King v. Douglass, Civil Action No. H-96-1033.

CourtUnited States District Courts. 5th Circuit. United States District Courts. 5th Circuit. Southern District of Texas
Writing for the CourtHarmon
Citation973 F.Supp. 707
PartiesKevin KING and David L. Massarano, on behalf of themselves and all others similarly situated, Plaintiffs, v. Sam P. DOUGLASS, Nolan Lehmann, Gregory J. Flanagan, Robert L. Knauss, John W. Storms, Francis D. Tuggle, Edward E. Williams, Gary R. Petersen, Equus Capital Management Corp., and Equus II, Inc., Defendants. Kevin KING and David L. Massarano, Plaintiffs, v. EQUUS CAPITAL MANAGEMENT CORP., Defendant and Equus II, Inc., Nominal Defendant.
Decision Date23 December 1996
Docket NumberCivil Action No. H-96-1033.

Page 707

973 F.Supp. 707
Kevin KING and David L. Massarano, on behalf of themselves and all others similarly situated, Plaintiffs,
v.
Sam P. DOUGLASS, Nolan Lehmann, Gregory J. Flanagan, Robert L. Knauss, John W. Storms, Francis D. Tuggle, Edward E. Williams, Gary R. Petersen, Equus Capital Management Corp., and Equus II, Inc., Defendants.
Kevin KING and David L. Massarano, Plaintiffs,
v.
EQUUS CAPITAL MANAGEMENT CORP., Defendant and Equus II, Inc., Nominal Defendant.
Civil Action No. H-96-1033.
United States District Court, S.D. Texas.
December 23, 1996.

Page 708

COPYRIGHT MATERIAL OMITTED

Page 709

Evan B. Glick, Houston, TX, Jeffrey M. Haber, John Halebian, Wechsler Harwood Halebian and Feffer, New York City, for plaintiffs.

Craig Smyser, Jr., Christina A. Bryan, Smyser Kaplan & Veselka, Houston, TX, for defendants.

ORDER

HARMON, District Judge.


Pending before the Court in the above referenced class action and derivative complaint, brought pursuant to Sections 36(a) and 36(b) of the Investment Company Act of 1940 ("ICA"), 15 U.S.C. § 80a-35(a) and (b) (1976) and alleging violations of the ICA and common-law breach of fiduciary duties to a closed-end fund's shareholders and ultra vires acts, illegally conducted without the required approval vote of a majority of the shares, are the following motions: Plaintiffs Kevin King and David L. Massarano's motion for class certification pursuant to Rule 23(b)(3) (instrument # 19); Defendants Sam P. Douglass, Nolan Lehmann, Gregory Flanagan, Robert L. Knauss, John W. Storms, Francis D. Tuggle, Edward E. Williams, Gary R. Peterson,1 Equus Capital Management Corporation ("ECM" or "the Adviser"), and Equus II, Inc.'s ("the Fund's")2 amended motion to dismiss (# 26); and Defendants' motion to partially stay discovery (# 28). Plaintiffs seek declaratory relief and damages.

Plaintiffs' complaint, at 10, explains that unlike open-end funds, which can repeatedly hold public offerings of new shares, closed-end funds do not usually issue new shares after the initial offering and therefore do not

Page 710

expand through infusions of new, outside capital. Instead, closed-end funds usually expand only through the gradual increase in the value of their underlying portfolio. Plaintiffs allege that Equus II, Inc. ("the Fund"), here, has been hurt by the steep discount of the market price of its stock in relation to its NAV, approximately 30%, in the past three years.

Kevin King currently owns 10,000 shares of the Fund, while David Massarano owns 1,199 shares. Plaintiffs sue on behalf of themselves and a proposed class of all persons who owned shares of the Fund as of March 5, 1996 other than named Defendants here. On that date, the complaint alleges, in breach of their fiduciary duties, the Fund's directors, the Fund, and the Fund's investment adviser, all Defendants here, announced that the Fund would conduct a rights offering and issue up to 1,046,191 new shares of stock, thereby increasing the number of outstanding shares by up to 33% if fully subscribed.3 Pointing to authority in the investment field, Plaintiffs assert that in most cases, since closed-end funds cannot sell shares whenever they need more cash, such rights offerings to shareholders are not for the benefit of the shareholders because they constitute a way to extort more money from existing shareholders who feel compelled to pay for initial shares to avoid having the value of their holdings diluted. Plaintiffs contend that the Securities and Exchange Commission ("SEC"), in interpreting and applying the ICA, has indicated that a closed-end fund's directors and investment adviser have a heavy burden to demonstrate that a proposed rights offering's "expected" benefits "clearly outweigh" any injury to participating and nonparticipating shareholders. Plaintiffs contend that the March 1996 rights offering will injure both participating and nonparticipating shareholders by diluting both the net asset value ("NAV") and the market value of their investment in the Fund. Plaintiffs also bring this action pursuant to Section 36(b)4 of the ICA derivatively, on behalf of the Fund, against its investment adviser, ECM, for breach of fiduciary duty regarding the Fund's compensation.

