# Petition for Writ of Certiorari — Harnett v. Billman

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## Record

- **Collection:** Supreme Court brief
- **Document type:** Petition for Writ of Certiorari
- **Published:** January 1, 1987
- **Citation:** 480 U.S. 932

## Text

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No.

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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?

1]

TABLE OF CONTENTS

CED FING: Pee ee asehiattiearnencncimenineennanes
TABLE OP A Tans OO ccvvsievanniaviesdicpesiblonsincoanainsen
COP EINES Te IP hss scinnepsaninapietenusdelniapmianitnautibiamecs
PURE BRIT mrevstonidinininatsieerbapeauaneens aaie paentan

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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NA NY NY

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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,

I a cs cimsianisonaeiansenene AlS
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

I\

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
BS Baits hacknlocses Guvotechesaicossosaaaanads ne euaecacbceiin

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

2B USC. 8 USES CUD iivccrictcsncisnisiinstiaciienseinisian
yi RAE oe Be OE. | |) meer err errn mer
2B US. © UGG Z CPB) es vsccnniccccssrvensntesiccntecsrccunernicscens

UNITED STATES CONSTITUTION
CSS Cie OE, TE SB icicsneashtssinencinesdbatiiaebenionsavinnany
U.S Ce RG GE Go wiccssscsvecdeisencsdiickccrcmpescrmcenenicns

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

Page

Nm Nw

14

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).

5

=

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

ty

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

4

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.

6

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

8

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

10

(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).

1]

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.

{2

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).

13

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

14

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

=

15

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

Al

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.

A3

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

A4

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

A

A)

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.

Il

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.

a

A7

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 ).

A&

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

AY

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.

IV

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.
i]

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,
V.

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

a

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-

4

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.

A2

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,
V.

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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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385019_0168%3A1. Public record. Not legal advice.