element of a private cause of action under Rule
10b-5 is scienter, defined in Ernst & Ernst v. Hochfelder, supra,
425 U.S. 185, to exclude mere negligence. That case left open
the question of whether recklessness is enough. In Sundstrand
Corp. V. Sun Chemical Corp., No. 76-1316, et al. (February 23,
1977). this court held that it is. See also Sanders v. John Nuveen
& Co., No. 74-2074, et al. (7th Cir. April 22, 1977) (Sanders
II). The District Court in the case at bar, while characterizing
Heizer’s conduct in the fourth and fifth transactions as “rapa-
cious,” made no other findings cencerning defendant’s mental
state in failing to disclose. The record, however, indicates that
defendant’s omissions were at least reckless.
In Sundstrand and again in Sanders I] this court quoted with
approval the definition of recklessness in the context of an
omission in Franke v. Midwestern Oklahoma Development
Authority, 428 F.Supp 719, 725 (W.D. Okla. 1976):
“reckless conduct may be defined as a highly unreasonable
omission, involving not merely simple, or even inexcusable
negligence, but an extreme departure from the standards of
ordinary care, and which presents a danger of misleading
buyers or sellers that is either known to the defendant or
is so obvious that the actor must have been aware of it.”
Heizer’ failure to disclose any of the terms of the fourth
transaction was “highly unreasonable.” Heizer knew that the
proposed transaction was controversial: a Heizer vice-president
testified that during negotiations “Joe Mitchell [president of
plaintiff Beneficial] screamed adamantly that he didn’t think
{it) was a fair deal,” [Tr. 1968] and threatened suit if the
transaction was consummated. Yet Kury, Heizer’s counsel who
had been delegated to oversee the approval procedure, did not
include any mention of the transaction in the written consents
or an adequate description of it in the notice to shareholders
who had not signed, never gave Jordon Ross any instructions
on what he should tell the shareholders when he orally
A26
solicited their consents, and failed to ask Ross what he had said
when he returned, approximately a day and a half later, with
the signed consent forms. [Tr. 1144, 1147.] Instead, Kury and
Heizer officers testified that they assumed the shareholders
would know what was going on because they were Ross’ friends
and business associates [e.g., E. Heizer, Tr. 734-737] and be-
cause, in the past, those who spoke at the shareholders’ meet-
ings had always appeared well-informed. [E. Heizer, Tr. 748.]
At trial IDC’s outside counsel testified that Jordon Ross had
told him and Kury that, because the shareholders were his
friends, he would be able to get their signatures in the short
period of time available. [Tr. 1785.] On its face this statement
implies that consents would be solicited on the basis of friend-
ship rather than on the basis of properly disclosed facts. The
shareholders’ natural tendency to trust Ross’ judgment would
be further enhanced by the fact that Ross, who was the single
largest shareholder, would seem to be the most vitally con-
cerned with the corporation’s welfare. Heizer officers had already
decided that Ross was a gifted salesman, with an unfortunate
tendency, however, to be unrealistic about IDC and its prospects
for acquiring outside financing. [See, e.g., Pl. Ex. 66.] Thus,
even if he did disclose some facts about the transaction, he
could be expected to present them in the most attractive light
possible. Under these circumstances, delegating Ross to solicit
consents without any instructions whatsoever constituted “an
extreme departure from the standards of ordinary care” that
defendant should have observed in discharging its duty of in-
suring full and fair disclosure.
Heizer’s conduct in the fifth transaction also bespeaks a
reckless disregard of its duty to disclose. Heizer must have been
aware that the pledge was for its own benefit and thus would
arouse a great deal of opposition on the part of IDC’s com-
mon shareholders. Yet it consciously decided, through Heizer
counsel, not to take the proposal to the shareholders. The effect
of this decision was to insure that at least plaintiff Beneficial,
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A27
who no longer had a representative on IDC’s board of direc-
tors, would not learn of a transaction admittedly designed, in
part at least, to discourage its suit until after its consummation.
