Petition for Writ of Certiorari — Harnett v. Billman

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IN THE {

Supreme Court of the United States

October Term, 1986

WILLIAM J. HARNETT,

Petitioner,

Vv.

Tom J. BILLMAN,

CLAYTON C. MCCUISTION,

Respondents.

PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

JAMES D. CRAWFORD

THOMAS EARL PATTON*

Brett L. ANTONIDES

AMY R. DOBERMAN

Attorneys for Petitioners

Of Counsel:

SCHNADER, HARRISON, SEGAL & LEWIS

1111-19th Street, N.W.

Suite 1000

Washington, D.C. 20036

(202) 463-2900

* Attorney of Record

QUESTIONS PRESENTED

1. (a) In a district court civil action in which subject

matter jurisdicuon 1s based upon diversity of citizenship, may

the district court. consistent with the constitutional and statutory

mandate announced in Erie R.R. Co. v. Tompkins, 304 U.S. 64

(1938), fashion a rule of decision for the federal courts that

produces a different outcome from the rule that weuld be

applied in the courts of the forum state?

(b) Specifically, after a judgment in a federal diversity

action, may the district court in a subsequent diversity case

apply a federal court-created principle of res judicata to bar the

second action, where the foum state’s courts would not bar the

subsequent action but would afford a remedy under that state’s

res judicata principles?

2. If a “federal” principle of res judicata is to be applied in

diversity actions, should not it be a uniform one which includes

an exception for cases of fraudulent concealment by defend-

ants?

TABLE OF CONTENTS

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COP EINES Te IP hss scinnepsaninapietenusdelniapmianitnautibiamecs

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CONSTITUTIONAL AND STATUTORY PROVI-

FPO BPP WON. YM aistsiciessnsa<hcateilessanbicasenmesehbeasasusesicains

1. THE COURT SHOULD REVIEW THIS CASE

BECAUSE THE DECISION OF THE COURT

OF APPEALS OFFENDS THE CON-

STITUTIONAL HOLDING OF ERIE AND

VIOLATES THE RULES OF DECISION ACT,

AND BECAUSE THE COURTS OF APPEALS

ARE SHARPLY DIVIDED ON THE ISSUE........

Il. IF A FEDERAL COMMON LAW PRINCIPLE

OF RES JUDICATA SHOULD APPLY TO

SUCCESSIVE DIVERSITY ACTIONS, THIS

COURT SHOULD ESTABLISH A UNIFORM

PRINCIPLE, INCLUDING A RULE THAT A

CLAIM RAISED IN THE SUBSEQUENT

LAWSUIT SHOULD NOT BF PRECLUDED

IF PLAINTIFF WAS UNAWa~a. _ OF ITS EX-

ISTENCE DUE TO DEFENDANTS’

FRAUDULENT CONCEALMENT......................

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Page

APPENDIX:

OPINION OF COURT OF APPEALS, September

so Sereda ana douhivaeghaseiineaninesessrpecensousateneses: Al

COURT OF APPEALS ORDER DENYING

PLAINTIFF’S PETITION FOR REHEARING,

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OPINION AND ORDER OF DISTRICT COURT,

a a sassundnkndesndvonienivess Al6

DISTRICT COURT ORDER of November 1, 1985... A29

DISTRICT COURT ORDER of March 22, 1985........ A30

DISTRICT COURT ORDER of July 16, 1985............ A32

DISTRICT COURT ORDER of February 16, 1984

from Harnett v. Billman, et al., Civil Action No. 83-

SS EID ss cuanescnisndesssncnnsesveessorsnens A34

TABLE OF AUTHORITIES

CASES

Allstar Towing v. Alexandria. 231 Va. 421. 344

Pee Eh SED css cpuscieninid vactecvussiniotehvasaiassinadiiociesks

bf OIA ENTE T Man O RTE Se Tina Ee BOAT RPE SATU eT ee

Bates v. Devers, 214 Va. 667, 202 S.E.2d 917 (1974).

Black & White Taxicab Transfer Co. v. Brown &

Yellow Taxicab & Transfer Co., 276 U.S. 518

PET a icdtarsarreuststecuatciaetineg hac aitaetiant Rosca yet

Boeing Co. v. Shipman, 411 F.2d 365 ( 5th Cir. 1969).

Byrd v. Blue Ridge Rural Electric Cooperative, 356

RAs et A WI Ressrciy islassotsiceescusasdatdemnlicbeeiasnceepbenaoseiee

Carter v. Hinkle, 189 Va. 1, 52 S.E.2d 135 (1949)...

Cities Service Oil Co. v. Dunlap, 308 U.S. 208 (1939)

Cohen v. Beneficial Industrial Loan Corp., 337 US.

POE ARMIN i ciiiaitiladiannctataisdaitandabslacalidanGielniniiiaiismibabiiacdicc

Commercial Box & Lumber Co. v. Uniroyal, Inc., 623

FE ee UE Ge FE iv itictnscscetncercisiatenebdiunbnsianencces

Day & Zimmerman, Inc. v. Challoner, 423 U.S. 3

RE Tot aecssseassececpeesiesd icnatsuaniiaswdhne cue vieissbnnscibsacaniesattionces

Gasbarra v. Park-Ohio Industries, 655 F.2d 119 (7th

ay | ERRORS EARS OT OVER IE ON ARSE POTEET

Guaranty Trust Co. v. York, 326 U.S. 99 (1945) 0.0...

Hanna v. Plumer, 380 U.S. 463 (1964) ......ccccccecceeeeeeee

Hayles v. Randall Motor Co., 455 F.2d 169 (10th Cir.

WPI Nisnssaridessiishpsasimnardsebnatinalacdesdcmanhtmas asada niuicteadalcesidaiabsiic

Rf RnR ARO OE PRE I Oe Ko APC NONE

Makariw v. Rinard, 336 F.2d 333 (3d Cir. 1964)........

McCarty v. First of Georgia Insurance Co., 713 F.2d

re © a WEE dati citss irs eh iniccseaduccscainacdssess

Precision Air Parts v. Avco Corp., 736 F.2d 1499

(llth Cir. 1984), cert. denied, 469 U.S. 1191

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Page

Semler v. Psychiatric Institute 575 F.2d 922 (D.C.

Ce FTI vn reckessisiciarsoccccsniocemtntonvsionsnaaamaaareanaee

Szantay v. Beech Aircraf. Corp., 349 F.2d 60 (4th

ie.) FS ovis castcccercerehacdicasts ree leetinenegnies

Textile Workers Union of America v. Lincoln Mills of

Alabama: 353 U.S. 406 C1GS7 ) .ncassccececcsnssessssnssnssonses

Walker v. Armco Steel Corp., 446 U.S. 740 (1980).....

Weilock v. Rogers Cartage Co., 290 F.2d 235 (7th

a. PE Vickinisdeciiconmenet ienisieatitesdbeentaasamanadann

STATUTES

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UNITED STATES CONSTITUTION

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OTHER AUTHORITIES

Restatement (Second) of Judgments § 26 (198]) .......

Page

Nm Nw

IN THE

Supreme Court of the United States

October Term. 1986

No.

WILLIAM J. HARNETT,

Petitioner,

Tom J. BILLMAN,

CLAYTON C. MCCUISTION,

Respondents.

PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

Petitioner William J. Harnett prays that a wnt of certiorari

be issued to review the judgment of the United States Court of

Appeals for the Fourth Circuit entered on September 16, 1986.

OPINIONS BELOW

The opinion of the Court of Appeals (Al) is reported at

800 F.2d 1308 (4th Cir. 1986). The petition for rehearing was

denied on October 29, 1986 (A15). The principal decision of

the district court (A16) has not been published.

JURISDICTION

The judgment of the Court of Appeals was entered on

September 16, 1986. A timely petition for rehearing was

denied on October 29, 1986. This petition is being filed within

90 days of the denial of the petition for rehearing.

This Court has jurisdiction to review the judgment of the

Court of Appeals under 28 U.S.C. § 1254(1).

CONSTITUTIONAL AND STATUTORY PROVISIONS

INVOLVED

This case involves the following constitutional provisions

and statutes:

U.S. Constitution

Article III, Section 1. Judicial Power of the United States.

The judicial Power of the United States, shall be vested in

one Supreme Court, and in such inferior Courts as the Congress

may from time to time ordain and establish;

Article III], Section 2. Controversies between citizens of dif-

ferent states.

The judicial Power shall extend to all Cases, in Law and

Equity, . . . between Citizens of different States... .

Title 28, United States Code, Judiciary and Judicial Procedure

§ 1332 Diversity of citizenship; amount in controversy; costs.

(a) The district courts shall have original jurisdiction of all

civil actions where the matter in controversy exceeds the sum or

value of $10,000, exclusive of interest and costs, and is be-

tween—

(1) citizens of different states....

§ 1652 State laws as rules of decision.

The laws of the several states, except where the Con-

stitution or treaties of the United States or Act of Congress

otherwise require or provide, shall be regarded as rules of

decision in civil actions in the courts of the United States, in

cases where they apply.

STATEMENT OF THE CASE

This petition seeks review of a decision of the United States

Court of Appeals for the Fourth Circuit which applied federal,

instead of state, res judicata principles when it considered the

effect of a prior federal diversity action in a subsequent diversity

case between the same parties. The Fourth Circuit fashioned a

broad federal rule of claim preclusion that had the effect

claim would not have been barred by the law of Virginia. the

forum state. The broad rule of claim preclusion adopted by the

Court of Appeals “asks only if a claim made in the second

action involves a right arising out of the same transaction or

series of connected transactions that gave mse to the claims in

the first action,” irrespective of whether or not it constitutes a

separate injury or cause of action under state law (A8) This

rule excludes consideration of whether or not different harms

are involved or different relief is sought (A10). Under Virginia

law, a separate cause of action for a separate injury may be

maintained although it arose out of the same series of transac-

tions involved in the prior action.

The unresolved issues raised by this petition revulve pnnc-

pally around the authority of the federal courts, under both the

constitutional mandate of Erie R.R. Co. v. Tompkins, 304 US

64 (1938), and the statutory directive of 28 U.S.C. § 1652, t

fashion a rule of decision that would produce a different

outcome from the rule that would be applied in the courts of the

forum state. In adopting a federal res judicata rule for diversity

cases, the Fourth Circuit’s decision so deviates from Erie and

from decisions in other circuits as to require this Court's

intervention.

