Petition — Cramer v. General Telephone & Electronics Corp.

r

Supreme Court, U.S -

{ FILED

NOV 27 1978

IN THE

Supreme Court of the United States "="

OCTOBER TERM, 1978

"%8-853

HAROLD CRAMER, Custodian for Patricia Gail Cramer, \

Petitioner,

vs.

GENERAL TELEPHONE & ELECTRONICS

CORPORATION, LESLIE H. WARNER,

THEODORE F. BROPHY, JOHN J. DOUGLAS,

WILLIAM F. BENNETT and ARTHUR ANDERSEN & CO.,

Respondents.

PETITION FOR WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF

APPEALS FOR THE THIRD CIRCUIT

MITCHELL A. KRAMER

STEVEN KAPUSTIN

JOHN S. M. KARNASH

KRAMER AND SALUS

1520 Locust Street

Seventh Floor

Philadelphia, PA 19102

(215) 545-7700

Attorneys for Petitioner,

HAROLD CRAMER, Custodian

for Patricia Gail Cramer

The Winchell Company—Phila., Pa. 19107—(215) 568-1770

TABLE OF CONTENTS

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Statutory Provision Involved ............-.--.00+055

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Reasons for Granting the Writ .................--55-

I. The Third Circuit Court of Appeals’ interpretation

of Fed. R. Civ. P. 23.1’s procedural “particulari-

zation” requirement, upon which the Complaint

was dismissed, is contrary to both the interpreta-

tions and decisions of other Circuits ...........

II. Alternatively, if the Third Circuit Court of Ap-

peals correctly interpreted Fed. R. Civ. P. 23.1’s

procedural “particularization” requirement, in dis-

missing this case it departed from the accepted and

usual course of judicial proceedings by failing to

remand the case to the District Court with leave

A Pea a endo kk wa o's Av eee ses

Appendix A (Opinion and Judgment of the

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Appendix B (Opinion and Judgment of the

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Appendix C (Judgment of the Court of Appeals,

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TABLE OF CITATIONS—(Continued)

Cases: PAGE

Untermeyer v. Fidelity Daily Income Trust, 79 F.R.D. 36

RL eee eee eee 11

Walden v. Elrod, 72 F.R.D. 5 (W.D. Okla. 1976) ...... 10

Williams v. United States, 405 F.2d 234 (Sth Circ. 1968) 13

Statutes:

Federal Rules of Civil Procedure

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McKinney's Consolidated Laws of New York, 39

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Securities Exchange Act of 1934

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Other Authorities:

3B Moore's Federal Practice (2d Ed. 1974) © 23.1 19 .. 6

5 Wright & Miller, Federal Practice and Procedure (1969)

i SS FS SC a Oe 14

IN THE

Supreme Court of the United States

OCTOBER TERM, 1978

No.

HAROLD CRAMER, Custodian for Patricia Gail Cramer,

Petitioner,

vs.

GENERAL TELEPHONE & ELECTRONICS

CORPORATION, LESLIE H. WARNER,

THEODORE F. BROPHY, JOHN J. DOUGLAS,

WILLIAM F. BENNETT and ARTHUR ANDERSEN & CO.,

Respondents.

PETITION FOR WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

The petitioner, Harold Cramer, Custodian for Patricia

Gail Cramer, respectfully prays that a Writ of Certiorari issue

to review the judgment and opinion of the United States Court

of Appeals in this proceeding on July 18, 1978.

OPINION BELOW

The opinion and judgment of the Court of Appeals for the

Third Circuit, unofficially reported in CCH Fed. Sec. L. Rep. ¢

96,510, at 93, 981 (3rd Cir. 1978), appears as Appendix A

hereto. The opinion of the United States District Court for the

Eastern District of Pennsylvania, reported in 443 F Supp. 516

(E.D.Pa. 1977), appears as Appendix B. The judgment of the

Court of Appeals for the Third Circuit denying Rehearing ap-

pears as Appendix C.

2

JURISDICTION

The judgment of the Court of Appeals for the Third Cir-

cuit was entered on July 18, 1978. The jurisdiction of this

Court is invoked under Title 28 U.S.C. §1254(1).

QUESTIONS PRESENTED

I. Is the Third Circuit Court of Appeals’ interpretation of’

Fed. R. Civ. P. 23.1’s procedural “particularization” require-

ment, upon which the Complaint was dismissed, contrary to

both the interpretations and decisions of other “ircuits?

II. Alternatively, if the Third Circuit Court of Appeals

correctly interpreted Fed. R. Civ. P. 23.1.’s procedural “par-

ticularization” requirement, in dismissing this case did it depart

from the accepted and usual course of judicial proceedings by

failing to remand the case to the District Court with leave to

amend?

STATUTORY PROVISION INVOLVED

Rule 23.1, Federal Rules of Civil Procedure, is set out in

Appendix D.

3

STATEMENT OF CASE

This is a shareholder derivative suit brought by Harold

Cramer (“Petitioner”), the custodian of common stock of Gen-

eral Telephone & Electronics (“GTE”) for Patricia Gail Cramer

pursuant to the Pennsylvania Uniform Gift to Minors Act,

against GTE, four of the members of its Board of Directors

(“Board”), and its auditor, Arthur Andersen & Co. The suit

contends that the defendants(1) violated Sections 10(b),

12(b)(1), 13(a) and 14(a) of the Securities Exchange Act

of 1934 [15 U.S.C. $§ 78j(b), 781(b) (1), 78m(a), and

78n(a)], (2) defrauded GTE in violation of New York state law

(GTE’s state of incorporation), and (3) breached their com-

.mon-law fiduciary duties to GTE. The action, filed on June 18,

1976, was originally brought in the United States District Court,

Eastern District of Pennsylvania. The jurisdiction of that Court

was invoked under 28 U.S.C. § 1332.

The Complaint alleges that defendants’ illegal acts con-

sisted of the payment of commercial bribes, kickbacks, unearned

commissions, the creation of “slush” funds, the transfer of a

GTE subsidiary, the falsification of GTE’s financial statements

and the concealment of said acts. See Complaint, paras, 14 and

15. These allegations were borne out via a report prepared by an

Audit Committee of the Board, dated March 4, 1976, and dis-

tributed to GTE’s shareholders as part of a proxy statement prior

to the stockholders’ annual meeting on April 21, 1976. The

Audit Committee specifically found that defendants, Leslie H.

Warner (Chairman of the Board) (“Warner”), Theodore F.

Brophy (President of GTE) (“Brophy”), John J. Douglas (Ex-

ecutive Vice-President of Finance) (“Douglas”) and William F.

Bennett (Executive Vice-President, Manufacturing Group)

(“Bennett”) were personally involved, in varying degress, in the

illegal acts alleged herein. See Complaint, Exhibit “A”. The

Audit Committee consisted of four members of the Board who.

although assumedly not involved in the illegal activities, were

“outside” directors throughout the time period in which the acts

occurred: William M. Fuller, John H. Knowles, John H. Paze

and James W. Walter. Despite its findings, the Audit Committee

4

not only failed to pursue legal action, it, incredibly, failed to dis-

cuss even the possibility of litigation.’

Petitioner commenced this action without making a “de-

mand” on the Board to institute suit. See Fed. R. Civ. P. 23.1.

Based on the failure of the Audit Committee to pursue litiga-

tion and the composition of both the Board and the Audit Com-

mittee, petitioner has contended that to do so would have been

“futile”. See Complaint, para. 13.

On August 22, 1977, the District Court below granted de-

fendants’ Motion for Summary Judgment as to the §§ 13(a),

14(a) and pendant state law claims. The basis for granting this

motion was the Court’s holding that prior decisions in Auerbach

and Limmer precluded it from considering the instant case,

under the doctrine of res judicata.” Though the District Court

did not find that the claims under Section 10(b) were barred by

res judicata, it dismissed the § 10(b) and Rule 10b-5 claims

for failure to state a claim upon which relief can be granted,

pursuant to Rule 12(b)(6) of the Fed. R. Civ. P. The § 12(b)

(1) claim was also dismissed under Fed. R. Civ. P. 12(b) (6),

for lack of compliance with the standing requirements of Sec-

tion 18(a) of the Securities Exchange Act of 1934 [15 U.S.C.

§ 78r(a)].

Petitioner thereafter appealed the decision of the District

Court to the Third Circuit Court of Appeals (“Court of Ap-

peals”). On July 18, 1978, the Court of Appeals affirmed the

decision of the District Court granting defendants’ Motions to

Dismiss and for Summary Judgment. But the Court of Appeals,

' The Audit Committee's Action (more appropriately, inaction) precipitated

the filing of three separate derivative suits in different forums, the instant case

being the last filed:

-Auerbach v. Bennett, Civil Action No. 572-77 (Sup. Ct. of N.Y., West-

chester County, filed March 16, 1976) (“Auerbach”).

-Limmer v. General Telephone & Electrics Corp., Civil Action No.

76-1494 (S.D.N.Y., filed March 30, 1976) (“Limmer”).

Essentially, the Auerbach suit alleged that the same defendants as herein

breached their fiduciary duties to GTE. The Limmer suit charged that Warner,

Brophy, Douglas and Bennett had violated §§ 13(a) and 14(a) of the Securi-

= we Act of 1934, and did not name Arthur Andersen & Co. as a

efendant.

‘ For a concise discussion of the respective court's holding in Auerbach and

Limmer, see Cramer v. General Telephone & Electronics Corp., CCH Fed.

Sec. L. Rep., ©96,510, at 93,981-93,982, attached as Appendix A. (“Cramer”).

5

in affirming dismissal, held that a valid § 10(b) claim was

alleged. However, the § 10(b) claim was dismissed, and con-

sequently the complaint without leave to amend, for failure to

comply with the demand requirements of Rule 23.1.

Finally, petitioner subsequently filed a Petition For Re-

hearing with the Court of Appeals. On August 28, 1978, said

Petition was denied.

6

REASONS FOR GRANTING THE WRIT

I. The Third Circuit Court of Appeals’ interpretation of Fed.

R. Civ. P. 23.1’s procedural “particularization” requirement,

upon which the complaint was dismissed, is contrary to both

the interpretations and decisions of other Circuits.

Federal Rule of Civil Procedure 23.1 requires, in pertinent’

part, that in a shareholder derivative action “. . . [t]he complaint

shall . . . allege with particularity the efforts, if any, made by

the plaintiff [shareholder] to obtain the action he desires from

the directors . . . and the reasons for his failure to obtain the

action or for not making the effort.” Thus, although a share-

holder need not make an effort to secure the desired action from

the Board of Directors in every case, he must particularize the

reasons for not doing so. Judicial interpretations of this pro-

vision of Rule 23.1, as noted by one prominent commentator,

have served to create an absence of “. . unanimity of opinion

amongst the courts . . .” as to what constitutes compliance with

the procedural requirement of “particularization.” 3 B Moore’s

Federal Practice, 23.1.19 at 83 (2d, Ed. 1974). However, de-

spite the acknowledged inconsistency amongst the Circuits, the

preferable and prevailing view has been one of leniency in sus-

taining allegations of “futility’’ of demand. See Hanna v.

Plumer, 380 U.S. 460 (1965) (certiorari granted due to threat

to goal of federal procedural unanimity).

In the instant case, paragraph 13 of the Complaint suc-

cinctly sets forth the basis for petitioner's lack of demand on

the Board:

“Plaintiff has made no demand upon the Board of Direc-

tors of General (herein “the Board”), to bring and prose-

cute this action. Such a demand would have been futile

since the Board has already conducted an investigation of

the facts alleged, as set forth in the Proxy statement at-

tached hereto and made part hereof as Exhibit “A”, and

made recommendations none of which include the reme-

‘The term “futile” has been generically applied by the courts to encompass

those situations where, based on the allegations of the complaint ef al., a

demand is justifiably forgone. See, e.g. Smith v. Sperling, 354 U.S. 91 (1957):

Jannes v. Microwave Communications, Inc., 57 F.R.D. 18,21 ON.D. Hl. 1972).

7

dies requested herein. Further, the Board is dominated by

the individual defendants herein and it is unreasonable to

believe they would authorize suit to be brought against

themselves. Further, the Board consists of fourteen per-

sons, four of whom are named as defendants herein, one

of whom (Charle G. Farris) is an employee of General

and dominated by individual defendants herein, and four

of whom, as outside directors (William M. Fuller, John H.

Knowles, John H. Paze, and James W. Walter) conducted

the investigation and failed to recommend the actions and

remedies herein demanded.”

Analyzing the Complaint, it is readily apparent that petitioner's

“futility” argument consisted of three key ingredients:

|. The four defendant-directors were also the chief oper-

ating officers of GTE. Due to their illegal activities and respec-

tive positions of domination, it would be unreasonable to believe

that they would authorize a lawsuit to be brought against them-

selves.

2. The other four members of the Board who conducted

the Audit Committee investigation (Fuller, Knowles, Paze and

Walker) had full knowledge of all the facts upon which this

action was based and took no action at this point im time, and,

it could reasonably be assumed that they would take no action

thereafter. These individuals plus the four defendant-directors

constituted a majority of the Board.

3. The Board, so comprised. and will full knowledge of all

the facts (via personal participation’ and the Audit Committee

findings) upon which this lawsuit is based, failed to take any

legal action whatsoever. ’

' Parenthetically, the defendant-directors conduct violated, inter alia, Sec-

tions 180.00 (Commercial Bribing in the Second Degree), 180.03 (Commercial

Bribing in the First Degree) and 200 (Bribery in the Second Degree) of the

New York Penal Code. 39 McKinney's Consolidated Laws of New York,

$§ 180.00, 180.03 and 200.

*On April 26, 1976, the Board simply created a “Special Litigation Com-

mittee” to ussess GTE's position with respect to the Auerbach and Limmer

allegations. The Board subsequently authorized this Committee to evaluate

those of the instant lawsuit. Without disputing the findings of fact made by the

Audit Committee Report, this Committee ultimately concluded that all these

actions should be opposed by GTE:

“The Special Litigation Committee advised GTE’s General Counsel to

take the position in Limmer and Cramer that the federal claims were

meritless, that the state-law claims should be dismissed for lack of subject

Summarily examining these allegations and their implications,

the Court of Appeals dismissed the Compaint (§ 10(b) and

Rule 10b-5 claims) for failure to particularize “futility”:

“, ,. Cramer's complaint does not adequately explain why

he failed to make a demand upon the directors. Cramer

correctly states that the Audit Committee did not recom-

mend litigation against the directors. But so far as the

complaint discloses, that Committee had not been in-

structed to determine whether litigation against the direc-

tors would be appropriate. Its primary functions were to

examine GTE’s foreign business transactions, to disclose

any questionable overseas payments, and to suggest in-

ternal procedures for remedying the prior practices. We

do not believe that the Audit Committee’s report neces-

sarily demonstrated management’s opposition to an action

against the directors who had participated in the foreign

activities in which the payments had been made. . . . The

futility of making the demand required by Rule 23.1 must

be gauged at the time the derivative action is commenced,

not afterward with the benefit of hindsight. At the time

Cramer filed his complaint, the Board of Directors had not

yet expressed opposition to such derivative actions.

Nor do we think that the defendants herein so dominated

the Board of Directors as to made a demand on the Board

futile. At the time Cramer commenced this suit, there were

14 individuals on GTE’s Board of Directors. Only four of

matter jurisdiction, and that the suits, even if meritorious, were not in the

best interests of GTE or its shareholders and thus should not be prose-

cuted on GTE’'s behalf. The Committee recommended that the Auerbach

action should be opposed as being contrary to the best interests of GTE

or its shareholders.” [footnote omitted] Cramer, Supra. at 93,981.

The Committee arrived at the startling conclusion that the lawsuits would take

time and money and, therefore, would not be in the best interests of GTE.

See, nares of the yy Litigation Committee of the Board of Directors of

General Telephone & Electronics, pps. 17-22. GTE apparently feels that it is

neither worth the time nor the money to determine the extent of its own

corruption. Petitioner contends that this Committee's “assessment” was inade-

uate, in that the full extent of GTE’s improper activities were not ascertained.

his view is shared by the Securities and Exchange Commission, which delayed

a five million (5,000,000) share offering of GTE Common Stock on December

13, 1976, and again on December 14, 1976, because GTE had not disclosed

enough about improper payments. See Wall Street Journal articles of Decem-

ber 14 and 15, 1976, attached as Exhibit “B” to Plaintiff's Memorandum in

Opposition To Motion of Defendant GTE To Dismiss the Complaint for

Summary Judgment.

9

these were named as defendants in this action. The remain-

ing ten directors had not been involved in the allegedly

fraudulent activities. Indeed several of the directors had not

even been members of the Board at the time the question-

able transactions occurred. Under these circumstances, we

cannot agree with Cramer that the four directors named 4s

defendants in the instant case dominated the Board to such

an extent that the plaintiff should be excused from the

mandatory requirement of Rule 23.1 that he first make a

demand on the directors.” (footnote omitted). (emphasis

added).

Cramer, supra at 93,991

It is respectfully submitted that the Court of Appeals’ interpre-

tation of Rule 23.1’s “particularization” requirement in the in-

stant case is contrary to both the interpretations and decisions

of the Second, Tenth, Fifth, Seventh and Ninth Circuits.

The Second Circuit, which has been in the forefront of

the prevailing view of leniency in pleading futility, has looked

primarily at the antagonism, adverse interest or involvement the

“controlling” directors (or shareholders) possess. Cathedral

Estates, Inc. v. Taft Realty Corp., 228 F.2d 85 (2nd Cir. 1955)

(court construed Rule 23(b), predecessor of Rule 23.1). In

Papilsky v. Berndt, 59 F.R.D. 95 (S.D.N.Y. 1973), a share-

holder derivative suit was commenced in which it was alleged

that demand was futile due to the fact that the unaffiliated di-

rectors were “controlled” by the affiliated.” The complaint

asserted that the element of control was brought about by the

“strategic positions” of the affiliated directors, who were also the

principal officers of the derivatively-sued company. Defendants

moved to dismiss the complaint, arguing that the allegation of

domination and/or control was insufficiently precise for pur-

poses of Rule 23.1. The District Court denied the motion to

dismiss, and held that this allegation of “control” was “suffici-

ently particular.” Papilsky, supra at 97. Analogizing the Papilsky

“The “unaffiliated” directors comprised a majority of the Board of

defendant, Affiliated Fund, Inc., (“Fund”) on whose behalf the action was

brought. The “affiliated” directors, who were in the minority on the deriva-

tively-sued Fund's Board, were the partners in the management company

accused of improper management practices vis-a-vis Fund. 59 F.R.D. 95, 96.

10

rationale to the instant case, it is clear that petitioner's Com-

plaint particularizes domination and/or control by the defend-

ant-directors over GTE’s Board. It is alleged that defendant

Warner is Chairman of the Board, defendant Douglas is Execu-

tive Vice-President of Finance, defendant Bennett is Executive

Vice-President of Manufacturing Group and defendant Brophy

is President. It is implicit in this situation, as in Papilsky, that:

the “strategic” positions held by these individuals provided them

with control over GTE and its Board. This element of domina-

tion and/or control is further confirmed by the fact that the

Audit Committee (comprised of the four outside directors who,

with the defendant-directors, constitute a majority of GTE’s

Board), despite obtaining information concerning the illegal

transactions herein, took no appropriate legal action.’ There-

fore, under the Second Circuit’s Papilsky rationale, petitioner's

complaint “adequately explained” why a demand was not made

and was improperly dismissed*. Accord: Abbe v. Goss, 411 F.

Supp. 923 (S.D.N.Y. 1975). See Cathedral Estates, Inc. v. Taft

Realty Corp., supra, (cited and followed in Papilsky); Dopp v.

American Electronic Laboratories, Inc. 55 F.R.D. 151 (S.D.N.Y.

1972). See also, Brick v. Dominion Mortg. & Realty Trust,

442 F. Supp. 283 (W.D.N.Y. 1977) (demand on directors

excused in view of allegations; derivative 10b-5 claim dismissed

for failure to comply with Massachusetts’ minority “business

decision” rule). But see, Brouks v. American Export Indus-

tries, 68 F.R.D. 506, (S.D.N.Y. 1975). Likewise, the Tenth

Circuit has excused demand once “domination” is so estab-

lished. de Haas v. Empire Petroleum Co., 286 F. Supp. 809,

aff'd, 435 F.2d 1223 (10th Cir. 1970); Walden v. Elrod, 72

F.R:D. 5 (W.D. Okla. 1976).

In essence, the defendant-directors and the Audit Commit-

tee (a controlling majority of the Board) “ratified” the illega!

transactions et al. complained of, the former by their personal

>It should be noted that Charles G. Farris, a member of the Audit Com-

mittee, was also an employee of GTE. Mr. Farris, it is submitted, would be

unable to make an unbiased, informed decision to authorize suit against the

defendants, who had the power to remove him from his position.

~ In holding that the Board was not “dominated” in order to excuse demand,

the Court of Appeals never considered the crucial fact that the four defendant-

directors and the four Audit Committee directors constituted a “controlling

majority”.

<< ae

11

involvement and the latter by its failure to instigate legal action

despite its knowledgeability. In a somewhat similar situation, the

Fifth Circuit was held that,

a

.. . given plaintiff's allegations that all of the trustees

either actively participated in the wrongful transactions or,

at the least approved or ratified such transactions with

knowledge or notice of their illegality, the court concludes

that demand upon the trustees to bring this action should

be excused.” (emphasis added).

Oldfield v. Alston, 77 F.R.D. 735, 740 (N.D. Ga. 1978)."

As pointed-out by the Court of Appeals in the instant case,

“(t]he futility of making the demand required by Rule 23.1

must be gauged at the time the derivative action is com-

menced...”

Cramer, supra at 93,991,

As was previously noted, at the time this case was filed, eight

directors (four by personal involvement, four by ratification)

had clearly indicated their disposition on the matter of suit. See

Complaint, para, 13 and Exhibit “A” attached thereto. Any de-

mand on the Board, its majority so comprised, would certainly

have been futile.'" The Oldfield court's rationale was buttressed

by an earlier Fifth Circuit decision that focused on the “ac-

"The Oldfield court, in finding that “ratification” plus knowledge of the

illegal transactions equalled futility of demand, considered /n re Kauffman

Mutual Fund Actions, [479 F.2d 257 (1st. Cir.), cert. denied, 414 U.S, 857

(1973)] and its progeny, a line of predominantly First Circuit cases expressing

conservative treatment of shareholder derivative actions. The Court distin-

guished the Kauffman line of cases on the basis of sufficiency of ratification.

For First Circuit cases relying on the Kauffman “restrictive view", see, ¢.x..

Heit v. Baird, $67 F.2d 1157 (ist Cir. 1977); Untermeyer v. Fidelity Daily

Income Trust, 79 F.R.D. 36 (D. Mass. 1978); GA Enterprices, Inc. v. Leisure

Living Communities, Inc., 66 F.R.D 123 (D. Mass, 1974). To the same effect

in other Circuits, see, ¢.g., Jones v. Equitable Life Assurance Society of U.S..

409 F. Supp. 370 (S.D.N.Y. 1975); Royston v. Eastern Empire Corp., 393 F.

Supp. 1010 (E.D. Pa. 1975). Kauffman and its progeny, and clearly the First

Circuit, continue to oppose the “leniency” employed by many of the Circuits

in sustaining futility allegations in derivative suits.

"As held by the Seventh Circuit, when “. . . the message is loud and

clear...” that the majority of a Board of Directors are opposed to bringing

the action, Rule 23-1's futility requirement is satisfied. Nusyshacher v. Con-

tinental Ill. Nat. B. & T. Co., Chicago, 518 F.2d 873, 878-79 (7th Cir. 1975).

decord: Jannes v. Microwave Communications, Inc., supra. The Board's

“message” herein was extremely “loud and clear” at the time this lawsuit was

filed, for the Auerbach complaint was filed a month earlier and it (Board) did

not bring suit on behalf of GTE, despite its duty to do so.

12

quiescence in or approval of” the acts complained of by the

controlling-majority directors. Liboff v. Wolfson, 437 F.2d 121

(Sth Cir. 1971). In Liboff, the trial court dismissed plaintiff's

complaint on the ground that it failed to comply with Rule 23.1.

The complaint alleged as follows:

“Demand by plaintiff that the Board of Directors of the ~

Corporation bring this action would have been futile. The

majority of said directors participated, approved of and ac-

quiesced in said transaction and are liable therefor. The di-

rectors of the Corporation would not and could not dili-

gently prosecute this action because they would have to

bring it against themselves which would prevent its effec-

tive prosecution.” (emphasis added).

437 F.2d 121,122.

The Fifth Circuit Court of Appeals reversed the lower court’s

dismissal, and held that the above-quoted futility allegation

satisfied the “particularity” requirement of Rule 23.1:

“Recognizing both the general approach to the rules of

pleading, which tends to minimize the requirements for

specificity, as well as the particular requirements of Rule

23.1, . . . we have not the slightest difficulty in deciding

that the allegations as to the reason why demand was not

made upon the board of directors fully meet the require-

ments of the rule. The complainant clearly alleged ‘with

particularity’ his ‘reasons for his failure * * * for not mak-

ing the effort,’ whether or not the reasons may ultimately be

found not to be fully supported.”

Id.

Clearly, petitioner herein has alleged with particularity the “ap-

proval of, ratification of, or acquiescence in” illegal transactions'’

by a majority of the Board. Hence, under the rationale of the

Fifth (and Seventh) Circuit, petitioner has articulated within

his pleadings the element of futility. See Nelson v. Pacific South-

'! The illegal transactions et al. constitute inextricably linked federal and

state law claims. See Complaint, para. 10; note 4, infra. The Third Circuit has

reversed the dismissal of a like complaint, holding that the illegal act(s) itself

rohibited such. Miller v. American Telephone & Telegraph Company, 507

F 2d 759 (3rd Cir. 1974).

13

west Airlines, 399 F.Supp. 1025 (S.D. Cal. 1975) (facts pleaded

futility) (Ninth Circuit view).

Desipte the variance existing amongst the Circuits as to

what constitutes Rule 23.1 particularization of futility, which

has served to create a conflict of authority therein, the “lenient”

viewpoint remains preferential. Consequently, based on the

above, petitioners Complaint did in fact “adequately explain”

futility and should not have been dismissed. The Petition for

Certiorari should be granted to consider the policies and impli-

cations this decision presents.

II. Alternatively, if the Third Circuit Court of Appeals cor-

rectly interpreted Fed. R. Civ. P. 23.1’s procedural “par-

ticularization” requirement, in dismissing this case it de-

parted from the accepted and usual course of judicial pro-

ceedings by failing to remand the case to the District Court

with leave to amend.

Although the Court of Appeals determined that the instant

Complaint alleged a proper Section 10(b) cause of action, it

affirmed the District Court's dismissal of this valid claim due to

its additional finding that Rule 23.1’s technical pleading re-

quirement was not satisfied. Assuming, arguendo, that the Court

correctly interpreted Rule 23.1’s “particularization” standard, it

is respectfully submitted that said court departed from the

accepted and usual course of judicial proceedings by failing to

remand this case to the District Court with lease to amend the

Complaint.

Courts freely and consistently grant leave to amend in situa-

tions where the amendment would be curative of a defective or

imperfect pleading. Foman v. Davis, 371 U.S. 178 (1962);

Gaffney v. Silk, 488 F.2d 1248 (1st Cir. 1973); Williams v.

United States, 405 F.2d 234 (Sth Cir. 1968); Ballou v. General

Electric Company, 393 F.2d 398 (1st Cir. 1968); Harris v.

Palm Springs Alpine Estates, Inc., 329 F.2d 909 (9th Cir.

1964); Nagler v. Admiral Corp., 248 F.2d 319 (2d Cir. 1957);

McMinn County, Tennessee v. City of Athens, Tennessee, 219

F.Supp. 705 (E.D. Tenn. 1963). Concomitantly, Fed. R. Civ. P.

15 requires that the right be granted freely as long as the amend-

14

ment is to be made in good faith and no prejudice results to the

non-moving party. Jensen v. Continental Financial Corporation,

404 F.Supp. 792 (D.Minn. 1975). The rationale for this prac-

tice of allowing a plaintiff every opportunity to cure a defect in

his pleadings is obvious:

“. . . [T]he policy of deciding case; on the basis of the_

substantial rights involved rather than on technicalities re-

quires that plaintiff be given every opportunity to cure a

formal defeci in his pleading. This is true even though the

court doubts that plaintiff will be able to overcome the

defects in his initial pleading . . . The better practice is to

allow at least one amendment regardless of how unpromis-

ing the initial pleading appears . . .” (emphasis added)

5 Wright & Miller, Federal Practice and Procedure, §1357

(1969).

* * *

“If the underlying facts or circumstances relied upon by a

plaintiff may be a proper subject of relief, he ought to be

afforded an opportunity to test his claims on the merits.”

Foman, supra at 182.

See, McMinn County, Tennessee, supra.

Upon viewing the factual allegations of petitioner's Com-

plaint (for purposes of the motion to dismiss the 10(b) claim)"’,

the Court of Appeals held that neither control nor opposition to

an action by the Audit Committee was shown. Consequently,

futility was not “adequately explained”. Cramer, supra at

93,991. In light of this technical defect, petitioner clearly

should have been granted leave to amend. The defendants

herein were put on notice of the petitioner’s claims from the

time the Complaint was filed. The petitioner seeks to add no

new parties or causes of action by amendment. Therefore, the

defendants cannot be prejudiced by the amendment. Nor

'* The normal procedure in cases involving Rule 23.1's particularization

requirement is to look “solely” to all factual allegations in the complaint. See,

v.g., De Pinto v. Provident Security Life Insurance Company, 323 F.2d

826.830 (9th Cir. 1963), cert. denied, 376 U.S. 950 (1964); Citrin v. Greater

New York Industries, Inc., 79 F.Supp. 692,697 (S.D.N.Y. 1948). To consider

materials and/or matters extraneous to the pleadings is to convert the motion

to dismiss to one for summary judgment. Mortensen vy. First Federal Sav. and

Loan Ass'n., 549 F.2d 884,891 (3rd Cir. 1977).

15

would petitioner be acting in bad faith, or empluying dilatory

tactics, in seeking leave to amend. The defect enunciated by

the Court of Appeals that was the basis for its decision was

neither raised by the defendants nor considered by the District

Court. The petitioner was first put on notice of the possible

defect in his pleadings when he received the decision of the

Court of Appeals. Since the court concluded that the Com-

plaint alleges a proper cause of action, “justice” and accepted

judicial practices requires that leave to amend be granted. An

amended complaint could then more specifically allege the

“futility” of making a demand on the Board during the time

period prior to the filing of this action."

Accordingly, the Court of Appeals failure to remand with

leave to amend was improper and violative of established

judicial procedure.

CONCLUSION

For these reasons, a Writ of Certiorari should issue to

review the judgment and opinion of the Third Circuit Court of

Appeals.

Respectfully submitted,

MITCHELL A. KRAMER

STEVEN KAPUSTIN

JOHN S. M. KARNASH

KRAMER AND SALUS

1520 Locust Street

The Seventh Floor

Philadelphia, PA 19102

(215) 545-7700

Attorneys for Petitioner,

HAROLD CRAMER, Custodian

for Patricia Gail Cramer

'* Pursuant to Fed.R.Civ.P. 15(c), the amendment of the Complaint con-

cerning the Rule 23.1 pleadings should relate back to the time the complaint

was filed. The proposed Amended Complaint will refer to exactly the same

occurence(s) that formed the basis for the original Complaint. The defendant

was previously put on notice of the claim by the first Complaint. Travelers

Insurance Company v. Brown, 338 F.2d 229 (Sth Cir. 1964).

16

APPENDIX A

[4 96,510]

Cramer

v.

General Telephone & Electronics Corporation, et al.

United States Court of Appeals,

Third Circuit.

No. 77-2372.

July 18, 1978.

Appeal from the United States District Court for the

Eastern District of Pennsylvania. Opinion in full text. Opinion

amended to add attorney’s names by order of August 8, 1978.

Exchange Act—Derivative Action—Res Judicata—Proxy

Violatiohs.—A shareholder’s derivative action claim alleging

violations of Section 14(a) of the Exchange Act was barred by

the previous dismissal of another shareholder’s derivative suit

alleging the same violations. Although different shareholders

brought the two actions, the actual plaintiff on whose behalf the

claims were brought was the identical corporation. Thus, the

doctrine of res judicata was applicable.