More specifically, the complaint explains that on December 31, 1995, the Fund's shares traded at a 30% discount to the NAV of the stocks owned, and that at the end of February 1996, the Lipper Analytic Survey ranked the Fund's 26.6% discount as the largest of those it surveyed.5

Plaintiffs argue that by pricing the 1996 transferable rights offering's new shares at a

Page 711

steep discount to current market prices, the offering imposes a downward pressure on the trading price for the Fund's shares and threatens dilution of existing shareholders' interests.6 Moreover because of the "coercive" structure of the rights offering, Plaintiffs claim that existing shareholders are faced with three unsatisfactory choices: purchasing additional shares of newly issued stock at a steep discount to the Fund's NAV, suffer dilution of their pro rata ownership interest in the Fund and monetary damage to their existing investment, or sell their shares in a depressed market and suffer market damages.

Under the ICA and under Delaware common law, allege Plaintiffs, the Director Defendants and Adviser ECM have fiduciary duties to the Fund's shareholders to act fairly, equitably and with due care in promoting and protecting the interests of the Fund's shareholders. Therefore, when faced with a proposed discounted rights offering, since section 23(b) of the ICA7 generally prohibits a registered, closed-end investment company from selling to the public its shares at a price below the NAV with certain exceptions, because transferable rights offerings below the NAV involve dilution of existing shareholders' assets, earnings, and relative voting power the fiduciary directors and adviser bear a heavy burden to demonstrate the "expected" benefits of the offering "clearly outweigh"8 injuries to the shareholders of the Fund. Before approving such an offering, the fiduciaries

Page 712

must demonstrate that the benefits created by the offering (1) are "expected" benefits, not just possible, speculative, or hoped for benefits, (2) will accrue to all shareholders, whether they exercise their rights or not, and (3) are larger than the harm caused by the approved offering.

Plaintiffs maintain that the transferable rights9 offering by Defendants will depress the market trading values of the Fund's shares for all shareholders and dilute the value of shareholder investment in the Fund, especially for shareholders who do not exercise their rights. Nor, argue Plaintiffs, are the dilutive effects offset by the "speculative" benefits claimed by Defendants, i.e., providing the Fund with capital to pay down debt and reduce the Fund's expense ratio and providing existing shareholders with an opportunity to purchase additional shares of common stock at a price that may be below market value of NAV without the transaction costs that would be associated with open-market purchases. Furthermore, the amount of the management fees paid to ECM will increase with the increase in total assets.

Plaintiffs insist that under Section 23(b) of the ICA, 15 U.S.C. § 80a-23(b), closed-end funds are prohibited from conducting the kind of discounted offering at issue here:

No registered closed-end company shall sell any common stock of which it is the issuer at a price below the current net asset value of such stock, exclusive of any distributing commission or discount.

While Section 23(b)(1) permits funds to make discounted offering to their current shareholders, Plaintiffs insist that the SEC has repeatedly stated that

[T]he exceptions in Section 23(b) for sales or issuances at a price below NAV are designed for exceptional and not routine circumstances.

"Closed-End Investment Company (Transferable Rights Offering)," 1993 WL 45914, at *1 (SEC Jan 26, 1993) (the "1993 Letter") (referring to the 1977 Release). See also "Interpretive Position Relating to Rights Offering by Closed End Investment Companies Below Net Asset Value," Release No. IC-9932, Fed. Sec. L. Rep. Vol. 6(CCH) par. 48,868, at 37,643 (Sept. 15, 1977) (the "1977 Release")("[Discounted closed-end rights offerings are only justified in] rare circumstances [where] the sale would be in the interest of the Company and not to the substantial derogation of its shareholders.").

Having provided this background on the nature of Plaintiffs' claims, the Court addresses the pending motions. Defendants' motion to partially stay discovery requests the Court to defer ruling on the class certification issues until after it has resolved Defendants' amended motion to dismiss, which asserts that Plaintiffs lack standing to assert any direct claims against Defendants. If the Court rules that all of Plaintiffs' direct class action allegations are derivative in nature and must be brought in a shareholder derivative suit, Plaintiffs' class action claims should be dismissed and the class certification will be a moot issue. Because this contention makes logical sense, the Court addresses the amended motion to dismiss first.

