Drachman v. Harvey

• Decision Date: 21 July 1971
• Docket Number: Docket 35077.,No. 338,338
• Parties: Harold DRACHMAN and Claire Drachman, Plaintiffs-Appellants, v. Lawrence A. HARVEY et al., Defendants-Appellees.
• Court: U.S. Court of Appeals — Second Circuit

453 F.2d 722 (1971)

Harold DRACHMAN and Claire Drachman, Plaintiffs-Appellants, v. Lawrence A. HARVEY et al., Defendants-Appellees.

No. 338, Docket 35077.

United States Court of Appeals, Second Circuit.

Argued January 5, 1971.

Decided July 21, 1971.

On Rehearing January 18, 1972.

Leibowitt, Milberg, Weiss & Fox, New York City (Melvyn I. Weiss and Lawrence Milberg, New York City, of counsel), for plaintiffs-appellants.

Cullen & Dykman, Brooklyn, N. Y. (Arnold & Porter, Washington, D. C., Thomas M. Lamberti, New York City, G. Duane Vieth and Richard J. Wertheimer, Washington, D. C., of counsel), for appellee Martin Marietta Corp.

Dewey, Ballantine, Bushby, Palmer & Wood, New York City (Edward N. Sherry and Robert A. Meister, New York City, of counsel), for appellee Leo M. Harvey.

Simpson, Thacher & Bartlett, New York City (Peter J. Schlesinger, New York City, of counsel), for appellee C. Fitzhugh Gordon.

G. Bradford Cook, Gen. Counsel, S. E. C., Washington, D. C., (Walter P. North, Associate Gen. Counsel, Theodore Sonde, Asst. Gen. Counsel, and W. Bruce McConnel, Atty., S.E.C., of counsel), for Securities & Exchange Comm., amicus curiae.

Before LUMBARD, MOORE and SMITH, Circuit Judges.

On Rehearing in Banc January 18, 1972.

MOORE, Circuit Judge:

This is an appeal from a judgment dismissing the complaint and the supplemental complaint (collectively referred to as "the complaint") in a shareholder's derivative action for alleged violations of § 10(b) of the Securities Exchange Act of 1934,¹ Rule 10b-5² promulgated thereunder, and of state corporate fiduciary law, the last of which claims are asserted under pendent jurisdiction. Judgment was entered without opinion by Judge Travia upon appellees' motion to dismiss under Fed.R.Civ.P. 12(b) (6) and 17(b).

This case presents three issues of not inconsiderable interest: (1) whether shareholders who held stock in "street name" at the time of the fraudulent transactions alleged in the complaint have standing to maintain a derivative action for violations of § 10(b) and Rule 10b-5, when state law (in this case California law) would require as a prerequisite to standing that derivative plaintiffs be "registered" or "record" owners at the time of the wrongs alleged; (2) whether a corporation's redemption of its convertible debentures is a "purchase" within the meaning of § 10(b) and Rule 10b-5, so as potentially to come within the sphere of securities transactions intended to be covered by the Exchange Act; and (3) whether the fraudulent transactions complained of, taken individually or collectively, are cognizable under § 10(b) and Rule 10b-5. We hold that appellants have standing; but we conclude that appellants have failed to state a claim for which relief can be granted under § 10(b) and that the judgment below must therefore be affirmed,³ thus rendering it unnecessary for us to reach the question of whether the debenture redemption is a "purchase" within the meaning of the Exchange Act.

I. FACTS

The Major Parties

Plaintiffs-appellants, residents of New York, are shareholders of Harvey Aluminum Incorporated (Harvey Aluminum) and were shareholders, though not "record owners," of 100 shares of Harvey Aluminum stock at the times of the fraudulent transactions complained of. Defendants-appellees include Harvey Aluminum, as a nominal defendant, Harvey Aluminum's seven directors (four of whom were also officers) and Martin Marietta Corporation (Martin Marietta). Harvey Aluminum is incorporated and based in California; Martin Marietta is incorporated in Maryland and its principal place of business is in New York. Both Harvey Aluminum and Martin Marietta are publicly owned corporations listed on the New York Stock Exchange. Defendants-appellees Lawrence A. Harvey and Homer M. Harvey (the Harveys), two of the leading actors in the transactions in issue, were individually substantial and collectively controlling, shareholders of Harvey Aluminum and enjoyed the corporate positions of President and Director and Executive Vice President and Director of Harvey Aluminum, respectively.

