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November 12, 1947

SLAVIN et al.

The opinion of the court was delivered by: WELSH

This is a stockholders' derivative suit in which the plaintiffs base their cause on alleged violations of the Securities Exchange Act of 1934, 15 U.S.C.A. ยง 78a et seq. There is no diversity of citizenship and jurisdiction is wholly dependent upon the applicability of that Act and the regulations promulgated thereunder.

The Mutual Fire Insurance Company of Germantown, a 100-year old mutual having a surplus of approximately $ 3,500,000 was converted into a stock company, now called Germantown Fire Insurance Company, by the actions of its policyholders under a plan which provided the policyholders with pre-emptive rights to subscribe to the stock in proportion to the premiums paid. This case grows out of that conversion and the issuance of the stock of the new company.

 The plaintiffs are stockholders who seek redress on behalf of the Germantown Fire Insurance Company. The defendants are the new company, directors of the old or mutual company, and Arthur O. Rosenlund, an insurance broker now occupying the positions of President and Chairman of the Board of the new company.

 Section 10 of the Act provides that it shall be unlawful for any person, by the use of any instrumentality of interstate commerce, or of the mails, or of the facilities of any national securities exchange, to use or employ, in connection with the purchase or sale of securities, any manipulative or deceptive device or contrivance in contravention of the rules and regulations of the Securities Exchange Commission. Rule X-10B-5 of the Commission declares it unlawful, in securities transactions using such facilities, (1) to employ any device, scheme or artifice to defraud; (2) to make any untrue statement of a material fact or to omit to state a material fact necessary to make expressed statements not misleading; or, (3) to engage in any act or practice which operates or would operate as a fraud or deceit upon any person.

 Section 27 of the Act gives to the district courts exclusive jurisdiction of violations of the Act and rules, and of all suits in equity and at law to enforce any liability or duty created by the Act or regulations. Section 29(b) provides that every contract made in violation of the Act and regulations, or the performance of which involves such violations, shall be void as regards the right of any person who shall have made or engaged in the performance of such contract.

 The allegations of the bill were deemed sufficient to give preliminary jurisdiction in that they averred the accomplishment of a manipulative device or scheme, dominated and directed by Rosenlund and involving the use of the mails, which resulted in the acquisition of stock at substantially less than its true value. It was alleged that the scheme or device consisted of the transferring of Rosenlund's extensive insurance business to Mutual, inducing his assureds to extend their insurance, placing and controlling Rosenlund's associated, E. M. and C. L. Cushmore, in the key positions respectively of manager and counsel for Mutual, promoting the conversion of Mutual into a stock company in which process false and misleading statements were filed with the S.E.C., obtaining subscription warrants from policyholders by fraudulent representations, and connivance between Rosenlund and the directors for the purpose of enabling Rosenlund to gain control of the new company, and enabling him and the directors to obtain its shares at a mere fraction of their worth. The bill demanded the appointment of a receiver, surrender of the stock issued to Rosenlund and the directors, termination of a voting trust and other agreements, an election of new directors, and general relief.

 The evidence submitted at the trial falls short of establishing the comprehensive device or scheme alleged, and the plaintiffs, although still demanding the redress originally prayed for, have modified their theory of recovery. As stated in their brief, they now 'seek on behalf of the Company to have restored to the Company the secret profit which Rosenlund and a few directors were able to obtain and did obtain by the misuse of their confidential relationship to the Company in its conversion'; and deem this action one 'in the nature of an accounting to compel Rosenlund to turn over to the Company the fruits of the abuse of fiduciary duty', the essential nature of the suit being 'to restore to the corporation the profits which they (defendants) obtained through the abuse of their confidential relationship with the Company'. The specific relief claimed is the surrender and cancellation of the stock issued to the defendants and the repayment to them of the amount of their subscriptions, with supplemental relief deemed essential to making rescission of the subscriptions effective.

