Appeal from the United States District Court for the Northern District of Illinois, Eastern Division. No. 72-C-2536 - Prentice H. Marshall, Judge.
Castle, Senior Circuit Judge, and Tone and Wood, Circuit Judges.
Order RULING ON PETITION FOR REHEARING
The modified opinion and judgment of this date are ordered filed and entered.
The opinion and judgment heretofore filed and entered in this cause having been modified in the respects shown in the modified opinion and judgment, which supersede the original opinion and judgment, the petition for rehearing is denied except to the extent that any relief requested in the petition may be granted in the modified opinion. TONE, Circuit Judge.
These consolidated appeals arising out of a single case present issues under § 10(b) of The Securities Exchange Act of 1934, 15 U.S.C. § 78j, and Rule 10b-5 thereunder. Both plaintiffs join in a shareholders' derivative claim, asserting that the dominant shareholder defrauded the corporation in a series of five securities transactions. In addition, one of the plaintiffs asserts a claim against the corporation itself, alleging that false representations by one of the corporation's officers induced that plaintiff to convert a debenture into common stock.
International Digisonics Corporation (IDC) was formed in 1969 to develop electronic monitoring of television commercials as a service for the advertising industry. IDC's founder was Jordon Ross, who since 1962 had been successfully operating a company called Talent & Residuals, Inc. (T&R), which provided advertising agencies with the complex accounting and payroll services required by the "residuals" paid to actors performing in television commercials.
The first investor in IDC, plaintiff Beneficial Standard Corporation, purchased a $425,000 convertible IDC debenture on the condition that the well-established and profitable T&R be made a subsidiary of IDC. In anticipation of a planned public offering of its stock, IDC requested that Beneficial convert its debenture to IDC common stock, at a $2.50 per share exchange ratio. This conversion is the subject of the individual action, discussed in Part II, infra. After the conversion, Ross and Beneficial owned approximately two-thirds of the corporation's stock; the remaining third was held by Ross' friends and business associates.
As originally conceived, electronic monitoring involved encoding film or videotape commercials with electronic impulses which, while invisible to the viewer, could be read by electronic monitors. Placed in all major television markets, these monitors would report to a central computer, which would then use the data to generate a proof-of-performance report. This report would replace the affidavits from television stations that the advertising agencies were relying upon as proof that their commercials had been properly broadcast at the agreed-upon time.*fn1
In the fall of 1969 IDC was seeking a $1,000,000 capital contribution from a private investor as a preliminary step to taking the company public. One investor it approached was defendant Heizer Corporation, which specializes in venture capital investments in newly-formed companies considered too risky for Heizer's stockholders - banks, pension funds, and universities - to invest in directly. Heizer was told that, provided FCC approval could be obtained, its $1,000,000 investment would enable the monitoring business to reach the break-even point necessary for a successful public offering. They were also told that, given a $5,000,000 capital investment from that public offering, a $5,500,000 profit could be anticipated from the monitoring business by 1971. [Pl. Ex. 62, Heizer Pre-Investment Summary & Analysis.] These "exceptional" prospects, coupled with the protection afforded by T&R's consistently good performance, convinced Heizer that IDC was a desirable investment opportunity. [ Id.]
Heizer offered to purchase IDC preferred stock, accompanied by warrants to purchase common stock, for $1,000,000; it also agreed to loan IDC $500,000 for one year. Following unanimous approval of this first transaction by the board of directors and stockholders of IDC on November 9, 1969, Heizer was issued 100,000 shares of a newly-created class A common stock (in reality a preferred stock) at $10 per share and warrants to purchase 155,000 shares of common stock at $8.50 per share. Although the preferred stock was not made expressly convertible, it was redeemable at Heizer's option and could be used at par in lieu of cash in exercising the warrants. During negotiations, the proper exercise price of the warrants was hotly disputed, with Jordon Ross, who negotiated for IDC, insisting on at least $10 per share and Heizer offering only $5 per share. The dispute was settled by compromising on the price and adding to the warrants an "antidilution clause" - or, as a Heizer vice-president called it, a price-adjustment clause - which would automatically readjust the price downward and the number of shares purchasable upward if IDC sold stock or rights to stock at a price lower than $8.50 per share.*fn2 The agreement also contained a number of other provisions designed to protect the Heizer investment, including IDC's agreement not to pledge its T&R stock or to change the nature of its business without Heizer's consent.
