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Harris Trust and Savings Bank v. Ellis

decided: January 27, 1987.

HARRIS TRUST AND SAVINGS BANK, AS EXECUTOR OF THE ESTATE OF MARY ELLIS, PLAINTIFF-APPELLANT-CROSS-APPELLEE,
v.
JAMES ELLIS, ET AL., DEFENDANTS-APPELLEES-CROSS-APPELLANTS



Appeals from the United States District Court for the Northern District of Illinois, Eastern Division. No. 84 C 5148 -- Marvin E. Aspen, Judge.

Author: Easterbrook

Before CUDAHY, EASTERBROOK, and RIPPLE, Circuit Judges.

EASTERBROOK, Circuit Judge.

When Oscar Ellis died in 1968, his will apportioned his estate between marital trust for the benefit of his wife Mary and a residuary trust for the benefit of Mary and his two children. The estate's principal assets were four farms and stock in three closely held corporations. Oscar had founded one of these, Moline Consumers Co., in 1917, and working control had passed to his son James by the time of Oscar's death. James was also a member of the board of First National Bank of Moline, which served as the executor of the will and trustee of both trusts. Oscar's will gave James, as "advisor" to the trustee, power to veto the trustee's sale of any stock and to vote the shares held by both trusts. It gave Mary the power to obtain from the trustee "such amounts from the principal of the trust as she from time to time may request in writing" and afforded her a power of appointment over the trust's assets on her death. Until then, however, the trustee had discretion (subject to James's veto and Mary's right to withdraw principal) to make all investment decisions.

A dispute with the Internal Revenue Service about the valuation of the closely held corporation was settled by valuing the stock of Moline Consumers at $325 per share. Nonetheless, in parceling the stock between the marital and the residuary trusts to achieve the appropriate funding of each, the executor valued the stock at $271 per share. The probate court in Illinois approved the apportionment and closed the estate in June 1981.

Shortly after the trusts had been funded, the trustee proposed to sell the marital stock of Moline Consumers to that firm, for $271 cash per share. The total exceeded $880,000. The presence of James Ellis on the trustee's board created a conflict of interest, so the trustee filed a petition asking for a decree authorizing the sale. The petition also asked for the appointment of a guardian ad litem for Mary Ellis, then 85 years old and in a nursing home. The court appointed a guardian, who demanded "strict proof" of the trustee's contention that the sale would be advantageous to the trust.

The court later held an evidentiary hearing, in which the guardian participated. An officer of the trustee testified that the sale was advantageous because the estate should hold cash (to provide for Mary) rather than illiquid stock that paid low dividends (about 1% of the estimated value). The trustee's application to approve the sale was backed up by a report prepared by Duff & Phelps, Inc. Moline Consumers makes and sells ready mix concrete and other construction aggregates. The Duff & Phelps report compared Moline Consumers' income, profits, and assets with those of three publicly-traded firms in the same line of business. Duff & Phelps concluded that the Moline Consumers stock, if traded, would sell for $417 per share -- a multiple of 4.4 times its average yearly earnings for the last five years, and only 28% of the firm's "book value", which the report disclosed. Duff & Phelps then applied a discount of 35% to reach $271. The report stated that the discount reflected the illiquidity of the stock and the fact that the estate held a minority bloc. After listening to the evidence, the court entered an order finding, among other things, "that the sale of said stock to Moline Consumers Company is advantageous to the trust".

The bank, as executor, discovered in 1983 an error in the computations that had produced the division between the marital and residuary trusts. The marital trust had underfunded by about $224,000. The executor proposed to move 423 shares of Moline Consumers stock from the residuary trust to the marital trust, again at a valuation of $271 per share, to satisfy $114,633 of the shortfall. (The lower the valuation, the more stock the marital trust would get, because the shortfall had been computed in dollars.) A new petition was filed in the estate case, and a new guardian ad litem was appointed. The court approved the transfer at $271 per share. The trustee proposed a new sale to Moline Consumers at $271. Before this cold be approved Mary died, and Harris Trust & Savings Bank became the executor of her estate. Harris Trust opposed the sale at $271, claiming that the value of Moline Consumers was closer to $1,400 per share (book value) and that the apportionments and sales had been fraudulent. Despite these protests the court found that the second sale at $271 was appropriate, and it also found that there had been no fraud in any earlier proceeding. The Appellate Court of Illinois, in an unpublished opinion, affirmed the order approving the sale but vacated the finding concerning fraud, concluding that these were gratuitous. In re Estate of Mary Ellis, No. 3-84-0583 (3d Dist. July 22, 1985).

