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OTIS & CO. v. PENNSYLVANIA R. CO.

November 1, 1944

OTIS & CO.
v.
PENNSYLVANIA R. CO. et al.



The opinion of the court was delivered by: KALODNER

In this stockholders' suit plaintiff now moves to strike the answers of the corporate defendants, the Pennsylvania Railroad Company and the Pennsylvania, Ohio & Detroit Railroad Company, and to remove counsel.

The important issue raised by the motion is whether, in a stockholders' secondary (derivative) action against the officers and directors of a corporation for breach of duty, the corporation, joined as a party defendant, may file an answer to the complaint setting forth affirmative defenses.

 A brief statement of the case is necessary to the decision. Plaintiff, Otis & Co., an investment banking house, and owner of 60 shares out of a total of 17,400,000 shares of the stock of the Pennsylvanis Railroad Company, instituted this action to recover $1,000,000 from certain, but not all, of the directors and officers of the Pennsylvania Railroad Company, hereafter referred to as P.R.R., and the Pennsylvania, Ohio & Detroit Railroad Company, hereafter referred to as P.O. & D.; the two corporations were also joined as defendants, relief being asked in their favor. It is alleged in the complaint that the defendant P.R.R. owned all of the capital stock of the defendant P.O. & D. As of June, 1943, the P.O. & D. had outstanding a certain issue of 4 1/2% Series "A" Bonds of the total face amount of $28,483,000, with maturity date in 1977. *fn1" It is alleged that in June, 1943, defendant Martin W. Clement, president of P.R.R., and defendant, George Pabst, Jr., vice-president of P.R.R. and president of P.O. & D., entered into negotiations with Kuhn, Loeb & Co., with a view to P.O. & D. selling to the latter a new bond issue (eventually named Series "D" bonds), and with the proceeds of such sale pay off the outstanding Series "A" bonds. On June 23, 1943, the directors of P.O. & D. authorized the issuance of the new bonds and their sale "at the best obtainable price"; on that same date the directors of P.R.R. met and authorized the guarantee by that company of the proposed issuance. Thereafter, P.O. & D. entered into a contract with Kuhn, Loeb & Co. to sell the bonds at par subject to approval by the Interstate Commerce Commission. The Interstate Commerce Commission approved the issuance and sale at par and a quarter. 254 I.C.C. 473.

 The gist of the complaint is that the transaction was entirely private, that a half million dollars was lost in failing to "shop around", and another half million lost in failing to put the new issue to competitive bidding; therefore, it is alleged, the "best obtainable price" was not obtained. It is also asserted that certain of the directors and officers were influenced because of their position as directors or officers of several companies which had made agreements with Kuhn, Loeb & Co. to purchase from the latter part of the bonds.

 It is contended in support of plaintiff's motion that the corporations are made defendants merely for a technical reason, that is, the refusal on their part to prosecute the alleged cause of action against the individual defendants; that in substance, the corporations are the real plaintiffs; that actually the interests of P.R.R. and P.O. & D. are allied with the plaintiff's, in view of the fact that any money recovery will go to the corporations and not to plaintiff. Accordingly it is urged that the defendant corporations ought not to be permitted to file answers designed to defeat plaintiff's claims, and that the proper conduct is to remain neutral or aid plaintiff.

 Despite the great familiarity of the courts with stockholders' suits, the problem raised by the instant motion is one on which there are few satisfactory cases, and little other helpful authority. Exceptional difficulty is generated by he breakdown of the legal entity theory of corporate existence. The complaint of plaintiff in this motion is understandable, for the individual defendants are the very persons charged with carrying on the everyday affairs of these corporations, and upon whom developes the duty of determining the corporations' stand in this case. Nevertheless, it is possible in an equity court to preserve to a great degree the entity fiction of corporate existence in a case of this sort.

 The clearest example of a stockholders' secondary action against the corporate directors in which the corporation ought not to be permitted to defend the individual defendants may be found in the case of Meyers v. Smith, 1933, 190 Minn. 157, 251 N.W. 20. There the minority stockholder sued, on behalf of a corporation, to recover money claimed to have been misappropriated by certain of its directors out of corporate funds. The court properly struck an answer of the corporation containing affirmative defenses to the charges against the officers. Cf. Monahan v. Kenny, 1936, 248 App.Div. 159, 288 N.Y.S. 323.

 On the other hand, a clear case in which the corporation ought to be permitted to file an answer is Godley v. Crandall & Godley Co., 1917, 181 App.Div. 75, 168 N.Y.S. 251, where it appears that an attempt had been made to procure a receiver of the corporate assets; and see Oshrin v. Celanese Corp. of America, Sup.1942, 37 N.Y.S.2d 548.

 The court in Meyers v. Smith, supra, applied a very broad theory denying the corporation's right to answer (page 21 of 251 N.W.): "The corporation is a nominal party only. It was properly joined as a party for the protection of the defendants, so that when final judgment herein is entered the two individual defendants may be thereby protected from a second suit on the same causes of action brought by the corporation * * *. But that does not vest in the corporation the right to here step in and, by answer, attempt to defeat what is practically its own suit and causes of action." Similarly, Slutzker v. Rieber, 1942, 132 N.J.Eq. 412, 28 A.2d 528.

 While the court reached the correct result in that case, it would appear that the theory underlying the decision is too narrow to take care of the case where, say, the corporation would be otherwise directly affected. (1934) 43 Yale L.J. 661, 663.

 On the other hand, the court in McHarg v. Commonwealth Finance Corp., 1921, 44 S.D. 144, 182 N.W. 705, 706, states an equally broad view the other way: "Of course, this is a representative action, and the corporation is a necessary party to the action; but because a minority stockholder charges a wrongdoing by directors of a corporation which, if he succeeds in the action, will inure to the benefit of the corporation, he does not thereby become possessed of the right to dictate the defense or manner of defense that the corporation may undertake * * *."

 Manifestly this theory would bring about an undesirable result if applied to a case where the directors are charged with fraud or misappropriation of corporate funds. But see Brown v. DeYoung, 1897, 167 Ill. 549, 47 N.E. 863.

 Finally, many stockholders' secondary actions have been heard by the courts wherein the corporation has interposed defenses without objection. Brown v. DeYoung, supra; Katz v. New England Fuel Co., 1936, 135 Me. 452, 199 A. 274; ...


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