* = ~ *

This action (the “EMSI action”’) was brought in February,

1985 in the United States District Court for the Eastern District

of Virginia by petitioner William Harnett, a shareholder of

EPIC Mortgage Servicing, Inc. (““EMSI”), for damages to his

EMSI shareholdings resulting, inter alia, from the fraudulent

diversion by respondents Tom J. Billman and Clayton C

McCuistion, of EMSI’s mortgage servicing business and assets

to another company, EPIC Mortgage, Inc. (“EMI”), also

controlled and operated by respondents. The fraud began on

March 2, 1983 when EMSI shares were spun off from EMI. a

mortgage banking subsidiary of Equity Programs Investment

Corporation (‘“‘EPIC”’), to the shareholders of EPIC ( including

petitioner), in order that a separate corporate entity perform

the mortgage servicing business previously conducted by EMI.

(A19-23). Petitioner, Chairman of Washington, Homes, Inc.,

was an original investor in EPIC and, by March 1983, the only

remaining minority shareholder. Respondents owned more

than 90% of EPIC stock. Shortly after the spin-off of EMSI,

respondents began diverting this business back into EMI, an

EPIC subsidy, after petitioner had lost his stock interest in EPIC

as a result of a merger. This fraudulent diversion of EMSI’s

business continued until November 1984, when EMSI under-

went a statutory short form merger with yet another company

controlled by respondents, freezing out petitioner as an EMSI

shareholder (A23). Throughout EMSI’s existence, the diver-

sion of its business to EMI was concealed from petitioner ( A23-

24). By the ttme EMSI was merged out of existence, it was a

virtual shell with few assets and no business operations. EMSI

never performed any mortgage servicing work (A22-23).

The EMSI action was tned to the district court on Septem-

ber 17 and 18, 1985. On October 7, 1985, the district court

entered judgment in petitioner Harnett’s favor for actual and

punitive damages against the individual respondents (A28).

Petitioner established by clear and convincing evidence that

respondents had committed common law fraud by engaging in

a twenty-month scheme to conceal from him the material fact

that EMSI’s business and assets had been diverted to EMI in

order to eliminate petitioner’s interest in that business. The

district court further held that respondents fraudulently mis-

represented to petitioner that the EMSI spin-off would be tax-

free when, in fact, it was not, because EMSI was not an active

trade or business. The district court’s judgment was modified

on November 1, 1985 to increase the amount of compensatory

damages (A29).

In October, 1983, petitioner had brought a diversity action

in the Eastern District of Virginia as a shareholder of EPIC (the

“EPIC Action” ).1 Petitioner had sued for damages to his EPIC

shareholdings resulting from non-disclosures in connection with

the March 15, 1983 merger of EPIC and Community Savings &

1 Harnett v. Billman, et al., Civil Action No. 83-1029-A (E.D. Va. 1984).

Loan, Inc., a Maryland company also controlled by respond-

ents. Respondents were defendants in that action as well. That

action was dismissed with prejudice in February, 1984 pursuant

to a settlement agreement whereby petitioner would be per-

mitted to have the value of his EPIC stock determined in an

appraisal proceeding in the Virginia state courts and, in the

course of that proceeding, to raise any of the issues asserted in

the federal action bearing on the value of his EPIC stock.?

The fraudulent diversion of EMSI’s business was not raised

in petitioner’s prior EPIC action (A23). Nor was the claimed

misrepresentation of a tax-free EMS1 spin-off raised in the

EPIC action. The sole allegation raised in the EPIC action that

related to EMSI was that the amount of stock that petitioner

received in the EMSI spin-off was less than he was entitled to

because his percentage stock interest in EPIC previously had

been diluted (A23). However, no damages to petitioner’s

EMSI shareholdings were claimed. Because it was settled and

dismissed, petitioner’s earlier action was never adjudicated on

the merits.

The fraudulent diversion of EMSI’s business which forms

the basis of this case occurred both before and after the earlier

action was dismissed, and it was concealed from petitioner even

after the settlement and dismissal of that first suit (A23).

Petitioner did not discover that EMSI’s business had been

diverted until he received notice of the short form merger of

EMSI in November 1984, which notice was accompanied by

financial information showing that EMSI’s business and assets

had been depleted (A23). Petitioner then commenced this

second diversity action in the Eastern District of Virginia in

February 1985 against respondents, EMI and certain other

corporate defendants, seeking damages caused to his EMSI

stock interest in several claims for relief.

Judge Albert V. Bryan, Jr., the same district judge who had

dismissed petitioner’s earlier action, heard several motions by

‘ 2 Petitioner’s EPIC appraisal proceeding is currently pending in the

Circuit Court of Fairfax County, Virginia. Harnett v. Equity Programs

Investment Corporation, In Chancery No. 95800.

the defendants in this action raising the res judicata effect of

that prior judgment. The district court agreed that certain of

petitioner’s claims in the EMS] action relating to the dilution of

stock were barred by its order dismissing the earlier action, but

held that petitioner’s claim based on respondents’ fraudulent

concealment of the diversion of EMSI’s business was not barred

by res judicata (A23). During pre-trial motions, and again in a

post-trial motion, the district court found that the facts relating

to the claim of diversion of EMSI’s business (1) were not

known by petitioner until November 1984, (2) could not

reasonably have been raised in the prior action because re-

spondents continued to conceal the fraud, and (3) were based

upon a different transaction and a different stock interest than

those asserted in the earlier suit (A23, 30-31, 32-33).

Respondents appealed from the judgment against them on

the common law fraud count. The Court of Appeals reversed

the district court’s judgment and held that petitioner’s claim

was barred under a federal rule of res judicata which, the court

acknowledged, would likely produce a different result from that

which would occur in the Virginia state courts. Essentially the

Court of Appeals held that, absent a strongly expressed state

policy, res judicata principles applicable in federal courts

should be fashioned by the federal courts, even in diversity

cases.

REASONS FOR GRANTING THE WRIT

Introduction

Among the many important cases competing for this

Court’s attention, this case stands out in its significance to the

administration of civil justice in the federal court system, for the

following reasons:

1. By formulating a federal common law principle of

res judicata instead of applying that of the forum state, the

3 Petitioner Harnett cross-appealed from the district court’s dismissal of

other claims, including federaj securities laws claims and breach of fiduciary

duty claims, for failure to state claims upon which relief could be granted.

Court of Appeals ignored the Rules of Decision Act, 28

U.S.C. § 1652 (1966), and circumvented the constitutional

mandate and jurisprudential policies underlying Erie R.R.

Co. v. Tompkins, 304 U.S. 64 (1938). Through Erie and

its progeny, this Court has implemented core policies of

federalism that govern the interrelationship between the

state and federal judiciaries. The Court of Appeals’

decision undermines the goals of Erie by virtually ensuring

inequitable administration of the laws, as well as forum

shopping. Had petitioner brought his fraud claim in a

Virginia court, the Virginia law of res judicata would have

permitted him relief on the merits. Application of the

federal principle is thus outcome-determinative in the most

severe sense—the effect of the Fourth Circuit’s decision is

to prevent redress for perpetration of a serious fraud where

the Virginia courts would have granted relief.

2. The Courts of Appeals are sharply divided over the

issue of whether state or federal preclusion pnnciples apply

in a subsequent diversity suit. This Court should defini-

tively answer such an important question of judicial admin-

istration and competence rather than leave it to ad hoc

determination in each circuit.

3. If a federal rule of res judicata should apply in

successive diversity cases, this Court should establish a

uniform rule to guide all federal courts, and explain the

scope as well as the source of such a rule. Otherwise, the

district courts will apply varying principles and theories of

claim preclusion.

4. If such a federal rule applies, it should include the

well-established concealment exception to all res judicata

principles. A plaintuff cannot be expected to merge all

related causes of action into one lawsuit when the defend-

ants intentionally and fraudulently have concealed infor-

mation that would notify him that a related claim exists.

Here, petitioner’s claims are based on two separate transac-

tions. The latter transaction involved an ongoing fraud

which, due to respondents’ concealment, petitioner could

not have discovered until after the first lawsuit was dis-

misse’ Petitioner should not be denied recovery, then,

regardless of which principle of res judicata is applied.

For all of these reasons, as amplified below, this Court’s

review is necessary.

I. THE COURT SHOULD REVIEW THIS CASE BE-

CAUSE THE DECISION OF THE COURT OF AP-

PEALS OFFENDS THE CONSTITUTIONAL HOLD-

ING OF ERIE AND VIOLATES THE RULES OF

DECISION ACT, AND BECAUSE THE COURTS OF

APPEALS ARE SHARPLY DIVIDED ON THE ISSUE

Despite the teachings of Erie R.R. Co. v. Tompkins, 304

U.S. 64 (1938), and the Rules of Decision Act, 28 U.S.C.

§ 1652, the United States Court of Appeals for the Fourth

Circuit held that a federal common law of res judicata should

be applied in this diversity action to preclude a claim which

would not have been precluded under the res judicata rules of

Virginia, the forum state. In so doing, the Fourth Circuit joined

the minority of the sharply divided circuits on this question.

Only review by this Court can resolve this conflict of circuits

and restore the vigor of Erie on this important question.

The conflict of circuits on this issue is deep and serious.

Including the present case, seven circuits have addressed the

issue of federal versus state res judicata rules in successive

diversity actions. The majority have decided that, in accord-

ance with Erie and its progeny, state law applied because

principles of res judicata are intricately related to the state-

created rights and obligations which comprise the substance of

federal diversity actions, while the minority have viewed this

merely as a question of federal procedure.

Specifically, four circuits have applied state law in this

situation. See Answering Service, Inc. v. Egan, 728 F.2d 1500

(D.C. Cir. 1984); Semler v. Psychiatric Institute, 575 F.2d 922

(D.C. Cir. 1978); Gasbarra v. Park-Ohio Industries, 655 F.2d

119 (7th Cir. 1981); Hayles v. Randall Motor Co., 455 F.2d 169

(10th Cir. 1971); Makariw v. Rinard, 336 F.2d 333 (3d Cir.

1964). However, two circuits beside the Fourth have applied

federal preclusion laws in the context of successive diversity

actions. See Precision Air Parts v. Avco Corp., 736 F.2d 1499

(llth Cir. 1984) (following pre-division Fifth Circuit rule).

cert. denied, 469 U.S. 1191 (1985). Commercial Box & Lumber

Co. v. Uniroyal, Inc., 623 F.2d 371 (Sth Cir. 1980).