The contemplated public offering did not take place, however. Over the next eleven months IDC encountered a number of technical problems with monitoring, as well as administrative delay. At last, in April 1970, the FCC ruled favorably on the company's request for rulemaking, and in June 1970, IDC began actively marketing its services. [DeKraker monthly memos to IDC board, Def. Ex. 1(b)-1(i).] Although a public offering was still contemplated [Def. Ex. 24], IDC was by this time also investigating other financing alternatives.*fn3 Needing additional operating capital immediately, IDC turned once again to Heizer. In September 1970 the second transaction, a $2,000,000 investment in two takedowns of $1,000,000 each, was arranged on the same general basis as before and was unanimously approved by IDC's board and shareholders. Heizer was to receive 200,000 shares of a new preferred stock at $100 per share,*fn4 with warrants to purchase 400,000 shares of common stock at an initial exercise price of $6 per share. If IDC had not met certain conditions not relevant here at the time of the second takedown, the price of the warrants would drop to $4 per share.*fn5 These warrants had an antidilution clause identical to that used in the first transaction; however, Heizer waived the antidilution provision in its first set of warrants so that their exercise price remained at $8.50 per share. [C. Palmer, Tr. 1903.]
In the next six months IDC was faced with more technical problems: film commercials often could not be monitored because of improper coding by film processors or improper alignment in broadcasting, and the apparent solution to these problems could not be implemented without a new ruling from the FCC. However, in his reports to IDC's board, the president of the company, Glenn DeKraker, stated that monitors had been placed in all twenty-five top markets and that, while the system was turning out to be more complex than originally thought, it was being successfully debugged. [Def. Ex. 1(j)-1(n).]
In May of 1971, after several possible alternative sources of financing had fallen through, IDC again found it necessary to turn to Heizer for a third financing. IDC's board and stockholders again unanimously approved a transaction in which Heizer invested $1,700,000 ($500,000 of which was used to repay the Heizer loan due May 25th) in return for a twenty-year note in that amount and warrants to purchase an additional 472,222 shares of common stock at $3.60 per share. The prior antidilution clauses were partially triggered and, as a result, Heizer became entitled to 1,304,000 shares at $3.60 per share,*fn6 or a total of 61 per cent of the company's equity. In order to equate Heizer's voting power with this pro forma equity position, IDC's charter was amended to provide that the preferred stock would receive 4.4 votes per share. [E. Heizer, Tr. 660.] Two Heizer officers, Edgar Heizer and Charles Palmer, also became members of the IDC board at this time.
Over the next six months, IDC continued to experience technical difficulties with film encoding while pursuing a constant search for financing from sources other than Heizer. [Def. Ex. 1(o)-1(u).] The most promising source in the summer and fall of 1971 was the underwriting firm of McCormick & Co. Impressed by IDC's profit projections and by Heizer's substantial commitment to the company [Tr. 1687], McCormick issued a letter of intent in October 1971 looking toward a public offering. [Def. Ex. 78.] Because it appeared that $1,500,000 would be needed before such an offering could be made, McCormick also agreed to attempt to locate private investors. By November, these efforts had not proved successful and IDC's financial situation was desperate. Again, IDC looked to Heizer for an interim financing of up to $600,000 to be repaid from the private placement, which was now expected to materialize in January. [Tr. 179-180, 995, 1620.] An agreement was reached whereby Heizer would lend IDC up to $600,000, payable on demand after March 31, 1972; if the full amount had been lent and not repaid by that date, the loan would become convertible to common stock at $1 per share.*fn7 At that point the antidilution clauses in the warrants from the previous three transactions would be triggered and Heizer would become entitled to 4,694,400 shares of IDC common stock at $1 per share, or approximately 85 per cent of the corporation's equity.
The resignation of two directors from the IDC board*fn8 and the absence from the country of another, who was Beneficial's representative, left only four participating directors, two of whom were Heizer nominees, when a board meeting was held on November 19, 1971. Because of their conflict of interest, the Heizer nominees allowed the two independent directors to vote first, after telling them that there would be no transaction if either of them disapproved. The vote was unanimous in favor of the proposal.
Once the board had approved this fourth transaction, it was necessary to obtain the common shareholders' approval of a charter amendment increasing the number of authorized shares of common stock from three to seven million. Counsel for Heizer and for IDC testified that, because of the company's pressing need for immediate financing, they decided that the best procedure was to obtain written consents from a majority of the stockholders, as permitted by the law of Delaware, the state in which IDC was incorporated. [Tr. 1135, 1629-1630, 1784.] Because Beneficial opposed the transaction, the consents had to be secured from Jordon Ross and his friends and business associates. Ross made the necessary contacts himself, obtaining consents from shareholders (including plaintiff Peter Wright) holding 52.4 per cent of the corporation's outstanding common stock.
In December 1971 McCormick & Co. informed IDC that it would not be able to arrange financing. One month later it became apparent that film monitoring was not technically feasible. After a period of re-evaluation, Heizer decided that the monitoring effort should focus on the feasibility of videotape monitoring, and, so limited, should be continued while a search for new management was conducted. [Def. Ex. 95, 100-101, 103-108, 111-112.]