Defendants' amended motion to dismiss under Fed.R.Civ.P. 12(b)(6) summarizes Plaintiffs' claims as three: (1) Defendants' rights offering should not be permitted on public policy grounds, i.e., that closed-end funds should not be permitted to have rights offerings at below the NAV; (2) the rights offering here constitutes a breach of fiduciary duty; and/or (3) the rights offering amounts to an ultra vires act. Defendants argue that these allegations fail to state a claim for which relief can be granted, that Plaintiffs lack standing to assert the direct cause of action on which they base their class action claim, and that because Plaintiffs' direct claims are actually derivative in nature, the direct claims should be dismissed.10...

To continue reading

Request your trial
13 practice notes
  • Judson Atkinson Candies v. Latini-Hohberger, No. 07-1660.
    • United States
    • United States Courts of Appeals. United States Court of Appeals (7th Circuit)
    • June 3, 2008
    ...duty Under Texas choice-of-law rules, the state of incorporation governs claims for breaches of fiduciary duties. See King v. Douglass, 973 F.Supp. 707, 723 (S.D.Tex.1996). Illinois law thus governs 529 F.3d 384 Judson Atkinson's claim that LMC's officers breached their fiduciary duties. Ju......
  • In re Sec., No. MDL–1446
    • United States
    • United States District Courts. 5th Circuit. United States District Courts. 5th Circuit. Southern District of Texas
    • January 6, 2011
    ...and this Court has ruled, choice-of-law determinations can be made at a motion-to-dismiss stage of the litigation. King v. Douglass, 973 F.Supp. 707, 723–24 (S.D.Tex.1996). Deutsche Bank agrees with Plaintiffs that New York and Texas common-law for fraud and civil conspiracy do not differ s......
  • Stegall v. Ladner, No. CIV.A. 05-10062-DPW.
    • United States
    • United States District Courts. 1st Circuit. United States District Courts. 1st Circuit. District of Massachusetts
    • October 14, 2005
    ...Fleming, 1999 WL 104795, 1999 U.S. Dist. LEXIS 22001 (D.Md. Jan. 20, 1999), aff'd by, 248 F.3d 321 (4th Cir.2001); and King v. Douglass, 973 F.Supp. 707, 722 (S.D.Tex.1996)). The District of Maryland decision was later affirmed by the Fourth Circuit. See also Miller v. Mitchell Hutchins Ass......
  • Cypress/Spanish Fort I, L.P. v. Prof'l Serv. Indus., Inc., Civil Action No. 3:10–CV–1507–B.
    • United States
    • United States District Courts. 5th Circuit. United States District Courts. 5th Circuit. Northern District of Texas
    • August 29, 2011
    ...... extort[ing] a settlement with the threat that trying the cases poses a danger to the existence of the company.” King v. Douglass, 973 F.Supp. 707, 719...
  • Request a trial to view additional results
13 cases
  • Judson Atkinson Candies v. Latini-Hohberger, No. 07-1660.
    • United States
    • United States Courts of Appeals. United States Court of Appeals (7th Circuit)
    • June 3, 2008
    ...duty Under Texas choice-of-law rules, the state of incorporation governs claims for breaches of fiduciary duties. See King v. Douglass, 973 F.Supp. 707, 723 (S.D.Tex.1996). Illinois law thus governs 529 F.3d 384 Judson Atkinson's claim that LMC's officers breached their fiduciary duties. Ju......
  • In re Sec., No. MDL–1446
    • United States
    • United States District Courts. 5th Circuit. United States District Courts. 5th Circuit. Southern District of Texas
    • January 6, 2011
    ...and this Court has ruled, choice-of-law determinations can be made at a motion-to-dismiss stage of the litigation. King v. Douglass, 973 F.Supp. 707, 723–24 (S.D.Tex.1996). Deutsche Bank agrees with Plaintiffs that New York and Texas common-law for fraud and civil conspiracy do not differ s......
  • Stegall v. Ladner, No. CIV.A. 05-10062-DPW.
    • United States
    • United States District Courts. 1st Circuit. United States District Courts. 1st Circuit. District of Massachusetts
    • October 14, 2005
    ...Fleming, 1999 WL 104795, 1999 U.S. Dist. LEXIS 22001 (D.Md. Jan. 20, 1999), aff'd by, 248 F.3d 321 (4th Cir.2001); and King v. Douglass, 973 F.Supp. 707, 722 (S.D.Tex.1996)). The District of Maryland decision was later affirmed by the Fourth Circuit. See also Miller v. Mitchell Hutchins Ass......
  • Cypress/Spanish Fort I, L.P. v. Prof'l Serv. Indus., Inc., Civil Action No. 3:10–CV–1507–B.
    • United States
    • United States District Courts. 5th Circuit. United States District Courts. 5th Circuit. Northern District of Texas
    • August 29, 2011
    ...... extort[ing] a settlement with the threat that trying the cases poses a danger to the existence of the company.” King v. Douglass, 973 F.Supp. 707, 719...
  • Request a trial to view additional results

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT