The opinion of the court was delivered by: KIRKPATRICK
This is a suit brought by a corporation against its former officers, directors, certain of its former stockholders, and others, to recover damages incurred by the corporation as a result of the sale of its control to a group who proceeded to rob it of most of its assets. The plaintiff is an investment trust, specializing in shares of small life insurance companies.
A number of the defendants have not been served with process. Those before the Court are three Philadelphia banks, formerly stockholders, and William W. Hepburn, their representative on the board of directors.
Certain of the defendants were, prior to December 21, 1937, the owners of 75,933 of the corporation's total outstanding 284,032 shares. These defendants will be referred to collectively as the management group. This group consisted of the Philadelphia banks, with 23,106 shares, and their agent, Hepburn; Blair (the president of the corporation) and his associates, Simmons, Moore and Burnell (all former directors), and Ogden, with 24,111 shares; the Continental Bank, with 26,569 shares (subsequently taken over by Fahnestock & Co.); and Logan, receiver of the Seaboard Continental Corporation, with 6,647 shares. The board of directors of the corporation was composed entirely of this management group or their nominees. The defendants, Robb, Morris and Solomont, who bought control and who, with their satellites Quint, Stanton, Tracy and Hansell, looted the corporation, constitute the Boston Group.
There is little dispute about the main facts. On December 21, 1937, the management group transferred the control of the corporation to the Boston Group, none of whom had ever had any interest of any kind in it. With the control, as that term is here used, went plenary power under the by-laws to sell, exchange or transfer all of the securities in the corporation's portfolio, as well as access to and physical possession of them. In this case, acquisition of control was the indispensible first step of a scheme, planned by Robb, Morris and Solomont with the connivance of Paine, Webber & Co., brokers, the purpose of which was to strip the corporation of its valuable assets, leaving its mere shell to the remaining stockholders. The project was carried out with thoroughness and dispatch, but its subsequent steps and its disastrous results to the corporation are not in dispute and need not be detailed here.
The actual transfer was made in accordance with a program to which the Philadelphia group assented and the steps of which they followed. Immediate and complete passing of control was ensured by the successive resignation of the old directors, each resignation being followed by the election of a new member of the board, on the nomination of the Boston group. At the same time, the management group sold and delivered their stock to the Boston group.
The defendants have insisted throughout the case that the transfer of December 21, 1937, was simply a sale of stock, the passing of control being merely a normal concomitant, and most of their argument was based upon this premise. This view, however, I think is fundamentally wrong. If the whole record be read, I do not see how the transaction can be considered as anything other than a sale of control, to which the stock sale was requisite, but nevertheless a secondary matter. The fact is that the Boston group were interested in only one thing, namely, to have a free hand with the corporation's portfolio for a few weeks, and all they needed for that purpose was to be able to name and control the officers and directors. Perhaps there would have had to have been some modifications in their procedure, but practically everything they did could have been done without their owning more than directors' qualifying shares. As a matter of fact, they bought only about 27% of the outstanding issue, and, throughout their operations, they were never anything but minority stockholders. Of course, I am not suggesting that the purchase of the stock was not a sine qua non for the success of their plans. It assured them, temporarily, of noninterference from stockholders, since the majority, who had bought for investment, could be counted on to remain inert. It would have been absurd to expect such acquiescence from the management group, had they retained any stock interest, and equally absurd to expect them to part with control, without at the same time getting out of their investment in the corporation. Hence the necessity for the purchase of the stock. The buyers were primarily interested in getting control of the corporation together with such stock ownership as would make that control secure and untrammelled, and the sellers were primarily interested in getting as much money as possible for what they had to sell -- both the control and their interest in the assets.
The price is strongly indicative of the true nature of the transaction. The sellers obtained $3.60 a share at a time when the price of the stock in the over-the-counter market was $1 to $1.25, and when the book value was $2.25 -- a figure substantially higher than could have been realized on actual liquidation. The history of the bitter dispute between the Continental Bank and the rest of the management group, beginning in June of 1937, shows that the latter, although they had no desire (and most of them no special capacity) to operate the corporation, were not content to liquidate and take the cash and actual market value of the securities represented by their shares, but were determined to obtain the additional premium which a sale, carrying with it control of the corporation, would bring. Confirmation is given by the fact that from June 1937 the principal activities of the managers consisted of negotiations for the sale of their stock. The facts that the first of the potential purchasers turned out to be irresponsible and that they had only the vaguest notion as to the identity of the second (who withdrew at the last minute) were apparently no discouragement.