Meanwhile Harris Trust filed this suit under § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5, 17 C.F.R. § 240.10b-5, and the Racketeer Influenced and Corrupt Organizations Act (RICO), 18 U.S.C. §§ 1961-68. James Ellis, Moline Consumers, Duff & Phelps, and the First National Bank of Moline are the defendants. Harris Trust maintained that James had used his position to acquire the stock in 1981 and 1984 at an insufficient price and that the disclosures made in connection with the judicial proceedings had been inadequate and fraudulent. Because some of the documents has been mailed, Harris Trust insisted, there must have been at least two instances of mail fraud, producing a "pattern" of racketeering under RICO and authorizing treble damages.

I

The district court dismissed the securities claim for failure to allege fraud "in connection with" the purchase or sale of a security and the RICO claim largely because of failure to plead with particularity under Fed. R. Civ. P. 9(b). 609 F. Supp. 1118 (N.D. Ill. 1985). The court relied on "O'Brien v. Continental Illinois National Bank & Trust Co., 593 F.2d 54 (7th Cir. 1979), and distinguished Norris v. Wirtz, 719 F.2d 256 (7th Cir. 1983), cert. denied, 466 U.S. 929, 80 L. Ed. 2d 185, 104 S. Ct. 1713 (1984). O'Brien, a suit by trustees against an investment adviser, held that an adviser's misdeeds in buying and selling stock on a national stock exchange (including poor investments and potential conflicts of interest) are not "in connection with the purchase of sale" of securities, when the adviser has absolute authority and the trustee's or trust beneficiary's only recourses are to dissolve the rust or sue under state law. Norris held, in contrast, that § 10(b) supported an action against a trustee accused of nondisclosure and self-dealing i the sale of closely held stock from a trust to a family corporation (as the defendants stand accused), when the beneficiary of the trust had the right to approve each transaction. The right to approve, we concluded, meant that the beneficiary made a securities decision each time the trustee acted.

Each side in this case claims the benefit of one decision and tries to distinguish the other. Harris Trust says that the case is like Norris because Mary Ellis made an investment decision every day (in deciding not to withdraw the principal of the trust) and was consulted in the judicial proceedings about the sale of the stock. Defendants say the case is like O'Brien because Mary lacked veto power over any sale and could not necessarily withdraw the Moline Consumers stock (as opposed to principal of a fixed value). They maintain that the grievance concerns the price, which is not actionable under the securities laws, rather than the disclosure, which is. Harris Bank replies that only disclosure is at issue, that the defendants did not disclose that the marital trust's share, combined with shares in James Ellis's control, were a majority and should have been valued as a majority, and did not disclose that book value was the best method of valuation. We could resolve this dispute only by going back to first principles, as the panel in O'Brien did. But we need not resolve the dispute; the findings of the state court make it clear that the plaintiff could not establish damages, so the merits of the dispute become irrelevant. The effect of the state judgments was presented to the district court (which did not reach the matter) and to us by a cross-appeal. We affirm the district court's judgment on this basis.

The first question is whether the securities laws authorize us to disregard findings by state courts, to which the answer is not. We have been reminded, see Marrese v. American Academy of Orthopaedic Surgeons, 470 U.S. 373, 84 L. Ed. 2d 274, 105 S. Ct. 1327 (1985), that 28 U.S.C. § 1738 requires federal courts to give to state judgments the same preclusive effect they would have in state courts -- even when the federal proceeding is one within the federal courts' exclusive jurisdiction. So we must determine what effect the approval of the sales at $271 would have in an Illinois court.

That some facts may have been withheld from the state court is not a federal reason to disregard the state's decision. We held in Metlyn Realty Corp. v. Esmark, Inc., 763 F.2d 826, 833-34 (7th Cir. 1985), that the securities laws do not govern the adequacy of disclosure during judicial proceedings. What happens in court is regulated by the rules of discovery and procedure in the jurisdiction. So a claim that the Duff & Phelps report was incomplete and misled the court, or that the trustee's lawyers should have been more forthcoming, coupled with an assertion that more information would have led the judge to a different conclusion, does not state a claim under § 10(b). Otherwise the securities laws would govern all appraisal proceedings in state court. Many corporate transactions produce a right to dissent and obtain valuation from a judge. These appraisal proceedings are contentious. The corporation will introduce a valuation study; the dissenting investors will produce another; the parties will wrangle about which is the best estimate; often it will be possible to argue for wildly different values. See Metlyn, 763 F.2d at 834-38; Beerly v. Department of the Treasury, 768 F.2d 942, 945-48 (7th Cir. 1985), cert denied, 475 U.S. 1010, 106 S. Ct. 1184, 89 L. Ed. 2d 301 (1986); Fischel, The Appraisal Remedy in Corporate Law 1983 Am. Bar Found, Res. J. 875, 889-96. Cf. Berg v. First American Bankshares, Inc., 254 U.S. App. D.C. 198, 796 F.2d 489, 498-501 (D.C. Cir. 1986). If the securities laws overrode state principles of finality, the losing side in the ...


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