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Broenen v. Beaunit Corp.

December 7, 1970


Swygert, Chief Judge, and Fairchild and Kerner, Circuit Judges.

Author: Swygert

SWYGERT, Chief Judge.

This is an action for damages and equitable relief brought by a holder of one $2,000 face value certificate representing two shares of 4 1/4 per cent convertible subordinated debentures due August 1, 1990 of Beaunit Corporation (hereinafter called "Old Beaunit"), a nonsurviving party to the corporate merger which gave rise to this action. Jurisdiction is based upon diversity of citizenship in that the plaintiff, who seeks to represent all such debenture holders for purposes of this action, is a resident of Wisconsin and none of the corporate defendants are residents of that state. The jurisdictional amount requirement of 28 U.S.C. § 1332 is satisfied by reason of the class nature of the claims asserted as noted and explained by the district court below.*fn1

Plaintiff's claim is predicated on the theory that defendants each violated or caused the violation of the covenants of a certain indenture executed in August of 1965 between Old Beaunit and Manufacturers Hanover Trust Company ("Manufacturers Hanover") pursuant to which Manufacturers Hanover became trustee for purposes of the issuance and subsequent conversions, if any, of $25,000,000 principal amount of the above described 4 1/4 per cent convertible debentures of Old Beaunit. Plaintiff alleges that she purchased her two shares of the debentures on September 3, 1968 and has owned them continuously since that time without exercise of the conversion privilege.

On February 23, 1967, El Paso Natural Gas Company ("El Paso"), EPNG Corp. (a wholly-owned subsidiary of El Paso which was a mere corporate shell) and Old Beaunit executed an agreement of merger by which Old Beaunit was to be merged into EPNG in a three-cornered merger. The merger was effected on October 11, 1967, so that Old Beaunit merged into EPNG which simultaneously changed its corporate name to Beaunit Corporation ("New Beaunit"). On the same date, a supplemental indenture was executed by New Beaunit, El Paso and Manufacturers Hanover pursuant to the merger agreement and in compliance with the requirements of § 5.10 of the original indenture. The supplemental indenture provided, inter alia, that the conversion privilege inherent in the convertible debentures was to be exercisable so as to allow conversion of the debentures into common stock of El Paso, the parent corporation of EPNG (and, hence, of New Beaunit). It is undisputed that under the merger agreement and supplemental indenture a debenture holder who exercised the conversion privilege would receive the same number of shares of El Paso common stock upon conversion whether he converted immediately prior to or after the effective date of the merger.

Plaintiff's claim of injury derives from the fact that, as the parties all agree, the federal income tax effect of the post-merger relationship of the parties to the merger is such as to render the conversion of the debentures into El Paso common stock, should such occur, an exchange of property which requires recognition for purposes of taxation. The parties herein also agree that conversion would not have been an event requiring income tax recognition but for the three-cornered form of this particular merger. As Fleischer and Cary have noted:

The so-called "convertible-bond rule" has been in existence since 1920. It was promulgated in Article 1563, Regulations 45, pursuant to the Revenue Act of 1918, and made applicable to subsequent revenue acts by a series of revenue rulings. The rule may be stated as follows: Where the owner of a bond exercises the right provided in the instrument to convert it into another security of the obligor corporation, the conversion is not considered a closed transaction for tax purposes and therefore does not result in the realization of gain or loss.*fn2

Plaintiff asserts that the nonrecognition of gain or loss upon the exercise of the conversion privilege is a major inducement to purchase convertible bonds and that the loss of this attractive feature of Beaunit convertibles has caused a permanent reduction in the market value of the debentures. Plaintiff further avers that the cause of this reduction, the undesirable tax treatment of a postmerger conversion, derives from defendants having breached or having caused the breach of the original indenture.

The plaintiff and all defendants filed and briefed cross motions for summary judgment in the district court, and each defendant moved to dismiss the cause for failure to state a claim upon which relief could be granted. El Paso also moved that service of process upon it be quashed and that the action against it be dismissed for lack of personal jurisdiction. The district court granted the motions of all defendants for summary judgment, denied all other motions and dismissed the cause. We agree that the defendants were entitled to summary judgment as a matter of law, and we affirm that finding of the district court for the reasons which follow. Since we affirm dismissal of the action against all defendants on the ground stated above, we find it unnecessary to pass on the other issues raised by defendants on this appeal.

Plaintiff argues that the form of the merger of October 11, 1967 violates certain covenants contained in §§ 13.01 and 13.02 of the original indenture between Old Beaunit and Manufacturers Hanover of which the debenture holders are, of course, third party beneficiaries. She urges that New Beaunit breached and that El Paso procured, precipitated and participated in breaches of the indenture. She further contends that Manufacturers Hanover violated its fiduciary duties or violated its specific obligations under the indenture, or both, by failing to object to such breaches, by failing to notify debenture holders of the breaches and by participating in the execution of the supplemental indenture which she contends violates the original indenture because of an allegedly unauthorized division of Old Beaunit's obligations thereunder.

Section 13.01 of the indenture provides in pertinent part:

Consolidation, Merger or Sale of Assets Permitted.

The Company covenants that it will not merge or consolidate with any other corporation or sell or convey all or substantially all of its assets to any person, firm or corporation, (i) unless * * * (b) the successor corporation (if other than the Company) shall be a corporation organized and existing under the laws of the United States of America or a State thereof and such corporation [ sic] shall expressly assume the due and punctual payment of the principal of (and premium, if any) and interest on all the Debentures, according to their tenor, and the due and punctual performance and observance of all of the covenants and conditions of this Indenture to be performed by the Company by supplemental indenture satisfactory to the Trustee, executed and delivered to the Trustee by such corporation, and (ii) unless the Company or such successor corporation, as the case may be, shall not, immediately after such merger or consolidation, or such sale or conveyance, be in default in the performance of any such covenant or condition. (Emphasis added.)

Plaintiff's argument is that the italicized language of the foregoing section of the indenture was breached by the substitution of El Paso common stock as the security into which the Old Beaunit debentures became convertible after the merger. She contends that as a result of the substitution, EPNG/New Beaunit did not assume the performance of "all of the covenants and conditions of this Indenture to be performed by [Old Beaunit]" after the merger, as required by § 13.01, but rather EPNG/New Beaunit assumed some of those obligations and El ...

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