We think this is a case for the application of the reasoning of
the distirct court, adopted by this court in Bailey v. Meister
Brau, Inc., supra, 535 F.2d at 993:
“(Blinded by a conflict of interest, [defendant] wantonly
ignore[d] evidence of the unfairness of [the] securities
transaction to the corporation and therefore fail[ed] to dis-
close this evidence to those shareholders whose interests
lie with the corporation.’ ”
F. Relief
1. Unraveling Past Transactions.
In granting relief in a case such as this, a court of equity
should attempt to return the parties to the status quo ante, un-
raveling transactions effected through violations of Rule 10b-5
to the extent that it may do so fairly and without injuring the
rights of innocent parties. See Mills v. Electric Auto-Lite Co.,
supra, 396 U.S. at 388. Heizer agrees that, if its conduct in the
fourth transaction violated Rule 10b-5, the District Court was
correct in cancelling the conversion feature of, and any price
adjustment effected through, that transaction. Another con-
sequence of the fourth transaction that may also be easily un-
raveled is the IDC charter amendment permitting an increase
in the number of authorized common shares.
With respect to the fifth transaction, Heizer again agrees
that the pledge should be nullified if its conduct in obtaining it
was wrongful. We, however, would hold the pledge void even
if Heizer’s conduct in the fifth tranaction was not in itself ac-
tionable under Rule 10b-5. As we noted above, the pledge was
designed to discourage the instant suit and to protect Heizer’s
position in the event it was found to have deceived the cor-
poration. Thus, in a sense, the pledge was a consequence of the
A28
violation, and, like other, more direct consequences, should be
dispelled insofar as possible. Voiding the pledge would injure
no innocent party « id would be consistent with a state law
fiduciary analysis, s 2 supra. Therefore, whether as an inde-
pendent violation or a consequence of the violation in the fourth
transaction, the pledge was properly nullified by the District
Court.
Pursuant to the improperly disclosed fourth and fifth transac-
tions, Heizer also extended approximatley $3 million in short-
term or demand loans to IDC. In his opinion, the district judge
did not modify these obligations in any wav, although he did
enjoin Heizer from dealing unfairly with IDC in the future. After
his opinion was filed, Heizer presented a recapitalization plan
to IDC’s common shareholders. In a proxy solicitation mailed
to those shareholders, Heizer pointed out that “IDC does not
have the financial resources necessary to repay all of the debts
currently due and payable to Heizer,” and threatened to put
the company into bankruptcy if the plan was not approved.
On plaintiffs’ motion, the district judge enjoined the con-
summation of this plan pending appeal, observing that the
proposal itself appeared unfair. He also enjoined Heizer from
collecting interest or principal on its loans to IDC.
Plaintiffs too complain of the District Court’s disposition
with respect to the demand loans. By way of a “Petition for
Supplemental Relief,” filed with the District Court on May 6,
1975, prior to the issuance of the court’s opinion, but after
the court had indicated to the parties what its decision would
be, plaintiffs argued that these loans were in themselves an im-
position on IDC’s common shareholders and as such should be
cancelled or reformed into common stock. In their petition
plaintiffs also sought a permanent injunction to prevent Heizer
from attempting to enforce any of the demand notes issued by
IDC after November 19, 1971.
In May, 1975, the court stated that the petition would be
taken under advisement. In its opinion issued on December 3,
|
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A29
1975, however, the court specifically denied one of plaintiffs’
requests for relief, but failed even to mention the relief they
had sought with respect to the demand loans. On January 6,
1976, plaintiffs attempted to reiterate their petition for supple-
mental reliet by filing a motion to require defendant to answer.
On May 28, 1976, after a remand from this court ordered for
the purpose of enabling the District Court to rule on the peti-
tion and other still pending matters, that court finally denied
plaintiffs’ petition on the ground that it
“was mooted by or merged into the December 3 decree
and the renewed petition was an untimely effort to modify
the decree. Rule 59(e), Fed. R. Civ. P.”
Heizer argues that the District Court’s finding of untimeliness
or merger was correct and that, inasmuch as plaintiffs failed to
appeal from the December 3rd decree, we are without jurisdic-
tion to consider the merits of plaintiffs’ claim. In our opinion
as originally issued we stated, without giving reasons, that we
agreed with this position. On further consideration, however,
we believe we were incorrect. Inasmuch as neither the opinion
nor the decree of December 3, 1975 mentioned the petition for
supplemental relief and concededly did not dispose of the entire
case (a finding under Rule 54(b), Fed. Rev. Civ. P. was in-
cluded in the decree), and plaintiffs were not notified until
May 28, 1976 of the District Court’s view that it had ruled
on the petition sub silentio, we think the decree should not be
construed as having had that effect. It would be overly technical
and unjust to hold that plaintiffs lost their right to appeal a
ruling before they knew it had been made. Such a result is not
required by anything in the Federal Rules of Civil Procedure
and would be contrary to the admonition of Rule 1 that those
rules “be construed to secure the just . . . determination of
every action.” We therefore consider the merits of the supple-
mental petition.