Those who control a corporation, either through majority stock ownership, ownership of large blocks of stock less than a majority, officeholding, management contracts, or otherwise, owe some duty to the corporation in respect of the transfer of the control to outsiders. The law has long ago reached the point where it is recognized that such persons may not be wholly oblivious of the interests of everyone but themselves, even in the act of parting with control, and that, under certain circumstances, they may be held liable for whatever injury to the corporation made possible by the transfer. Without attempting any general definition, and stating the duty in minimum terms as applicable to the facts of this case, it may be said that the owners of control are under a duty not to transfer it to outsiders if the circumstances surrounding the proposed transfer are such as to awaken suspicion and put a prudent man on his guard -- unless a reasonably adequate investigation discloses such facts as would convince a reasonable person that no fraud is intended or likely to result. Thus, whatever the extent of the primary duty may be, circumstances may be sufficient to call into being the duty of active vigilence and inquiry. If, after such investigation, the sellers are deceived by false representations, there might not be liability, but if the circumstances put the seller on notice and if no adequate investigation is made and harm follows, then liability also follows.
From a careful reading of the voluminous evidence in this case, I have become convinced that facts and circumstances leading up to this sale, as known to Hepburn, the agent of the banks, and as largely relayed by him to Hardt, his immediate principal, were sufficient to indicate to any reasonable man in his position that the Boston group were acquiring the control of the corporation by improper means and for an improper purpose.
I have just referred to acquisition by improper means. What happened was that the buyers had arranged with Paine, Webber & Co. that the latter would advance the price of the purchase (some $310,000) on an unsecured loan, and that, immediately after they had obtained control, the portfolio, or as much of it as was necessary, would be pledged with Paine, Webber & Co. as collateral, sold by them from time to time, the proceeds applied to liquidating the note, and the balance turned over. Comment as to the legality and ethics of this procedure is unnecessary, but the point is that if Hepburn had good reason to suspect that the purchase was to be financed in toto with the corporation's assets, it would be fair warning of the fraudulent nature of the whole thing. So, in considering whether the circumstances of this sale called for a real investigation, one matter of importance is what was known or to be inferred as to the manner in which the purchase was to be financed.
On turning to the record, one learns, with some surprise, that this same corporation had been systematically looted some five years before by a different group who bought control, using exactly the same means of financing the deal, and who stole the assets of the corporation in much the same general way. This episode was known in all of its details to Hepburn. In fact, the banks had become stockholders, unwillingly, as a result of the wreckage caused by it. In June, 1937, the persons responsible for the loss had settled their liability from some $650,000, of which perhaps half had come into the treasury of the corporation. This, of course, is not proof that a new group would do the same thing, but it certainly was a vivid reminder of the special dangers to which these small and helpless investment trusts were constantly exposed.
In the second place, by December, if not before, Hepburn knew perfectly well that in arranging for the sale of the banks' interests he had, in Blair, a collaborator who was entirely willing that the corporation's assets should be used to finance the deal. Even accepting at its face value Hepburn's testimony as to his own limited role in the negotiations, it is a fact that he was in frequent consultation with Blair, the corporation's president and the most active figure in promoting the various attempts to sell. Hepburn, Blair and Simmons constituted the executive committee of the board. During the entire summer of 1937 Blair had been busily engaged in conducting negotiations for the sale of the interest of the management group to another financially irresponsible syndicate, headed by a promoter named Johnston. This sale aborted but, previous to that and for the purpose of getting rid of the determined opposition of the Continental Bank with its 26,569 shares, it had been arranged that Johnston should buy out the Continental Bank and that he should obtain the money on a loan from Fahnestock & Co. upon a promise that he would put up securities from the corporation's portfolio as collateral security after he obtained control of the corporation. This was exactly like the Paine, Webber financing of the Boston group later on in December. The sale to Johnston failed to go through, and Fahnestock, who had advanced the money to the Continental Bank and acquired its shares for the account of Johnston, was thus left holding the bag, with plenty of recrimination against Blair, who, they said, had arranged the whole thing and ...