By March 13, 1972, IDC had borrowed the entire $600,000 authorized in the fourth transaction and was again in need of funds. At that point the IDC board, with the Beneficial nominee dissenting, authorized an amendment to the November 19th agreement whereby Heizer would lend the company up to $250,000 more and the amount lent, plus unpaid management fees and interest, would also become a loan convertible to common stock at $1 per share if not paid by March 31, 1972. On March 31 IDC had not repaid any of these loans, and Heizer therefore gained the right to purchase 5,513,908 shares of IDC common stock, or 87 per cent of the company's equity on a pro forma basis, at $1 per share.
A new board of directors, consisting of three Heizer nominees, a representative of Beneficial, and Jordon Ross, was elected in May 1972. The Beneficial director, however, resigned less than a month later. In June 1972, Paul Roth was elected president of the company by the three Heizer directors voting in Jordon Ross' absence and apparently over his objections. Roth was given six months to study the viability of a videotape-only monitoring system. [P. Roth, Tr. 301.] In the meantime, from April 14, 1972 to April 19, 1973, Heizer extended $2,015,000 in non-convertible demand loans to IDC to make up the difference between its operating losses and T&R's profits.
In October 1972, Beneficial and Peter Wright, an individual shareholder, filed this derivative action. In their complaint, twice amended, they alleged that Heizer had effectively gained control of IDC through the protective provisions of the first transaction and had then violated Rule 10b-5 by failing to disclose to IDC's shareholders its controlling position and the unfair valuation placed on IDC stock in the second, third, and fourth transactions. Alternatively, they alleged that Heizer, if not in control of IDC, had aided and abetted IDC's management in its failure to disclose material facts concerning the four transactions. They also alleged that Heizer was liable as a controlling person for the actions of its nominees on the IDC board in voting for the allegedly unfair and improperly disclosed fourth transaction.
In June 1973, while this case was pending, the fifth transaction now complained of was consummated. Paul Roth and Heizer officers testified that they had found it impossible to arrange outside financing without recapitalizing the corporation. Once this suit was filed, recapitalization, which would have involved exercise of the disputed warrants, also became impossible. Heizer was thus left as IDC's sole source of financing. Edgar Heizer testified that because Heizer Corp. is not in the business of making unsecured loans, it was at that point "totally justified" in demanding security for its continued support of the business - even though its investment was not in any immediate danger. [Tr. 933, 936-937.] The security it received for all its loans after April 14, 1972 was a pledge of all the stock of T&R. In return, Heizer agreed to postpone demand on the various short-term and demand loans extended pursuant to, and after, the fourth transaction until January 1974 and agreed to lend the company a minimum of $460,000 and a maximum of $1,181,700 during the remainder of 1973, also to be secured by the pledge and payable in January 1974.
Paul Roth testified that he was told one purpose of the pledge was to "smoke [plaintiffs] out of the woodwork," [Tr. 1291] apparently by threatening to foreclose on IDC's most profitable asset, T&R. In count II of their second amended complaint, plaintiffs challenged this pledge transaction, alleging that Heizer had demanded the pledge as protection against the outcome of the litigation and that this use of its control over the corporation constituted a manipulative and deceptive device operating as a fraud on IDC in violation of Rule 10b-5.
B. The District Court Opinion
In Wright v. Heizer Corp., 411 F. Supp. 23 (N.D. Ill. 1975), the District Court held that plaintiffs could maintain a derivative action on behalf of IDC but ruled that, in light of the Supreme Court's re-affirmance of the Birnbaum purchaser-seller standing requirement in Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 44 L. Ed. 2d 539, 95 S. Ct. 1917 (1975), they could not sue personally as shareholder-investors in IDC. The court then ruled that the first three transactions, which it found to be "open and at arm's length," could not be attacked on the ground that they had not been fully disclosed to the shareholders because under the Blue Chip limitation "this theory of fraud by concealment practiced on the shareholders" was not available. 411 F. Supp. at 36. The court went on to hold, however, that even if the theory were available, plaintiffs had failed to provide proof of nondisclosure.
With respect to the fourth and fifth transactions, the court held that because Heizer was a fiduciary engaged in self-dealing in the sale of securities, it had the "heavy burden of proving [the] fairness" of those transactions. Id. Finding its proof inadequate, the court ordered the notes from the fourth transaction declared nonconvertible, cancelled any warrants issued in connection with that transaction, declared void the triggering of the prior warrants, and cancelled the pledge of T&R stock. Heizer was also enjoined from purchasing securities from or lending money to IDC in the future under conditions that were not "fair and equitable."
On appeal, plaintiffs do not challenge the District Court's ruling on the first three transactions. By means of the appeal in No. 76-1700 from an order denying a petition for supplemental relief, they challenge the scope of the relief granted, arguing that the court also should have forced Heizer to assume a portion of IDC's monitoring losses by requiring it to give up its senior position. In No. 76-1140, Heizer challenges the court's ruling on liability under 10b-5; it also argues that, even if that ruling was correct, the court erred in granting overly broad prospective relief. Finally, in No. 76-1702, ...