The loans themselves should not be subordinated unless it
was unfair for Heizer to continue the monitoring business or to
A30
finance that business by extending loans rather than by con-
tributing equity capital. On the first issue, in the absence of a
finding by the District Court, we cannot say that Heizer’s con-
tinuation of the monitoring business, which after all also in-
volved risk to itself, was unfair to the corporation or the
minority shareholders. And, insofar as the second issue is con-
cerned, there is no requirement under state law that a fiduciary
who agrees to provide financing must do so by means of an
equity investment. Thus, the only inquiry that remains is whether
the terms of the loans, apart from the convertibility feature and
the security that have already been nullified, were fair to IDC
and its common shareholders.
The combined effect of the short-term or demand maturity
features of the loans made after the third transaction was to
give Heizer the right to obtain a lion’s share of the equity in
IDC if the monitoring effort was successful and, if that effort
was not successful, the power to recoup promptly its entire
investment by calling the loans and putting IDC into bank-
ruptcy. It is perhaps not inconceivable that fully informed
minority shareholders would have jeopardized their indirect
interest in the valuable T&R business for the prospect of a small
interest in the increasingly dubious monitoring venture, and,
to gain that end, would have placed themselves at the mercy
of Heizer by entering into the fourth transaction and the ensuing
loans. This possibility is not enough, however, to satisfy the
burden of the self-dealing controlling shareholder to demon-
strate the fairness of this heads-l-win-tails-you-lose series of
transactions. The maturity features of the loans were hardly
consistent with Heizer’s duty to deal fairly with the corporation
and its shareholders. See Baron v. Allied Artists Pictures Corp.,
337 A. 2d 653, 658 (Del. Ch. 1975), appeal dismissed, 365
A. 2d 136 (1976). Thus, in order to unravel in an equitable
manner the transactions resulting from Heizer’s wrongful con-
duct, the maturities of the loans should be adjusted to make
oo
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A3l
them commensurate with IDC’s ability to pay.’* On remand,
the District Court should make the necessary determinations and
modify the terms of the loans accordingly.’®
From this disposition, it follows that the District Court was
correct in enjoining Heizer from seeking to collect its loans or
coercing agreement to its recapitalization plan by threatening
collection pending appeal.**
15. This relief does not seem unduly harsh. The monitoring
program has been dropped and T&R has always been a growing,
profitable company; with T&R’s earnings sheltered by IDC’s loss
carryovers, IDC should be able to pay back the loans eventually.
16. Ordering this relief is not inconsistent with the principle
relied upon by Heizer in its petition for rehearing and declared in
Morley Construction Co. vy. Maryland Casualty Co., 300 U.S. 185
(1937), that the rights of the appellee may not be enlarged in the
absence of a cross-appeal. Statements made by the district judge at
hearings on June 9 and June 18, 1975, and the relief granted by him
pending appeal, viz., enjoining Heizer from collecting or threatening
to collect its loans, indicate that he believed efforts by Heizer to
enforce the present maturities were forbidden by paragraph 5 of the
decree, which permanently enjoins Heizer “from entering, directly
or indirectly, into any transaction with IDC except upon such terms
and conditions as shall be fair and equitable.” He obviously viewed
his prohibition, pending appeal, against enforcing the existing
maturity provisions of the notes as not exnanding that relief. In any
event alteration of the maturities is within our power to order as a
lesser included form of one kind of relief sought in the petition for
supplemental relief, viz., a complete prohibition against enforcement
of those notes. The denial of relief under that petition is the subject
of the appeal in No. 76-1700.
17. Heizer’s procedural attack on that injunction is without
merit. In light of our modification of the demand loans, Heizer was
not prejudiced by the denial of “the chance to present expert wit-
nesses to explain how the recapitalization plan operated and how it
was fair to all parties concerned.” The only relevant evidence,
Heizer’s communication to the IDC shareholders, was before the
District Court. Heizer also argues that plaintiffs should have been
required to post bond. As plaintiffs point out, however, it was
defendant who was acting under a permanent injunction and who
nevertheless sought to change the status quo. Moreover, in view of
our affirmance of the District Court’s order, any error in not requir-
ing a bond would have been harmless.
