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ZILKER v. KLEIN

April 6, 1981

FRED ZILKER, ETC., PLAINTIFF,
v.
SAM W. KLEIN ET AL., DEFENDANTS.



The opinion of the court was delivered by: Shadur, District Judge.

MEMORANDUM OPINION AND ORDER

Plaintiff Fred Zilker ("Zilker"), a shareholder of Bally Manufacturing Corporation ("Bally"), brings this derivative action against current and former directors of Bally and, of course, against Bally itself. Zilker's six-count Complaint charges the individual defendants ("Defendants") with violations of the Securities Exchange Act of 1934 (the "1934 Act") and, under pendent jurisdiction principles, with breaches of fiduciary duties under state law. Defendants have moved for summary judgment on all counts of the Complaint. For the reasons stated in this memorandum opinion and order Defendants' motion is granted in part and denied in part.

Facts*fn1

In 1965 Bally, then a privately-owned corporation, began manufacturing slot machines. At that time its only United States market was Nevada, and a company and its directors had to be licensed by the State of Nevada in order to sell slot machines there. According to the Complaint, certain "questionable business practices and associations" of some of the directors of Bally, particularly William T. O'Donnell (Bally's president) and Sam W. Klein (Bally's vice-president), prevented Bally from obtaining its own license.

Because Bally was not licensed, it conducted its sales in Nevada through two independent distributors: Bally Sales Company ("Bally Sales") and Currency Gaming Devices, Inc. ("Currency Gaming"). In November 1965 O'Donnell purchased a 30% interest in Currency Gaming for $63,600.98. About a year later the owner of the remaining 70% interest in Currency Gaming (who was also its active manager) decided to retire. As a temporary measure O'Donnell purchased the remaining 70% interest for resale at cost to Currency Gaming's new manager William Redd.*fn2 In 1969 Bally became a publicly-held corporation as the result of an SEC-registered public offering. In 1972 Currency Gaming, its name having been changed to Bally Distributing Company ("Bally Distributing"), acquired Bally Sales and thus became Bally's sole Nevada distributor.

In 1973 Bally applied for its own Nevada registration to sell and operate slot machines, to enable it to purchase Bally Distributing. Shortly after Nevada registered Bally in 1975, it purchased Bally Distributing for approximately $9.5 million ($1 million to O'Donnell for his then 29.5% interest and the other approximately $8.5 million to Redd for his 69.5% interest and to the remaining 1% shareholder).*fn3

Zilker charges that the "questionable business practices and associations" of Bally's directors prevented Bally from obtaining a Nevada license at a much earlier date. Consequently Zilker claims that Bally ought to recover from its directors (1) the approximately $9.5 million paid for Bally Distributing and (2) $250,000 in expenses incurred in securing a license. In addition, the Complaint charges that in 1976 one of Bally's directors, Sam Klein, was seen with a reputed underworld figure. Resulting pressure from the Nevada authorities forced Klein to resign as a Bally director. In settlement of Klein's pre-existing contract, Bally agreed to pay him sums aggregating $576,000. Zilker seeks recovery of that sum from Klein and the other Defendants.*fn4

Demand Under Fed.R.Civ.P. ("Rule") 23.1

Zilker has not made the demand on Bally's board of directors (the "Board") normally mandated by Rule 23.1 as a prerequisite to every derivative action. Rule 23.1 excuses such demand only if the suing shareholder states with particularity the reasons that the demand would have been futile. Determination of such excusability rests within the sound discretion of the District Court. Fields v. Fidelity General Insurance Co., 454 F.2d 682 (7th Cir. 1971).

Zilker contends any demand was unnecessary because, as Complaint ¶ 11 alleges:

  No demand has been made by plaintiff upon BALLY or
  its board of directors to institute and prosecute an
  action against the defendants named herein for the
  acts and transactions complained of, for the reason
  that all but one of the present directors of BALLY
  are named as defendants herein, are controlled by
  defendant O'Donnell as hereinbefore alleged, and are
  responsible for the acts, transactions and
  delinquencies herein complained of. No action could
  be or would be permitted to be instituted by BALLY,
  without the consent of the defendant-directors of
  BALLY, and demand upon them would be entirely useless
  and futile. BALLY's board of directors could not and
  would not diligently prosecute this action, because
  by so doing the directors would, in effect, be suing
  themselves.

It is true that the Complaint alleges no specific wrongdoings by most of the directors. However, after Count I attacks proxy statements used to elect Defendants as directors, the balance of the Complaint is essentially based on an extended course of conduct involving numerous management decisions by the Board. Thus Count II involves a decision by the Board to purchase a distributorship. Counts III, V and VI involve numerous decisions throughout Bally's effort to get a license in Nevada and purchase Bally Distributors. Count IV involves a settlement agreement negotiated with one of the directors after his resignation.

Courts have not been uniform in their approach to the question whether a demand should be excused if the transactions complained of were approved by the board of directors. In In re Kauffman Mutual Fund Actions, 479 F.2d 257 (1st Cir. 1973), cert. denied, 414 U.S. 857, 94 S.Ct. 161, 38 L.Ed.2d 107 (1973), the Court held that in cases charging poor business judgment a plaintiff must show more than such mere approval. Other courts, though, have accepted just the bare allegation that demand would be futile. Liboff v. Wolfson, 437 F.2d 121 (5th Cir. 1971).

Our Court of Appeals has taken an intermediate position. It has said something more is required than an "empty allegation" that demand would be futile. Robison v. Caster, 356 F.2d 924, 926 (7th Cir. 1966). But it does not seem to have accepted the stringent requirements of the First Circuit in Kauffman.

Nussbacher v. Continental Illinois Bank & Trust Company of Chicago, 518 F.2d 873 (7th Cir. 1975), cert. denied, 424 U.S. 928, 96 S.Ct. 1142, 47 L.Ed.2d 338 (1976), is the most recent Seventh Circuit decision in this area. There the Court excused a demand where the board of directors had previously refused to file suit in an almost identical situation and stated generally that demand would be excused if (518 F.2d at 879):

  the majority unaffiliated directors also participated
  in or even approved of the acts of which complaint
  was made.

In so doing the Court cited approvingly Judge Coffin's opinion in Kauffman, 479 F.2d at 269:

  I find it hard to imagine that a director, however
  unaffiliated, who had participated, or under these
  circumstances knowingly acquiesced, in a major
  transaction, albeit for a corporate purpose, would
  authorize a suit, effectively against himself,
  claiming that the transaction violated the federal
  antitrust laws. Even independent watchdogs cannot be
  thought ready to sign a confession of that magnitude.

Zilker's complaint concerns a long course of events involving many decisions either participated or acquiesced in by the entire Board. Under such circumstances there is force in Zilker's argument that a demand on the Board against themselves on Bally's behalf would be a useless formality.

Moreover, Defendants' reply memorandum urges at pages 23-24:

  Had plaintiff complied with Rule 23.1 and made the
  requisite demand upon Bally's directors to bring this
  action in the corporation's own name, the board could
  have referred the matter to a subcommittee of the
  board of directors comprised solely of outside
  directors. . . . If the merits of this complaint had
  been submitted to a subcommittee of outside directors
  of Bally, these directors could have determined in
  their business judgment whether the bringing of this
  complaint was in the best interest of Bally. In doing
  so, these outside directors could have determined
  whether this purported ...

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