Moreover, the Fourth Circuit resolution is incorrect. Al-

most fifty years ago, in Erie, Justice Brandeis wrote that the

federai courts have no constitutional power to create a federal

rule of decision to apply in a diversity case seeking to enforce

state created rights. Erie similarly established that the Rules of

Decision Act requires that state rules of decision govern the

rights and obligations of parties in a diversity action. In

addition to bringing the federal courts into compliance with

constitutional and statutory requirements, Erie also served the

interest of assuring comity, consistency and uniformity between

state and federal courts that are adjudicating identical claims,

preventing forum shopping and_ unseemly litigation

gamesmanship.

The First Congress passed the Rules of Decision Act to

ensure that civil remedies fashioned by a state’s legislature and

courts would be equally respected and enforced by federal

courts adjudicating state-based claims, so that different results

do not obtain for the same claim merely in consequence of the

accident of the parties’ citizenship. Erie, and the line of cases

subsequent to Erie, have invoked and evolved these fundamen-

tal principles in varying contexts to ensure that common law

remedies in diversity actions are applied in an equitable fashion

regardless of the parties’ citizenship. See Erie, 304 U.S. at 75;

Klaxon v. Stentor Electric Manufacturing Co., 313 U.S. 487,

496 (1941). As stated in Guaranty Trust Co. v. York, 326 U.S.

99, 109 (1944), Erie “expressed a policy that touches vitally the

proper distribution of judicial power between the state and

federal courts.”

Since Erie, these concerns have led this Court to require

the application in diversity actions of a state statute of limita-

tions, Guaranty Trust, 326 U.S. 99, state rules governing

burdens of proof, Cities Service Oil Co. v. Dunlap, 308 U.S. 208

(1939). state principles of conflicts of laws. Day & Zimmerman.

Inc. v. Challoner, 423 U.S. 3 (1975): Klaxon, 313 U.S. at 487,

state security for costs statutes. Cohen v. Beneficial Industrial

Loan Corp., 337 U.S. 541 (1949). and state rules determining

the timing of commencement of an action for statute of

limitations purposes. Walker v. Armco Steel Corp., 446 U.S. 740

(1980).

In these cases this Court rejected formalistic distinctions

between “substantive” and “procedural” rights. Whether a

state law is labeled substantive or procedural, a federal court

must apply it if it sets forth a right or policy intimately bound

up in the state remedy. Erie “‘was not an endeavor to formulate

scientific legal terminology.” Guaranty Trust, 326 U.S. at 109.

Erie and subsequent decisions were intended to discourage

forum shopping by eliminating the possibility that a choice of

forum would depend on whether federal or state common law

is more favorable, and to avoid inequitable administration of

the law solely because of the parties’ citizenship. Hanna v.

Plumer, 380 U.S. 463, 467 (1964).

In determining whether the application of federal common

law would encourage forum shopping or inequitable adminis-

tration of the law, the courts consider whether the application

of federal common law to a plaintiff's claims would result in a

different outcome than if a state rule was applied. “‘The Ene

rule is rooted in part in a realization that it would be unfair for

the character or result of a litigation materially to differ because

the suit had been brought in a federal court.” Jd. Accordingly,

federal judges have fashioned a federal rule only where an

overriding federal interest compels them to do so, see, Byrd v.

Blue Ridge Rural Electric Cooperative, 356 U.S. 525 (1958),4

4In Byrd, 356 U.S. at 537, this Court held that affirmative countervailing

federal interests in complying with the Seventh Amendment of the United

States Constitution compelled the application of a federal rule so that a jury

rather than a judge would decide questions of fact. Since Byrd, the Courts of

Appeals have divided over whether to apply a state or federal law test to

determine the sufficiency of evidence to create a jury question. Compare

Wielock v. Rogers Cartage Co., 290 F.2d 235 (7th Cir. 1961), with Boeing Co.

v. Shipman, 411 F.2d 365 (Sth Cir. 1969).

or where Congress has validly enacted a governing procedural

rule. Hanna, 380 U.S. 463.

The Fourth Circuit’s decision directly contravenes these

constitutional. statutory and policy mandates by creating a

federal principle of res judicata applicable to the adjudication

of a diversity claim based purely on state common law. As a

consequence, substantive rights that would have been enforced

in Virginia’s courts were precluded in a federal court. In the

face of Erie’s reminder that there is no such thing as general

federal common law, and no constitutional power in federal

courts to create local law, the Fourth Circuit has plucked from

the air a federal common law of claim preclusion that alters and

removes a state-created remedy.

The scope and effect of a prior ruling is fundamentally

bound up with the interpretation and adjudication of state

rights and obligations, and with the enforcement of state-

imposed remedies for violations of those nights. In Virginia, as

in most states, the doctrine of res judicata has been expressly

recognized as a part of the state’s “public policy” concerning

what rights are judicially cognizable in that state’s courts. Bates

v. Devers, 214 Va. 667, 202 S.E.2d 917 (1974). It is not

surprising. then, that the majority of Courts of Appeals which

have ruled on the question have invoked the policies un-

derlying Erie to apply state res judicata principles to determine

the effect of a prior federal diversity action.

In this case, however, the Fourth Circuit applied what it

perceived to be a federal common law of res judicata to bar all

claims related to the transactions which were the subject of the

earlier litigation. It did so despite the consequent disparity in

outcome which offends the objectives of Erie to avoid forum-

shopping and inequitable administration of the law. The res

judicata \aw of Virginia, the forum state, would not have barred

petitioner’s fraud claim.5 The court itself acknowledged that a

5 Virginia’s res judicata law bars subsequent claims only if they give nse

to the same cause of action as the claims in the initial lawsuit. Bates, 214 Va.

667: Carter v. Hinkle, 189 Va. 1, 52 S.E.2d 135 (1949). “Cause of action” for

these purposes, is defined by the Virginia courts as an assertion of local nghts

which have risen out of a single definable factual] transaction. Allstar Towing

v. Alexandria, 23\ Va. 421, 425, 344 S.E.2d 903 (1986), citing Bates, 214 Va.

at 672 n.8.

different outcome would have resulted if Virginia preclusion

law had been applied (A7).

In creating a federal principle of res judicata, the Fourth

Circuit inquired as to whether any affirinative state policies

dictated a contrary result (A&). This mode of analysis.

however. is precisely the converse of what this Court mandated

in Byrd, where the state rule was held to be applicable unless

there was an overriding and substantial federa/ interest in

applying federal common law.® Byrd, 356 U.S. at 537.

The Court of Appeals’ decision undermines the forum

state’s ability to enforce its common-law anti-fraud laws. It

thus offends and frustrates state-created remedies. The decision

below also encourages the very kind of forum-shopping and

procedural tactics that Erie found so objectionable. See Black

& White Taxicab Transfer Co. v. Brown & Yellow Taxicab &

Transfer Co., 276 U.S. 518 (1928).

The question of which res judicata principle to apply in

successive diversity actions is critical to the efficient manage-

ment and administration of diversity litigation. The effect of

one federal court’s judgment on a subsequent federal diversity

action goes to the heart of the federal courts’ function to

administer justice equitably and influences the smooth oper-

auon of the federal judiciary. Accordingly, it 1s crucial that all

federal courts resolve the issue uniformly. See Textile Workers

Union of America v. Lincoln Mills of Alabama, 353 U.S. 448,

449 (1957).

Forty-nine years have passed since Erie, and this

fundamental question of judicial administration and com-

petence remains disputed and has not been settled by this

Court. It is necessary, in the interest of the administration of

justice by the federal judiciary, for this Court now to settle the

issue.

6 Indeed, the Fourth Circuit itself had previously held both that state

procedural rules “intimately bound up with the state nght or obligation” are

constitutionally controlling, and that even if a state rule is not an integral part

of the remedy. it controls “unless there are affirmative countervailing federal

considerations.” Szantay v. Beech Aircraft Corp., 349 F.2d 60 ( 4th Cir. 1965).

Il. IF AFEDERAL COMMON LAW PRINCIPLE OF RES

JUDICATA SHOULD APPLY TO SUCCESSIVE DI-

VERSITY ACTIONS, THIS COURT SHOULD ES-

TABLISH A UNIFORM PRINCIPLE, INCLUDING A

RULE THAT A CLAIM RAISED IN’ THE.

SUBSEQUENT LAWSUIT SHOULD NOT BE PRE-

CLUDED IF PLAINTIFF WAS UNAWARE OF ITS

EXISTENCE DUE TO DEFENDANTS’ FRAUDULENT

CONCEALMENT

Through their diversity jurisdiction, the federal district

courts adjudicate state-created claims and remedies. This case.

therefore, poses the fundamental question of whether the scope

of the federal courts’ power includes the authority to formulate

federal rules that govern the preclusive effects of a prior federal

diversity judgment. If the grant of diversity jurisdiction was

intended to encompass the power to formulate a federal

common law of res judicata, then such a significant determina-

tion ought to issue from this Court. A rule of law such as res

judicata does not spring Venus-like from nowhere. Claim

preclusion rules are not uniform. Some jurisdictions, like

Virginia, focus on the cause of action or specific claim; others

broadly preclude any claim generally related to a transaction

which was the subject of a previously decided claim. Only this

Court can define the scope of a federal res judicata rule.

In this case, the Court of Appeals overlooked a fact-finding

of fundamental importance by District Judge Bryan (who

presided over both actions initiated by the petitioner), namely,

that petitioner could not have discovered the fraudulent trans-

actions at issue in the second action until after the first action

was dismissed (A23).

The first action, in which petitioner requested damages to

his EPIC shareholdings resulting from non-disclosures in con-

nection with the merger of EPIC and Community Savings &

Loan, was instituted in October, 1983 and dismissed by a

settlement in February 1984. Although the fraudulent diver-

sion of EMSI’s business had begun in 1983, respondents were

successful at concealing their fraud from petitioner until

November. 1984. He instituted the second action in federal

district court in February, 1985. Judge Bryan, fully versed in all

the facts surrounding both actions. decided that the doctrine of

res judicata did not preclude the second action for two reasons.

First. he held that the two claims involved two separate

transactions and stock interests; the fraud surrounding the

diversion of EMSI’s business was distinct from the claimed non-

disclosures surrounding EPIC’s merger with Community, and

was therefore actionable regardless of the first dismissal with

prejudice. Second, Judge Bryan recognized that fraudulent

concealment of information was an essential component of the

respondents’ fraudulent diversion of business from EMSI. He

refused to penalize petitioner for respondents’ success in con-

cealing information that would have led to his discovery of an

additional claim, and therefore refused to bar the second

action.

Petitioner should not be denied recovery even if a federal

common law principle of res judicata is applied. A fundamen-

tal injustice occurred when the Court of Appeals overlooked the

fraudulent concealment aspect of Judge Bryan’s opinion. The

federal law of res judicata should recognize the universal

principle that claims which were unknown to plaintiffs at the

time of their earlier suits cannot be barred. See Restatement

(Second) of Judgments § 26, comment j (1981); McCarty v.

First of Georgia Insurance Co., 713 F.2d 609, 612-13 (10th Cir.

1983). Any other rule will bar actions which, as a matter of

fact, could not have been brought at the time of the initial

litigation. Such a rule is neither just nor in keeping with general

common law principles. It should not be the federal rule.

Di iiighitst \Oad Aceetbe

CONCLUSION

For each and all of the foregoing reasons. a writ of

ceruorari should be granted.

Respectfully submitted.

JAMES D. CRAWFORD

THOMAS EarRL PaTTOon*

BRETT L. ANTONIDES

AMY R. DOBERMAN

Attorneys for Petitioners

Of Counsel:

SCHNADER, HARRISON, SEGAL & LEwIs

1111-19th Street, N.W.

Suite 1000

Washington, D.C. 20036

(202) 463-2900

* Attorney of Record

OPINION OF COURT OF APPEALS.

September 16. 1986

United States Court of Appeals

For THE FOURTH CIRCUIT

No. 85-2338

WILLIAM J. HARNETT,

Appellee

versus

Tom J. BILLMAN: CLAYTON C. MCCUISTION

Appellant:

and

Epic MorTGAGE, INC., a Delaware corporation; CAVALIER O

CORPORATION, a Delaware corporation; Epic REALTY SERV!

INc., a Delaware corporation,

Defendant:

No. 85-2339

WILLIAM J. HARNETT.

Appellant,

versus

Tom J. BILLMAN: CLAYTON C. MCCUISTION,

Appellees,

and

Epic REALTY SERVICES, INC., a Delaware corporation,

Defendants.

Appeal from the United States District Court for the

Eastern District of Virginia, at Alexandria. Albert V. Bryan, Jr.,

Chief District Judge. (C/A 85-157)

Argued July 14, 1986. Decided September 16, 1986

Before RUSSELL, PHILLIPS. and CHAPMAN,

Circuit Judges.

John R. Fornaciari (Robert M. Disch; Steele,

Simmons & Fornaciari on brief) for Appel-

lants/cross Appellees, Billman and McCu-

istion; Thomas Earl Patton (Brett L. Anto-

nides; Louis R. Moffa, Jr.; Schnader, Harri-

son, Segal & Lewis; John E. Harrison; Light

& Harrison, P.C. on brief) for Appellee/cross

Appellant.

PHILLIPS. Circuit Judge:

Tom Billman and Clayton McCuistion appeal from the

district court’s judgment, after a bench trial. awarding William

Harnett more than $60.000 in compensatory damages and

$35.000 in punitive damages on his claims of common-law

fraud. Harnett has cross-appealed from orders of the district

court granting summary judgment against some of his claims on

res judicata grounds and dismissing other claims based on

federal and state securities law violations and on alleged

breaches of fiduciary duty. We conclude that Harnett’s fraud

claims, as well as much of the securities and fiduciary duty

claims upon which he did not prevail, were subject to the bar of

a prior judgment involving these same parties. We also hold

that to the extent that Harnett’s securities and fiduciary duty

claims survived the prior judgment, they were properly dis-

missed because, as a matter of law, Harnett could not prevail on

these claims. We therefore reverse the judgment in favor of

Harnett on his fraud claim and affirm the dismissal of his other

claims.

In 1975, Harnett purchased 1,250 shares of the Equity

Programs Investment Corporation (EPIC) for $5,000. By

1983, Billman and McCuistion together owned more than 90%

of EPIC’s shares. Over the years, EPIC had become the parent

corporation of a number of subsidiaries, including EPIC Mort-

gage, Inc. (EMI) and EPIC Realty Services, Inc. (ERSI).

In June 1982, ERSI became an independent corporation in

a spin-off transaction, and a separate spin-off from EMI led to

the creation of EPIC Mortgage Servicing, Inc. (EMSI) on

March 1, 1983. Harnett received shares in both of the new

companies equal to what the defendants represented was his

proportion of ownership in EPIC. In December 1984, ERSI

was absorbed in a Delaware short form merger by Realty

Services Holdings, Inc., and in November 1984, EMSI was

similarly merged into Cavalier Oil Corp. (Cavalier). Billman

and McCuistion are the principal shareholders of Cavalier. A

short form merger permits the “freezing out” of minority

shareholders. Harnett had received stock in ERSI and EMSI

when they were spun off. but was frozen out in the short form

mergers.

After the spin-offs of ERSI and EMSI. Harnett still re-

mained a shareholder in the original EPIC corporation. In

early 1983. however, EPIC and its EMI subsidiary were

purchased by Community Savings and Loan, Inc. (CSL), a

Maryland-chartered savings and loan association. Billman and

McCuistion also owned a controlling interest in CSL. In

January 1983, Harnett received a notice seeking the approval

by EPIC’s shareholders of a merger of EPIC into a CSL

subsidiary. EPIC shareholders were to receive non-voting pre-

ferred CSL stock. For various reasons, most apparently relating

to the nature of the stock he would receive, Harnett was

unsatisfied with the merger plan. By February 1983, Harnett

had become the sole remaining minority shareholder of EPIC.

Harnett refused Billman’s offer to purchase Harnett’s shares in

EPIC.

The merger of CSL and EPIC was consummated on March

14, 1983. Prior to the merger, the principal business of EMI

consisted of mortgage servicing, but because for accounting

reasons the servicing portfolio then owned by EMI would not

be fully reflected on the books of the new CSL/EPIC con-

glomerate, EMI’s existing servicing portfolio became the pri-

mary asset of the new spin-off from EMI, EMSI. EMI and

EMSI entered into a sub-servicing agreement, dated March 1,

1983, under which EMI performed for a fee the servicing work

for mortgages in EMSI’s portfolio. After the EPIC/CSL

merger, EMI also became the servicer, and itself owner of the

servicing rights, of new mortgages originated through the new

EPIC/CSL entity. EMSI, which was a company now indepen-

dent of the EPIC/CSL group, did not receive any of the new

servicing business, but retained only the servicing rights in its

portfolio at the time of its spin-off from EMI.

In October 1983, Harnett filed an action, which we will

refer to as Harnett J, in the United States District Court for the

Eastern District of Virginia. The amended complaint in

Harnett I alleged claims for common-law fraud, for state and

federal securities fraud. and under RICO, as well as a share-

holder derivative claim. These claims centered around Har-

nett’s allegations that Billman and McCuistion made fraudulent

misrepresentations OF Omissions in conversations and corre-

spondence to him in late February and early March 1983, that

the documents received by Harnett in connection with the

EPIC/CSL merger did not make adequate disclosures, and that

Billman and McCuistion had misappropriated, through em-

ployee stock options and assignments from other shareholders,

shares of EPIC. Paragraph 49(h) of the amended complaint in

Harnett J stated that “[djefendants, and each of them, failed to

disclose to Harnett that prior to the merger of EPIC into CS&L

Service Co. EPIC would spin off its mortgage servicing

operation, including escrow account balances, to a new

corporation.”

Harnett engaged in extensive discovery in Harnett I, and

his document production requests in that earlier litigation

included requests for the records of EMSI, as well as of other

companies connected to EPIC. Ultimately, pursuant to a

settlement that permitted Harnett to pursue state appraisal

rights in state court, Harnett ] was dismissed with prejudice in

February 1984.

Harnett was subsequently frozen out of his interests in

ERSI and EMSI, and commenced the instant action in the

district court in February 1985. The complaint in this case

alleged claims under federal and state securities acts, for

common-law fraud, and for breaches of fiduciary duty by

Billman and McCuistion. The acts that form the predicate for

these claims included the dilution of Harnett’s interest in the

ERSI and EMSI spin-off companies by virtue of the mis-

appropriation of EPIC stock by Billman and McCuistion,

alleged misrepresentations to Harnett that the new EMSI

company would receive the benefit not only of EMI’s existing

mortgage servicing business but also that generated by future

mortgages originated through the EPIC/CSL group, the execu-

tion of an EMI/EMSI sub-servicing agreement, and the alleged

concealment from Harnett of the true fact that EMI, and not

EMSI, was receiving the servicing business on new mortgages

originated through EPIC/CSL.

A6é

Following motions for summary judgment by the defen-

dants in this case. the district court dismissed on res judicata

grounds Harnett’s claims relating to share misappropriations,

dismissed the securities law claims as not arising out of “the

purchase or sale of securities,”’ and dismissed the fiduciary duty

claim because Harnett, who was no longer a shareholder of

ERSI or EMSI, had no standing to make a derivative claim.

The district court refused. however, to dismiss Harnett’s

common-law fraud claims relating to the EMSI spin-off and the

alleged misrepresentations about the allocation of servicing

work between EMI and EMSI.

After discovery, the case proceeded to a bench trial. The

district court found in favor of Harnett, crediting Harnett’s

tesumony that Billman and McCuistion represented an original

intention that EMSI would receive all future mortgage servicing

originated by the EPIC/CSL entity, but had failed to inform

Harnett when this representation was no longer the true state of

affairs. The court found that Harnett had reasonably relied to

his detriment upon the misrepresentations by Billman and

McCuistion, and awarded compensatory damages in excess of

$60,000 and punitive damages of $35,000. The compensatory

award was arrived at by calculating the amount Harnett would

have received for his EMSI stock if EMSI had, in fact, done the

servicing work retained by EMI. These appeals followed.

The principal argument advanced by Billman and

McCuistion on appeal is that the district court should have

dismissed Harnett’s fraud claims, as well as the other claims

that were dismissed for other reasons, as barred by the prior

judgment entered in Harnett J. Res judicata precludes the

assertion of a claim when “‘a judgment on the merits [in a prior

suit] bars further claims by parties or their privies based on the

same cause of action.” See Montana v. United States, 440 U.S.

147, 153 (1979); Nash County Board of Education v. Biltmore

Co., 640 F.2d 484, 486 (4th Cir. 1981): see also Adkins v.

Allstate Insurance Co., 729 F.2d 974, 976 (4th Cir. 1984).

There is no question but that the final judgment entered in

Harnett I is “a judgment on the merits” involving the same

“parties or their privies” as those involved in the instant case.

