United States District Court, Northern District of Illinois, E.D
April 6, 1981
FRED ZILKER, ETC., PLAINTIFF,
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.
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
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
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
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
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 derivative action would
benefit Bally or whether this complaint was designed
simply to "induce settlement beneficial to the named
plaintiff or his counsel."
Unfortunately Defendants' argument proves too much, for there
is nothing to have prevented Defendants from taking precisely
that action after Zilker's complaint was filed. Indeed that has
become established practice in derivative actions (evidenced in
part by the recurring controversy over whether a board of
directors may exercise its business judgment by deciding to
discontinue already-filed derivative suits). It should be
remembered that on Defendants' motion for summary judgment all
reasonable inferences are to be drawn in plaintiff's favor.
Defendants' failure to deal with the matter independently for
nearly four years supports the
inference that a demand would in fact have been futile and thus
defeats summary judgment on this score.
This Court therefore finds that Defendants are not entitled
to summary judgment because of Zilker's failure to make a
demand under Rule 23.1.
Count I — Alleged Proxy Violations
Complaint Count I alleges that Bally's 1974, 1975 and 1976
proxy statements for the election of directors were materially
misleading in violation of Section 14(a) of the 1934 Act and
its related Rule 14a-9. Zilker alleges that the proxies
contained material omissions in a number of respects, such as
(1) O'Donnell's profit on the sale of his Bally
Distributing stock to Bally;
(2) other matters relating to O'Donnell's
relationship with Bally Distributing; and
(3) the reasons for, and the harm caused by,
Bally's failure to sell its products in Nevada
This Court need not reach the question whether the proxies
were in fact misleading. As it has previously stated in Kennedy
v. Nicastro, 503 F. Supp. 1116
, 1119 (N.D.Ill. 1980):
Section 14 liability requires that the false or
misleading proxy statement had been related to a
solicitation for an identifiable transaction.
Zilker has failed to establish that direct nexus between the
allegedly misleading proxies and the transactions he seeks to
Section 14 actions cannot be grounded on allegations that
directors, elected by proxies thus tainted, thereafter during
their term of office carried out transactions harmful to their
corporation. Lewis v. Elan [1976-77 Transfer Binder]
Fed.Sec.L.Rep. (CCH) ¶ 96,013 (S.D.N.Y. 1977); Levy v. Johnson
[1976-77 Transfer Binder] Fed.Sec.L.Rep. (CCH) ¶ 95,899 (S.D.N Y
1977). Directors so elected do not become outlaws each of whose
actions on behalf of the corporation is rendered voidable. On the
contrary, Section 14 actions based on defective proxies have been
sustained only as direct attacks seeking to void transactions
specifically solicited in the flawed proxy materials or (as a
special application of that principle) to void the election of
directors and institute new elections. Weisberg v. Coastal States
Gas Corp., 609 F.2d 650 (2d Cir. 1979), cert. denied,
445 U.S. 951, 100 S.Ct. 1600, 63 L.Ed.2d 786 (1980).
Zilker's complaint does not meet that standard. Instead it
seeks to recoup losses allegedly incurred as a result of various
actions taken by the directors, not submitted for shareholder
approval in the challenged proxy materials. Accordingly Zilker
has failed to allege any facts sufficient to state a claim under
Section 14 and its Rule 14a-9, and Complaint Count I must be
Count II — Alleged Rule 10b-5 Violations
In Count II Zilker alleges that Bally's directors deceived
Bally in connection with the purchase of Bally Distributing.
Because Bally purchased Bally Distributing by acquiring all its
outstanding shares, Zilker alleges that the acts of the directors
constituted a "fraud and deceit upon Bally" in violation of
Section 10(b) of the 1934 Act and related SEC Rule 10b-5.
This Court need not reach the sufficiency of Zilker's
substantive claims or Defendants' other arguments,*fn6 for it is
the definitive construction of the term "security" announced by
our Court of Appeals earlier this year. In Frederiksen v.
Poloway, 637 F.2d 1147, 1148 (7th Cir. 1981), the Court stated:
Not all sales transactions which involve "stock" are
necessarily covered by the securities laws. Rather,
the test for coverage, in general, is whether the
purchaser is placing money in the hands of another
who will control the funds and the business
decisions. If, however, the purchaser is assuming
control of the critical decisions of the corporation,
then the transaction is not considered to involve
In those terms the Frederiksen holding (637 F.2d at 1151-52)
paraphrases directly to the Bally Distributing-Bally
Here, in contrast to the situation in Coffin [v.
Polishing Machines, Inc., 596 F.2d 1202 (4th Cir.
1979)], the transaction did not involve a sale of
corporate stock to raise capital for profit-making
purposes. [Bally] sought to acquire [Bally
Distributing's] business in its entirety. The "stock"
sale was a method used to vest [Bally] with ownership
of that business. There was no offer of investment
"securities." The stock of [Bally Distributing]
merely was passed incidentally as an indicia of
ownership of the business assets sold to [Bally].
