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Slavin v. Germantown Fire Ins. Co.

decided.: April 1, 1949.


Author: Kalodner

Before BIGGS, Chief Judge, and GOODRICH and KALODNER, Circuit Judges.

KALODNER, Circuit Judge.

This is a shareholders' derivative action based upon Section 10(b)*fn1 of the Securities Exchange Act of 1934, 15 U.S.C.A. § 78j(b), and Rule X-10B-5,*fn2 C.F.R. (Cum. Supp.) Title 17, Section 240.10b-5, promulgated pursuant thereto by the Securities and Exchange Commission, jurisdiction being conferred upon the district courts by Section 27 cf the Act, 15 U.S.C.A. § 78aa.

The Germantown Fire Insurance Company ("Germantown"), a stock company organized under the insurance laws of Pennsylvania, became, on or about January 2, 1946, the capitalized successor to the Mutual Fire Insurance Company of Germantown ("Mutual"), a mutual company which, for over a century, had operated under the Pennsylvania insurance laws. The instant controversy arises out of the conversion of the mutual company to the stock company. The force of the plaintiffs' case is chiefly directed against the conduct of one Arthur O. Rosenlund, an independent insurance broker, and the manner in which he became the owner of approximately 17,500 shares of stock in Germantown. It is the contention of the plaintiffs that Rosenlund, together with one E. M. Cushmore, an officer and director of Mutual, conspired to take advantage of an existing approximate $3,000,000 surplus, by bringing about the conversion; that they succeeded in their design; that when it became apparent to the other officers and directors of Mutual that Rosenlund was in a dominant position, they "went along", making an agreement with him whereby he was to become the senior officer of the new corporation with a salary of $25,000 per annum and a share in the profits; that the aforesaid conduct was in contravention of the specific statutes referred to inasmuch as the designated purpose of the conversion and the methods of bringing it about, as stated in the registration statement filed with the Securities and Exchange Commission and the prospectus mailed to the policyholders of Mutual, were circumvented and falsified; and that the end result constituted a fraud upon Germantown in the sale and purchase of its securities.

The complaint originally included a prayer for the appointment of a receiver for Germantown, but that being withdrawn, the primary relief now sought is cancellation of the stock holdings of Rosenlund and disestablishment of a voting trust containing voluntary stock deposits and deposits required of those who purchased through the stock issue underwriter.*fn3 Section 29(b)*fn4 of the Securities Exchange Act of 1934, 15 U.S.C.A. § 78cc (b), is relied upon, as well as general principles of equity.No monetary damage is claimed.

Upon the conclusion of the presentation of evidence by all parties,*fn5 the Court below dismissed the complaint for want of jurisdiction. It found neither use of the mails within the meaning of the applicable statute and Rule, nor diversity of citizenship to sustain the complaint upon independent grounds in the local law.D.C., 74 F.Supp. 876. It did not give express consideration to the authority of Hurn v. Oursler, 1933, 289 U.S. 238, 53 S. Ct. 586, 77 L. Ed. 1148, and cases of like import.

To reach the stated result, the District Court made extensive findings of fact wherein the individual defendants other that Rosenlund were absolved of offenses under the Act; the conversion per se was separated from the activities of Rosenlund; and Rosenlund's conduct was found to be outside the Act for want of use of the mails by him in what was assumed, arguendo, to have been a scheme on his part to acquire large holdings in Germantown. The Court, however, expressed the view that Rosenlund had, contrary to good morals, concealed his activities from the officers and directors of Mutual in acquiring such holdings.

On this appeal, the defendants have conceded such a use of the mails as would bring the allegations of the complaint within Section 10(b) of the Securities Exchange Act of 1934, and the Commission's rule X-10B-5. Moreover, they do not take issue over the failure of the Act to explicitly permit civil suits by private persons, nor the failure of the plaintiffs to seek money damages. They do assert, however, that Germantown is not the proper party to sue under the Act. In addition, they contend that no wrong has been done to Germantown, and that, in general, no actionable fraud or deceit has been committed.

The evidence in the case is voluminous, and a fair summary of all of it would overreach the bounds of necessity. For the purposes of orientation, a basic outline of the framework of the case may be set forth.