 There has been no substantive evidence of the setting up of a device, scheme or artifice to defraud any person by the means and for the purposes alleged in the bill; nor is there any proof that Rosenlund and his alleged conspirators dominated and controlled Mutual and its directors in the process of conversion, or in the filing and distribution of false or incomplete statements and prospectuses through the mails or otherwise. There is no evidence that the directors devised the plan of conversion, fixed the issue price at $ 20, and filed or issued untrue or incomplete statements or prospectuses with the view to misleading or discouraging subscribers so that the directors could buy the stock at less than its value. To construe the evidence in such light would require the adoption of inferences and suppositions not warranted or justified by the facts.

 The evidence upon which the plaintiffs base their demand for recovery, and which we adopt as the basis for our disposition of the principal issues, shows: In the course of the conversion of the company, Rosenlund, its principal broker and business producer, was given full details of the plan of conversion and asked by the company to obtain waivers by certain assureds of their rights to subscribe to stock in excess of 1,000 shares. Rosenlund procured such waivers, and subsequently at the request of the company procured proxies sufficient to enable the company to effect the conversion. In the course of such contacts, and notwithstanding his knowledge that the company planned and sought to limit the holding of stock of any stockholder to 1,000 shares, he obtained from his policyholders agreements to assign their rights to subscribe, and later the warrants themselves.

 The method by which he procured those warrants is in some dispute, but is deemed unimportant for present purposes. It seems clear however that Rosenlund concealed or refrained from disclosing to the company his acquisition of the warrants until just prior to the closing of the subscription period, at which time it became known to the company that he had acquired 17,500 of the 50,000 shares authorized. The directors, who were 'shocked' to learn of the situation and the defeat of their plan to secure wide distribution of the stock, made an investigation, and with the aid of counsel, concluded that there were no available means of avoiding the issuance of shares to Rosenlund in accordance with the warrants. Shares were issued to Rosenlund for the $ 20 subscription price, whereas the book value exceeded $ 80 a share.

 Assuming the existence of the fiduciary relationship of Rosenlund and the directors with Mutual, and that such relationship and all its incidental rights and obligations were carried over to the successor corporation, and conceding for the purpose of demonstration that the facts recited constitute breaches of fiduciary duties of the defendants, the question arises as to whether such breaches are violations of the Act and regulations. In order to construe them as such, and thereby give this court jurisdiction, it must be shown that they constituted a device, scheme, artifice, concealment, practice or course of business which would operate as a fraud or deceit employed in connection with the purchase or sale of securities, and that they involved the use of an instrumentality of interstate commerce, or of the mails, or of a national securities exchange. We may also concede that a party to a purchase or sale made in contravention of the Act impliedly has a right to redress upon proof of injury or damage ( Kardon v. National Gypsum Co., D.C., 73 F.Supp. 798); although no direct injury to the company or its policyholders has been shown.

 We are unable to discover any use of the designated instrumentalities in the acquisition of the warrants and the subscriptions for the stock in question. Rosenlund's device of concealment by which he deceived the company in regard to the ultimate distribution of shares and by which he precluded the company from altering or abandoning its plan of conversion and stock distribution, notwithstanding any duty to do so, was accomplished without the use of the mails or of any interstate instrumentality or securities exchange.

 The alleged breaches of the directors were likewise accomplished without the use of the designated instrumentalities. The only use of the mails involved in the conversion and distribution in this case consisted of the mailing of proxies, prospectuses and subscription warrants, with incidental correspondence, having nothing to do with the purchase of the warrants or the subscriptions of the stock in question, and not in any manner constituting a part of any scheme or device to commit fraud.

 The case resolves itself into one in which the plaintiffs, on behalf of the corporation, seek the equitable redress of accounting for unlawful profits acquired by reason of breaches of fiduciary duties owed to it by the defendants. The profits alleged are the differences between the subscription price and the book value of the shares in question; and the demand is that they be restored to the corporation by cancellation of the stock and repayment of the subscription price to the defendants, with the view to the reselling or redistributing of the stock by some method other than the one involved in the conversion and approved by the policyholders, the insurance commissioner and the S.E.C.

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