See € 24,001, “Exchange Act—Proxies” division, Volume

Exchange Act—Reports—False Statements—C ausation.—

Although a corporation’s sale of its ownership interest in a

foreign subsidiary qualified as a sale of securities, a shareholder's

derivative action claim that the corporation was injured by the

transaction failed to state a claim for relicf under Section 18 of

the Exchange Act because the sale was not made in reliance upon

a false statement in an annual report filed by the corporation.

Section 18 provides a civil remedy for damages resulting from

the purchase or sale of a security in reliance upon a misleading

statement in a document filed with the SEC. Absent that causal

nexus, no cause of action was stated.

17

See 4 23,501, “Exchange Act—Registration; Reports” di-

vision, Volume 2 and 4 26,226, “Exchange Act—Insiders; Rec-

ordkeeping; Clearance & Transfer” division, Volume 3.

Exchange Act—Antifraud—Illegal Payments—In Connec-

tion With Requirement—Damages.—A claim that a corpora-

tion financed part of the purchase price on the sale of its owner- |

ship in a foreign subsidiary by paying commissions on future

equipment sales sufficiently alleged that the fraud on the cor-

poration occurred in connection with the purchase or sale of

securities. The sale of the ownership interest constituted a sale

of securities under the Exchange Act’s antifraud provisions. Since

the commission payments were inextricably linked to that sale,

the alleged fraud occurred in connection with the sale of a

security. Even assuming that the commission arrangement saved

business for the corporation, the transaction may have injured

the corporation. Thus, the district court erroneously concluded

that no claim was stated under the antifraud provisions.

See 4 22,721 and 22,725, “Exchange Act—Manipulations;

National Market System” division, Volume 2.

Exchange Act— Antifraud—Scienter— Knowledge.— A

shareholder’s allegation that the corporation’s directors know-

ingly participated in a scheme to defraud the corporation suffi-

ciently alleged scienter. If the directors intended to commit the

acts which constituted a fraud upon the corporation, whether or

not their acts were motivated by good faith is irrelevant.

See 4 22,721 and 22,725, “Exchange Act—Manipulations;

National Market System” division, Volume 2.

Exchange Act— Antifraud— Derivative Action— Demand

Requirement.—A shareholder’s derivative action was dismissed

because the complaint failed to allege either an adequate demand

on the corporate directors to sue or a sufficient reason for failing

to make that demand. The fact that an audit committee did not

recommend litigation did not excuse the failure to comply with

the demand requirement.

See 4 22,721 and 22,725, “Exchange Act—Manipulations;

National Market System” division, Volume 2.

18

Kramer and Salus, Mitchell A Kramer, Steven Kapustin,

and Stuart Perin, Philadelphia, Pa., for Appellant.

Kaye, Scholer, Fierman, Hays & Handler, Peter M. Fish-

bein, Steven J. Glassman and Myron Kirschbaum, New York,

N. Y., for Appellees, Warner, Brophy & Douglas.

_Morrison Paul & Beiley, Peter H. Morrison, Benjamin

Zelermyer, Gerald G. Paul, Bobbe A. Brown, New York, N. Y.

and Schnader, Harrison, Segal & Lewis, Arthur H. Kahn and

Joseph A. Tate, Philadelphia, Pa., of counsel, for appellee

Bennett.

Pepper Hamilton & Scheetz, John G. Harkins, Jr. and

Patricia L. Freeland, Philadelphia, Pa. and Dean C. Rohrer and

Samuel J. Wilson, Stamford, Connecticut, of counsel, for ap-

pellee General Telephone & Electronics Corporation.

Oliver C. Biddle, Helen P. Pudlin, Ballard, Spahr, An-

drews & Ingersoll, Philadelphia, Pennsylvania; Charles W.

Boand, Wilson & Mcllvane, Chicago, Illinois, attorneys for ap-

pellee Arthur Andersen & Co.

GiBBONS, Circuit Judge: This is an appeal from the termi-

nation of a shareholder’s derivatiye suit brought by Harold

Cramer’ on behalf of the shareholders of General Telephone &

Electronics Corporation (GTE). The defendants are Leslie H.

Warner, Theodore F. Brophy, John C. Douglas, and William

Bennett, directors of the corporation, and Arthur Andersen &

Co., GTE’s auditors. In his complaint, the plaintiff contends that

the defendants (1) violated Sections 10(b), 12(b)(1), 13(a), and

14(a) of the Securities Exchange Act of 1934, 15 U.S.C.

$§ 78j(b), 781(b)(1), 78m(a), & 78n(a), and the regulations pro-

mulgated thereunder, (2) defrauded the corporation in violation

of state law, and (3) breached their common-law fiduciary duties

to the corporation. Plaintiff's Complaint, € 10. The district court

granted the defendants’ joint motion for summary judgment on

the §§ 13(a) and 14(a) claims on the ground that such claims

were barred by res judicata. The court dismissed the claims

under § 10(b), Rule 10b-5, and § 12(a) for failure to state claims

upon which relief could be granted. Fed. R. Civ. P. 12(b)(6).

' Harold Cramer is the custodian of the GTE common stock for Patricia

Gail Cramer, a minor. Plaintiff's Complaint, 4 1.

19

The state-law claims were dismissed on two grounds—res ju-

dicata and lack of subject matter jurisdictions. Although we dis-

agree somewhat with the reasons underlying the district court's

decision, we affirm its judgment in all respects.”

I.

The thrust of the plaintiff's claim is that the corporation

was injured by the making of illegal overseas payments by GTE

subsidiaries to foreign governmental officials and to private per-

sons. The plaintiff contends that the defendants participated

both in the making of the payments and in the failure to dis-

close the payments in reports disseminated to GTE stockholders.

Paragraph 14 of the complaint contains the major allegations:

14. During a period commencing at a time unknown

to plaintiff, and continuing at least until November, 1975,

defendants, in violation of the Exchange Act and the Rules

and Regulations promulgated thereunder and in violation

of the Common law in connection with General partici-

pated, and/or acquiesced in, and/or aided and abetted,

and/or failed to discover when in the exercise of due dili-

gence they would have discovered, devices; schemes and

artifices to defraud General, to waste the assets of General,

to utilize the assets of General for unlawful purposes, to

falsify the records of General, to defraud the United States

Government by falsifying tax returns; to make untrue

statements of material facts and to omit to state material

facts in reports disseminated to shareholders of General;

and, in the case of the individual defendants, breached

their fiduciary duties and obligations to General.

Cramer rests his allegations largely on the findings which

appear in a report on a special investigation conducted by the

Audit Committee of the Board of Directors of GTE. That re-

port, which is incorporated by reference in paragraph 15 of the

plaintiff's complaint, was distributed to the shareholders as part

of the proxy statement prior to the stockholders’ annual meet-

ing on April 21, 1976. The Audit Committee, which consisted

* The district court also denied the plaintiff's motion for a protective order.

That decision is not before us on appeal.

20

of four outside directors who had not been involved in the ques-

tionable transactions, had been authorized by the Board of Di-

rectors to determine whether between January 1, 1971, and

December 31, 1975, GTE or any of its international subsidi-

aries had made “illegal contributions, unlawful payments to do-

mestic or foreign government officials or other payments which

were Otherwise improper or improperly recorded. . . .” Audit

Committee Report [Exhibit A to Plaintiff's Complaint], at 13.

The Committee was assisted by the Washington, D. C. law firm

of Wilmer, Cutler and Pickering, which had never previously

represented GTE, and by the accounting firm of Arthur Ander-

sen, a defendant herein.

After investigating GTE’s international operations for three

months, the Audit Committee produced a 51-page report. That

report, which was dated March 4, 1976, revealed that GTE and

its subsidiaries had paid approximately $8 million to, or for the

benefit of, foreign governmental officials. Most of these pay-

ments took the form of commercial kickbacks, rebates, or bribes

to officials of private foreign customers. Another sum of ap-

proximately $2 million was paid pursuant to a pre-January

1, 1971 commission arrangement between GTE officials and

officers of a single foreign company (called the “Customer” in

the Audit Committee’s report). This commission arrangement

stemmed from GTE’s sale of its substantial ownership interest

in the Customer to a private investment company controlled by

a group of foreign nationals (the “Group”). The foreign gov-

ernment itself had urged GTE to make the sale. Since the pur-

chasing group did not have adequate financial resources to ac-

quire GTE’s interest, GTE agreed to finance part of the pur-

chase price by paying the Group commissions on future GTE

equipment sales to the Customer. After being told that com-

petitor would agree to such an arrangement if it declined*to do

so, GTE agreed to pay the commissions to a company desig-

nated by the purchasers and located in a third country.* Mem-

‘The Audit Committee found that GTE International had paid the Group

$373,872 in commissions and had applied another $2,271,481 in earned com-

missions to reduce the principal amount owed by the Group for its purchase

of GTE’s substantial interest in the Customer, In addition, as of December 31,

1975, GTE International had on its books $1,678,000 in accrued but unpaid

commissions earned under this arrangement. Audit Committee Report, at 22.

21

bers of the Group became officers and directors of the Cus-

tomer. Audit Committee Report, at 22.

The Audit Committee found that Warner, Brophy, Doug-

las, and Bennett, the defendants herein, had been involved, in

varying degrees, “in the negotiation, formalization and imple-

mentation” of the commission arrangement described above. /d..

at 28. Bennett was found to be at least aware of two other

questionable financial transactions. However, the Committee

concluded that none of these directors profited personally from

these payments and that all of them believed they were acting in

the best interests of the corporation. /d. at 28-29. The Com-

mittee’s report did not discuss the possibility of litigation against

these directors, and its recommendations to the Board did not

include the pursuit of such litigation."

After the Audit Committee’s report had been distributed to

the GTE shareholders, three separate derivative suits were filed

in different courts. The first of these was brought by Elias Auer-

bach, a GTE stockholder, against the same defendants as are

named in the instant litigation. Auerbach’s suit, which was filed

in the Supreme Court of New York in Westchester County on

March 16, 1976, alleged that the illegal payments constituted

a waste of GTE’s assets and that the defendants, by permitting

such payments, had breached their fiduciary duties to the corpo-

ration. Two weeks later, Ralph Limmer filed another share-

holder’s derivative suit in the United States District Court for

the Southern District of New York, charging that Warner,

Brophy, Douglas and Bennett had violated §§ 13(a) and 14(a)

of the 1934 Act and had breached their fiduciary duties to the

shareholders. Arthur Andersen was not made a defendant in

that action. Finally, on June 18, 1976, Cramer commenced the

present suit in the United States District Court for the Eastern

District of Pennsylvania.

+The Committee recommended only: (1) “that the Board instruct manage-

ment to submit to the Board at an early date its plans to prevent a recurrence

of the problems that have occurred,” and (2) that GTE urge the United States

Government to “mount a major political and diplomatic effort to formulate

and enforce a common code of ethical standards for the conduct of inter-

national business.”” Audit Committee Report, at 30-31.

22

Cramer did not, before filing this suit, make a demand

upon the GTE directors to institute the litigation. See Fed. R.

Civ. P. 23.1. In paragraph 13 of this complaint, he alleges that

such a demand would have been futile since the Audit Com-

mittee had not recommended litigation against the directors and

since, in his opinion, the individual defendants dominated the

Board of Directors.

On April 21, 1976, 1976, after the. Auerbach and Limmer

actions had been filed but before the instant action had been

commenced, GTE’s Board of Directors resolved to create a

Special Litigation Committee to assess GTE’s position with re-

spect to the shareholders’ derivative suits.’ After Cramer had

filed the instant lawsuit, the Board authorized the Committee to

examine that suit too. The Committee consisted of three out-

side directors who had not been members of the Board of Direc-

tors at the time the events described in the Audit Committee’s

report occurred. Chief Judge Charles S. Desmond, now retired

from the New York Court of Appeals, served as Special Coun-

sel to the Committee.

After examining the work of the Audit Committee, the

Special Litigation Committee made several findings and recom-

mendations. The Committee found first that the investigation

by the Audit Committee had been “complete, comprehensive

and thorough.” Special Litigation Committee Report, at 11.

Judge Desmond informed the Committee members that in his

opinion neither the state nor the federal claims were meritori-

ous. The Special Litigation Committee advised GTE’s General

Counsel to take the position in Limmer and Cramer that the

federal claims were meritless, that the state-law claims should

be dismissed for lack of subject matter jurisdiction, and that the

suits, even if meritorious, were not in the best interests of GTE

or its shareholders and thus should not be prosecuted on GTE’s

behalf. The Committee recommended that the Auerbach action

‘In forming this Committee, GTE’s Board of Directors claimed that they

were acting pursuant to § 712 of the New York Business Corporation Law

und to § 20 of GTE’s corporate by-laws.

23

be opposed as being contrary to the best interests of GTE or its

shareholders."

Relying on the conclusions of the Special Litigation Com-

sittee, the defendants moved to dismiss the complaints in

Auerbach and Limmer. The state court dismissed Auerbach’s

complaint on the ground that this Committee’s business judg-.

ment that the suit was not in GTE’s best interests barred the

prosecution of the suit. Auerbach v. Bennett, No. 572/77

(Sup. Ct. of New York, Westchester County, April 29, 1977).

In Limmer, the district court dismissed the § 14(a) claim for

failure to state a claim upon which relief could be granted. The

§$ 13(a) claim was voluntarily withdrawn by the plaintiff and

later dismissed with prejudice. Once the federal claims had been

terminated, the district court dismissed the pendent state-law

claims for lack of subject matter jurisdiction. Limmer v, Gen-

eral Tel. & Elec. Corp., 76 Civ. 1494 (S. D. N. Y. March ILI,

1977).

The defendants also moved to dismiss the complaint in the

present case. The defendants claimed that all the federal claims

were barred, under principles of res judicata and collateral

estoppel, by the district court’s decision in Limmer. The district

court below agreed that Cramer’s §§ 13(a) and 14(a) claims

were barred by res judicata. However, because claims under

$$ 10 (b) and 13(b)(1) require elements of proof different

from those necessary under §§ 13 (a) and 14(a), the court

concluded that those claims were not barred by Limmer. Never-

theless, the court dismissed the § 10 (b) and Rule LOb-5 claims

on the grounds: (1) that the alleged fraud was not in connec-

tion with the purchase or sale of a security; (2) that GTE

was not damaged by the fraudulent activities; and (3) that the

plaintiff's complaint failed to allege that the defendants had in-

tended to defraud the corporation. The § 12(b)(1) claim was

dismissed because the plaintiff had not satisfied the standing re-

“The Committee also found (1) that the defendant directors had acted

“with that degree of diligence, care and skill which ordinarily prudent men

would exercise under similar circumstances in like positions. Special Litigation

Committee Report, at 12, and (2) that Arthur Andersen had acted in accord-

ance with accepted auditing standards and in good faith, fd. at 14.

24

quirements of § 18(a) of the 1934 Act, 15 U.S. C. § 78r(a).’

The state-law claims were dismissed for two reasons. First, the

court concluded that those claims were precluded by the res

judicata effect of the New York judgment in Auerbach. Sec-

ondly, even assuming that the claims were not barred by res

judicata, the district court declined to exercise its pendent

jurisdiction over those claims. See United Mine Workers v.

Gibbs, 383 U.S. 715 (1966). The plaintiff filed a timely notice

of appeal from the district court’s decision.”

I]. SECTION 14(a) CLAIM"

The doctrine of res judicata bars repetitious litigation of

the same cause of action. As the Supreme Court has explained,

the doctrine “rests upon considerations of economy of judicial

time and public policy favoring the establishment of certainty

in legal relations.” Commission v. Sunnen, 333 U. S. 591, 597

(1948). Once a court of competent jurisdiction has entered a

final judgment on the merits of a particular cause of action, the

parties to that action are bound not only by every matter which

was offered and considered in reaching that judgment, but also

by every other matter which could have been offered. Cromwell

v. County of Sac, 94 U.S. 351, 352 (1876); Hubicki v. ACT

Industries, Inc., 484 F. 2d 519, 524 (3d Cir. 1973). Absent

’ The district court explained that part of its holding as follows:

_ The complaint herein contains none of the allegations required to estab-

lish standing under § 18. There is no allegation that the corporation relied

on any false or misleading filings in making any sale; there is no allegation

that any filing affected the price of GTE securities. Finally, there is no

causal nexus made, or even attempted, between any filing and any alleged

loss which GTE suffered.