The agreed dismissal of Harnett J] binds the parties to that

litigation. and each of the parties in this case was a named party

or privy to a party in Harnett J. Although Harnett’s complaint

in this case names some different corporate entities than those

named in the earlier litigation, the principal parties in each

action were Harnett, Billman, McCuistion, and corporations

that Billman and McCuistion controlled and of which Harnett

was a present or former shareholder.

Harnett argues, however, that his claims in this case escape

the preclusive effect of the judgment in Harnett J because the

claims made in the two lawsuits are not the same claims for res

judicata purposes, and because, as regards the EMSI fraud

claim, he did not know of the existence of the allegedly

fraudulent behavior at the time the judgment in Harnett ] was

entered. We conclude, however, that most of the claims made

by Harnett in this case are barred by the judgment entered in

Harnett I, and that the district court improperly failed to enter

summary judgment for defendants on this basis.

We first address the question whether the res judicata

effect to be given the judgment in Harnett J is a matter of

federal or state law.1 We conclude that whether a federal court

1 The parties have not raised this issue. In many cases, the issue whether

state or federal law governs a res judicata question arising out of a prior

judgment entered by a federal court sitting in diversity is irrelevant, for often

the state and federal rules on judgment will coincide. See 18 C. Wright, A.

Miller & E. Cooper, Federal Practice and Procedure § 4472, at 735-36 & n.28

(1981 and Supp. 1986). It is not clear to us that such is the case here,

however, and although we do not attempt to determine what effect a

judgment entered by a Virginia federal court would have if Virginia claim

preclusion law were to be applied, we note the possible divergence of federal

and state judgment rules on the critical matter of the breadth of claim

preclusion. Compare Restatement (Second) of Judgments § 24(1) (claims

precluded are those arising out of the same transaction or series of connected

transactions, and are precluded even if they constitute separate “causes of

action”), with Bates v. Devers, 202 S.E.2d 917, 920 (Va. 1974) (res judicata

applies only to claims arising out of “same cause of action”); Carter v. Hinkle,

52 S.E.2d 135 (Va. 1949) (because separate causes of action exist for

personal injury and property damage arising out of same automobile

accident, judgment on one cause of action does not preclude litigation of

second ).

sits In diversity or has some other basis of jurisdiction, questions

of the effect and scope of its judgment involve the power of the

federal tribunal itself. and are not varied merely because state

rules of decision underlie the judgment. See Restatement

(Second) of Judgments § 87 (1982): C. Wright, Law of Federal

Courts § 100A, at 695-96 (4th ed. 1983) (advocating this rule.

and approving of Restatement position). Burt cf. Restatement

(Second) of Judgments § 87 comment b ( federal courts should

adopt state law to determine preclusive effect when issue

involves “considerations going to stability of legal relation-

ships.” such as privity); Spiker v. Capitol Milk Producers

Cooperative, Inc., 577 F. Supp. 416, 418-19 (W.D. Va. 1983)

(applying this exception in case where privity at issue). In this

case, where the application of res judicata rules does not touch

upon an important question of state law such as privity, we will

apply federal rules of decision to measure the preclusive effect

of the judgment in Harnett J.

Having decided that federal res judicata law determines

the effect of the judgment in Harnett I, we look to Harnett’s

contentions that res judicata principles do not apply to his

claims in this litigation. In its opinion on the merits of this case,

the district court observed that Harnett’s EMSI fraud claim

could not be subject to res judicata because the failures of the

defendants to abide by alleged promises to channel new

servicing business to EMS] were “not known [by Harnett] to

be misrepresentations at the time” of the dismissal of Harnett J

in February 1984. The district court therefore reasoned that

because Harnett did not know of the actual division of servicing

business between EMI and EMSI until he received notice of the

freeze out merger of EMSI in November 1984, the fraud claim

alleged in this case could not have been the subject of Harnett

I, and thus could not be precluded by the judgment in that

action.

Actual knowledge of a potential claim is not a requirement

for application of the rules of merger and bar, however; rather,

the appropriate inquiry is whether the new claim arises out of

the same transaction or series of transactions as the claim

resolved by the prior judgment. See Restatement (Second) of

Judgments § 24(1) (1982). For purposes of res judicata, it is

not necessary to ask if the plaintiff knew of his present c!aim at

the time of the former judgment, for it is the existence of the

present claim, not party awareness of it, that controls. This

principle distinguishes from this case those cases where the

challenged claim did not exist at the time of the prior litigation,

see, e.g., Lawlor v. National Screen Service Corp., 349 U.S. 322

(1955). Here, the record is clear that at the time of the

judgment in Harnett I, the alleged diversion of servicing

business away from EMSI had already taken place.

An exception to the general principle that lack of knowl-

edge will not avoid the application of res judicata rules is found

in cases where fraud, concealment, or misrepresentation have

caused the plaintiff to fail to include a claim in a former action.

See Restatement (Second) of Judgments §26 comment j/.

Nevertheless, although Harnett alleged that the defendants’

fraud in this case included concealment of the actual] business of

both EMI and EMSI, Harnett cannot assert that the con-

cealment was such that it prevented his raising these fraud

claims as part of Harnett J. Harnett sought and obtained

discovery in Harnett J of the business records of EM] and EMS]

to the date of that litigation, so he necessarily received informa-

tion enabling him to conclude both that EMI was servicing

mortgages and that EMSI’s servicing portfolio had not ex-

panded beyond that which it held at the time of its spin-off

from EMI in early 1983. Moreover, Harnett possessed a copy

of the EPIC/CSL consolidated annual report, dated March 31,

1983, which disclosed the spin-off of EMSI, mentioned that

EMSI received in the spin-off the “existing mortgage servicing

operations of EPIC,” and indicated that EPIC might enter into

sub-servicing agreements with EMSI. The financial statement

unambiguously indicated that EMI was continuing to engage in

mortgage servicing, a fact thoroughly inconsistent with the

purported representations of Billman and McCuistion to Har-

nett that EMI would turn over its future servicing business to

EMSI. In view of discovery material made available to Harnett

in Harnett I, as well as this report received by Harnett prior to

commencing Harnett I, it is impossible to say that any con-

cealment or fraud by Billman and McCuistion, even if they

EST

Al0

existed. acted to prevent the assertion of Harnett’s EMSI fraud

claim during the pendency of Harnett J.

Harnett is therefore subject to the general principle that the

judgment in Harnett J extinguishes any claims that might have

been raised in that litigation and that are, for res judicata

purposes. the same claims as those advanced in the earlier case.

Res judicata precludes the litigation by the plaintiff in a

subsequent action of claims “‘with respect to all or any part of

the transaction, or series of connected transactions, out of which

the [first] action arose.” Restatement (Second) of Judgments

§ 24( 1) (1982): Adkins v. Allstate Insurance Co., 729 F.2d 974,

976 (4th Cir. 1984) (embracing Restatement rule).

Harnett argues that because the claims he raised in this

litigation were not for the identical injuries and remedies that

were the subject of Harnett J, they should not be precluded.

The rule of claim preclusion we apply, however, asks only if a

claim made in the second action involves a right arising out of

the same transaction or series of connected transactions that

gave rise to the claims in the first action. To decide this, we

measure the scope of “transaction or series of connected

transactions” by considering pragmatic factors such as common

origin and relation, as well as whether the act giving rise to the

claim would be considered as part of the same unit by the

parties in their business capacities. See Restatement (Second)

of Judgments § 24(2) (1982). Claims may arise out of the

same transaction or series of transactions even if they involve

different harms or different theories or measures of relief. Jd.

comment c.

Analysis under this transactional test reveals that virtually

all the claims that Harnett now raises are precluded by the

judgment entered in Harnett J. Harnett set out seven “claims

for relief’ in his complaint below. The first claim, arising under

§ 10(b) of the Securities Exchange Act of 1934, 15 U.S.C.

§ 78(j) (1982) and Rule 10b-5, 17 C.F.R. § 240.10b-5, alleged

securities fraud in connection with the ERSI and EMSI spin-

offs and with the freeze out mergers involving ERSI and EMSI

in November and December of 1984. The second claim, under

All

§17(a) of the Securities Act of 1933, 15 U.S.C. § 77(q)

(1982). and the third claim, under § 12(2) of the Securities Act

of 1933. 15 U.S.C. § 77( 7) (1982), made claims relating solely

to the ERSI and EMSI spin-offs. Harnett’s fourth and fifth

claims alleged violations of Delaware and Virginia securities

laws arising out of both the spin-offs and the freeze out mergers.

In Harnett J, Harnett alleged that prior to the ERSI and

EMSI spin-offs, Billman and McCuistion had _ illegitimately

obtained EPIC stock to which they were not entitled. In

Paragraph 45 of his complaint in the prior action, Harnett

alleged that:

This assignment of shares and/or option to

Billman and McCuistion diluted the value of Har-

nett’s interest in EPIC both with respect to the

purported merger of EPIC into CS&L Service Co. as

well as with respect to EPIC’s spin-off of EPIC Realty

Services, Inc. and EPIC Mortgage Servicing, Inc.

Harnett’s securities claims in this case are based on his asser-

tions that he was damaged in his interests in ERSI and EMSI

by the misappropriation of shares, that in both the ERSI and

EMSI spin-offs defendants misrepresented the number of EPIC

shares outstanding, that at the time of the freeze outs these

misrepresentations were continued, and that the defendants

misrepresented, in connection with the EMSI spin-off, the

nature of the servicing business to be received and conducted

by EMSI. The complaint in Harnett J, however, made the

claim relating to the dilution of Harnett’s interest in EMSI and

ERSI, and that claim is precluded from litigation here as part of

Harnett’s federal or state securities law claims. Moreover, as

we concluded above, all of the essential elements of the claim

that Billman and McCuistion had misrepresented the nature of

EMSI’s future business operations existed at the time Harnett ]

was dismissed, and because that claim arises directly out of the

EPIC/CSL merger and EMS] spin-off that were an integral part

of Harnett’s claims in Harnett J, it is necessarily part of the

same transaction or series of transactions at issue in the earlier

case. To the extent that Harnett’s securities claims depend on

the alleged misrepresentations by Billman and McCuistion at

Al2

the time of the EMSI spin-off. the claims are precluded by the

judgment in Harnett 7. The only securities claims that survive

Harnett I, therefore. are those contained in Claim | and in the

State securities law claims that depend on misrepresentations in

connection with the purchase of Harnett’s EMSI and ERSI

stock on the freeze out mergers. which took place several

months after the judgment in Harnett I.