Still in Frederiksen's terms, Bally, in purchasing all of the
stock of Bally Distributing, was "assuming control of the
critical decisions of the corporation." Hence under Frederiksen
no "securities" were involved and no 1934 Act liability exists.
Zilker seeks to distinguish Frederiksen on the ground that it
applies only to the purchase of non-publicly held corporations.
Such a distinction does not withstand analysis. Frederiksen
referred to the definition of "security" in both the 1934 Act
and Securities Act of 1933, and its analysis was in no way
dependent on the size or nature of the acquired enterprise.
Instead the decision was based on the purpose of the purchase;
business acquisition v. investment securities acquisition.
Because this Court must follow Frederiksen, Zilker's reductio
ad absurdum arguments should be addressed to the Court of
Appeals rather than to this Court. Complaint Count II must be
dismissed as well.
Counts III, IV, V and VI — Alleged Breaches of Fiduciary Duty
Counts III through VI charge Bally's directors with numerous
breaches of their fiduciary duty to Bally.*fn7 Each allegation
under those counts must be examined individually.
1. $9.5 Million Purchase Price of Bally Distributing
Zilker asserts Bally's right to recover the approximately $9.5
million it spent to acquire Bally Distributing. Zilker concedes
that the $9.5 million was a fair price for Bally Distributing but
claims that the imposition of that cost on Bally was unnecessary.
According to the complaint the money was spent solely because the
questionable business practices and associations of the
directors, particularly O'Donnell and Klein, prevented Bally from
receiving its own license to distribute slot machines in Nevada.
Because the thrust of Zilker's complaint is that Bally's best
interests are served by distribution of its own products in
Nevada, by definition the decision to purchase the
distributorship cannot be a breach of the directors' fiduciary
duty. Nor can the payment of a fair price to implement that
decision constitute such a breach. Thus the only directors'
action of which Zilker can complain must be the failure to
decide earlier to rid the corporation of O'Donnell and Klein,
thereby enabling Bally to obtain a Nevada license earlier and
purchase Bally Distributing at a much lower cost. On Zilker's
theory payment of the $9.5 million price was the harm produced
by the action (or inaction) of the Board, but once again the
claimed fiduciary breach must be the decision not to seek such
a license at an earlier date.
Although neither party has pinpointed the precise time when
the decision to seek a license was made by Bally's directors,
Complaint ¶ 23 states that a license was granted in 1975 "after
several years of investigation" by the Nevada Gaming Commission.
Accordingly Bally's decision to seek to obtain its own Nevada
license must have been made before April 1974, when Zilker
acquired his stock.
Rule 23.1 requires that "the complaint shall be verified and
shall allege (1) that the plaintiff was a shareholder or member
at the time of the transaction of which he complains. . . ."
Because the "transaction of which he complains" is the directors'
failure to make the Nevada licensing decision as early as it
allegedly should have been made (when Bally Distributing could
have been bought more cheaply) and Zilker was not a shareholder
at that earlier time, he has no standing to assert the derivative
action in the complaint.
In certain situations a derivative action can be based on what
is termed a "continuing wrong." For example, in Palmer v. Morris,
316 F.2d 649 (5th Cir. 1963) the plaintiff was permitted to
attack a corporation's rental payments even though the contract
was signed before plaintiff purchased his stock. But in that case
the payments that continued after his purchase were exorbitant
and were for services of no use to the corporation. Thus the
payments themselves constituted a wrong that continued after the
contract. Indeed all of the cases involving the so-called
"continuing wrong" specify something — unlike the situation here
— that the corporation should not have done after the date on
which the plaintiff purchased stock.See Lawson v. Krock, 17
Fed.R.Serv.2d 700 (4th Cir. 1973); Bateson v. Magna Oil
Corporation, 414 F.2d 128 (5th Cir. 1969).
Much more to the point is our Court of Appeals' decision in
Weinhaus v. Gale, 237 F.2d 197 (7th Cir. 1956). In Weinhaus
defendants paid $10 million to purchase from plaintiff's
corporation securities that were actually worth some $16 million.
Defendants' purchase occurred before plaintiff acquired stock in
the defrauded corporation, but defendants sold the stock for a
profit after plaintiff had acquired his stock. As the Court
stated in language applicable to this case (237 F.2d at 200):
That wrong, if such it be, was neither enhanced nor
diminished by anything that subsequently took place.
The fact, unexplained, that such shares were sold by
Edison almost a year later at a greatly increased
price might tend to prove they were purchased from
Gas Company for less than their true value, but such
sale certainly did not constitute a wrong to
plaintiff and other stockholders of Gas Company.