A32
2. Prospective Relief
Paragraph 5 of the decree permanently enjoins Heizer “from
entering, directly or indirectly, into any transaction with IDC
except upon such terms and conditions as shall be fair and
equitable.” Heizer argues that this provision is too vague to
comply with the requirement of Rule 65(d), Fed. R. Civ. P.,
that “Every order granting an injunction . . . shall be specific
in terms [and] shall describe in reasonable detail . . . the act
or acts thought to be restrained,” because it “cannot possibly
know how to conform its conduct to Paragraph 5,” which
would require it “to try to predict whether its evaluation of its
conduct will coincide with that [of] Judge Marshall—or whoever
else might be called upon to judicially decide what is ‘fair and
equitable.’ ”
in determining the appropriate prospective relief, we must
consider, on the one hand, the specificity requirement of Rule
65(d), on which Heizer relies, and, on the other, the difficulty
of predicting the form of possible future undisclosed, unfair
transactions which may result from Heizer’s conflict of interest
as the major creditor and controlling stockholder of IDC. There
is a sufficient basis for the District Court’s determination that
some kind of restraint on future abuses is warranted, but Heizer
must be specifically apprised of what is forbidden.
We must also consider whether an injunction requiring ad-
vance disclosure of any proposed transaction between IDC and
Heizer would be sufficient, or whether the decree should address
itself in any way to the substance of future transactions. Where
the independent shareholders have the power under state law
to approve or disapprove a transaction, fairness is, as we have
said, irrelevant under Rule 10b-5. In that case, an injunction
requiring full disclosure of all material facts concerning a self-
dealing securities transaction would be sufficient. But where the
self-dealing fiduciary controls the corporate voting machinery,
the materiality of any future failure to disclose challenged under
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A33
Rule 10b-5 will depend, as we have also seen, upon its fairness.
If such a transaction were challenged in an independent federal
action, a determination of unfairness, coupled with the breach
of the 10b-5 duty to disclose, would lead the federal court to
prohibit or set aside the transaction. As is apparent from our
approval of the unravelling of the fourth and fifth transactions,
we do not view Green as requiring the federal court merely to
declare the breach of the duty to disclose and send the plain-
tiff to the state court to remedy the unfairness. The preventive
prospective relief should not be narrower in scope than the
relief that could be obtained in a new federal action to remedy
the future wrong.
In light of the foregoing considerations, paragraph 5 of the
decree should be deleted, and Heizer should be enjoined from
failing to disclose to the common shareholders any material
facts concerning future transactions it proposes to enter into,
directly or indirectly, involving securities of, or held by, IDC.
Specifically, Heizer should be required to disclose all facts bear-
ing on the fairness of such a transaction, including its own valua-
tion of the company and its future prospects. Furthermore,
Heizer should be enjoined from entering into, directly or in-
directly, any securities transaction with IDC unless that trans-
action has been approved by a majority of the shareholders
other than Heizer or, failing such approval, has been found to
be fair and equitable by the District Court or another court
having jurisdiction to make such a finding. The foregoing relief
makes more specific but does not expand the relief granted by
the District Court: Heizer will thus be able to avoid the necessity
of obtaining judicial approval for its self-dealing, but will not
be foreclosed from using its voting power to approve a fair
transaction which the common shareholders have capriciously
rejected.
Heizer also argues that the District Court’s decree enjoins
the future operation of its antidilution or price-adjustment clause
in the warrants obtained in the first three transactions and
A34
prohibits it from purchasing IDC stock, at any time in the
future, for less than $3.60 per share. Plaintiffs read the District
Court’s order less broadly, arguing that it merely cancels the
warrants in the fourth transaction and prohibits Heizer from
using its price-adjustment provision unfairly in the future.
We think that the court’s order is susceptible to the interpre-
tation advanced by Heizer.’* And we agree with Heizer that it
would be inappropriate to limit the future warrant exercise price,
in light of the District Court’s determination, not challenged
here, that the antidilution provisions in the first three sets of
warrants were not improperly acquired. Moreover, as we have
already held, federal law does not impose a limitation on the
substantive terms of any future transaction which IDC’s com-
18. Paragraph 2 of the decree, which plaintiffs quote in their
brief, nullifies the future effect of warrants acquired through the
fourth transaction and returns the parties to their positions prior to
that transaction. Two subparagraphs, however, seem to go beyond a
simple unraveling of the fourth transaction in permanently enjoining
Heizer from
“(a) Exercising or attempting to exercise, directly or indirectly,
any warrants to purchase shares of common stock of IDC, at an
exercise price of less than $3.60 per share; and
(b) Issuing or attempting to issue, directly or indirectly, any
shares of common stock of IDC at a price of less than $3.60
per share upon the exercise of any warrants held by Heizer
Corporation . . . to purchase shares of common stock of IDC.”
Paragraph 3 also seems to refer to the antidilution clauses of the first
three transactions:
“In any transaction . . . between Heizer Corporation . . . and
IDC, from and after the date hereof, no provision contained in
any agreement heretofore entered into which authorizes or
permits an adjustment in the purchase price of any outstanding
warrants to purchase IDC common stock, shall be of any force
or effect. . . . Nothing herein contained shall prohibit Heizer
Corporation from otherwise purchasing securities from or lend-
ing money to IDC under such terms and conditions as shall be
fair and equitable.”
The district judge’s remarks at the June 18, 1976 hearing on plain-
tiffs’ motion for an injunction pending appeal also indicated that he
intended the decree to freeze the warrant exercise price at $3.60
per share.
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A35
mon shareholders are free to approve or disapprove.’® On re-
mand, the judgment will therefore be modified to so state.
II.
The Individual Claim
In No. 76-1701, plaintiff Beneficial appeals from the Dis-
trict Court’s order of May 28, 1976 granting summary, judg-
ment to defendants on count III of the second amended com-
plaint. In that count Beneficial alleged that in January 1969 it
purchased a five-year, $435,000 debenture, convertible at its
option to 21.25% of IDC’s common stock. The agreement
between Beneficial and IDC provided that
“ .. it shall be mandatory upon BSC to convert the afore-
mentioned debentures on or before the filing by IDC of
the necessary documents and an ‘S-1’ statement with the
Securities and Exchange Commission which sets forth
that IDC earnestly desires and seeks to make a public
offering of its common stock in a minimum amount of
Two Million Dollars.”
A notice provision was included, requiring IDC to serve Bene-
ficial with a copy of its registration statement and resolutions
authorizing it ten days before filing. Plaintiff submitted exhibits
and affidavits showing that there was a verbal understanding
that, if the debenture was converted to facilitate a public offer-
ing and no such offering was made, it would be reconverted to
a debenture.
On July 8, 1969, plaintiff was told by an attorney repre-
senting IDC that it was necessary for it to convert immediately
19. The decree will not, of course, prevent a minority share-
holder who contends that a proposed transaction is an unfair exercise
of the self-dealing fiduciary’s control from so asserting in a state
court action, even though it has been by the other minority
shareholders. The claims in this action being federal, the relief
granted is designed only to vindicate federal rights.
A36
in order for the public offering to progress. Plaintiff alleges
that this representation was false”? and was made
“
. in order to induce it to convert its debenture at its
option, pursuant to the voluntary conversion provisions of
said debenture agreement, and to make it unnecessary for
IDC to invoke the mandatory conversion provision of said
debenture agreement. The intent and purpose of IDC in
so inducing BSC to voluntarily convert its debenture was
to make such conversion irrevocable and to deprive BSC
of its right to cancel and rescind such conversion in the
event that the proposed public offering failed.”
IDC filed a registration statement on July 23, 1969. The state-
ment not having become effective by October Ist of that year,
Beneficial demanded reconversion of its debenture. IDC as-
sured it that the offering was proceeding and allegedly agreed
to return the debenture if the offering did not go through. On
November 1, 1970 Beneficial was informed that IDC’s registra-
tion statement had been withdrawn. This action was filed on
October 11, 1972.
In an unreported memorandum opinion the District Court
granted IDC’s motion for summary judgment on the grounds
that, the fraud having been discovered on October 1, 1969, the
action was barred by the three-year statute of limitations, Ill.
Rev. Stat. ch. 121%, § 137.13(D), see Parrent v. Midwest Rug
Mills, Inc., 455 F.2d 123, 125 (7th Cir. 1972), and that, even
if it were not barred, Beneficial had failed to establish a prima
20. Plaintiff also alleges that there were false representations
that a firm underwriting agreement existed, that the registration
statement would become effective, and that the — offering would
be consummated. There was a letter of intent from an underwriting
firm, conditioning its support cf the offering on the effectiveness of
the registration statement and general market conditions. Any rep-
resentations as to future events would have to be based on similar
assumptions of favorable market conditions and favorable business
operations for IDC. Plaintiff, however, does not allege that the public
offering was a sham intended to induce it to convert its debenture,
nor does not allege any cause for IDC’s failure to make a public
offering. Rather, it rests its claim on the distinction between a volun-
tary and a mandatory conversion, discussed below.
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A37
facie case that it had been injured by the alleged misrepresenta-
tions. We affirm this ruling.
Plaintiff argues that IDC should be estopped from claiming
that the action was time-barred because plaintiff was induced
to forego filing suit by IDC’s representations that it would reissue
the debenture if there was no public offering. Even assuming
that the facts support plaintiffs claim of reasonable reliance
on an offer of settlement, we think the district judge was correct
in finding that plaintiff was not injured by the alleged mis-
representation.
Plaintiffs contention that the conversion was not required
by the mandatory conversion provision of the agreement, and
was therefore “voluntary” and induced by misrepresentation, is
based on IDC’s failure to give the notice called for in that pro-
vision. The conversion was not voluntary in the sense that Bene-
ficial had decided to convert for its own reasons. IDC was
clearly invoking the provision of the contract requiring con-
version in the event of a public offering. A defect in the notice
or demand given by IDC would not affect the duty to convert.
The failure to observe the notice requirement, had it been raised
at the time, could have been cured. Beneficial, however, waived
the notice requirement by not insisting upon it at the time of the
transaction and proceeding without the required notice. The
other conditions upon which a duty to convert would arise were
satisfied within two weeks after the conversion took place.*'
Beneficial could not have been injured by being induced to do
something which it would have been required to do two weeks
later in any event. Any undertaking by IDC to allow recon-
version might give rise to a claim under state law, but not under
Rule 10b-5.
The District Court’s decree of December 3, 1975 is in part
affirmed and in part vacated with directions to modify. The
21. A registration statement as described in the agreement was
prepared (and a draft was forwarded to Beneficial before filing) and
filed with the SEC together with other necessary documents.
A38
order of May 28, 1976 is affirmed insofar as it entered summary
judgment in favor of IDC on Count III of the complaint and
modified insofar as it dismissed the petition for supplemental
relief. The case is remanded to the District Court for further
proceedings consistent with this opinion. In Nos. 1140, 1700,
and 1702, which were briefed together, plaintiffs shall recover
costs against Heizer. In No. 1701, IDC shall recover costs
against Beneficial.
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A39
ORDER OF THE COURT OF APPEALS,
SEPTEMBER 9, 1977.
UNITED STATES COURT OF APPEALS
For the Seventh Circuit
Chicago, Illinois 60604
September 9, 1977.
Before
Hon. Latham Castle, Senior Circuit Judge
Hon. Philip W. Tone, Circuit Judge
Hon. Harlington Wood, Jr., Circuit Judge
PETER WRIGHT and BENEFICIAL
STANDARD CORPORATION,
Plaintiffs-A ppellants, Appeals from the
Cross-Appellees, United States Dis-
trict Court for the
Nos. Lang sey A or came VS. Northern District of
P Illinois, Eastern Di-
THE HEIZER CORPORATION, Viss0n.
Defendant-Appellee, No. 72-C-2536
Cross-Appellant, and | Prentice H, Marshall,
INTERNATIONAL DIGISONICS Judge.
CORPORATION,
Defendant-A ppellee. J
These causes came on to be heard on the transcript of the
record from the United States District Court for the Northern
District of Illinois, Eastern Division, and were argued by
counsel.
On consideration whereof, it is ordered and adjudged by
this court that the judgment of the said District Court in these
causes appealed from be, and the same is hereby: The District
A40
Court’s decree of December 3, 1975 is in part AFFIRMED and
in part VACATED with directions to modify. The order of May
28, 1976 is AFFIRMED insofar as it entered summary judg-
ment in favor of IDC on Count III of the complaint and modi-
fied insofar as it dismissed the petition for supplemental relief.