The Plan

As this is an appeal from a judgment of dismissal upon the pleadings under Fed.R.Civ.P. 12(b) (6), we assume the following allegations of fact to be true.⁴ During November 1968, Martin Marietta determined that it would be to its interest to acquire control of Harvey Aluminum. In furtherance of this objective, Martin Marietta conspired with the Harveys to gain and secure control for Martin Marietta. The first phase of the plan called for the purchase by Martin Marietta from the Harveys of approximately 2.7 million shares of Harvey Aluminum Class B common stock, which represented approximately 40% of the outstanding voting stock, at a price of $40 per share. This price was some $11.20 per share over the then current market price and represented an aggregate premium of nearly $30 million. Phase One was completed in November 1968.

Phase Two called for continued use of the Harvey-Martin Marietta conspiracy: the Harveys remained in their positions as officers and directors of Harvey Aluminum "with the facade of acting solely in the interest of Harvey Aluminum and its shareholders when in fact they were acting under the domination and control of and in the interest of defendant Martin Marietta."⁵ Specifically, the Harveys "recommended" to, and voted at, the May 23, 1969 Harvey Aluminum board of directors meeting that on June 27, 1969, Harvey Aluminum call its entire then outstanding issue of 5½% convertible subordinated debentures due July 1, 1999, at a cost of $6.6 million. The action was approved. The call price of $105 exceeded the June 27, 1969 market value of the convertible debentures, and the conversion ratio to common stock was unfavorable. By causing holders to redeem their debentures at cost, thereby eliminating the possibility of a 222,000 share dilution through conversion to Harvey Aluminum Class A common stock, Martin Marietta increased its percentage holdings and secured its desired control position without having to acquire shares of common stock in the marketplace. Upon the successful completion of Phase Two, Martin Marietta assumed formal operating control of Harvey Aluminum by causing its designee to be elected president of the corporation.

Damage to Harvey Aluminum Alleged and Recovery Sought

Appellants claim that as a result of the conspiracy Harvey Aluminum has suffered damage in the amount of $6.6 million, the amount caused by appellees to be paid to the holders of the entire issue of convertible debentures outstanding pursuant to Phase Two. The alleged harm to Harvey Aluminum by the debenture redemption was caused by appellees' "defrauding," or acceding in the "defrauding," of Harvey Aluminum out of the use of its $6.6 million working capital at a time when it was borrowing and contemplating borrowing additional funds in a critically tight capital market with record high interest rates.⁶ Moreover, as a result of the improvident redemption for wrongful purposes, Harvey Aluminum also allegedly lost the foreseeable opportunity to gain additional equity capital, free and clear of all expenses involved in going to the capital market, from debentureholders who subsequently, but for the redemption, might have decided to convert into common stock.

Appellants also seek to recover on behalf of Harvey Aluminum from Martin Marietta and the individual appellees the nearly $30 million premium paid and received in connection with Phase One, apparently on the theory that the otherwise lawful sale of the 2.7 million shares of Harvey Aluminum Class B common stock was "infected" with an overriding fraudulent purpose and thereby was made "in connection with" the subsequent "fraudulent" redemption transaction contemplated in Phase Two.

II. STANDING TO SUE

Appellants' capacity to sue derivatively on behalf of Harvey Aluminum is challenged on the ground that neither Fed.R.Civ.P. 23.1⁷ nor the Exchange Act confers standing on beneficial shareholders⁸ and that therefore state law must apply. It is suggested that California General Corporation Law § 834, which permits derivative actions by plaintiffs only if they are "registered shareholders * * * at the time of the transactions or any part thereof" of which they complain, controls the disposition of this case⁹ and requires dismissal at the threshold. The questions of who is a "shareholder" for purposes of a derivative action brought under the Exchange Act and by reference to what law (procedural or substantive, state or federal) the answer to the principal question is to be determined, do not appear to have been answered in precedent to be found in reported appellate court decisions. We agree with appellees that Fed.R.Civ.P. 23.1 leaves open the question of who is a "shareholder,"¹⁰ and that for state causes of action, standing is determined under state substantive law.¹¹ We believe, however, that Federal law must be consulted to decide whether there is standing to sue under the Exchange Act,¹² and that federal law confers standing upon beneficial shareholders such as the Drachmans.

Only two reported cases under the Exchange Act, both in the Southern District of New York, even raised the question under consideration. In the first, Treves v. Servel, Inc.,¹³ the court held that "a shareholder need not be of record to maintain a derivative action"¹⁴ brought under the Securities Act of 1933,¹⁵ the Exchange Act and § 8 of the Clayton Act.¹⁶ In support of its conclusion the court relied on the authorities collected in Marco v. Dulles;¹⁷ but Marco was a derivative action founded solely on diverse citizenship¹⁸ in which the court was squarely presented with the issue of whether the Marco estate's equitable ownership of stock was sufficient to confer standing to sue derivatively. The Marco court concluded, upon a review of the leading state and federal decisions on the subject, that

"under the law of the state of incorporation of

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