District Court Opinion at 14.

~On this appeal, Cramer does not contend that the district court erred in

dismissing his § 12(b)(1) claim or his state-law claims. Thus, we need not

decide the correctness of those dismissals.

" Section 14(a) reads:

(a) It shall be unlawful for any person, by the use of the mails or by

any means or instrumentality of interstate commerce or of any facility of a

national securities exchange or otherwise, in contravention of such rules and

regulations as the Commission may prescribe as necessary or appropriate

in the public interest or for the prote@ion of investors, to solicit or to per-

mit the use of his name to solicit any proxy or consent or authorization in

respect of any security (other than an exempted security) registered pur-

suant to section 78/ of this title.

15 U.S.C. § 78N(a).

25

circumstances which would render inequitable the application

of res judicata, a judgment on the merits will generally not be

disturbed by a court in a subsequent suit involving the same

parties.

We agree with the district court that the Limmer decision

bars Cramer’s § 14(a) claim against the directors. In Limmer,

the district court granted the directors’ motion to dismiss the

plaintiff's § 14(a) claim. The court explained its decision as

follows:

Section 14(a), after all, contemplates the prevention,

or redress, of such injury as would be, or is, directly trace-

able to a transaction authorized by a corporate electorate

in the partial light of a misleading proxy solicitation. In

the present case, by contrast, the damages claimed, if

actually suffered, “flow from breach of a fiduciary obliga-

tion owed as a director or officer, rather than from any

shareholder vote obtained by false proxy solicitation

materials.

Limmer Opinion, at 4. Before a judgment can be given res

judicata effect, both the parties and the issues in the prior and

subsequent suits must be identical. Expert Elec., Inc. v. Levine,

554 F. 2d 1227, 1233 (2d Cir.) cert. denied, 46 U. S. L. W.

3262 (U. S. Oct. 11, 1977). Both of these conditions are satis-

fied here. Limmer’s and Cramer’s claims arose out of the same

transactions. All four directors named as defendants in the in-

stant case were defendants in Limmer. In a shareholder’s deriva-

tive suit, the substantive claim belongs to the corporation. See

Ross v. Bernard, 396 U. S. 531, 538-39 (1970). Although

different shareholders brought the two actions, the actual plain-

tiff on whose behalf the claims were brought is the identical

corporation, GTE. Since the Limmer court’s dismissal of the

$ 14(a) claim is a final judgment on the merits and since the

other requirements of res judicata are met, the plaintiff here

cannot relitigate the § 14(a) claim against the directors in this

or any other forum.

Cramer argues, however, that the individual defendants

should be judicially estopped from asserting the res judicata bar

of the Limmer judgment. In making this argument, Cramer re-

26

lies on a single letter sent by the defendants’ counsel to the dis-

trict court in response to a question from the court. In that letter,

the relevant portion of which is quoted in the margin,'’ counsel

stated that consolidation of the instant case with Limmer would

be premature. Cramer contends that since in that letter the

defendants’ counsel stated that the parties and issues in the two

suits differed, they should be estopped from contending now

that the judgment in Limmer bars his claim under § 14(a). We

agree with the district court that this argument “approaches

absurdity.” District Court Opinion, at 16. No motion was ever

filed under 28 U. S. C. §§ 1404(a) or 1407 to transfer the

instant case to the Southern District of New York or to con-

solidate the two actions. Thus, at the time the letter was written,

the question of the similarities between the two suits was not

squarely before the court. Since no question was ever directly

before the court, we do not think that the principle of judicial

estoppel should preclude the defendants from asserting the res

judicata bar of Limmer.

The district court also held that Arthur Andersen was en-

titled to summary judgment on the § 14(a) claim by virtue of

the Limmer decision. We agree, though we base our decision on

collateral estoppel, not res judicata. Although Arthur Andersen

would not have been bound by a judgment in Limmer adverse

to the defendants, we think it is entitled to avail itself of a

judgment favorable to those defendants. Mutuality of estoppel

is no longer required for the principle of collateral estoppel to

apply, at least “where the prior judgment is being invoked de-

fensively in a second action against a plaintiff bringing suit on

an issue he litigated and lost as plaintiff in a prior action.”

Blonder-Tongue Laboratories, Inc. v. University Foundation,

402 U. S. 313, 324 (1971). See Bruszewski v. United States,

181 F. 2d 419, 421 (3d Cir.), cert. denied, 340 U. S. 865

* The last paragraph of this letter reads:

“Although it is conceivable that, should both actions survive Motions to

Dismiss, consolidation or coordination of pre-trial discovery may be ap-

propriate, where there are different parties and issues in the respective plead-

ings, and where motions to dismiss on jurisdictional grounds may dispose of

the actions at the pleading stage, it is our view that any such consolidation

or coordination would be premature and inappropriate at this time.”

Letter from Joseph A. Tate, Esquire, to the Honorable A. Leon Higginbotham,

dated September 10, 1976. App. at 363a.

27

(1950); Bernhard v. Bank of America Nat. Trust & Sav. Ass'n,

19 Cal. 2d 807, 122 P. 2d 892 (1942). See generally Currie,

Mutality of Collateral Estoppel: Limits of the Bernard Doctrine,

9 Stan. L. Rev. 281 (1957). As long as the unsuccessful plain-

tiff had a full and fair opportunity to litigate the issue in the

prior lawsuit, he will not be permitted to reassert the identical

claim against a different defendant in a second suit. Bruszewski

v. United States, 181 F. 2d at 421. The plaintiff in Limmer had

a full and fair opportunity to litigate the § 14(a) claim in that

forum. He had every incentive to prosecute vigorously the ac-

tion against the individual defendants. There is no indication

either that Limmer could not have recovered from the individ-

ual directors or that he could have recovered additional damages

from Arthur Andersen. Under these circumstances, the judicial

interest in avoiding repetitive litigation must prevail. Cramer is

collaterally estopped from asserting the § 14(a) claim on behalf

of GTE against Arthur Andersen."’

IU. ‘SEcTION 13(a) CLAIM

In its opinion, the district court devoted very little attention

to the effect of Limmeh on Cramer's § 13(a) claim.'* The court’s

entire discussion appears as follows:

The claim asserted under § 13 was voluntarily with-

drawn by the plaintiff in Limmer and dismissed with prej-

'' Arthur Andersen contends that an independent auditor cannot be held

liable under § 14(a) and Rule I4a-9, 17 CFR § 240.14a-9, which together

impose liability for misleading statements on those who either solicit proxies

or permit the use of their names in soliciting proxies. Since we hold that

Arthur Andersen is entitled to avail itself of the protection of collateral

estoppel, we need not consider this claim.

'2 Section 13(a) reads:

(a) Every issuer of a security registered pursuant to section 78/ of this

title shall file with the Commission, in accordance with such rules and

regulations as the Commission may prescribe as necessary or appropriate

for the proper protection of investors and to insure fair dealing in the

security—

(1) such information and documents (and such copies thereof) as the

Commission shall require to keep reasonably current the information and

documents required to be included in or filed with an application or reg-

istration statement filed pursuant to section 78/ of this title, except that the

Commission may not require the filing of any material contract wholly

executed before July 1, 1962.

(2) such annual reports (and such copies thereof), certified if required

by the rules and regulations of the Commission by independent public ac-

countants, and such quarterly reports (and such copies thereof), as the

Commission may prescribe.

28

udice pursuant to stipulation. Limmer, supra, page a, fn.

1. Defendant’s Motion for Summary Judgment, June 7,

1977, page 23. Thus, res judicata bars Cramer’s claims

under both §§ 13 and |4a.

District Court Opinion, at 7.

Cramer contends that the district court erred in according

full res judicata and collateral estoppel effect to the voluntary

dismissal of the § 13(a) claim in Limmer. Relying on Papilsky

v. Berndt, 466 F. 2d 251 (2d Cir.), cert. denied, 409 U. S.

1077 (1972), Cramer argues that in order for a voluntary dis-

missal in a derivative suit to bar a later derivative suit brought

by a shareholder who was not a party in the first one, that share-

holder must have had notice of the voluntary dismissal. We

agree.

Rule 23.1 of the Federal Rules of Civil Procedure provides

that a shareholder's derivative action “shall not be dismissed

or compromised without the approval of the court, and

notice of the proposed dismissal or compromise shall be

given to shareholders or members in such manner as the court

directs.” The notice requirement of Rule 23.1 is not re-

stricted to dismissals following settlements, but extends as well

to voluntary dismissals under Rule 41(a). Papilsky v. Berndt,

466 F. 2d at 257; 3B J. Moore, Federal Practice 23.1.24 2

(1969). See also Certain-Teed Prod. Corp. v. Topping, 171 F.

2d 241, 243 (2d Cir. 1948) (applying notice requirement to

plaintiff-shareholder’s consent to entry of summary judgment

against him). The wisdom of this rule is clear. Although a de-

rivative action is brought by a single shareholder, the named

plaintiff represents both the corporation itself and the entire class

of stockholders. Notice is essential to ensure that the dismissal of

the derivative action comports with the best interests of the cor-

poration and its shareholders. If notice of a proposed voluntary

dismissal were not required to be given to nonparty shareholders,

the plaintiff or his counsel might be tempted to enter into a col-

lusive settlement with the defendants. In addition, the notice re-

quirement guards against dismissals which are due primarily if

not entirely to the named plaintiff's change of heart about prose-

cuting the action. Finally, if notice were not required and if the

29

dismissal were to occur after the staute of limitations had run,

the dismissal would bar any prosecution of the claim against

the corporate officials. Papilsky v. Berndt, 466 F. 2d at 258. We

conclude that before a shareholder's derivative action can be vol-

untarily dismissed, notice of the dismissal must be sent to non-

party shareholders. Absent such notice, the voluntary dismissal

will not bar a subsequent action by a shareholder who did not:

participate in the prior suit.

The defendants claim, however, that Limmer’s § 13(a)

claim remained pending until it was involuntarily dismissed by

the court. Since the claim was still pending, the defendants con-

tend, the court was not required to give notice to nonparty share-

holders. We find this argument unpersuasive. Limmer stipulated

to the dismissal of his § 13(a) claim. The district court did not

rule on the merits of Limmer’s cause of action, but instead dis-

missed the claim with prejudice pursuant to that stipulation.

Where the parties stipulate to the dismissal of a derivative action

prior to any adjudication of the merits, all of the policies under-

lying the notice requirement are implicated. The district court's

dismissal of the claim with prejudice magnifies the need for

notice to the other shareholders. Since no notice was given, the

voluntary dismissal cannot be given res judicata or collateral

estoppel effect.

Any other result, we think, would raise serious due process

questions. Nonparty shareholders are usually bound by a judg-

ment in a derivative suit on the theory that the named plaintiff

represented their interests in the case. But that rationale is valid

only if the representation of the shareholders’ interests was ade-

quate. Papilsky v. Berndt, 466 F. 2d at 260. Cf. Hansberry v.

Lee, 311 U. S. 32, 44-46 (1940). Rule 23.1 itself forbids a

court from going forward with a derivative action “if it appears

that the plaintiff does not fairly and adequately represent the in-

terests of the shareholders. . . .” The voluntary dismissal of a

cause of action raises some doubt as to whether the named plain-

tiff vigorously prosecuted that particular claim. The notice re-

quirement of Rule 23.1 helps to ensure that the shareholders’

interests are adequately represented in any dismissal prior to ad-

judication on the merits. Since notice of a proposed voluntary

30

dismissal must be sent to nonparty stockholders for that dis-

missal to be given res judicata and collateral estoppel effect, we

need not decide whether Limmer adequately represented the in-

terests of the stockholders.

Although Cramer’s § 13(a) claim is not foreclosed by

Limmer, the lower court’s dismissal of that claim should never-

theless be affirmed. Section 13 is one of several statutory pro-

visions requiring the filing of applications, documents, and re-

ports with the Securities Exchange Commission. See also

$$ 12(b), 12(g), 15(b)(1), 16(a), and 17(a) of the Act,

1S U.S.C. $$ 78/(b), 78/(g), 780(b) (1), 78p(a), & 78q(a).

In enacting § 13(a), Congress intended to protect investors by

ensuring that they would receive adequate periodic reports con-

cerning the operation and financial condition of corporations.

See S. Rep. No. 792, 73rd Cong., 2d Sess. 11 (1934). Section

18, 15 U. S. C. § 78r, provides a civil remedy for damages re-

sulting from the purchase or sale of a security in reliance upon a

misleading statement in a document or report filed within the

meaning of $$ 13(a) and 18, that curities Litigation, 347 F.

Supp. 1327, 1340 (E. D. Pa. 1972), modified in part, 357 F.

Supp. 869 (E. D. Pa. 1973), aff'd, 494 F. 2d 528 (3d Cir.

i974). Although GTE’s sale of its ownership interest in the

foreign subsidiary qualifies as a sale of securities with the mean-

ing of §§ 13(a) and 18, that sale was not made in reliance upon

a false statement in an annual report filed by GTE with the SEC.

Absent that causal nexus, Cramer’s complaint fails to state a

cause of action in favor of GTE under these sections. In fact, at

oral argument in this case, Cramer’s counsel conceded that his

complaint “probably did not” state a claim under § 13(a). Ac-

cordingly, we affirm the district court’s entry of summary judg-

ment in favor of the defendants on the § 13(a) claim.

31

IV. SECTION 10(b) AND RULE LOb-5 CLAIMS

Section 10(b) of the 1934 Act, 15 U.S.C. § 78j(b),"* and

Rule 10b-5, 17 C. F. R. § 240.10b-5,"' promulgated thereunder

make unlawful the use of any deceptive or manipulative device

in connection with the purchase or sale of a security. See Super-

intendent of Ins. v. Bankers Life & Cas. Co., 404 U. S. 6

(1971). Where it is alleged that corporate officials have de-

frauded the corporation in connection with the purchase or sale

of securities, a shareholder’s derivative action under § 10(b)

can be maintained against those officials. See Pappas v. Moss,

393 F. 2d 865, 869 (3d Cir. 1968). Such a derivative action

can be maintained, however, only if the corporation itself was a

purchaser or seller of securities. See Blue Chip Stamps v. Manor

Drug Stores, 421 U. S. 723 (1975).

Cramer contends that the overseas payments by GTE’s

subsidiaries constituted a fraud on the corporation in violation

of § 10(b) and Rule 10b-5.'* Specifically, he argues that, be-

'' Section 10(b) reads:

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 manipulative or deceptive device or contrivance in contra-

vention of such rules and regulations as the Commission may prescribe as

necessary Or appropriate in the public interest or for the protection of

investors.

15 U.S.C. § 78j(b).

'* The text of Rule 10b-5 reads as follows:

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.

(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.

17 C.F.R. § 240.10b-5.

'* Although Cramer has asserted a § 10(b) claim on behalf of GTE against

the defendants, neither Auerbach nor Limmer made comparable claims. Auer-

bach’s failure to assert a § 10(b) claim is understandable, since federal courts

have exclusive jurisdiction over suits alleging violations of this statutory provi-

sion. Sce § 27 of 1934 Act, 15 U.S.C. § 78aa; Wolfson v. Blumberg, 299 F.

Supp. 191, 192 (S.D. N.Y. 1964), appeal dismissed, 340 F.2d 89 (2d Cir.

1965). Limmer brought suit in a federal forum, however, and thus could have

asserted a § 10(b) claim if he had chosen to do so.

32

cause of these payments, GTE failed to receive adequate con-

sideration for the sale of its equipment and, in one instance, for

the sale of its ownership interest in a foreign company (the

“Customer”). The district court concluded that GTE had

bought or sold securities within the meaning of § 10(b) and

thus that Cramer had standing to assert the claim on behalf of

the corporation.'” Nevertheless, the court dismissed the § 10(b)

claim for three reasons:

Cramer's § 10b and Rule 10b-5 claims against the

defendants fail when the court asks whether the manipula-

tive devices, the alleged fraud and the alleged breaches of

fiduciary duty were “in connection with” the purchase or

sale of any security and whether these activities resulted

in any damage to GTE.

* * *

The complaint herein is devoid of any allegation that

either the defendant officers, the Corporation or the

accountants intended to defraud GTE.

District Court Opinion, at 1! and 13 (emphasis added). In

our opinion, none of these grounds provides a sufficient basis

for dismissing Cramer's complaint on a Rule 12(b)(6) motion.

A. The “In-Connection-With” Requirement.

The district court did not explain its statement that the

allegedly fraudulent activities were not in connection with the

purchase or sale of a security. Cramer contends that the court's

conclusion is erroneous for two reasons. First, he urges that

GTE’s payment of commissions on its equipment sales to the

' In concluding that Cramer had standing to bring this claim, the district

court noted first that a corporation’s issuance of its own shares is a sale of

securities within the meaning of § 10(b) and Rule 10b-5. Securities & Exch.

Comm'n v. National Sec., Inc., 393 U.S. 453 (1969). The court then stated:

The complaint recites several instances in which GTE either bought or

sold securities. In one transaction, GTE sold its substantial ownership inter-

est in One subsidiary company to a group of foreign nations under a com-

mission arrangement wherein GTE allegedly did not ultimately receive full

value. (Complaint, Exhibit A, pp. 21-22]. Three other transactions are con-

tained in GTE’s 1975 Annual Report; in 1974 GTE offered 6,000,000

shares for public sale and issued $04,935 shares for exchange purposes:

GTE purchased 4775 of its own shares in 1974.

District Court Opinion, at 11.

33

company designated by the foreign investors was part of the

sume financing package whereby GTE sold its ownership inter-

est in the Customer to the Group. By paying commissions on

the later sales, GTE allegedly paid the purchase price with its

own funds and thus received inadequate consideration for the

sale of its controlling interest in the Customer. This, Cramer

alleges, constituted a fraud in violation of § 10(b) and Rule’

10b-5. Secondly, Cramer claims that the other foreign payments

disclosed in the Audit Committee’s report were made in the

“same general time frame” as sales of stock by GTE.

We need not decide the correctness of Cramer’s second

contention, for we conclude that the complaint sufficiently

alleges that the commissions on the equipment sales were paid

in connection with GTE’s sale of its controlling interest in the

Customer. As the district court stated, see footnote 12 supra,

the sale of this ownership interest does constitute a sale of

securities under § 10(b) and Rule 10b-5. The defendants

claim that any damages to GTE caused by the commission

arrangement were sustained in connection not with the sale of

securities, but with the subsequent sales of equipment to the

foreign company. We think that the defendants are taking a

much too narrow view of the financing arrangement whereby

GTE agreed to sell its interest in the Customer to the group of

foreign investors. GTE’s promise to pay commissions on equip-

ment sales was not a separate agreement. Rather, that promise

was an essential part of GTE’s original agreement to sell its

interest in the foreign company. The following excerpt from the

Audit Committee report makes this connection abundantly

clear:

Since the Group did not have sufficient financial

resources to purchase GTE’s interest, it was agreed that

GTE would finance a part of the purchase price by paying

the Group a commission on sales of equipment by GTE

to the Customer.

Audit Committee Report, at 22. Since the commission payments

were inextricably linked to GTE’s sale of its ownership interest

in the Customer, we think the district court erred in concluding

34

that the alleged fraud was not alleged to be in connection with

the sale of a security.

B. Injury to GTE.

Nor do we agree with the district court that GTE was not,

for purposes of a Rule 12(b)(6) motion, injured by the

allegedly fraudulent devices. In reaching this conclusion, we

focus, as did the district court, on GTE’s sale of its owner-

ship interest in the foreign company. The Audit Committee

found that GTE paid out approximately $2% million in com-

missions in connection with the sale of its interest in that com-

pany. GTE made these payments because the foreign investors

were unable to finance the entire purchase price. In effect, GTE

supplied some of the money which it received in exchange for

its own stock. Surely, such a transaction, if proved, would

establish a prima facie injury to the corporation.

The Audit Committee found that GTE entered into this

arrangement only after it had been informed that, if it declined

to do so, one of its competitors would agree to pay similar

commissions. Relying on this finding, the district court con-

cluded that without the commission arrangement GTE would

not have been able to sell its equipment to the Customer. Since

the commission arrangement in effect saved business for GTE,

the court concluded, that arrangement did not damage GTE.

A complaint should not be dismissed under Rule 12(b)(6)

“unless it appears beyond doubt that the plaintiff can prove

no set of facts in support of his claim which would entitle him

to relief.” Conley v. Gibson, 355 U.S. 41, 45-46 (1957). See

2A J. Moore, Federal Practice 412.08, at 2274 (2d ed. 1975).

Applying this standard, we think the district court could not

properly dismiss Cramer’s complaint on the ground that GTE

was not injured by the allegedly fraudulent activities. The Audit

Committee did not find that the commission arrangement nec-

essarily saved business for GTE. That Committee found only

that GTE was told that if it did not enter into such an arrange-

ment, one of its competitors would agree to a similar deal. The

report does not indicate that GTE explored the veracity of the

35

investors’ statement before it entered into the arrangement. It is

quite possible that no competitor in fact offered to enter into a

similar agreement. Even assuming that the commission arrange-

ment saved business for GTE, we still cannot be sure, at this

posture of the case, that GTE was not injured by the transac-

tion. Neither the Audit Committee nor the district court com-

pared the total amount of commissions with the profits gen-

erated by GTE’s equipment sales to these foreign investors.

Since no such comparison was undertaken, we cannot be certain

that the commission arrangement benefited GTE. The district

court could not properly terminate the claim at such an early

stage on this ground.

C. Allegation of Intent to Defraud.

As stated earlier, a private cause of action will not lie

under § 10(b) or under Rule 10b-5 unless the plaintiff alleges

scienter—i.e., an intent to deceive, manipulate, or defraud.

Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). The district

court concluded that Cramer’s complaint failed to allege that the

defendants intended to defraud the corporation. Relying on

Shemtob v. Shearson, Hammill & Co., 448 F.2d 442, 444-45

(2d Cir. 1971), it reasoned that the facts constituting both the

fraud and the scienter must be alleged with particularity. District

Court Opinion, at 13. '

Under the Federal Rules of Civil Procedure, most com-

plaints need be phrased only in general terms sufficient to put

the defendants on notice as to the nature of the claims. being

asserted against them. See Fed. R. Civ. P. 8(a). However, Rule

9(b) imposes additional requirements where the complaint

alleges fraud. That rule, which applies to claims alleging fraud-

ulent activities in violation of the federal securities laws, see

Segal v. Gordon, 467 F.2d 602, 606-08 (2d Cir. 1972);

Shemtob v. Shearson, Hammill & Co., 448 F.2d at 444-45,

reads:

‘of b) Fraud, Mistake, Condition of the Mind. In all

averments of fraud or mistake, the circumstances consti-

36

tuting fraud or mistake shall be stated with particularity.

Malice, intent, knowledge, and other conditions of mind

of a person may be averred generally.

The district court failed to recognize the differences be-

tween the two sentences of Rule 9(b). The first sentence of

that rule requires that the complaint state with particularity the

circumstances constituting the fraud. It was this part of Rule

9(b) which formed the basis for the dismissal of the complaint

in Shemtob. But the problems with the complaint in Shemtob

are absent here. Paragraph 15 of Cramer’s complaint incorpo-

rdtes by reference the entire report of the Audit Committee.

That report describes in detail the facts of the foreign payments,

including the commissions paid in connection with GTE’s sale

of its ownership interest in the foreign company. By incorpo-

rating this committee’s report, Cramer’s complaint clearly

satisfies the specificity requirement of the first sentence of Rule

+(0).

The second sentence of Rule 9(b) requires only that “in-

cent, knowledge, and other condition of mind . . . be averred

generally.” (emphasis added). In paragraph 14 of this com-

plaint, Cramer alleges that the “defendants . . . participated

and/or acquiesced in, and/or aided and abetted, and/or failed

to discover when in the exercise of due diligence they would

have discovered, devices . . . to defraud General. . . .” Certainly,

this general allegation of the defendants’ state of mind meets the

minimal requirements of the second sentence of Rule 9(b).

The defendants claim, however, that this allegation fails to

meet the standard of Ernst & Ernst v. Hochfelder. We disagree.

In Ernst & Ernst, the Supreme Court held that an allegation of

negligence was insufficient to sustain a cause of action for dam-

ages under Rule 10b-5. The Court declined to determine

whether recklessness could support such a cause of action. 425

U.S. at 194 n.12. We need not decide here whether an allegation

of recklessness is sufficient under § 10b and Rule 10b-5, for we

think that Cramer’s complaint adequately alleges intent, at least

37

on the part of the individual directors.'’ The complaint alleges

that the defendants knowingly participated in a scheme to de-

fraud GTE. Indeed, the Audit Committee itself found that the

four directors had been involved in the negotiation, formaliza-

tion, and implementation of the commission arrangement. When

corporate officials have actively participated in such a scheme

with full knowledge of the consequences of their acts, such:

officials, we think, have acted with scienter within the meaning

of Ernst & Ernst. See In re Clinton Oil Co. Securities Litigation,

CCH Sec. Law Rptr., € 96,015 (D. Kan. March 18, 1977).

The Audit Committee’s finding that the directors did not profit

secretly from these payments does not alter our conclusion. If

the directors here intended to commit acts which constituted a

fraud upon the corporation, whether or not their acts were moti-

vated by good faith is irrelevant. Since we believe that the com-

plaint adequately alleges scienter on the part of the directors, we

cannot affirm the district court’s dismissal of Cramer's § 10(b)

and Rule 10b-5 claims on this ground.’*

D. Shareholder’s Demand on the Directors and the Business

Judgment Rule

The defendants assert several grounds for affirmance which

were not considered by the district court. Principally, they argue

that the Special Litigation Committee’s determination that

Cramer’s derivative suit is not in the best interests of the corpo-

ration bars the prosecution of this suit. The defendants empha-

size that the directors who comprised that Committee were not

part of inside management and had not served as directors when

the questionable events occurred, thereby guaranteeing the inde-

'? Arthur Andersen claims that no set of facts could be proven to support a

finding that it had the requisite intent to defraud GTE. While it seems very

unlikely that Cramer could prove that Arthur Andersen intended to defraud

the corporation, we nevertheless would be reluctant to dismiss the complaint

on that ground at such an early stage of the proceedings. Since we are affirm-

ing the district court's dismissal of the complaint on a separate ground, we

—_ not decide whether it sufficiently alleged scienter on the part of Arthur

ndersen.

_ ' Nor is it fatal to Cramer’s complaint that he alleges negligence in addi-

tion to scienter. While under Ernst & Ernst Cramer could not recover damages

under § 10(b) for mere negligence, we conclude that the remainder of para-

graph 14 of the complaint adequately alleges scienter. Since at this stage we

must construe the complaint liberally, we cannot dismiss the entire complaint

— because a single allegation is insufficient under the standard of Ernst &

rnst.

38

pendence of their determination. Moreover, the Committee acted

in good faith and with the full authority of the Board of Direc-

tors. Accordingly, the defendants claim, that Committee's deter-

mination was a business judgment of GTE’s management that

the derivative suit should not proceed—a business judgment

which is insulated from judicial review and which bars the main-

tenance of the derivative suit. See Gall v. Exxon Corp., 418 F.

Supp. 508 (S.D.N.Y. 1976).

The business judgment rule originated as a means of limit-

ing the liability of corporate directors and officers for mistakes

made while performing their duties. Absent bad faith or some

other corrupt motive, directors are normally not liable to the cor-

poration for mistakes of judgment, whether those mistakes are

classified as mistakes of fact or mistakes of law. See Briggs v.

Spaulding, 141 U. S. 132 (1891); 3A W. Fletcher, Corpora-

tions, ch. 11, § 1039 (1975 ed.). The rationale for the rule is

that in order for the corporation to be managed properly and

efficiently, directors must be given wide latitude in their handling

of corporate affairs.

Some courts have applied the business judgment rule to bar

a shareholder’s derivative action where an independent board of

directors has determined that such an action would not be in the

best interests of the corporation. In United Copper Securities Co.

v. Amalgamated Copper Co., 244 U. S. 261, 263 (1917), the

Supreme Court stated:

Whether or not a corporation shall seek to enforce in

the courts a cause of action for damages is, like other busi-

ness questions, ordinarily a matter of internal management

and is left to the discretion of the directors, in the absence

of instruction by vote of the stockholders. Courts interfere

seldom to control such discretion intra vires the corpora-

tion, except where the directors are guilty of misconduct

equivalent to a breach of trust, or where they stand in a

dual relation which prevents an unprejudiced exercise of

judgment....

This circuit previously considered the business judgment

rule as a bar to shareholders’ derivative suits in Ash v. Inter-

39

national Business Machines, Inc., 353 F. 2d 491, 492-93 (3d

Cir. 1965), cert. denied, 384 U. S. 927 (1966), and in Miller

v. American Tel. & Tel. Co., 507 F.2d 759 (3d Cir. 1974). In

Ash, a minority stockholder in three corporations competing

with IBM sued IBM to enjoin it from acquiring another corpo-

ration. The plaintiff contended that this acquisition would sub-

stantially lessen competition in violation of Section 7 of the

Clayton Act, 15 U. S. C. § 18. Because the directors of the

three corporations had refused the plaintiff's demand that they

sue IBM, we affirmed the district court’s dismissal of the com-

plaint. We held that in the absence of any showing that the di-

rectors’ refusal to sue was collusive or in bad faith, the directors’

business judgment barred the plaintiff's suit on behalf of the

corporation. In Miller, stockholders in AT&T brought a deriva-

tive action against the corporation and its directors, alleging that

the directors’ failure to collect a $1.5 million debt from the

Democratic National Committee constituted an illegal campaign

contribution and a breach of the directors’ fiduciary duty to the

corporation. We acknowledged that the directors’ judgment that

the derivative action was not in the best interests of the corpora-

tion would normally bar the suit. 507 F. 2d at 762. Neverthe-

less, we reversed the district court’s dismissal of the complaint,

holding that where the “decision not to collect a debt owed the

corporation is itself alleged to have been an illegal act,” the di-

rectors’ judgment cannot bar the derivative suit: /d.

The business judgment rule as a bar to a shareholder's

derivative action is inextricably linked to the requirement in a

number of jurisdictions that the plaintiff-shareholder first make a

demand on the directors to pursue the claim. See, e. g., Fed. R.

Civ. P. 23.1; Colo. R. Civ. P. 231; N. Y. Bus. Corp. Law

§$ 626(c) (McKinney 1963). Rule 23.1 of the Federal Rules of

Civil Procedure requires that the shareholder's complaint “allege

with particularity” either the efforts made to obtain the desired

action from the directors or the reasons for not making such an

effort. Once the shareholder has made a demand upon the direc-

tors, the directors are then able to determine whether in their

opinion a suit on behalf of the corporation would comport with

the best interests of the corporation.

“=

40

Important policies underlie both the demand requirement

and the business judgment rule as a bar to shareholders’ deriva-

tive actions. The demand requirement enables corporate man-

agement to pursue alternative remedies, thus often ending un-

necessary litigation. Moreover, deference to the directors’ judg-

ment might terminate meritless causes of actions and prevent the

corporation from incurring the costs of participating in deriva-

tive suits. Even if a-particular suit has some merit, the litigation

costs and the adverse’ effect on the business relationship between

the corporation and the potential defendant might outweigh any

potential recovery in the lawsuit. Finally, derivative actions

could be brought not to remedy wrongs to the corporation, but

to induce settlements beneficial to the named plaintiff or his

counsel. See Note, The Demand and Standing Requirements in

Stockholder Derivative Actions, 44 U. Chi. L. Rev. 168,

(1976).

On the other hand, shareholders’ derivative suits can be

important weapons for remedying abuses of corporate manage-

ment. Thus, while the demand requirement of Rule 23.1 should

be rigorously enforced, we do not think that the business judg-

ment of the directors should be totally insulated from judicial

review. In order for the directors’ judgment to merit judicial

deference, that judgment must have been made in good faith

and independently of any influence of those persons suspected

of wrongdoing. In addition, where the shareholder contends

that the directors’ judgment is so unwise or unreasonable as to

fall outside the permissible bounds of the directors’ sound dis-

cretion, a court should, we think, be able to conduct its own

analysis of the reasonableness of that business judgment. The

opinions in United Copper Securities Co.,'” and Miller? both

suggest that courts have some limited power to review the

'* Although the Supreme Court in United Copper Securities Co. deferred

to the business judgment of the directors, the Court pointed out that there was

not “even an allegation that [the directors’) action in refusing to bring suit

[was] unwise.” 244 U.S. at 264.

“” Underlying the business judgment rule is the assumption that reasonable

diligence has been used in reaching the decision which the rule is invoked to

justify.

Miller v. American Tel. & Tel. Co., 507 F.2d at 762 (emphasis added).

41

reasonableness of the directors’ iudgment that a derivative suit

is not in the best interests of the corporation.”

Neither United Copper Securities Co., Ash, nor Miller

discusses in any depth whether state or federal law determines

the effect of the business judgment rule on a Rule 23.1 deriva-

tive action. At oral argument in this case, both counsel argued

that the law of the state of incorporation governs this question:

To be sure, in Miller we applied the law of New York to deter-

mine whether the directors’ judgment barred the derivative ac-

tion. But the federal claim asserted in Miller was inextricably

linked to the state law claim for wasting corporate assets. It is

not at all clear that state law should determine the effect of the

directors’ judgment on a derivative action under the federal

securities laws, where Congress has expressed a more compre-

hensive interest. **

In the instant case, we need not decide whether state or

federal law governs the scope of review by a court of the busi-

ness judgment decision not to pursue a cause of action. Nor do

we have to decide whether the Special Litigation Committee’s

judgment should bar Cramer's derivative suit, for in our opinion

the complaint should have been dismissed for failing to comply

with the demand requirement of Rule 23.1. In Shlensky v.

*1 See Note, The Demand and Standing Requirements in Stockholder Deriv-

ative Actions, 44 U, Chi. L. Rev. 168, 196 (1976) (despite adverse business

judgment, shareholder should be able to maintain a derivative action “where

the corporation claim is clear, the costs of litigation are relatively small in

relation to the probable recovery, and a lawsuit would not overly disrupt the

commercial relation of the corporation”). Note, Demand on Directors and

Shareholders as a Prerequisite to a Derivative Suit, 73 Harv. L. Rev. 746, 759

(1960) (“Certainly the court must respect the board's decision if it is within

the broad bounds of reason, but the noninterference doctrine should not be

carried to the extreme of making an unreasonable reference of the board

dispositive of the issue.” ).

“2 It should be pointed out that a stockholder may maintain an action

against a corporate insider under § 16(b) of the 1934 Act, 15 U.S.C. § 78p(b).

“If the isguer shall fail or refuse to bring such suit within sixty days after

request or shall fail diligently to prosecute the same thereafter... .” Thus,

although a derivative action under § 16(b) cannot be brought unless the

shareholder has first made a demand on the directors, the directors’ decision

not to prosecute the suit does not preclude a subsequent action by the share-

holder himself.

We also take note of the Second Circuit's recent decision in Lasker v. Burks.

No. 77-7060 (2d Cir. Jan. 11, 1978), which declined to apply the business

judgment rule to bar a shareholder's derivative suit anion the majority di-

rectors of a registered mutual fund and its investment adviser. To permit “inde-

pendent” directors to bar such a suit, the court concluded, would be “contrary

to the public interests which Congress sought to protect” by enacting the In-

vestment Company Act and the Invesment Advisers Act. Slip Op, at 992-93.

42

Dorsey, Nos. 77-1156/57/58 (3d Cir. March 6, 1978), we

affirmed a district court’s dismissal of a defendant in a derivative

action on the ground that the amended complaint failed to

allege either an adequate demand on the corporate directors to

sue that defendant or a sufficient reason for failing to make that

demand. In affirming the dismissal, we stated that the amended

complaint “failed to comply with the express requirements of

Rule 23.1 which are mandatory. . . .” Slip Op., at 18. We reach

the same conclusion here.

In paragraph 13 of his complaint, Cramer admits not

having made a demand upon GTE’s directors. He claims that

such a demand would have been futile, however, since the

Audit Committee had not recommended litigation against the

defendants and since the individual defendants herein dominated

the Board of Directors. Courts have sometimes permitted deriv-

ative actions to go forward without a demand on the directors

where such a demand would have been futile and where the

plaintiff-shareholder has alleged with particularity the reasons

why a demand would have been futile. See, e. g., Nussbacher v.

Continental Illinois Nat. Bank & Trust Co., 518 F. 2d 873,

878-79 (7th Cir. 1975), cert. denied, 424 U. S. 928 (1976).

In the instant case, however, Cramer’s complaint does not ade-

quately explain why he failed to make a demand upon the

directors. Cramer correctly states that the Audit Committee did

not recommend litigation against the directors. But so far as the

complaint discloses, that Committee had not been instructed to

determine whether litigation against the directors would be

appropriate. Its primary functions were to examine GTE’s

foreign business transactions, to disclose any questionable over-

seas payments, and to suggest internal procedures for remedy-

ing the prior practices. We do not believe that the Audit Com-

mittee’s report necessarily demonstrated management's opposi-

tion to an action against the directors who had participated in

the foreign activities in which the payments had been made.

To be sure, the Special Litigation Committee later opposed the

maintenance of Cramer's derivative action, But that Commit-

tee’s determination was made after Cramer had already com-

menced his suit. The futility of making the demand required by

43

Rule 23.1 must be gauged at the time the derivative action is

commenced, not afterward with the benefit of hindsight. At the

time Cramer filed his complaint, the Board of Directors had not

yet expressed opposition to such derivative actions.

Nor do we think that the defendants herein so dominated

the Board of Directors as to make a demand on the Board futile.

At the time Cramer commenced this suit, there were 14 indi-’

viduals on GTE’s Board of Directors. Only four of these were

named as defendants in this action. The remaining ten directors

had not been involved in the allegedly fraudulent activities.

Indeed several of the directors had not even been members of

the Board at the time the questionable transactions occurred.

Under these circumstances, we cannot agree with Cramer that

the four directors named as defendants in the instant case

dominated the Board to such an extent that the plaintiff should

be excused from the mandatory requirement of Rule 23.1 that

he first make a demand on the directors.** Accordingly, we

affirm the district court’s dismissal of the Cramer’s § 10(b) and

Rule 10b-5 claims.*'

V.

Cramer argues, however, that the district court should not

have dismissed his.complaint without affording him adequate

discovery. But Cramer’s claims were all dismissed because they

are legally insufficient. We fail to see how additional discovery

could have cured those insufficiencies. Thus, we conclude that

the district court did not abuse its discretion in declining to

grant the plaintiff additional discovery prior to dismissing his

complaint.

VI.

The judgment appealed from will be affirmed.

“* We do not hold that a shareholder, before instituting a derivative action,

must always make a demand on the directors. But we do believe that unless

the plaintiff's complaint alleges some facts tending to show why a demand

would be futile, such a demand should be required, and the complaint should

be dismissed.

“The defendants also urge that we affirm the district court's dismissal of

the compiaint on the grounds: (1) that the collateral estoppel of the

Auerbach decision bars all of Cramer's claims; and (2) that since the plain-

tiff in Limmer could have brought a claim under § 10(b) and Rule 10b-5,

Cramer is barred by res judicata from bringing such a claim now. Because

we believe that Cramer's complaint should have been dismissed for failing to

comply with the demand requirements of Rule 23.1, we need not consider

these questions.

44

APPENDIX B

Harold CRAMER, custodian for

Patricia Gail Cramer

Vv.

GENERAL TELEPHONE &

ELECTRONICS et al.

Civ. A. No. 76-1231.

United States District Court,

E. D. Pennsylvania.

Aug. 22, 1977.

A shareholder derivative action was brought in which

plaintiff alleged violations of various provisions of federal se-

curities laws and breach of fiduciary duties. The District Court,

Higginbotham, J., held, inter alia, that plaintiffs’ claims were

insufficient and should be dismissed.

Defendants’ motion for summary judgment granted as to

some claims and remaining claims dismissed.

1. Judgment—677

For purposes of judging applicability of doctrine of res

judicata, two suits involved same parties where, in both cases,

plaintiff sued derivatively on behalf of same corporation and

claim pressed by each plaintiff against directors and third parties

was not his own, but the corporation’s.

2. Judgment—588

Court’s decision with respect to shareholder's derivative

suit charging violation of provisions of Securities Exchange Act

of 1934 relating to solicitation of proxies did not, under doctrine

of res judicata, bar assertion, in later derivative action against

same corporation by different shareholder, of allegations that

provisions of Act relating to use of manipulative or deceptive

device in purchase or sale of securities and registration of

securities on national securities exchange had been violated.

45

Securities Exchange Act of 1934, §§ 10(b), 12(b)(1), 13, 14(a)

as amended 15 U.S.C.A. §§ 78j(b), 78/(b) (1), 78m, 78n(a).

3. Securities Regulation—120

Where corporate stockholder sued derivatively on corpo-

rations’ behalf, and where complaint alleged that corporation

itself either bought or sold securities, stockholder had standing

to assert claim based on alleged violation of statute and rule

relating to use of manipulative or deceptive device in purchase

or sale of security. Securities Exchange Act of 1934, § 10(b) as

amended 15 U.S.C.A. § 78j(b).

4. Securities Regulation—117

Corporate shareholder’s derivative claim against corpora-

tion’s officers and auditors that they had violated provisions of

Securities Exchange Act of 1934 relating to use of manipula-

tive or deceptive device in purchase or sale of security failed

where corporation suffered no loss from transactions of which

defendants were accused and where no such loss was alleged.

Securities Exchange Act of 1934, § 10(b) as amended 15

U.S.C.A. § 78j(b).

5. Securities Regulation—139

Corporate stockholder, in his derivative action against

corporate officers and auditors, failed to state valid claim for

violation of provisions of Securities Exchange Act of 1934

relating to use of manipulative or deceptive device in connection

with purchase or sale of security where, although it alleged

tht corporation had been mismanaged and that defendants’

failure to disclose such mismanagement prior to publication of

annual report was at heart of larger scheme to defraud corpora-

tion, there was no allegation that either defendant officers, the

corporation or the auditors intended to defraud the corporation.

Securities Exchange Act of 1934, § 10(b) as amended 15

U.S.C.A. § 78j(b).

6 Securities Regulation—117

No claim for relief could be maintained under provisions

of Securities Exchange Act of 1934 relating to use of manipula-

ee

46

tive or deceptive device in purchase or sale of security based on

negligence. Securities Exchange Act of 1934, § 10(b) as amend-

ed 15 U.S.C.A. § 78)(b).

7. Securities Regulation—137

Claim for violation of provisions of Securities Exchange

Act of 1934 specifying information which issuer of securities

must provide in application to register such securities failed

where complaint did not allege that corporation on behalf of

which suit was brought relied on any false or misleading filings

in making any sale of securities, that any filing affected price

of corporation’s securities, or that there was any causal nexus

between filing and alleged loss suffered by corporation. Securi-

ties Exchange Act of 1934, §§ 10(b), 12(b)(1), 18, 18(a) as

amended 15 U.S.C.A. §§ 78j(b), 78/(b) (1), 78r, 78r(a).

8. Securities Regulation—122

Private cause of action would not lie for violation of pro-

visions of Securities Exchange Act of 1934 specifying informa-

tion which issuer of security must provide in application to

register such security where statutorily required allegations

cannot be made. Securities Exchange Act of 1934, §§ 10(b),

12(b)(1), 18, 18(a) as amended 15 U.S.C.A. §§ 78j(b),

781(b) (1), 78r, 78r(a).

9. Federal Courts—18

Judgment—828(3.24)

Where prior decision in state court, which was valid final

judgment involving same parties and same cause of action al-

leged as pendent claim in later derivative action brought by

stockholder in federal court, was decided adversely to plaintiff

in federal action, state court judgment barred pendent state

claim in federal action under doctrine of res judicata; even if

res judicata did not preclude consideration of such pendent

state law claim, federal district court would decline to consider

claim where plaintiff's federal claims under securities laws had

been dismissed.

47

Mitchell A. Kramer, Kramer & Salus, Philadelphia, Pa.,

for plaintiff.

Arthur H. Kahn, Philadelphia, Pa. of counsel, for Warner,

et al.

Oliver C. Biddle, New York City, for Arthur Andersen &

Co.

Kaye, Scholer, Fierman, Hays & Handler, New York City,

for defendants Brophy, Douglas and Warner.

Dean C. Rohrer, New York City, for General Telephone

and Electronics, John Haikins, Pepper, Hamilton & Scheetz,

Philadelphia, Pa., of counsel.

Morrison, Paul, Stillman & Beiley, New York City, for

Wm. F. Bennett.

OPINION AND ORDER

HIGGINBOTHAM,, District Judge.

This shareholder derivative action, alleging violations of

Sections 10(b), 12(b)(1), 13(a) and 14(a) of the 1934 Securities

and Exchange Acts as well as breach of fiduciary duties, was

commenced by Harold Cramer on behalf of the shareholders of

General Telephone & Electronics Corp. (GTE) against Leslie

H. Warner, Theodore F. Brophy, John G. Douglas and William

Bennett, corporate officers', and Arthur Andersen & Co., GTE’s

auditors. Jurisdiction is founded under § 27 of the 1934 Act, as

amended, 15 U.S.C. § 78aa, 28 U.S.C. § 1332, and pendent

jurisdiction.

Presently before the court are the following motions: plain-

tiffs motion for a Protective Order under Rule 26(c) of the

Federal Rules of Civil Procedure; defendants’ joint motion to

dismiss the complaint for failure to state a claim for which relief

can be granted under Fed. R. Civ. P. (12(b)(6); and, as an

alternative, defendants’ motion for summary judgment on

' The individual defendants held the following positions with GTE:

Leslie H. Warner, Chairman of the Board of GTE, Theodore F. Brophy,

President and Member of the Board of GTE; John J. Douglas, Executive

Vice-President of Finance and Director of GTE; William F. Bennett.

— Vice President of the Manufacturing Group and Director of

48

grounds that the complaint is barred by principles of res judicata

and collateral estoppel.*

For the reasons stated herein, the motion for summary

judgment is granted as to Sections 13(a), and 14(a) and the

pendent state claims. The claims under Sections 10(b) and Rule

10b-5 and Section 12(a) are dismissed. Finally, plaintiff's mo-

tion for protective order is denied.

FACTUAL BACKGROUND

In view of the diversity and complexity of the claims as-

serted and the number of legal actions filed pursuant thereto, a

review of the factual and legal history of this case is necessary.

Cramer, plaintiff herein, has alleged that the defendants

“participated, and/or acquiesced in, and/or aided and abetted

and/or failed to discover when in the exercise of due diligence

they would have discovered devices, schemes and artifices to

defraud . . . GTE.” (Complaint, page 4 ¢ 14]. It is further al-

leged that: GTE’s assets were unlawfully used; that corporate

financial records and corporate tax returns were falsified; and

that material facts were incompletely and/or inaccurately dis-

closed to GTE’s shareholders. Plaintiff has maintained that

GTE’s 1976 Annual Report contains all the facts relevant to

the claims he has asserted; he has incorporated that report into

his complaint.

In November, 1975, GTE’s Board of Directors authorized

the formation of an Audit Committee composed solely of out-

side, non-management directors, to conduct an investigation to

determine whether between January 1, 1971 and December 31.

1975, GTE or any of its international subsidiaries had made

“ . . illegal political contributions, unlawful payments to do-

mestic or foreign government officials or other payments which

were otherwise improper or improperly recorded. . . .” [Com-

plaint, Exhibit A, page 13]. The Washington, D.C. law firm of

Wilmer, Cutler and Pickering (which had not previously repre-

‘ Defendant Arthur Andersen & Co. and nominal defendant GTE have joined

the motion of defendants Warner, Brophy, Douglas and Bennett to dismiss the

complaint and for summary judgment. See Documents Number 35 (filed June

9, 1977) and Number 36 (filed June 10, 1977).

49

sented GTE) and the accounting firm of Arthur Andersen & Co.

were retained to assist this Committee.

The fifty-one page Audit Committee report, gated March

4, 1976, revealed that approximately $8,000,000 was illegally

paid to or for the benefit of government officials as commercial

kickbacks, rebates or bribes to officials of private foreign cus-

tomers.’ An additional sum, approximately $2,000,000, was

paid pursuant to a pre-January 1, 1971 commission arrangement

made between GTE officials and officers of a single foreign com-

pany, designated simply “The Customer” in the Audit Commit-

tee Report; GTE held a “substantial interest” in the company.’

This entire audit report was included in the 1976 Proxy

Statement and distributed to all GTE shareholders before the

Annual shareholder meeting was held on April 21, 1976. Both

the report, and the Supplemental Report dated November 4,

1976, were filed with the SEC.

On March 16, 1976, Mr. Auerbach, a GTE shareholder,

filed a derivative action against the corporate officials and Arthur

Andersen in the Supreme Court of New York in Westchester

County. He alleged that the illegal payments constituted a waste

of GTE’s assets, and that by permitting such payments, defend-

ants breached their fiduciary duty to the corporation. Auerbach

v. Bennett, Civil Action No. 572/77, Sup.Ct. of N.Y., West-

chester Cty., April 29, 1977, p. 3.

‘The Committee concluded that $2,219,639.00 was paid directly to or for

the benefit of government officials. It was further concluded that $5,086,028.00,

representing portions of payments, were paid as commercial kickbacks, rebates

or bribes. Said payments were made to officials of foreign customers. See

Plaintiff's Complaint, Exhibit A at p. 27.

‘ As the Audit Committee Report indicates:

“It [the Commission arrangement] arose out of the sale by GTE of its

substantial ownership interest in the Customer, at the urging of a foreign

government, to a group of foreign nationals (the “Group”) in good stand-

ing with the government. Since the Group did not have sufficient financial

resources to purchase GTE’s interest, it was agreed that GTE would

finance a part of the purchase B gn by paying the Group a commission

on sales of equipment by GTE to the Customer. The Group informed

GTE that one of GTE's equipment competitors had offered to enter into

such an arrangement if GTE was not willing to do so. GTE ultimately

agreed to pay sales commissions to a company designated by the Group

and located in a third country. GTE subsequently sold its controlling

interest In an investment company controlled by the Group; the stock

of the customer is listed and traded on two stock exchanges in the United

States and, according to the Audit Committee report, the commission

agreement is no longer honored by GTE. Emphasis added. Complaint,

Exhibit A, pp. 21-22.

50

Two weeks after the filing of the Auerbach suit, Mr. Lim-

mer filed a derivative suit in the United States District Court for

the Southern District of New York, charging that corporate

officials had violated Sections 13(a) and 14(a) of the 1934 Se-

curities and Exchange Act and had breached their fiduciary duty

to shareholders. Warner, Brophy, Douglas and Bennett were

named as defendants; Arthur Andersen & Co. was not made

party to that suit. Limmer v. GTE, No. 76 Civ. 1494 (S.D.N.Y.,

March 11, 1977). Finally, on June 18, 1976, plaintiff herein

commenced the instant litigation in this Court.

In order to assess GTE’s position with respect to these ac-

tions, GTE’s Board of Directors, acting pursuant to § 712 of the

Business Corporation Law of New York and § 20 of the Corpo-

rate By-Laws, formed a Special Litigation Committee. The

Committee was composed of three independent directors who

had had no prior connection with GTE; Chief Judge Charles S.

Desmond, now retired from the New York Court of Appeals

acting as Special Counsel to the Committee. [Defendants’ Mo-

tion for Summary Judgment, p. 5].

The Committee concluded that the defendants had satis-

fied their responsibilities under state law and that the three

derivative actions were without merit. Moreover, the Committee

determined that even if a cause of action could be said to exist, it

would not be in‘}GTE’s best interests for any of the suits to be

pursued by either GTE or the three named litigants. [Defendants’

Motion for Summary Judgment, p. 5].

Based on the conclusions of GTE’s Special Litigation Com-

mittee that the defendants had acted in good faith, that they had

satisfied their fiduciary responsibilities, that the claims asserted

in each derivative action were without merit, and that prosecu-

tion of these claims were not in the best interests of the corpora-

tion, GTE moved to dismiss the complaint in each suit. While

motions to dismiss were pending in this suit, the complaints in

Auerbach v. Bennett and Limmer v. GTE, were dismissed.

It is defendants’ contention that Auerbach v. Bennett and

Limmer v. GTE preclude this court’s consideration of the in-

51

stant case under doctrines of res judicata and collateral estoppel.

Plaintiff, on the other hand, argues that such a contention is

both unfounded under applicable law and inconsistent with de-

fendants’ earlier position, stated in court on September 9, 1976,

that the consolidation of Limmer and the instant case under 28

U.S.C. § 1407 would be inappropriate at that time.”

This Court will first determine whether plaintiff's federal

claims are barred by the res judicata or collateral estoppel effect

of the Auerbach and Limmer judgments. Because it appears that

there are no viable federal claims, the pendent state law claims

will not be reached by this court as the exercise of jurisdiction

over pendent state law claims by a federal district court is dis-

cretionary. United Mineworkers of America v. Gibbs, 383 U.S.

715, 86 S.Ct. 1130, 16 L.Ed.2d 218 (1966); Aldens, Ind. vy.

Packel, 524 F.2d 38 (3d Cir. 1975), cert. denied 425 U.S. 943.

96 S.Ct. 1684, 48 L.Ed.2d 187 (1976): Robinson v. Penn Cen-

tral Co., 484 F.2d 553 (3d Cir. 1973). Cf. Hagans v. Lavine,

pe U.S. 528, 549-550, 94 S.Ct. 1372-1385, 39 L.Ed.2d 577

(1974).

RES JUDICATA: CLAIMS UNDER §$§ 13 AND 14A

The doctrine*of res judicata bars repetitious litigation. As

the Court of Appeals for this Circuit reasoned in Hubicki v.

ACF Industries, Inc., 484 F.2d 519 (3d Cir. 1973):

The rule provides that when a court of competent juris-

diction has entered a final judgment on the merits of a

cause of action, the parties to the suit and their privies are

thereafter bound not only as to every matter which was

‘In response to an inquiry made by the Court during oral ar

on September 9, 1976, Steven J. Glassman, Esquire, pow gy stow

Warner, Brophy and Douglas, indicated that consolidation of the two federal

cases Was inappropriate ar that time because all defendants were not involved

in both cases. Transcript, September 9, 1976, pp. 18-20. Plaintiff also cites a

letter sent to the Court by Joseph A. Tate, Esquire, local council for the

corporate defendants wherein Mr. Tate states that at the time in question, the

presence of diverse parties in the litigation as well as the pendency of different

Jurisdictional challenges to the complaints suggested that, at least to the de-

pg Wd . i. — b saypemwogy would be premature and inappropriate

: r to the cour

Sih baat ideo urt from Joseph A. Tate, Esq. September 10.

The inference of counsel's comment was the .

a transfer under 28 U.S.C. § 1404(a). ee ee ee

52

offered and received to sustain or defeat the claim on de-

mand, but as to any other admissible matter which might

have been offered for that purpose. [484 F.2d 524, citing

Commissioner v. Sunnen, 333 U.S. 591, 597, 68 S.Ct. 715,

719, 92 L.Ed. 898 (1948).]

As there can be no valid dispute that the Limmer judgment was

a final adjudication on the merits of the issues presented, the

threshold question for this Court is whether Limmer and Cramer

involve the same parties and allege the same cause of action.

[1] I find that the Limmer suit and the present litigation

involve the same parties. In both cases plaintiffs have sued

derivatively in benalf of the corporation; the claim pressed by

each shareholder against directors and third parties was not his

own, but the corporation’s. The United States Supreme Court

ruled in Ross v. Bernard, 396 U.S. 531, 538-539, 90 S.Ct. 733,

738, 24 L.Ed.2d 729 (1970) that:

The corporation is a necessary party to the action; without

it the case cannot proceed. Although named a defendant, it

is the real party in interest, The stockholder being at best

the nominal plaintiff. [Emphasis added]

Thus, as plaintiffs in both Cramer and Limmer seek relief

on behalf of GTE, the real party in interest, these actions in-

volve the same plaintiff.

Although defendant Arthur Andersen was not named as a

defendant in the Limmer case, in this case Arthur Andersen

claims that like the other defendants, it is entitled to summary

judgment by virtue of the res judicata effect of the Limmer de-

cision. [Document + 36] Since plaintiff has not opposed the res

judicata claim on the grounds that Arthur Andersen was not a

party in the Limmer case [Document # 37], defendants herein

will be considered as identical to those in Limmer for the limited

purposes of considering the res judicata issues. Plaintiff is not

prejudiced by this ruling even if plaintiff had opposed Arthur

Andersen’s joinder in the Motion for Summary Judgment, the

$ 10b claim asserted against the accountants must be dismissed

because plaintiff has failed to allege scienter. [See discussion on

§$ 10b, supra]

53

The operative facts in Cramer and Limmer are also identi-

cal. The complaints in both cases arise out of the same transac-

tions reported by the Audit Committee Report.

Yet, although arising out of the same operative facts, only

two of the federal claims are asserted in both complaints, namely

that defendants violated §§ 13 and 14(a), and Rule 14a-9, of

the 1934 Securities Act by failing to make full and complete dis-

closure of the illegal payments in proxy materials distributed to

GTE shareholders between 1970 and 1975.

In Limmer, Judge Conner specifically held that even as-

suming plaintiff's factual allegations to be true, plaintiff had failed

to state any claim upon which relief might be granted:

Section 14(a), after all, contemplates the prevention, or

redress of such injury as would be, or is, directly traceable

to a transaction authorized by a corporation in the partial

light of a misleading proxy solicitation. . . . In the present

case, by contrast, the damages claimed, . . . flow from a

breach of a fiduciary obligation owed as a director or offi-

cer, rather than from any shareholder vote obtained by

false proxy solicitation materials. [citations omitted, Lim-

mer v. GTE, supra, p. 4).

Thus, the Limmer court dismissed the § 14(a) claim.

The claim asserted under § 13 was voluntarily withdrawn

by the plaintiff in Limmer and dismissed with prejudice pursuant

to stipulation. Limmer, supra, page a, fn, 1. [Defendant's

Motion for Summary Judgment, June 7, 1977, page 23.] Thus,

res judicata bars Cramer’s claims under both §§ 13 and 14(a).

[2] Defendants herein forcefully argue that the doctrine of

res judicata also precludes plaintiff's claims under § 10(b), (and

Rule 10b-5) and § 12(b)(1), even though the plaintiff in

Limmer did not assert a claim under those sections of the 1934

act. Defendants maintain that “. . . the central element of a claim

under each of these sections of the 1934 Act is that the de-

fendant misled the plaintiff by making false statements of ma-

terial fact or omitting to state material facts necessary to make

the statement made not false or misleading.” [Defendants’ Mo-

54

tion for Summary Judgment, p. 23]. Thus, they urge that when

ruling on the § 14(a) claim, the court was holding in effect that

there were no meritorious claims under $$ 10(b) and 12(b)(1).

While it is true that the overriding purpose of the 1934

Securities Act was to protect investors against manipulation ol

stock prices by regulation of securities transactions [S.Rep.No.

792, 73d Cong., 2d Sess., 1-5 (1934), it is not true, as de-

fendants would have this court hold, that § 10(b) and § 14(a)

are identical causes of actions. Section 10(b) makes it:

unlawful for any person .. . (b) [t]o use or employ, in

connection with the purchase or sale of any security .. .

any manipulative or deceptive device or contrivance in con-

travention of such rules and regulations as the Commission

‘may prescribe as necessary or appropriate in the public

interest or for the protection of investors. 15 U.S.C. § 78).

Section 14(a), on the other hand, speaks not to the pur-

chase or sale of a security, but to the solicitation of proxies. This

section provides that:

It shall be unlawful for any person, by the use of the mails

or by any means or instrumentality of interstate commerce

or any facility of a national securities exchange or other-

wise, in contravention of such rules and regulations as the

commission may prescribe as necessary or appropriate in

the public interest . . . , to solicit or to permit the use of his

name to solicit any proxy or consent or authorization in

respect of any security . . . registered pursuant to section

781 of this title. 15 U.S.C. § 78n(a).

Because the elements necessary to make out a § 10(b)

claim differ from those necessary to establish a § 14(a) viola-

tion, a finding that defendants did not violate § 14(a) should

not preclude the other claim. In order to successfully maintain

a cause of action under § 14(a), a plaintiff must allege that

specific proxy statements were materially false and misleading,

that there was a causal connection between the alleged violation

of the proxy rules, and the injury suffered by the plaintiff. 7.S.C.

Industries, Inc. v. Northway, 426 U.S. 438, 96 S.Ct. 2126, 48

we Sa

55

L.Ed.2d 757 (1976); J. 1. Case v. Borak, 377 U.S. 426, 431,

84 S.Ct. 1555, 1559, 12 L.Ed.2d 423 (1964). This was the

standard applied by the Limmer court, which found that the

plaintiff had not met these requirements.

A successful § 10(b) derivative action requires plaintiff to

show the following: that the corporation was a purchaser, or

seller of securities, Blue Chip Stamps v. Manor Drug Stores, 421

U.S. 723, 95 S.Ct. 1917, 44 L.Ed.2d 539 (1975); that the

alleged fraud or manipulative device was employed in connec-

tion with the purchase or sale of the security, Superintendent of

Insurance v. Bankers Life and Casualty, 404 U.S. 6, 92 S.Ct.

165, 30 L.Ed2d 128 (1971); Tully v. Mott Supermarkets, Inc.,

540 F.2d 187, 194, (3d Cir. 1976); and that the defendants

herein had intended to deceive, manipulate or defraud the cor-

poration, Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct.

1375, 1381, 47 L.Ed.2d 668 (1976).

A finding that defendants did not distribute a materially

misleading proxy statement is not a fortiori a finding that as a

purchaser or seller of securities, GTE was intentionally de-

frauded by the defendants through use of a manipulative device

employed in connection with the purchase or sale of the security.

Defendants argue that the instant case is on all fours with,

and controlled by, the Third Circuit’s decision in Williamson v.

Columbia Gas and Electric Corp., 186 F.2d 464 (3d Cir.

1950), reaffirmed by that Court in 1968 in Clements v. Central

Railroad Company of New Jersey, 399 F.2d 825 (3d Cir.

1968). The Court, per Justice Goodrich, reasoned that one

claim against the defendant under Sections 1 and 2 of the

Sherman Act and a second claim under Section 7 of the Clayton

Act involved identical causes of action for purposes of res

judicata:

. . . the fact that different statutes are relied on does not

render the claims different “causes of action” for purposes

of res judicata. 186 F.2d 468.

However, a comparison of the Williamson case with Cramer

and Limmer reveal that these factual situations are not truly

analogous. The court in Williamson found that “[{w]hether Co-

ce

56

‘ .

lumbia is sought to be held as sole tortfeasor or sued singly as

one of several tortfeasors, assuming the injury is the same, does

not matter.’ 186 F.2d at 468. Yet, in the instant case, the injury

and damage to GTE alleged under § 10(b) of the 1934 Securi-

ties Act is not the same as that which must be shown under

§$ 14(a).

Because of the complexity of the record and the require-

ment that plaintiff allege scienter, defined by the Supreme Court

in Ernst & Ernst v. Hochfelder, supra, as “. . . a mental state em-

bracing intent to deceive, manipulate or defraud.” [425 U.S.

185, 194, 96 S.Ct. 1375, 1381, 47 L.Ed.2d 668], this court is

reluctant to accord res judicata effect to the Limmer decision on

§$ 14(a) to bar the § 10(b) claim. This court is guided by the

United States Supreme Court decision in Lawlor v. National

Screen Service Corp., 349 U.S. 322, 75 S.Ct. 865, 868, 99

L.Ed. 1122 (1955) that a judgment, “unaccompanied by find-

ings . . . [does] not bind the parties on any issue . . . which might

arise in connection with another cause of action.” The Court

further ruled “[t]hat both suits involved ‘essentially the same

course of wrongful conduct’ is not decisive. Such court of con-

duct . . . may frequently give rise to more than a single cause of

action.” Defendants also argue that Limmer bars the § 12(b) (1)

claim. That assertion is also incorrect.

In conclusion, the decision of the Limmer court does not

preclude either the § 10(b) or the § 12(b)(1) claim in the

instant case.

ALTERNATIVE GROUNDS FOR DISMISSAL OF THE

$ 10B CLAIM

Defendants have made a motion in the alternative, seeking

a dismissal of the § 10(b) claim pursuant to Rule 12(b)(6) of

the Federal Rules of Civil Procedure.

[3] Plaintiff has standing to assert § 10(b) and Rule 10b-5

claims in behalf of GTE against the defendants. In Blue Chip

Stamps v. Manor Drug Stores, 421 U.S:.723, 95 S.Ct. 1917, 44

L.Ed.2d 539 (1975), the Supreme Court limited standing under

}

57

§ 10(b) and Rule 10b-5 to one who is a purchaser or seller of

securities; in cases where plaintiff sues derivatively the corpora-

tion must be a purchaser or seller of securities. Blue Chip

Stamps, 421 U.S. at 738, 95 S.Ct. at 1926, citing to Schoenbaum

v. Firstbrook, 405 F.2d 215, 219 (2d Cir. '968), cert. denied

395 U.S. 906, 89 S.Ct. 1747, 23 L.Ed.2d 219 (1969); Pappas

v. Moss, 393 F.2d 865, 870 (3d Cir. 1968). For § 10(b) and

Rule 10b-5 purposes, the issuance by a corporation of its own

shares constitute a sale of securities. SEC v. National Securities,

Inc., 393 U.S. 453, 89 S.Ct. 564, 21 L.Ed.2d 668 (1969);

In re Penn Central Securities, 347 F.Supp. 1327, 1333

(E.D.Pa.1972).

The complaint recites several instances in which GTE

either bought or sold securities. In one transaction, GTE sold

its substantial ownership interest in one subsidiary company to

a group of foreign nationals under a commission arrangement

wherein GTE allegedly did not ultimately receive full value.

{Complaint, Exhibit A, pp. 21-22]. Three other transactions are

contained in GTE’s 1975 Annual Report: in 1974 GTE offered

6,000,000 shares for public sale and issued 504,935 shares for

exchange purposes; GTE purchased 4775 of its own shares in

1974.

[4] Cramer's § 10(b) and Rule 10b-5 claims against the

defendants fail when the court asks whether the manipulative de-

vices, the alleged fraud and the alleged breaches of fiduciary duty

were “in connection with” the purchase or sale of any security

and whether these activities resulted in any damage to GTE.

Tully v, Mott Supermarkets, Inc., 540 F.2d 187, 194 (3d Cir.

1976), relying on Superintendent of Insurance v. Bankers Life

& Casualty Co., 404 U.S. 6, 92 S.Ct. 165, 30 L.Ed.2d 128

(1971); Thomas v. Duralite Company, Inc., 524 F.2d 577 (3d

Cir. 1975); Rochez Bros., Inc. v Rhoades, 491 F.2d 402 (3d

Cir. 1974).

Even assuming that the defendants’ purported manipulative

devices were employed in connection with either the 1975 is-

suance and offering or the 1974 purchase of shares, GTE suf-

58

fered no loss from these transactions; moreover, no such loss

was alleged.

However, the sale of GTE’s substantial interest in its sub-

sidiary to 1 grcup of foreign nationals raises the question of

whether any claim for relief has been stated against the de-

fendants under § 10(b) and Rule 10b-5 based on GTE’s com-

mission agreement. Under this agreement, GTE financed a part

of the purchase price by paying the group a commission on sales

of equipment made by GTE to the customer.

The 1976 Annual Report is alleged to contain the facts

which form the basis of the complaint. (Complaint, € 15]. Ir. chat

report, GTE’s investigation of the commission arrangement is

examined in great detail. That investigation revealed that GTE

entered the agreement when the corporation was informed by

the foreign group that one of GTE’s competitors had agreed to

enter such an arrangement if GTE refused to do so. The com-

mission arrangement has since been terminated. Although the

amount paid to the foreign company was considerable, the Audit

Committee Report indicates that this arrangement may have

saved that business for GTE.

[5] Cramer’s theory is that the corporation has been mis-

managed and that the defendant's failure to disclose such mis-

management prior to publication of the 1976 Annual Report

was at the heart of a larger scheme to defraud the corporation.

Although § 10b was not intended to cover situations involving

“internal corporate mismanagement,” the Supreme Court recog-

nized in Superintendent of Insurance v. Bankers Life & Casualty

Co., supra, 404 U.S. at 12, 13, 92 S.Ct. 165, that a corporation

could suffer an injury as a result of deceptive practices which

touched a corporation’s sale or purchase of its own securities.

Even assuming that defendants’ actions could be said to be

corporate mismanagement which “touched” the sale or purchase

of a security, Ernst & Ernst v. Hochfelder, supra, limits § 10(b)

and Rule 10b-5 actions to those in which a defendant exhibits

... a mental state embracing intent to deceive, manipulate or

defraud.” Ernst & Ernst v. Hochfelder, 96 S.Ct. at 1381, fn. 12;

59

Straub v. Vaisman & Co., Inc., 540 F.2d 591, 597 (3d Cir.

1976).

The complaint herein is devoid of any allegation that either

the defendant officers, the Corporation or the accountants in-

tended to defraud GTE. In averments of fraud, the circum-

stances constituting fraud must be stated with particularity; “[i]n

the absence of allegation of facts amounting to fraud or scienter

. . . Mere conclusions are insufficient . . .”. Shemtab v. Shearin,

Hamill & Co., 448 F.2d 442, 444-445 (2d Cir. 1971). Accord

Seligson v. Plum Tree, Inc., 361 F.Supp. 748 (E.D.Pa. 1973).

[6] While it may be that the corporation and the individual

defendants were negligent because the questionable practices

were not discovered earlier, no claim for relief can be main-

tained under § 10 and Rule 10b-5 for negligence. The § 10(b)

claim is therefore dismissed.

SECTION 12(B)(1)

[7] Plaintiff has also alleged a violation of Section

12(b)(1). which specifies the information an issuer must pro-

vide in an application to register a security.” In order to suc-

"Section 12(b)(1) [15 U.S.C. § 78/(b)(1)(A)—(L)] provides:

(b) A security may be registered an a national securities exchange by

the issuer filing on application with the exchange (and filing with the

Commission such duplicate originals thereof as the Commission may

require), which application shall contain—

(1) Such information, in such detail, as to the issuer and any person

directly or indirectly controlling or controlled by, or under direct or

indirect common control with, the issuer, and any guarantor of the

security as to principe] or interest or both, as the Commission may by

rules and regulations require, as necessary or appropriate in the public

interest or for the protection of investors, in respect of the following:

(A) the organization, financial structure, and nature of the business:

(B) the terms, position, rights, and privileges of the different classes

of securities outstanding:

(C) the terms on which their securities are to be, and during the

preceding three years have been, offered to the public or otherwise:

(D) the directors, officers, and undrwriters, and each security holder

of record holding more than 10 per centum of any class of any equity

security of the issuer (other than an exempted security), their re-

muneration and their interests in the securities of, and their material

contracts with, the issuer and any person directly or indirectly con-

trolling or controlled by, or under direct or indirect common control

with, the issuer;

(E) remuneration to others than directors and officers exceeding

$20,000 per annum;

(F) bonus and profit-sharing arrangements:

60

cessfully maintain an action under § 12(b}( 1), a plaintiff must

meet the standing requirement of § 18 which limits the ability to

maintain a § 12(b)(1) claim to only those plaintiffs who pur-

chased or sold a security in reliance upon information filed

as required by § 12 or § 13, whose purchase or sales price was

affected by said information, and who had no knowledge of

omissions from or misrepresentations in the report.’ As Chief

Judge Lord stated in /n re Penn Central Securities Litigation,

347 F.Supp. 1327, 1340 (E.D.Pa.1972), petition for recon-

sideration denied, 357 F.Supp. 869, 876, aff'd, 494 F.2d 528,

(3d Cir. 1974):

(G) management and service contracts;

(H) options existing or to be created in respect of their securities:

(1) material contracts, not made in the ordinary course of business,

which are to be executed in whole or in part at or after the filing

of the application or which were made not more than two years

before such filing, and every material patent or contract for a ma-

terial patent right shall be deemed a material contract;

(J) balance sheets for not more than the three preceding fiscal years,

certified if required by the rules and regulations of the Commission

by independent public accountants;

(K) profit and loss statements for not more than the three preceding

fiscal years, certified if required by the rules and regulations of the

Commission by independent public accountants;

(L) any further financial statements which the Commission may

deem necessary or appropriate for the protection of investors.

715 U.S.C. § 78r:

(a) Any person who shall make or cause to be made any statement in

any application, report, or document filed pursuant to this chapter or

any rule or regulation thereunder or any undertuking contained in a

registration statement as provided in subsection (d) of section 780 of

this title, which statement was at the time and in the light of the

circumstances under which it was made false or misleading with

respect to any material fact, shall be liable to any person (not know-

ing that such statement was false or misleading) who, in reliance upon

such statement, shall have purchased or sold a security at a price

which was affected by such statement, for damages caused by such

reliance, unless the person sued shall prove that he acted in good

faith and had no knowledge that such statement was false or mis-

leading. A person seeking to enforce such liability may sue at law or

in equity in any court of competent jurisdiction. In any such suit the

court may, in its discretion, require an undertaking for the payment

of the costs of such suit, and assess reasonable costs, including rea-

sonable attorneys’ fees, against either party litigant.

(b) Every person who becomes liable to make payment under this section

may recover contribution as in cases of contract from any person,

who, if joined in the original suit, would have been liable to make

the same payment.

(c) No action shall be maintained to enforce any liability created under

this section unless brought within one year after the discovery of

the facts constituting the cause of action and within three years

after such cause of action accrued.

a

\

61

where Congress has specifically authorized a remedy for

violation of an act, the courts should not nullify the con-

gressional scheme by implying a right of action on behalf

of those not otherwise entitled to recover.

The complaint herein contains none of the allegations re-

quired to establish standing under § 18. There is no allegation

that the corporation relied on any false or misleading filings in

making any sale; there is no allegation that any filing affected

the price of GTE securities. Finally, there is no causal nexus

made, or even attempted, between any filing and any alleged loss

which GTE suffered.

[8] It is suggested by plaintiff that Kerber v. Kakos, 383

F.Supp. 625, 631 (N.D.IIl. 1974), supports the position that a

private cause of action will lie even when the § 18 requirements

heve not been completely satisfied. However, such reliance is

misplaced; in Kerber v. Kakos, the court implied a cause of

action under § 12(b) only in a case where the issuer had com-

pletely ignored the registration requirements. That situation is

distinguishable from the case where the issuer is alleged to have

made a false and misleading statement. 383 F.Supp. at 631.

The Cramer case falls into the latter category.

In sum, as plaintiff has failed to meet the standing require-

ments of § 18(a), plaintiff's claims under 12(b)(1) must be

dismissed.

PENDENT STATE CLAIM

[9] The decision of the state court in Auerbach v. Bennett

holds that as a matter of New York state law none of the de-

fendants breached the fiduciary duty owed to GTE. The court

also ruled that pursuant to the business judgment rule, GTE’s

decision not to maintain any legal action was proper. Auerbach

v. Bennett was a valid final judgment involving the same

parties and the same cause of action alleged by Cramer.

Therefore, the New York judgment bars the instant plaintiff's

pendent state claim under the doctrine of res judicata.

62

And, even if res judicata did not preclude consideration of

plaintiffs’ state law claims, this court, pursuant to the doctrine

of pendent jurisdiction, declines to consider these claims. For,

as the Supreme Court held in United Mineworkers of America

v. Gibbs, 383 U.S. 715, 726, 86 S.Ct. 1130, 1139, 16 L.Ed.2d

218,228 (1966);

_. it has consistently been recognized that pendent juris-

diction is a doctrine of discretion, not of plaintiff's right

...[and... if the federal claims are dismissed before

trial, even though not insubstantial in a jurisdictional sense,

the state claims should be dismissed as well.

See also Broderick v. Associated Hosp. Serv. of Philadelphia,

536 F.2d 1 (3d Cir. 1976); Deaktor v. Fox Grocery Co., 475

F.2d 1112 (3d Cir. 1973), cert. denied 414 U.S. 867, 94 S.Ct.

65, 38 L.Ed.2d 86.

| am not unaware that a a final alternative plaintiff asserts

that he should be entitled at least to further discovery to ac-

cumulate evidence which might contradict the findings of Judge

Conner in Limmer v. GTE or the findings of the Special Audit

Committee, or the decision of the New York state court in

Auerbach v. Bennett. On the surface, a request merely for

additional discovery has a certain appeal. But upon analysis,

the claim’ for more discovery can be made forever by any stock-

holder who chose not to join the first law suit and instead wanted

to go it alone. Plaintiff knew of the New York law suit; the

forum was not patently inconvenient; the issues were clear; it

was beyond dispute that it was a derivative stockholders’ suit,

there is no allegation of fraud or incompetence on the part of

the plaintiffs in litigating the case.

1 am also not unaware of plaintiff's argument that de-

fendants are judicially estopped from raising the res judicata

argument. In response to a query from the bench, defendants

indicated their resistance to a consolidation of the Cramer and

Limmer cases. But, no motion was ever filed for a transfer or

consolidation under 28 U.S.C. §§ 1404(a) and 1407. And, it

approaches absurdity for a court to rule that defense counsel

63

should be estopped because plaintiff's counsel relied on posi-

tions taken on issues not squarely before the court.

PLAINTIFF'S MOTION FOR A PROTECTIVE ORDER

The dismissal of plaintiff's §§ 10(b) and 12(b)(1) claims,

and the grant of summary judgment against plaintiff as to the

$$ 13 and 14(a) and pendent state law claims requires a

denial of plaintiff's motion for a protective order.

CONCLUSION

An analysis of the Cramer complaint reveals that plaintiff

attempted to base federal securities law claims on acts which

are arguably unwise from a business standpoint and probably,

in so far as the alleged bribes are concerned, questionable from

any ethical standpoint. However, our role is not to write a cod

of ethics for businessmen. Hopefully, they should strive for a

level of morality beyond reproach. But the sad fact is that their

faltering moral standards may not necessarily constitute a loss

or a fraud on the corporation. Some corporations reach new

economic plateaus not because of their morality but despite it.

In conclusion, therefore, defendants’ motion for summary

judgment is granted as to claims made pursuant to §§ 13 and

14(a) of the 1934 Securities and Exchange Act and as to the

pendent state law claims. The $§ 10(b) and 12(b)(1) claims

are dismissed. And, plaintiff's motion for a protective order is

denied.

64

APPENDIX C

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

No. 77-2372

Cramer, Harold, Custodian for Cramer, Patricia Gail,

Appellant,

Vv.

General Telephone & Electronics Corporation and Warner,

Leslie H., Brophy, Theodore F., Douglas, John J.,

Bennett, William F., Arthur Andersen & Co.

SUR PETITION FOR REHEARING

Present: SEITZ, Chief Judge, ALDISERT, ADAMS, GIBBONS,

ROSENN, HUNTER, WEIS, GARTH and HIGGINBOTHAM,

Circuit Judges

The petition for rehearing filed by

Appellant

in the above entitled case having been submitted to the judges

who participated in the decision of this court and to all the other

available circuit judges of the circuit in regular active service,

and no judge who concurred in the decision having asked for

rehearing, and a majority of the circuit judges of the circuit in

regular active service not having voted for rehearing by the court

in banc, the petition for rehearing is denied.

By the Court,

Dated: August 28, 1978 Judge

65

APPENDIX D

Rule 23.1 Derivative Actions by Shareholders

In a derivative action brought by one or more shareholders

or members to enforce a right of a corporation or of an un-

incorporated association, the corporation or association having

failed to enforce a right which may properly be asserted by it,

the complaint shall be verified and shall allege (1) that the

plaintiff was a shareholder or member at the time of the trans-

action of which he complains or that his share or membership

thereafter devolved on him by operation of law, and (2) that the

action is not a collusive one to confer jurisdiction on a court of

the United States which it would not otherwise have. The com-

plaint shall also allege with particularity the efforts, if any, made

by the plaintiff to obtain the action he desires from the directors

or comparable authority and, if necessary, from the shareholders

or members, and the reasons for his failure to obtain the action

or for not making the effort. The derivative action may not be

maintained if it appears that the plaintiff does not fairly and

adequately represent the interests of the shareholders or mem-

bers similarly situated in enforcing the right of the corporation

or association. The action shall not be dismissed or compromised

without the approval of the court, and notice of the proposed

dismissal or compromise shall be given to shareholders or mem-

bers in such manner as the court directs.

Added Feb. 28, 1966, eff. July 1, 1966.