The case is REMANDED to the District Court for further pro-
ceedings consistent with this opinion. In Nos. 76-1140, 76-1700
and 76-1702, which were briefed together, plaintiffs shall recover
costs against Heizer. In No. 76-1701, IDC shall recover costs
against Beneficial. The aforegoing is in accordance with the
opinion of this court filed this date.
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ORDER OF THE COURT OF APPEALS,
SEPTEMBER 9, 1977.
UNITED STATES COURT OF APPEALS
For the Seventh Circuit
Chicago, Illinois 60604
September 9, 1977.
Before
Hon. Latham Castle, Senior Circuit Judge
Hon. Philip W. Tone, Circuit Judge
Hon. Harlington Wood, Jr., Circuit Judge
PETER WRIGHT and BENEFICIAL )
STANDARD CORPORATION,
Plaintiffs-A ppellants,
Cross-A ppellees, Appeals from the
United States Dis-
Nos. 76-1140, 76-1700, trict Court for the
76-1701 & 76-1702 Sede Geman Oe
THE HEIZER CORPORATION, ——
Defendant-A ppellee, No. 72-C-2536
Cross-Appellant,and | Prentice H. Marshall,
Judge.
INTERNATIONAL DIGISONICS
CORPORATION,
Defendant-Appellee. J
ORDER RULING ON PETITION FOR REHEARING.
The modified opinion and judgment of this date are ordered
filed and entered.
The opinion and judgment heretofore filed and entered in
this cause having been modified in the respects shown in the
modified opinion and judgment, which supersede the original
opinion and judgment, the petition for rehearing is denied ex-
cept to the extent that any relief requested in the petition may
be granted in the modified opinion.
A42
OPINION OF THE DISTRICT COURT,
DECEMBER 3, 1975.
IN THE
UNITED STATES DISTRICT COURT
For the Northern District of Illinois
Eastern Division
PETER WRIGHT and BENEFICIAL _
STANDARD CORPORATION,
Plaintiffs,
VS.
> No. 72 C 2536
THE HEIZER CORPORATION and
INTERNATIONAL DIGISONICS
CORPORATION,
Defendants.
4
MEMORANDUM DECISION.
This action presents questions concerning the class of persons
who may maintain a private action for equitable relief under
Rule 10b-5 of the Securities and Exchange Commission; the
scope of the substantive provisions of that Rule; and the appro-
priate equitable relief to be granted in light of the violations of
the Rule which have been proved.
The case was tried without a jury’ prior to the Supreme
Court’s decision in Blue Chip Stamps, et al. Vv. Manor Drug
Stores, 421 U.S. 723 (1975). There the Court gave limited
1. When plaintiffs withdrew their jury demand, defendant Heizer
demanded trial by jury. Heizer’s demand was denied because all of
the relief sought is equitable and all of the issues of fact raised by the
pleadings are of a nature which can be tried by a chancellor without
a jury consistent with the Seventh Amendment. Cf. Ross v. Barnhard,
396 U.S. 531 (1970).
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A43
approval to the Birnbaum? purchaser-seller limitation on the
class of persons entitled to seek money damages under Rule
10b-5. It is that limitation which gives rise to the threshold
question of whether plaintiffs may maintain this action for
equitable relief in view of the fact that they did not participate
directly as either the purchasers or sellers of the securities in-
volved in this action.
Our starting point will be the basic facts which are essen-
tially undisputed. Jurisdiction is present under 15 U.S.C. §§ 78)
and 78aa. This memorandum will stand as our findings and
conclusions under Rule 52(a), Fed. R. Civ. P.
The Basic Facts
Plaintiffs, Peter Wright and Beneficial Standard Corporation
are and at all material times have been minority common share-
holders in defendant International Digisonics Corporation
(IDC), a Delaware corporation. IDC and its wholly owned
subsidiary Talent and Residuals, Inc. (TR), also a Delaware
corporation, are engaged in two separate but related service
businesses: IDC monitors television commericals as they are
shown on the air to assure that the commercials are shown as
agreed to by the television industry; TR performs the account-
ing and record keeping services necessary to the accurate and
adequate compensation of the persons performing in the com-
mercials. IDC and TR were organized in 1968 by Jordon Ross
who is IDC’s principal common shareholder and who, during
most of the transactions complained of, was IDC’s president
and chief executive officer.
IDC’s monitoring service has not prospered financially. The
fact of this financial distress is of significance; the reasons for
that distress are not and they were not fully developed at the
trial. Suffice it to say that IDC has encountered technical elec-
tronic problems occasioned in part by the fact that some com-
2. Birnbaum vy. Newport Steel Corp., 193 F.2d 461 (2d Cir.
1952), cert. denied, 343 U.S. 956 (1952).
A44
mercials are shown on film, others on video tape, some nation-
ally, others locally.
In contrast, TR’s talent accounting service has prospered
financially. So much so that, as we shall see, it became the
plum which defendant Heizer Corporation (Heizer) plucked as
a hedge against Heizer’s large investments in IDC’s monitoring
operation.
Heizer is a closely heid investment company specializing in
privately piaced venture capital investments in new and de-
veloping industries and businesses. Many of its own investors
are regulated institutions that could not invest directly in a
new and developing business or industry because of the risk.
Heizer and its investors hope to reap substantial profits from
their venture investments. But their hopes are not always real-
ized as the facts in this case show.
In November 1969, IDC was in need of cash for its moni-
toring business. It sought its needs from Heizer who invested
$1,500,000 on the following terms.
Pursuant to a written agreement, IDC amended its certifica-
tion of incorporation to create a new class of stock known as
Class A common stock. Heizer purchased 100,000 shares of
Class A common at $10 per share. IDC issued to Heizer a
warrant to purchase 155,000 shares of IDC common at a basic
purchase price of $8.50 per share, which contained an adjust-
ment of purchase price (“anti-dilution clause”) reducing the
price to Heizer in the event IDC issued or sold any of its com-
mon shares at less than $8.50. Heizer agreed to lend IDC, at
the latter’s option, up to $500,000 with interest at 2% over
prime. The agreement between Heizer and IDC contained rather
typical disclosure, continuation of business, and non-merger,
sale or encumbrance of assets clauses.
The documents embodying the agreement were presented to
the IDC board of directors at a duly called meeting held No-
vember 5, 1969. The directors unanimously approved all the
terms and conditions of the agreement and resolved to present
Luni
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A45
to the IDC stockholders the amendment to IDC’s certificate of
incorporation creating the Class A common stock.
The stockholders meeting was held immediately following
the directors meeting pursuant to notice given the stockholders,
which included a statement of the important terms of: the pro-
posed Class A common stock. In addition, prior to the meeting,
the holders of approximately 80% of IDC’s outstanding com-
mon stock, including plaintiff Beneficial Standard Corporation,
had received from IDC copies of all of the documents relating
to the total transaction with Heizer. A quorum of stockholders
attended the meeting and the proposed amendment to the cer-
tificate of incorporation was unanimously approved by those in
attendance. On November 6, 1969, the first transaction was
closed. On May 25, 1970, pursuant to the first transaction,
Heizer loaned IDC $500,000 until May 25, 1971 with interest
at 2% over prime.
In the summer of 1970 IDC was again in need of cash for its
monitoring business and it approached Heizer to make an addi-
tional investment for the monitoring business. On September 1,
1970, IDC and Heizer entered into and executed an agreement
which culminated in Heizer’s investment of $2,000,000. The
agreement provided that IDC would again amend its certificate
of incorporation, this time to authorize 350,000 shares of a new
class of preferred stock with certain rights and preferences, the
most significant of which was a weighted vote of 4.4 per share
on all shareholder votes. Heizer was to exchange the 100,000
shares of its previously purchased Class A common for 100,000
shares of the new preferred. IDC was to sell Heizer an additional
200,000 shares of the new preferred at $10 per share in two
takedowns of $1,000,000 each. Upon completion of the second
takedown, IDC was to issue to Heizer an additional warrant to
purchase 400,000 shares of IDC common at a basic purchase
price of $6 per share, with an anti-dilution clause comparable
to the first warrant. The protective provisions regarding con-
tinuation of business, etc., were, of course, repeated.
A46
The documents evidencing the second transaction were pre-
sented to the IDC board of directors at a meeting duly called
pursuant to notice on August 31, 1970. At that meeting a
majority of the IDC directors were present and those present
unanimously approved the terms and conditions of the second
transaction and resolved to present to the stockholders the pro-
posed amendment to IDC’s certificate of incorporation creating
the new preferred stock.
On August 5, 1970 IDC had mailed a notice of a special
meeting to stockholders calling the meeting for Septemb
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