Mutual, during its century of existence, had accumulated the $3,000,000 surplus previously mentioned, which was undistributable under the laws of Pennsylvania.*fn6 On June 21, 1944, Mutual's policyholders authorized conversion to a stock company pursuant to section 534, P.L. 682, May 17, 1921, 40 P.S. § 674, and further authorized the officers and directors of Mutual to take the necessary steps to accomplish that result. The plan contained in the Resolution approved by the policyholders contemplated that the converted company would have a capital of $1,000,000 consisting of 50,000 common shares of a par value of $20, pre-emptive rights to which were to be allotted to policyholders of Mutual of record on May 11, 1944, on the basis of onetenth of one share for each full dollar of premium paid by term policyholders, and one-tenth of one share for each full ten dollars of perpetual deposit by perpetual policyholders. The 100th annual statement of Mutual's condition, which the policy holders had before them, disclosed assets to the extent of $3,952,043.42, liabilities of $513,235.18, and a surplus of $3,438,808.24.*fn7 Thus, it was apparent that with the addition of the proposed $1,000,000 capital to be derived from the sale of stock, the 50,000 shares would have a book value somewhat in excess of $87 per share. It may be noted here that in addition to the proscription in the local law against distribution of the surplus of a mutual company, the surplus, on conversion, was required to remain intact as the surplus of the stock company.*fn8

Prior to the action of the policyholders in authorizing the conversion, the officers and directors of Mutual had, in April, 1943, concluded an agreement with Bioren & Co., to underwrite the stock issue for a fee of $30,000, in return for which that firm was to take up, at par, all the stock remaining after the exercise by policyholders of their pre-emptive rights, to deposit such stock in a voting trust, and to resell, at par, voting trust certificates therefor. On June 22, 1944, the voting trust arrangement was completed, with the National Bank of Germantown and Trust Co. as depositary, and with W. H. Emhardt, president and director of Mutual, and A. W. Jones and C. E. Dearnley, directors of Mutual, as trustees. The voting trust was authorized to hold the total issue of stock, but, of course, the number of certificates to be issued depended upon the number of shares deposited.

Although it had been contemplated that the plan would be ready and the warrants distributed shortly after June, 1944, various factors irrelevant here delayed the approval of the State Insurance Department. It was not until about July 5, 1945, that the prospectuses announcing the sale of stock were mailed to policyholders, and about July 9, 1945, that the warrants representing pre-emptive subscription rights were mailed to them. The warrants were effective until September 11, 1945.

The final plan for conversion, as stated in the prospectus, included (1) a regulation adopted by the Board of Directors to the effect that no policyholder would be issued pre-emptive rights entitling him, after proration, to subscribe to more than 1,000 shares of stock; (2) an oral agreement with Bioren & Co.; and (3) a ten year voting trust.

As revealed in the prospectus, the written underwriting contract with Bioren & Co. did not govern the manner in which it would distribute the voting trust certificates to be issued for the shares it was bound to take up. There was, however, an oral understanding between the Board of Directors and Bioren & Co. that:

"(a) Insofar as appears to the underwriter to be practicable, preference will be given to those policyholders who at the time of exercising their rights have indicated a desire, if possible, to subscribe for additional shares;

"(b) Insofar as the underwriter can control the situation, certificates will not be sold to persons or firms having a substantial interest in competing companies or whose interests are otherwise likely to be adverse to the company; and

"(c) The underwriter will not knowingly distribute certificates in such a way as to make it possible for any individual or firm to obtain control of more than 1000 shares whether or not all or any part of the same shall be represented by voting trust certificates."

With respect to the voting trust, in addition to the details already given, the prospectus stated that under the terms thereof the trustees were prohibited from voting for or approving the dissolution or merger of the company or the sale of all or substantially all of its assets without the unanimous written consent of the certificateholders. It further stated that the voting trustees "Who are three of the present directors of Mutual Fire Insurance Company of Germantown, including the president of that company and who will occupy similar offices with the new company", intended to use the voting rights to continue the present management of the company for the term of the voting trust agreement. The prospectus also disclosed that Emhardt proposed to acquire, in his own right, voting trust certificates representing 1000 shares of stock, and Jones and Dearnley proposed to acquire 500 shares each, by the exercise of rights which they would receive as policyholders, the purchase of rights or stock on the open market, or the purchase of unsubscribed stock from the underwriter. It further recited that Mutual had never paid any officer a salary in excess of $12,000 per annum, and that under present conditions no substantial change in that policy was contemplated; that the only person who, during the fiscal period ended December 31, 1944, received aggregate remuneration in excess of $20,000 was Rosenlund, who had received $30,265.81 in commissions; that the total payments to all of the officers and the directors, including committee fees, "are proposed to be a maximum of $38,500.00 for the first year after reorganization"; and that "No person other than officers or directors will receive compensation from the Company in excess of $12,000 per year" unless earned by way of commissions on insurance placed with the Company.

The warrants as finally issued to the policyholders contained the statement on their face that they were transferable and divisible; that subscriptions to fractions of shares would not be accepted; and that "Warrants to subscribe to fractions of shares must be presented with sufficient additional warrants to make up the number of whole shares subscribed for". On the reverse side of the warrants was an assignment form. In addition, there was a provision, effective unless deleted by the subscriber, authorizing the deposit of the shares subscribed for in the voting trust and the issuance of voting trust certificates in lieu thereof. There was a statement that the organizer of Germantown was Mutual; that the subscription was for stock in a total issue ...

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