Claim 6 of the complaint in Harnett J] set out a state law

claim for fraud. That claim. however, is also based on

Harnett’s allegations that the defendants fraudulently obtained

EPIC stock and misrepresented and later concealed the diver-

sion of servicing business between EMSI and ERSI and EMI.

These claims also arose out of the same transaction or series of

transactions, the various mergers and spin-offs, that were the

basis for Harnett’s claims in Harnett I, and the district court

should properly have dismissed these claims as res judicata.

Harnett’s final claim in this case is that Billman and

McCuistion breached their fiduciary duty to him, as a minority

shareholder, by their treatment of ERS] and EMSI. This claim

relies partially on the share misappropriation and mis-

representation questions we have held precluded under other

theories of relief, but also includes alleged breaches in the

interval between the Harnett J judgment in February 1984 and

the freeze out mergers later that year. To the extent that this

claim is limited to breaches and injuries during that interval, it

survives Harnett J. Accordingly, we conclude that res judicata

precludes the litigation of all of Harnett’s claim except this

portion of the fiduciary duty claim, and the portion of the

securities claims particular to the freeze out mergers of ERSI

and EMSI. The district court granted summary judgment

against each of these claims on other grounds, however, and we

now examine Harnett’s claims that the district court erred in

doing so.

Ill

The district court dismissed all of Harnett’s securities law

claims upon the conclusion that neither the acquisition of ERSI

and EMSI stock in the spin-offs, nor the disposition of Harnett’s

Al3

shares in the freeze outs. constituted a “purchase or sale of

securities” permitting Harnett to make claims arising under

federal or state securities laws. Having found that most of

Harnett’s securities claims are barred by res judicata, however.

we conclude that when Harnett’s securities claims are limited to

the freeze out mergers, li is unnecessary to resolve the question

whether the forced “sale” of stock in a freeze cut merger is a

“sale” giving rise to securities claims. This follows because it is

apparent on the record that Harnett has neither alleged, nor

could he prove, any injury arising out of fraud in connection

with the freeze out mergers.

Harnett’s remaining securities claims are his § 10 and Rule

10b-5 allegations in his first claim, and his state law claims that

incorporate the allegations of the federal claim. Examination of

Harnett’s complaint reveals, however, that there is no allegation

of injury from these remaining claims. Harnett asserts that the

misstatements and omissions in connection with the freeze outs,

which relate to Harnett’s claims that Billman and McCuistion

misappropriated EPIC shares and therefore received too great a

proportion of EMSI and ERSI shares, constituted mis-

statements and fraudulent behavior actionable under the secu-

rities laws. Although such behavior can only form the basis for

a cause of action in Harnett if it caused an injury, the complaint

makes no allegation of injury flowing from the alleged fraud,

and it is apparent to us that there could be none.

The actual injury allegedly suffered by Harnett as a result

of the share misappropriation is a dilution of Harnett’s interests

in ERSI and EMSI. While it is true that Harnett was further

injured if, after the freeze outs, the misappropriation caused

him to receive a lesser amount for his share of the companies,

that result is not caused by any deceptive statements in

connection with the share misappropriation. Not only did

Harnett already know of this dilution claim, so that any

misrepresentations did not conceal from him what he perceived

to be the true state of affairs, but the misrepresentations

themselves cannot have caused the dilution, which occurred as

a result of earlier behavior by the defendants.

Al4

Because Harnett’s remaining securities claims do not con-

tain an allegation of injury caused by securities law violations.

and because it was not possible for Harnett to show such an

injury. the securities claims were properly subject to dismissal

by the district court.

Finally, Harnett argues that the district court erred in

dismissing his claim for breach of fiduciary duty. The rationale

for the district court’s decision was that the fiduciary duty claim

asserted by Harnett was a derivative claim available only to

shareholders, and that because Harnett was no longer a share-

holder of EMSI or ERSI, a derivative claim was no longer

available to him.

We conclude that the district court properly applied Dela-

ware law 2 in finding that a former shareholder such as Harnett

was without standing to assert a derivative claim for breach of

fiduciary duty. Although Harnett asserts that he could make

these claims as a sole shareholder, it is clear that under

Delaware law such an action is to be made only derivatively,

see Cole v. Ford Motor Co., 566 F. Supp. 558, 568-69 ( W.D. Pa.

1983) (applying Delaware law). Moreover, a derivative action

is not among the remedies available to a minority shareholder

faced with a short form merger. Such shareholders are limited

to injunctive relief if the merger is unfair, and to appraisal

rights if the merger is fair. See Weinberger v. UOP, Inc., 457

A.2d 701, 711 (Del. 1983).

The judgment of the district court is affirmed in part and

reversed in part.

AFFIRMED IN PART:

REVERSED IN PART.

2 Prior to their acquisition in the freeze out mergers, and at the time

that Harnett was a shareholder, ERSI and EMSI were both Delaware

corporations.

Al5

COURT OF APPEALS ORDER DENYING

PLAINTIFF’S PETITION FOR REHEARING

October 29. 1986

United States Court of Appeals

For THE FOURTH CIRCUIT

No. 85-2338

No. 85-2339

WILLIAM J. HARNETT,

Appellee,

versus

Tom J. BILLMAN, ef ai,

Appellants,

and

Epic MORTGAGE, INC., etc., ef ai,

Defendants.

Appeals from the United States District Court for the Eastern

District of Virginia, at Alexandria. Albert V. Bryan, Jr..

District Judge.

Upon consideration of the appellee William J. Harnett’s

petition for rehearing,

IT IS ORDERED that the petition for rehearing is denied

Entered at the direction of Judge Phillips with the con-

currence of Judge Russell and Judge Chapman.

For the Court,

JOHN M. GREACEN

CLERK

Al6

OPINION OF DISTRICT COURT.

October 7, 1985

IN THE UNITED STATES DISTRICT COURT

FOR THE EASTERN DISTRICT

OF VIRGINIA

ALEXANDRIA DIVISION

CIVIL ACTION NO. 85-157-A

WILLIAM J. HARNETT,

Plaintiff,

Tom J. BILLMAN, ef ai.,

Defendants.

MEMORANDUM OPINION

This common law fraud ' action was tried to the court on

September 16-17, 1985. Decision was reserved to permit the

court to review portions of certain transcripts, and for the

parties to file and the court to consider post trial briefs. This

has now been accomplished.

The controversy arises out of the stockholdings of the

plaintiff, William J. Harnett (Harnett), in Equity Programs

Investment Corporation (EPIC). EPIC’s principal business

involves the purchase of model homes from builders who need

the capitol which is tied up by their holding of models for

lengthy periods of time. The model homes are then leased back

to the builders. Limited partnerships formed for the purpose of

holding title to the properties. Investors are sought as limited

partners and EPIC is the general partner.

' The amended complaint contained counts of violations of the Securities

Act of 1933 (Counts 2 and 3), the Securities Exchange Act of 1934 (Count

1). the Virginia Securities Act (Count 4), the Delaware Securities Act (Count

5). and common law fraud (Count 6). By the time of trial only Count 6

remained in the case.

Al7

Harnett was an original investor in EPIC, purchasing 1250

shares for $5,000 in 1975. The other investors and original

stockholders included the defendants Tom J. Billman (Bill-

man) and Clayton C. McCuistion (McCuistion). Minority

stockholdings other than the plaintiffs were acquired by Bill-

man and McCuistion over the years so that by the time the

events at issue here occurred in February and March of 1983,

Harnett was the only minority stockholder, and the share-

holdings were as follows: Biliman, 75,875; Billman, trustee,

1,250; McCuistion, 22,175; and Harnett, 1,250.

As late as June, 1982 the corporate structure of EPIC, and

the subsidiary of EPIC that is involved here, EPIC Mortgage,

Inc. (EMI), was as follows:

STOCKHOLDERS

Billman

McCuistion

Harnett

Forcuki

Dworshak

EPIC

EMI Other Subsidiaries

On June 18, 1982, EPIC Realty Services, Inc., was spun off

from EPIC, in a tax free transfer to its shareholders. That

corporation performed management and related realty service

operations for properties owned or controlled by EPIC or its

related corporation or by Billman and McCuistion. The spin-

off of ERSI is only relevant to the issues in this case because

Harnett asserts, as one of the fraudulent representations alleged

Als

to have been made by the defendants, that he was told in 1983

that the proposed spin-off from EMI of EPIC Mortgage Servic-

ing. Inc. (EMSI) would be just like the spin-off of ERsI.

Harnett received his proportionate share of ERSI stock in the

spin-off of that corporation from EPIC. It is arownd the spin-off

of EMSI that this controversy centers.

Unbeknownst to Harnett, by October 1982, Billman and

McCuistion had acquired, through various holding companies,

controlling interest in another company, Community Savings

and Lean, Inc. (Community Savings), and its subsidiary,

Community Savings and Loan Service Corporation (CSC), the

entity which was later to acquire EPIC by merger. The

structure of this interest was as follows:

Stockholders

Billman and McCuistion

EPIC Holdings, Ltd.

Equity Acquisition, Inc.

Community Savings & Loan, Inc.

Community Savings & Loan

Service Corporation (CSC)

On January 27, 1983, Harnett received a formal notice

from EPIC of its proposed merger into CSC. The notice

revealed that Billman and McCuistion controlled Community

Al9

Savings. The proposal in the notice was that, in exchange for

his shares in EPIC, Harnett was to receive preferred stock in

Community Savings. Notice was also given of a February 23.

i983 shareholders meeting to vote on the merger. The notice

recommended that Harnett consider selling his shares in EPIC

to Billman and McCuistion. Harnett was unhappy with the

proposal to receive only fixed value, non-convertible, non-

voting preferred stock in a company, Community Savings,

whose common stock was controlled by Billman and

McCuistion. The notice of merger did not mention any spin-off

from EMI of EMSI. Harnett called Billman, who indicated that

he was not surprised at Harnett’s dissatisfaction, and that he,

Billman, would pay Harnett a premium for his stock. In this or

a subsequent conversation prior to February 23, 1983, Billman

told Harnett that he was thinking of spinning off “the mortgage

company.” Later, on the day prior to the February 23 stock-

holders meeting, Billman told Harnett that all of the operations

related to mortgage servicing 2 were going to be spun off into a

new company which would do all the servicing of mortgages for

the combined EPIC/Community Savings operation. Also on

February 22, Billman and McCuistion indicated to Harnett that

they would pay up to $100,000 for his stock in EPIC. Harnett

asked for more information, more disclosure, and asked Bill-

man why nothing was said in the merger notice about the spin-

off. Billman said that he would let him know the answer to this

the next day before the shareholders’ meeting. Harnett at that

time indicated that he probably would dissent from the merger.

The next day, just prior to the proposed shareholders’ meeting,

Harnett again complained of a lack of disclosure and of

receiving worthless stock in exchange for his EPIC shares. He

was again told that all matters related to mortgage servicing for

EPIC and Community Savings portfolios were being trans-

ferred to a new and separate company. Harnett was told that

2 Mortgage servicing means collecting mortgage payments from the

mortgagor, and disbursing those payments to the mortgagee as well as setting

up escrow accounts from which timely payments of taxes and insurance

premiums would be paid. In the case of the EPIC “product” this included

collecting and paying homeowners’ association dues, which would otherwise

constitute a lien prior to the mortgagee’s lien, and various accounting and

reporting procedures necessitated by the limited partnership interests.

A20

the spin-off would be just like ERSI. Harnett knew that EMI.

the company from which the new company, EMSI. would be

spun off. would continue to originate loans. but was led to

believe that EMI would not continue to service loans—that was

to be done by EMSI.

Harnett’s complaints about what he was to receive from

the merger prompted Billman and McCuistion to offer him an

option to purchase his pro rata share in Community Savings at

a price per share. This was agreeable to Harnett, and the

necessary documents were to be drawn up and sent to Harnett.

According to Harnett the stockholders’ meeting was cancelled,

and he left to await the documents. When the documents

arrived (PX 28), he called EPIC’s counsel, Deerin, to ask for

more information and to indicate that he would not exercise the

option until he had more information.

A meeting was set up for March 3, 1983. At its beginning

Billman handed Harnett a retraction of the option (PX 48).

There was some discussion of the spin-off at this meeting.

Unbeknownst to Harnett, the spin-off had already occurred on

March 2. He received his certificate for 1250 shares in EMSI,

dated March 2, 1983, sometime after March 16, 1983 (PX 58).

Billman’s and McCuistion’s version of the happenings at

the meetings of February 22, 23 and March 3, differs from that

of Harnett. They say the discussion of the spin-off occupied a

minor part of only the meetings of February 22 and 23; that it

was not discussed at all on March 3; and that the discussion

consisted only of a statement that the spin-off would be like the

one for ERSI, to which Harnett responded “fine.” They further

state that the shareholders’ meeting was not cancelled, but went

ahead, and the merger was approved 3 despite objection from

Harnett as to lack of disclosure and “‘10-b-5” violations; and

most specifically they deny that Harnett was ever told that all

operations related to mortgage servicing of EPIC and

Community Savings loans would be transferred to EMSI.

3 The appraisal of the value of Harnett’s EPIC stock as a result of his

dissent is pending in an appropriate proceeding in the Circuit Court of Fairfax

County. Virginia.

A2l

The court accepts Harnett’s version of the meetings for the

most part. But the court finds, in any event, that Billman and

Harnett wanted to spin off the valuable rights to service the

mortgages of EPIC and Community Savings from EMI before

the merger took place. perhaps so they would not be encum-

bered by the spun off company having to deal with the

Maryland regulatory authorities. If the spin-off occurred while

Harnett was a stockholder of EPIC, then he would have to

receive a proportionate share in the new EMSI. This they did

not want, and it was for this reason that they did not tell him

originally of the proposed spin-off when notifying him of the

merger. When he asked for more disclosure, wisdom dictated

that he had to be told of the spin-off. But they first tried to buy

his stock. They made the proposed exchange to unattractive for

him that perhaps he would sell rather than accept 1t. When he

wouldn’t sell his stock, they spun off EMSI before the merger

but immediately took away from it the substantial earning

capacity it would have had if it had been given the capabilities

that had been represented as planned for it.

Indeed, it appears that such a plan existed. Minutes of a

February 25, 1983 board of directors of EMI meeting state, in

part:

... the principal business of [EMI] is the origination,

sale and servicing of commercial and residential

mortgage financing.

... the activities of servicing the loans... have here-

tofore been conducted by the Corporation.

... there exists an opportunity for expansion of the

mortgage servicing activity by enlarging same to

include all those services customarily offered by other

mortgage servicing organizations and to offer such

services to other unrelated corporations or lending

institutions.

~ * *~ *

it is deemed desirable to place under the control of a

separate corporate body the property of the Corpo-

See ee

ration devoted to the business of mortgage servicing

and its related operations. including. withou: limita-

tion. such escrow balances as are incidental there-

eee

* = * =

that following the creation of EMS and the adoption

of the plan set forth herein by the sole shareholder

hereof. this Corporation shall transfer and convey to

EMS all of the operations, including existing escrow

account balances, of the Corporation related to mort-

gage servicing as of the date of such transfer. ...

(PX 31)

Minutes of an EPIC board of directors meeting of March 1,

1983, state, in part:

... EMS will engage in the activities of servicing

commercial and residential mortgage loans omgi-

nated and sold by EMI....

x - bd *

there exists an opportunity for expansion of the

mortgage servicing activity by enlarging same to

inciude all those services customarily offered by other

mortgage servicing organizations and to offer such

services to other unrelated corporations or lending

institutions independently of the principal business of

the Corporation. ...

* * s *

it is deemed desirable to place under the control of

the shareholders of the Corporation the property of

the EMS devoted to the business of mortgage servic-

ing and its related operations. ...

(PX 41)

Despite the foregoing, on March 1, 1983, a subservicing

agreement (PX 69) between EMI and EMSI was executed

whereby the latter employed EMI to do ail the servicing of the

mortgages on a fee basis, producing some revenue for EMSI

A23

which was nearly all paid out in salaries to Billman and

McCuistion. While some limited new mortgage servicing was

transferred to EMSI immediately after the spin-off, nothing else

of substance was ever transferred by EMI to EMSI. It never

had any employees except Billman and McCuistion, president

and vice president, respectively, Ms. McKinney, who later

became a vice president, and perhaps one other individual.

EMSI never actually serviced a mortgage. None of the

employees was full time. There was no transfer of employees to

EMSI. It had no listed telephone, office, stationery or tangible

assets. EMSI’s only asset was the righi to service mortgages, a

right it transferred to EMI before exercising it. The spin-off in

all probability was not a tax free one.

Harnett knew none of the foregoing until November, 1984.

He received a letter from Ms. McKinney (PX 184) advising

him that as of November 28, 1984,4 the date of the letter, EMSI

had merged into Cavalier Oil Corporation (Cavalier), which

had apparently acquired nearly all of the holdings of Billman

and McCuistion in EMSI. The letter enclosed a check for

$93,950 for Harnett’s stock.5 Until November 1984, Harnett

assumed that EMSI was servicing the mortgages for

EPIC/Community as he had been told would be done.

The court finds from the foregoing, by clear and con-

vincing evidence, that both Billman and McCuistion made false

4 It is this late notification to Harnett, as a result of which he learned that

EMI, not EMSI, was reaping the benefits of the spin-off, and that EMSI had

since March, 1983, been only a paper company, that defeats the res judicata-

based motion to dismiss of the defendants. That motion relies on a February

4, 1984 dismissal with prejudice of prior fraud action brought by the plaintiff

in this court. The complaint in that action alleged fraud by Billman and

McCuistion and others in connection with the merger between EPIC and

CSC. Although the spin-off of EMSI is mentioned in the amended complaint

in that action [9 49(h)], that action did not embrace the allegations of

material misrepresentations regarding the spin-off, which are involved here

and which were not known to be misrepresentations at the time of the

February 4, 1984 dismissal of the fraud claims in the prior action.

5 The merger of Cavalier and EMSI was a so-called “short form” merger

under Delaware law. Under it a stockholder such as Harnett who is “frozen

out” can ask for an appraisal of his stock if he disagrees with what has been

offered him. This remedy is being pursued by Harnett in Delaware.

A24

representations to Harnett concerning their intentions with

regard to what EMSI’s future activity would be after the srin-

off. The March |. 1983 subservicing agreement was obviously

not conceived of on March 1. Moreover. even if the original

intention had been for a tax free spin-off of the mortgage

servicing functions of EMI and for EMSI to service thereafter

the mortgages of the combined EPIC/Community operation,

their failure to disclose this change of intention and their

divesting EMSI of all of its income producing capabilities

constituted a misrepresentation. Given what they had told

Harnett in the past, they owed him a disclosure of what actually

was being done in order for the past statements not to be

misleading. They had a continuing duty to so disclose as long

as the facts were material and remained undisclosed, which was

the case here. Moreover, they had a duty to correct previous

misrepresentations or misleading statements of material facts

since the facts which had not been disclosed continued to be

material. It is clear to the court that the failure to so advise

Harnett was in order to lull him into inaction, and it did. The

justifications proferred by Billman and McCuistion for their

change of mind are not convincing, but even if there were

arguable reasons for their actions, at the very least they owed it

to Harnett to tell him of what action was being taken.

The plaintiff asserts that his reliance on the mis-

representations resulted in the following:

1. He did not sell his EPIC stock to Billman and

McCuistion because he wanted to obtain the benefits of his

interest in the spun off corporation, EMSI.

2. He did not file a derivative suit as an EMSI shareholder

to recover sums unlawfully diverted from EMSI by Billman and

McCuistion. Since he is no longer a shareholder in EMSI this

remedy is not available to him now.

3. He did not exercise his option to purchase Community

Savings stock during the period before the option was retracted

by Billman on March 3, 1983.

LA)

4. He did not report his receipt of EMSI stock as a

petentially taxable transaction.

5. He maintained ownership of his EMSI stock and

made no effort to sell it.

6. He dismissed his prior fraud action in favor of a stock

appraisal proceeding.

The court is convinced that all of the foregoing assertions

are true. However, finding with any reasonable certainty and

without speculation that any one or more of them can be

quantified in terms of damages is not possible. But the court

finds, by clear and convincing evidence, that misrepresentations

have been made to the plaintiff and that the plaintiff has

reasonably relied upon them. Under these circumstances the

court ought not to deny the plaintiff damages because they

cannot be established with precision.

It seems to the court that the proper measure of damages

to which the plaintiff is entitled is that amount he would have

received as a result of his stock holdings in EMS] if EMSI had

done the mortgage servicing which Billman and McCuistion

represented it would do but which instead was done by EMI.