In this case the only possible wrong committed was the act of
not seeking a license at an earlier time. As in Weinhaus, a $9.5
million purchase price might tend to prove that there had been a
breach of fiduciary duty, but the purchase itself cannot
constitute an unlawful action. See, Wright and Miller, Federal
Practice and Procedure: Civil § 1828 at 346.
There is one aspect of the post-Zilker-purchase Bally
Distributing transaction that poses a different problem. True
enough, the total $9.5 million price was admittedly fair, and
O'Donnell's $1 million was less his pro rata share of that price.
But Zilker contends that O'Donnell, a Bally director, should have
turned over his Bally Distributing interest to Bally at his cost
because he was part of the reason that Bally was forced to incur
Were there such a breach of fiduciary duty, it would have
occurred after Zilker purchased his stock and therefore could be
asserted by Zilker. However, that allegation would state a cause
of action only if O'Donnell were in some way responsible for the
claimed "delay" in Bally obtaining its license to sell in Nevada.
For if O'Donnell were not so responsible, there is no reason that
he should not have been entitled to receive a fair price (in this
case he received less than a fair price) for his shares.
Zilker has presented no facts in support of the assertion that
O'Donnell was responsible for any difficulty Bally had in
receiving a Nevada license. As Defendants point out, O'Donnell
himself was personally licensed to sell slot machines in Nevada
from 1965 to the present date. It is true that when Nevada
undertook its initial examination of Bally's license request, the
Nevada Gaming Control Board (the "Control Board") recommended
that three officers, including O'Donnell, resign before license
be granted. But the Nevada Gaming Commission (the "Commission"),
the final authority, rejected that recommendation and granted
Bally's license. So there has been no showing that O'Donnell was
responsible for difficulty (if any) Bally had in obtaining a
Because O'Donnell was thus not personally responsible for any
claimed "harm" to Bally, he committed no breach of fiduciary duty
by selling his shares for more than his cost (and for less than a
fair price). If Zilker's argument is that O'Donnell, with the
other directors, failed to get Bally licensed earlier, he is
defeated by this opinion's prior discussion that any such
"breach" occurred before Zilker purchased his stock.
For the several reasons stated in this section, Defendants are
entitled to summary judgment on Zilker's derivative claim for the
approximately $9.5 million purchase price paid for the Bally
2. Investigation Costs
Zilker seeks to recover the approximately $250,000 Bally spent
in connection with the licensing proceeding before the
Commission. Again the allegation is that such expense was
necessary only because of the questionable business practices
and associations of O'Donnell and Klein and other persons
affiliated with Bally.
That claim has two fundamental weaknesses:
First, Bally began to seek a license in Nevada before Zilker
purchased his stock. To cut down on the investigation expenses,
Bally would have had to "expunge" its company of bad influences
before seeking the license. In that way the problem is much the
same as with the $9.5 million purchase price, for again the whole
thrust of Zilker's complaint is that Bally must distributeits own
products in Nevada. On that score he can complain only of Bally's
failure to expunge itself of "bad influences" before seeking a
license. That failure in turn occurred before Zilker's ownership
of Bally stock.
As a second and independent defect, Zilker presents no facts to
demonstrate that the $250,000 expenditure resulted from the
questionable business associations and practices of any Bally
director. As already stated earlier, though the Control Board
found some problems with Bally's license application, the
Commission did license Bally. Zilker has made no showing that
the licensing proceeding was unusually protracted or complex or
that the questionable business associations and practices of
Bally's directors forced Bally to incur any unnecessary
3. Bally's Settlement Contract with Klein
Zilker's final allegation is that Bally should not have entered
into the settlement contract under which Klein was paid $576,000
for resigning as a Bally director. Effectively Zilker claims it
was a breach of fiduciary duty for Bally's Board not to terminate
their relationship with Klein without compensation. Defendants
respond that approximately $400,000 remained to be paid Klein on
his employment contract, that to do as Zilker suggests surely
would have resulted in litigation and that negotiation of the
settlement was a valid business judgment.
Zilker has really made two claims:
(1) It was a breach of fiduciary duty for Klein as
a director to accept the money.
(2) It was a breach of fiduciary duty for the Board
to pay the money to Klein.
Although there is a presumption in favor of business judgments
made in good faith, the issue presented here cannot be resolved
on a motion for summary judgment. It is clear
that Klein resigned under pressure from the Commission, and the
Court cannot say as a matter of law whether or not the settlement
contract constitutes a breach of fiduciary duty on the part of
Bally's directors. Because the facts permit conflicting
inferences, a triable issue of fact remains.
As to each of Counts I, II, III, V and VI there is no genuine
issue as to any material fact and Defendants are entitled to a
judgment as a matter of law. As to Count IV, however, which seeks
reimbursement of all monies paid to Klein on the 1976 settlement
contract, material fact issues do exist and Defendants' motion
for summary judgment is therefore denied.