And this should be calculated by using what EMI actually

earned. Recent events, mainly the demise of the

EPIC/Community group of companies, establishes that in all

probability there will be no future loans from EPIC and

Community Savings for EMI to service. It will, presumably,

continue to service the existing portfolio. Harnett objects to any

consideration of these recent events. However, they undoubt-

edly would have occurred even if EMSI had received in the

spin-off all that had been represented.

Accepting the calculations of the plaintiff as to the income

of EMI, which properly belonged to EMSI, during the period

March 3, 1983 until October 31, 1984, a 20 month period (PX

205A) at $1,441,313; and assuming, as did the plaintiff's expert,

an 80% dividend pay out for this type of service company,

plaintiffs income over those 20 months would be $14,344. This

A26

equates to $717 per month. or $8.604 annually. This results in a

damage figure as follows:

Lost earnings for the period March 1.

1983 to October 31. 1984 $14,344.00

Lost earnings for the period October

31. 1984 to September 30, 1985 9,321.00

Total Damages $23,665.00

The court has thus rejected the plaintiffs method of

computing damages, which he measures by the value his stock

in EMSI would have had if EMSI had been doing all of the

business originally represented as projected for it. The value is

determined by capitalizing projected earnings, assuming in this

projection an increase each year. Plaintiff then arrives at his

damage total by deducting from the value so computed the

$93,950 offered him in the merger of EMSI and Cavalier. The

court does not feel that this is the proper measure of damages.

It gives the plaintiff more than he has lost as a result of the

particular fraudulent misrepresentation of which he complains.

Moreover, it duplicates, even with the $93,950 deduction, the

remedy afforded by the pending appraisal proceedings. Pro-

jecting damages beyond November 28, 1984 also gives the

plaintiff more than he lost, since after that date he no ionger

was an EMSI stockholder. It is only speculation that had EMSI

performed the mortgage servicing as represented, the merger

between Cavalier and EMSI would not have taken place.

As to the defendants EMI, Cavalier and ERSI, there has

been shown no activity on their behalf which amounts to fraud.

Billman and McCuistion were acting for their own individual

benefit. Indeed, they may have acted contrary to the best

interests of the corporate defendants, particularly EMI. Con-

sequently, the judgment to be awarded will be against Billman

and McCuistion only, and the action will be dismissed as to the

corporate defendants.

A27

The court has found the individual defendants guilty of

making frauculent representations, and the representations are

sufficiently egregious to constitute a willful and wanton dis-

regard of the plaintiffs nghts. Billman is, from the record in the

case. the more culpable of the two. Accordingly, punitive

damages will be awarded against Billman in the amount of

$25.000 and McCuistion in the amount of $10,000.

United States District Judge

Alexandria. Virginia

October 7th, 1985

A28

IN THE UNITED STATES DISTRICT COURT

FOR THE EASTERN DISTRICT

OF VIRGINIA

ALEXANDRIA DIVISION

CIVIL ACTION NO. 85-157-A

WILLIAM J. HARNETT,

Plaintiff,

Vv.

Tom J. BILLMAN, ef al.,

Defendants.

ORDER

For the reasons set forth in the Memorandum Opinion this

day filed, it is ORDERED that:

1. Judgment is entered on Count 6 of the Amended

Complaint in favor of the plaintiff William J. Harnett as

follows:

a. Against the defendants Tom J. Billman and Clay-

ton C. McCuistion, jointly and severally, in the amount of

$23,665.00 in compensatory damages, plus costs; and

b. Against the defendant Tom J. Billman in the

amount of $25,000.00 in punitive damages; and

c. Against the defendant Clayton C. McCuistion in the

amount of $10,000.00 in punitive damages.

2. Judgment is entered in favor of the defendants Epic

Mortgage, Inc., Cavalier Oil Corporation and Epic Realty

Services, Inc., against the plaintiff William J. Harnett on Count

6 of the Amended Complaint.

United States District Judge

Alexandria, Virginia

October 7th, 1985

A29

DISTRICT COURT ORDER of

November 1, 1985

IN THE UNITED STATES DISTRICT COURT

FOR THE EASTERN DISTRICT

OF VIRGINIA

ALEXANDRIA DIVISION

CIVIL ACTION NO. 85-157-A

WILLIAM J. HARNETT,

Plaintiff,

Vv.

Tom J. BILLMAN. ef al.,

Defendants

ORDER

For the reasons stated from the bench, it ts hereby

ORDERED that the judgment of October 7, 1985 is amended

so that the compensatory damages awarded are in the amount

of $69,132.00 instead of $23,665.00, the court accepting the

computations set forth in Paragraphs |, 2 and 3 of the plainuffs

memorandum in support of his motion to amend judgment.

finding them supported by the existing evidence in the case

In all other respects the judgment of October 7, 1985 shall

remain the same.

United States Distnct Judge

Alexandria, Virginia

November Ist, 1985

A30

DISTRICT COURT ORDER of March 22, 1985

IN THE UNITED STATES DISTRICT COURT

FOR THE EASTERN DISTRICT

OF VIRGINIA

ALEXANDRIA DIVISION

CIVIL ACTION NO. 85-157-A

WILLIAM J. HARNETT,

Plaintiff,

Tom J. BILLMAN, ef ai.,

Defendants.

ORDER

Upon consideration of the motion of the defendants for

summary judgment on all counts, it is, for the reasons stated

from the bench, ORDERED that:

1. The defendants’ plea of res judicata is sustained only

to the extent that the plaintiff may not litigate in this action

claims that:

a. On June 24, 1981, EPIC acquired an option to

purchase 29,000 shares of EPIC common stock from William J.

Moore and Mary B. Moore at a price of $400,000, or approxi-

mately $13.79 per share.

b. In June, 1982 defendants Billman, McCuistion and

Deerin, individually and as officers and directors of EPIC,

wrongfully and fraudulently caused EPIC to either assign its

option to purchase the Moores’ 29,000 shares to defendants

Billman and McCuistion, or assign the 29,000 shares themselves

to defendants Billman and McCuistion. In either case, the

assignment was made in exchange for inadequate consid-

eration.

A31

c. This assignment of shares and/or option to Billman

and McCuistion diluted the value of Harnett’s interest in EPIC

both with respect to the purported merger of EPIC into CS&L

Service Co.. as well as with respect to EPIC’s spin-off of EPIC

Realty Services, Inc.. and EPIC Mortgage Servicing, Inc.: or

any alleged improprieties directly ansing from the above

claims.

1. Counts 1, 2, 3, 4 and 5 are dismissed because the

court finds that the alleged misconduct was not in connection

with the sale or purchase of a security.

United States District Judge

Alexandria, Virginia

March 22nd, 1985

A32

DISTRICT COURT ORDER of July 16, 1985

IN THE UNITED STATES DISTRICT COURT

FOR THE EASTERN DISTRICT

OF VIRGINIA

Alexandria Division

Civil Action No. 85-00157-A

WILLIAM J. HARNETT,

Plaintiff,

Vv.

Tom J. BILLMAN, ef al.,

Defendants.

ORDER

This matter comes before the Court on defendants’ motion

for summary judgment on Counts 6 and 7 of plaintiffs com-

plaint and on defendants’ motion to strike claims barred by the

Court’s March 22, 1985 order.

The Court GRANTS IN PART and DENIES IN PART

defendants’ motion for summary judgment. The Court

GRANTS defendants’ motion as to Count 7 of the compiaint.

Plaintiffs claim for breach of fiduciary duties is derivative in

nature. Therefore, plaintiff cannot assert Count 7 in his

individual capacity. Plaintiff has neither alleged a special injury

nor can he claim that the alleged wrong affected a right that he

particularly held. Plaintiff admits that he cannot maintain an

stockholder derivative suit. Therefore, Count 7 of his complaint

must be dismissed. See Bennett v. Breuil Petroleum Corp., 99

A.2d 236 (1953); Elster v. American Airlines, 100 A.2d 219

(1953).

The Court DENIES defendants’ motion for summary

judgment as to Count 6. Plaintiff has raised issues of material

A33

fact regarding defendants’ fraudulent misrepresentation and his

reliance thereon. The fact that plaintiff could not have pre-

vented the EMSI spin-off by vote does not foreclose his

opportunity to assert that he relied upon the alleged mis-

representation when determining how to proceed with his

options. Furthermore, an issue for trial is whether the ERSI

spin-off was conducted in good faith and whether it was a

reasonable transaction in light of the fiduciary duties the

individual defendants owed to various corporations. Finally,

the alleged misrepresentation does not have to be in writing in

order for plaintiff to claim he relied upon it to his detriment.

Plaintiff does not assert that he and the individual defendants

entered into a contract. Therefore, Delaware’s Statue of Frauds

does not apply.

The Court GRANTS defendants’ motion to strike claims

barred by order dated March 22, 1985. In the previous order,

the Court held that res judicata barred plaintiff from litigating,

in the present action, any claims that directly arise from the

individual defendants’ acquisition, assignment or exercise of an

option to purchase 29,000 shares of EPIC common stock from

William J. Moore and Mary B. Moore. The fact that Mr. Ward

Dworshak held the 29,000 shares at the time of the ERSI spin-

off and Community Savings and Loan Service Corporation held

the stock at the time of the EMSI spin-off does not alter this

ruling. Plaintiff cannot rely on any facts involving the option to

purchase the Moores’ stock when proving his present allegation

of common law fraud.

Let the Clerk send a copy of this order to all counsel of

record.

DATE:

UNITED STATES

DISTRICT COURT

A34

DISTRICT COURT ORDER IN HARNETT

vr. BILLMAN, No. 83-1029-A,

February 16. 1984

IN THE UNITED STATES DISTRICT COURT

FOR THE EASTERN DISTRICT

OF VIRGINIA

ALEXANDRIA DIVISION

CIVIL ACTION NO. 83-1029-A

WILLIAM J. HARNETT,

Plaintiff,

Tom J. BILLMAN, ef ai.,

Defendants.

ORDER

In appearing that the parties have agreed to settle this case

by defendants’ allowing the plaintiff to exercise his appraisal

rights, it is hereby ORDERED that:

1. Count I of the Amended Complaint is dismissed with

prejudice.

2. Count V of the Amended Complaint is dismissed

without prejudice only insofar as the dismissal is not deemed to

prejudice the plaintiff's right to assert the facts underlying the

derivative action of Count V as those facts may affect the value

of the plaintiff's stock.

3. Discovery conducted in this action shall be available for

use in the appraisal proceedings.

And nothing further remaining to be done in this action, it

is hereby dismissed.

United States District Judge

Alexandria. Virginia

February 16th, 1984

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